Solutions Manual for International Economics 8th edition By James Gerber by ACADEMIAMILL

Chapter 01 - The World of International Economics

CHAPTER 1 THE WORLD OF INTERNATIONAL ECONOMICS I.

Outline Introduction The Nature of Merchandise Trade - The Geographical Composition of Trade - The Commodity Composition of Trade - U.S. International Trade World Trade in Services The Changing Degree of Economic Interdependence Summary Appendix: A General Reference List in International Economics

II.

Purpose of Chapter

The purpose of this introductory chapter is to provide the student with an overview of the current nature of international trade in goods and services for the world in general and for the United States in particular. It is useful to make the student aware not only of the broad nature of international transactions, but also of the increased international interdependence that now characterizes the world economy. Although this chapter contains a great amount of “data,” we have found that discussing this kind of information on the first day of class motivates student interest in the subject and in the course in general.

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© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

CHAPTER 2 EARLY TRADE THEORIES: MERCANTILISM AND THE TRANSITION TO THE CLASSICAL WORLD OF DAVID RICARDO Learning Objectives: ■ ■ ■ I.

Describe the basic concepts and policies associated with Mercantilism. Examine Hume’s price-specie-flow mechanism and the challenge it posed to Mercantilism. Discuss Adam Smith’s concepts of wealth and absolute advantage as foundations for international trade. Outline Introduction - The Oracle in the 21st Century Mercantilism - The Mercantilist Economic System - The Role of Government - Mercantilism and Domestic Economic Policy The Challenge to Mercantilism by Early Classical Writers - David Hume – The Price-Specie-Flow Mechanism - Adam Smith and the Invisible Hand Summary

II.

Special Chapter Features In the Real World: Mercantilism Is Still Alive Concept Box 1: Capsule Summary of the Price-Specie-Flow Mechanism Concept Box 2: Concept Review – Price Elasticity and Total Expenditures Titans of International Economics: Adam Smith (1723-1790)

III.

Purpose of Chapter

The purpose of this chapter is to trace out some of the early ideas regarding the basis for international trade and the distribution of the benefits to be gained from trade. The chapter not only provides some historical perspective to trade theory, but it also makes clear why certain contemporary protectionist attitudes can be seen as being based in a Mercantilist view of the world.

IV.

Teaching Tips 2-1

Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

A. It is important to focus on the principal tenets of the Mercantilist system and then to examine the policy positions that follow logically. This provides a good background for evaluating various trade policy positions later in the book. B. We feel that this is an excellent time to introduce the labor theory of value. It is a good opportunity to help the student begin thinking in relative terms. It is therefore important that the relative nature of this concept is clear in the students’ minds. C. Once the Mercantilist position is laid out and the economic policy implications discussed, one can examine how Hume’s price-specie-flow mechanism and Smith’s ideas of the mutual gains from trade based on absolute advantage contributed to the decline of the Mercantilist way of thinking. D. Discussing the price-specie-flow mechanism at this point gives the student an early insight into the macro aspect of international trade that often gets short shrift when the micro focus of Classical comparative advantage is introduced. V.

Answers to End-of-Chapter Questions and Problems

1. Wealth was viewed as synonymous with holdings of precious metals. Nation-states wished to become wealthy and this meant obtaining large holdings of precious metals. It is also argued by some that the shortage of coinage constrained the growth of these nation-states and that precious metals were required to increase the supply of coinage (money) in order for the countries to grow. 2.

Critical pillars of Mercantilism: a. the zero-sum nature of international trade; b. the need for strong, powerful governments; c. the labor theory of value; d. the need to regulate economic activity; and e. the need for a positive trade balance.

Because wealth was viewed in terms of holdings of precious metals, the objective of economic activity and policy was to foster increased holdings of specie. Mercantilists believed that individuals pursuing their own self interest would not accomplish this objective and that, consequently, economic activity had to be closely regulated and supervised. 3. The paradox of Mercantilism is that wealthy countries would contain large numbers of very poor people. A second paradox is that wealthy countries had to spend great amounts of specie to protect their holdings of specie. Wages were kept low (at institutional subsistence levels) to reduce labor costs, and families were encouraged to have children through various taxes and subsidies. These actions contributed to a very large poor working class. 4.

Critical assumptions of the price-specie-flow mechanism: a. a link between the money supply and the price level, e.g., the quantity theory of 2-2

Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

money; b. perfect competition, with flexible wages and prices; c. price-elastic demand for traded goods; and d. existence of a gold standard, with no government interference with the movement of gold and no actions to sterilize gold’s impact on the money supply. If the demand for traded goods were price inelastic, the movement of gold and prices would worsen trade balances, not correct them. This would be destabilizing, not stabilizing. 5. Hume’s price-specie-flow mechanism suggested that a country could not sustain a positive balance of trade because of the effect on money and prices. The external payments position had repercussions on internal economic variables. A continual positive trade balance was thus not a viable policy target, and not a continuous source of increased wealth. Smith’s concept of absolute advantage indicated that both countries could gain from trade, in direct contrast to the Mercantilist’s zero-sum-game view of trade. 6. The United States has an absolute advantage in the production of wheat (3 hrs./unit < 4 hrs./unit) and the United Kingdom has an absolute advantage in clothing (4 hrs./unit < 9 hrs./unit). The United States would gain at the barter price of 1C:2W (1W:0.5C) since it only gets 0.33C for 1W in autarky. Similarly, the United Kingdom would benefit because it takes only 0.5C to obtain a unit of wheat with trade instead of 1C in autarky. 7. (a) In autarky the United Kingdom would produce 75 units of clothing (300 labor hours/4 hrs.) and 50 units of wheat (200 labor hours/4 hrs.). (b) If the United Kingdom allocates all of its labor to clothing production, it will produce 125 units of clothing (500 total labor hours/4 hrs.). United Kingdom consumption of clothing with trade will be the difference between domestic production and exports, i.e., 85 units of cloth. United Kingdom consumption of wheat will be equal to the 80 units of wheat imports it receives for its 40 units of clothing exports [(40 units of exports) (2W/1C)]. Thus, with trade, United Kingdom consumption of clothing increased from 75 to 85 units and its consumption of wheat increased from 50 units to 80 units. 8. (a) In autarky United States wheat production will be 110 units (330 labor hrs./3 hrs.), and cloth production will be 30 units (270 labor hours/9 hrs.). (b) With trade, the United States will consume 120 units of wheat (200 units of production less the 80 units of exports) and 40 units of cloth imports. Consequently, with trade, U.S. consumption of wheat has risen from 110 to 120 units and its consumption of cloth has risen from 30 to 40 units.

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Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

In this case trade is a positive-sum game since both parties are able to consume more of both goods with trade compared to autarky, i.e., both countries unambiguously gain from trade. 9. A Mercantilist would view the continuing trade surplus as a very desirable outcome, since it produces a net increase in Chinese holdings of foreign exchange (claims on foreign country assets) which is similar to increased holdings of specie in Mercantilist times. To the Mercantilist, the surplus represents successful Chinese policy, not a problem. Hume would argue that the situation would be self-correcting if a fixed exchange rate system is in place as long as prices and wages are flexible and China does nothing to interfere with the flow of payment and its impact on the money supply. The increase in the money supply accompanying the trade surplus would lead to a relative increase in the prices of Chinese goods, thus reducing the trade surplus. In China’s trading partners, the money supply would decrease and prices would decrease, thus decreasing their deficits. Movement to a zero trade balance would also occur under a flexible-rate system because the trade surplus would lead to an increase in the value of the Chinese currency and therefore to a relative increase in the prices of Chinese goods and services. 10. With a price elasticity of demand of (-) 2.0, a 10 percent increase in price will cause the quantity demanded in Spain to fall by 20 percent [(-2.0) (0.10)]. Because Switzerland was initially exporting 5,000 units, the new level of exports will be 4,000 [(5,000) (1 - 0.20)]. The new value of Swiss exports will be 440,000 francs [(4,000) (110)], which is exactly equal to its new level of imports. The increase in Swiss prices has thus worked to remove its trade surplus with Spain. In the alternative case, with a price elasticity of demand for Swiss exports of (-) 0.2, the 10 percent rise in the price of Swiss goods will cause the quantity demanded in Spain to fall by only 2 percent [(-0.2)(0.10)]. The initial export of 5,000 units decreases by 2 percent of 5,000 or by 100 units, to a quantity of 4,900 units. The new value of Swiss exports to Spain will thus be 539,000 francs [(4,900)(110)]. The Swiss trade surplus with Spain will hence be 539,000 francs – 440,000 francs = 99,000 francs, which is larger than the original surplus of 90,000 francs. The inelastic demand situation has resulted in the price-specie-flow mechanism generating an increase in Switzerland’s surplus, not a decrease. VI.

Sample Exam Questions

Essay Questions

1. Explain how the price-specie-flow mechanism operates to maintain balanced trade between countries. What are the assumptions that are critical to the mechanism’s successful operation? 2. Why was a positive trade balance so important to Mercantilists? In Mercantilist thinking, why did a positive trade balance not result in domestic inflation and a loss of international competitiveness? 3.

What were the critical foundations of Mercantilist thought? What trade policies resulted 2-4

Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

from this way of thinking? 4. Explain what is meant by a zero-sum game, and why it was central to Mercantilist thinking. Then, explain how Smith’s idea of absolute advantage altered the nature of the “game.” 5.

(a) Why did the Mercantilists think that a situation where a country’s exports exceed its imports is a “favorable” situation for the country? Briefly, what policies would a Mercantilist recommend in order to generate such a “favorable” situation? (b) What was the “price-specie-flow doctrine” and how did it undermine Mercantilist thinking? Why would a situation where the demands for traded goods are “inelastic” with respect to price changes pose a problem for the “price-specie-flow doctrine” in its attack on Mercantilist thinking?

Multiple-Choice Questions

In the price-specie-flow doctrine, a deficit country will __________ gold, and this gold flow will ultimately lead to __________ in the deficit country’s exports. a. lose; a decrease * b. lose; an increase c. gain; a decrease d. gain; an increase

In the Mercantilist view of international trade (in a two-country world), a. both countries could gain from trade at the same time, but the distribution of the gains depended upon the terms of trade. b. both countries could gain from trade at the same time, and the terms of trade were of no consequence for the distribution of the gains. c. neither country could ever gain from trade. * d. one country’s gain from trade was associated with a loss for the other country.

According to the labor theory of value, a. the value of labor is determined by its value in production. b. the value of a good is determined by the amount of labor with which each unit of capital in an industry works. * c. the price of a good A compared to the price of good B bears the same relationship as the relative amounts of labor used in producing each good. d. the values of two minerals such as coal and gold with similar production costs may be very different.

If the demand for traded goods is price-inelastic, the price-specie-flow mechanism will result in 2-5

Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

a. gold movements between countries that remove trade deficits and surpluses. * b. gold movements between countries that worsen trade deficits and surpluses. c. negligible movements of gold between countries and hence little or no adjustment of trade deficits and surpluses. d. a removal of the basis for trade between countries. 10.

In Adam Smith’s view, international trade a. benefited both trading countries. b. was based on absolute cost differences. c. reflected the resource base of the countries in question. * d. all of the above.

11.

Which of the following policies would NOT be consistent with the Mercantilist balanceof-trade doctrine? * a. payment of high wages to labor b. import duties on final products c. export subsidies d. prohibition of imports of manufactured goods

12.

During the price-specie-flow adjustment process to a trade imbalance, if demands for goods are inelastic, then, when the price level __________ in the country with the trade deficit, the value of that country’s exports will __________ as the price-specie-flow process takes place. a. falls; increase * b. falls; decrease c. rises; increase d. rises; decrease

13.

David Hume’s price-specie-flow mechanism a. reinforced the Mercantilist notion that a country could maintain a permanent “favorable” balance of trade where exports exceeded imports. * b. works more effectively if demands for traded goods are “price-elastic” rather than “price-inelastic.” c. assumed that the countries involved have substantial unemployment. d. works equally effectively whether demands for traded goods are “price-elastic” or “price-inelastic.”

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Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

14.

The price-specie-flow mechanism suggested that a. a country could easily maintain a balance-of-payments surplus for a long period of time. b. a deficit country would experience an increase in its money supply and its price level. * c. a surplus country would experience an increase in its money supply and its price level. d. a country’s internal price level has no relation to the country’s foreign trade activities.

15.

The policy of minimum government interference in or regulation of economic activity, advocated by Adam Smith and the Classical economists, was known as a. the law of comparative advantage. * b. laissez-faire. c. the labor theory of value. d. Mercantilism.

16.

A Mercantilist policymaker would be in favor of which of the following policies or events pertaining to his/her country? a. a decrease in the size of the population b. a minimum wage bill to protect the standard of living of workers c. a prohibition on the export of manufactured goods * d. an increase in the percentage of factors of production devoted to adding value to imported raw materials in order to later export the resulting manufactured goods.

17.

In the context of David Hume’s price-specie-flow mechanism that challenged the feasibility of the Mercantilist ideas regarding a trade surplus, which one of the following statements is NOT correct? a. There is a decrease in the money supply in the deficit country. b. There is an increase in the price level in the surplus country. * c. There is an increase in real income in the surplus country. d. Price changes in the surplus country cause that country’s exports to decrease.

18.

In David Hume’s price-specie-flow doctrine or adjustment mechanism, the assumption is made that changes in the money supply have an impact on __________. Further, the demand for traded goods is assumed to be __________ with respect to price. * a. prices rather than on output; elastic b. prices rather than on output; inelastic c. output rather than on prices; elastic d. output rather than on prices; inelastic

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Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

19.

Two important assumptions contained in David Hume’s price specie-flow adjustment mechanism are that a. countries are at full employment and the demands for traded goods are “inelastic.” b. countries are at full employment and the price level of a country moves in inverse proportion to movements in the country’s money supply. c. a country with a balance-of-payments deficit will experience a gold outflow and countries are at a level of employment that is below full employment. * d. the demands for traded goods are “elastic” and countries are at full employment.

20.

The “paradox of Mercantilism” reflected that fact that a. trade surpluses were fostered by protective tariffs. * b. rich countries were comprised of large numbers of poor people. c. gold inflows led to higher prices and reduced exports. d. gold could not be hoarded and provide money for the economy at the same time.

21.

Given the following Classical-type table showing the number of days of labor input required to obtain one unit of output of each of the two commodities in each of the two countries:

United States United Kingdom

bicycles

computers

4 days 5 days

3 days 6 days

The United States has an absolute advantage in the production of __________. a. bicycles (only) b. computers (only) * c. both bicycles and computers d. neither bicycles nor computers 22.

With MS = supply of money, V = velocity of money, P = price level, and Y = real output, which one of the following indicates the quantity theory of money expression? a. MSY = PV b. MSP = VY c. MS = PY - V * d. MSV = PY

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Chapter 02 - Early Trade Theories: Mercantilism and the Transition to the Classical World of David Ricardo

23. In the price-specie-flow mechanism, there is a gold __________ a country with a balanceof-trade surplus, and this gold flow ultimately leads to __________ in the surplus country’s exports. a. inflow into; an increase * b. inflow into; a decrease c. outflow from; an increase d. outflow from; a decrease 24.

In the price-specie-flow adjustment mechanism, a country with a balance-of-trade surplus experiences a. a gold inflow and a decrease in the price level. b. a gold outflow and an increase in the money supply. * c. an increase in the money supply and a decrease in exports. d. a decrease in the money supply and a decrease in imports.

25.

Suppose that country A’s total exports are 10,000 units of good X at a price of $20 per unit, meaning that country A’s export earnings or receipts are $200,000. Suppose also that the foreign price elasticity of demand for country A’s exports of good X is (-) 0.6. If country A’s prices for all goods, including its exports, now rise by 10% because of a gold inflow such as in the Mercantilist model, then, other things equal, country A’s exports of good X will fall by __________ and country A’s export earnings or receipts will become __________. a. 600 units; less than $200,000 * b. 600 units; greater than $200,000 c. 1,000 units; less than $200,000 d. 1,000 units; greater than $200,000

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Chapter 03 - The Classical World of David Ricardo and Comparative Advantage

CHAPTER 3 THE CLASSICAL WORLD OF DAVID RICARDO AND COMPARATIVE ADVANTAGE Learning Objectives: ■ ■ ■ ■

Explain comparative advantage as a basis for trade between nations. Identify the difference between comparative advantage and absolute advantage. Calculate the gains from trade in a two-country, two-good model. Illustrate comparative advantage and the potential gains from trade using productionpossibilities frontiers.

Outline Introduction - Some Common Myths Assumptions of the Basic Ricardian Model Ricardian Comparative Advantage Comparative Advantage and the Total Gains from Trade - Resource Constraints - Complete Specialization Representing the Ricardian Model with Production-Possibilities Frontiers - Production Possibilities – An Example - Maximum Gains from Trade Comparative Advantage – Some Concluding Observations Summary

II.

Special Chapter Features Titans of International Economics: David Ricardo (1772-1823) In the Real World: Export Concentration of Selected Countries

III.

Purpose of Chapter

The purpose of this chapter is to introduce students to the basic idea of Classical comparative advantage, demonstrate the gains from trade, and explain why trade will lead a country to specialize in production of its export good(s). IV.

Teaching Tips

A. This chapter begins with a look at some common myths about international trade. An examination of these myths can be a nice stimulus to class discussion. It is useful to begin with a list of misconceptions about trade that can gradually be dispelled in the coming chapters. B. This chapter should be used to develop a good understanding of comparative advantage. This is perhaps best accomplished by giving the class several different examples of two-country 3-1 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 03 - The Classical World of David Ricardo and Comparative Advantage

by two-commodity examples similar to those in the text, pointing out when there is a basis for trade. C. This is also a good place to drive home the idea that the international terms of trade must lie between the autarky price ratios of the two countries if both countries are to gain from trade. D. After the class is comfortable with the basic idea of comparative advantage, then move on to demonstrate the overall country gains from trade. We find it useful to demonstrate the country gains from trade in two different ways – in a numerical example with fixed resources and with a production-possibilities frontier. E. It is important to demonstrate comparative advantage using the PPF because it not only allows one to generalize beyond the labor theory of value (to opportunity cost in general), but also demonstrates that trade allows a country to consume beyond its PPF. Using the PPF thus provides a good transition between the Classical model and the upcoming neoclassical presentation. V.

Answers to End-of-Chapter Questions and Problems

(a) The autarky price ratios: France: 1 computer:25 wheat, or 1 wheat:1/25 computer Germany: 1 computer:20 wheat, or 1 wheat:1/20 computer (b) France has a comparative advantage in wheat and Germany in computers. France’s disadvantage is relatively smaller in wheat than in computers, i.e., 4/3 < 100/60; Germany’s advantage is relatively greater in computers than wheat, i.e., 60/100 < 3/4. (c) In autarky in France it takes 25 wheat to buy a computer (or 100 days). If it only takes 22 wheat to import the computer, France will save 12 days (= 3 x 4) of labor/computer. In Germany in autarky it takes 1/20 of a computer (3 days) to acquire one wheat. If with trade it only takes 1/22 of a computer (2.73 days)/wheat, Germany saves 0.27 days/wheat import. (d) France saves 4 days of labor/computer; Germany saves 0.5 days of labor/wheat. (e) As the international terms of trade move closer to those of France in autarky, the benefits accruing to Germany increase (e.g., a saving of 0.5 days/wheat instead of 0.28 days), and the benefits accruing to France decrease (e.g., a saving of only 4 days/computer instead of 12 days).

(a) In the United Kingdom one day of labor can produce ⅓ of a unit of textiles and 1/6 of a unit of automobiles. In the United States, one day of labor can produce ½ of a unit of textiles and 1/5 of a unit of automobiles.

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Chapter 03 - The Classical World of David Ricardo and Comparative Advantage

3. In autarky, the production (and consumption) of textiles and autos will utilize all the available 1,000 days of labor. Thus, with T = number of units of textiles produced and A = number of autos produced, 1,000 = (2 days/unit)T + (5 days/unit)A. The consumption requirement is that 10 units of textiles be consumed for every unit of automobiles. Hence, total textile production is equal to (10) (total auto production), i.e., 10A. Thus, given the available labor, and substituting 10A for T, 1,000 = (2) (10A) + 5 A A = 40 units If A = 40 units, then textile production = [1000 - (40)(5)]/[2 days/unit] = 400 units. With specialization in textile production and trade, textile production equals 500 units. Consumption of textiles (CT) is equal to textile production minus the textile exports used to acquire auto imports, and auto imports are equal to auto consumption (CA). With the international terms of trade of 1A:2T, auto imports = (1A/2T)(exports of textiles) = (1A/2T)· (textile production - textile consumption). By the demand assumption, consumption of autos is also equal to (1/10)(textile consumption). Hence, CA = (1/2)(500 - CT) and CA = (1/10)(CT). Thus, (1/2)(500 - CT) = (1/10)(CT) 250 - (1/2)(CT) = (1/10)(CT) 0.6CT = 250 CT = 416⅔ units With CT = 416⅔ units, CA therefore equals 41⅔ units. Because of specialization and trade, the United States has gained 16⅔ units of textiles (416⅔ - 400) and 1⅔ autos (41⅔ - 40) in comparison with the autarky situation. Another method of arriving at these results is to utilize the equations for the PPF and for the consumption pattern. In autarky the PPF equation is T = 500 - 2½A, and the consumption equation is CT = 10CA. Solving the two equations for the two unknowns (there are only two unknowns because A = CA and T = CT in equilibrium) yields A = CA = 40 and T = CT = 400. With trade, the equations to be utilized are for the consumption-possibilities frontier with trade (the trading line) and the consumption equation. The consumption-possibilities frontier with 3-3 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 03 - The Classical World of David Ricardo and Comparative Advantage

trade has the equation T = 500 - 2A. When this equation is put with the consumption equation CT = 10CA and the two equations are solved for the two unknowns, the equilibrium results are A = CA = 41⅔ and T = CT = 416⅔. 4. Classical comparative advantage indicates that when a small price-taking country trades with a large country, the benefits of trade go to the small country. Developing countries may not feel that this is the case due to conditions that violate the Classical assumptions. Examples of these conditions would include such phenomena as imperfect competition, economies of scale in production, different product knowledge, and trade policies such as tariffs, quotas, and production subsidies. 5. Portugal has an absolute advantage in the production of both goods because the absolute labor requirements for both wine and cloth are less than in Spain. However, since the relative labor costs are the same in both countries (4/8 = 6/12), there is no basis for trade based on comparative advantage. Consequently, trade would not take place between the two countries based on either absolute or comparative advantage. 6. Because the price of the import good falls and the price of the export good rises with trade, the slope of the consumption-possibilities frontier originating at the production point is now different from that of the domestic production-possibilities frontier. Trading away from the domestic production point by exporting some of the comparative advantage good and importing the comparative disadvantage good results in the country being able to consume outside the production-possibilities frontier. This is sometimes referred to as the gains from exchange. 7. This could follow from the conclusions reached regarding the distribution of benefits from trade between countries of different economic size. If the impact of the difference in size between the two countries leads to the international terms of trade changing relatively more for the smaller country, then the smaller country will receive relatively more of the benefits of trade between the two. Because the United States is much larger than Mexico, Mexico would receive more of the gains from increased trade accompanying NAFTA as long as the relative change in its prices is greater. However, because the United States is certainly not a “large” country economically or dominant in all of the traded goods and services between the two, both countries should experience some gains from the increased trade and specialization accompanying the trade agreement. 8. This statement could be true if trade was based on absolute advantage. However, since trade can take place on the basis of comparative advantage, what counts is relative cost differences. Consequently a country can be less efficient or become less efficient in all goods and yet gain from trade as long as there are relative cost differences in autarky. Thus, different rates of productivity growth may change what a country exports, but it is unlikely that it would ever take away the basis for trade, i.e., its ability to export.

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Chapter 03 - The Classical World of David Ricardo and Comparative Advantage

9. Because country A is more efficient in the production of both goods, its PPF lies outside that of country B. However, if its comparative advantage is in steel, its autarky price ratio will indicate that steel is relatively less costly in terms of wheat, compared to country B, and its PPF will have a steeper slope, i.e., [(PW/PS)country A > (PW/PS)country B].

VI.

Sample Exam Questions

Essay Questions

1. Why did Ricardo think that international trade was based on comparative advantage while internal (domestic) trade was based on absolute advantage? 2. Suppose that the pre-trade price ratio is 2 grain:5 hardware and that the international terms of trade are 3 grain:5 hardware. Which commodity will the country in question export? Why? What will happen to production in the country under the Classical assumptions? Why? 3. Did the concept of comparative advantage strengthen or worsen the case against Mercantilist trade doctrine? Why? 4. Is it possible for trade to take place in the Classical world of David Ricardo without complete specialization of production in both countries? If so, when? Who will receive the gains from trade in this instance? Why? 5. It is often said that international trade involves both absolute and comparative advantage. Can this be so? Why or why not? 6. Set up a Ricardo-type comparative advantage numerical example with two countries and two goods. Distinguish “absolute advantage” from “comparative advantage” in the context of your example. Then select an international terms-or-trade ratio and explain in some detail how trade between the two countries benefits each of them in comparison with autarky. When would either of your countries NOT benefit from engaging in trade? Explain.

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Chapter 03 - The Classical World of David Ricardo and Comparative Advantage

Multiple-Choice Questions

In the following Classical-type table showing the output per 10-days of labor input in each of the two commodities in each of the two countries,

France Germany

Cameras

Wine

100 units 150 units

40 units 50 units

a. Germany has a comparative advantage in both goods. b. France has an absolute advantage in both goods. c. France has a comparative advantage in cameras. * d. the pretrade price ratio in France is 1 wine = 2.5 cameras. 8.

Given the following Ricardo-type table shows the labor input required per unit of output in each of the two industries in each of the two countries:

United States France

Shirts

Brandy

4 days 6 days

12 days 12 days

Which one of the following statements is correct? * a. France’s pretrade price ratio is 1 brandy = 2 shirts. b. The U.S. pretrade price ratio is 1 shirt = 3 brandy. c. The United States has an absolute advantage in both goods. d. France will export shirts after trade begins. 9.

In the situation in Question #8 above, if the countries engage in trade at posttrade prices (terms of trade) of 1 shirt = 0.5 brandy, then a. France gets all the gains from trade. * b. the United States gets all the gains from trade. c. neither country gains from trade. d. the two countries share equally in the gains from trade.

10.

The assumption of constant costs of production in the Classical model results in a __________ production possibilities frontier, and, in the case of a “small” country, __________ specialization in production when trade takes place. a. linear; incomplete b. concave-to-the-origin; complete c. convex-to-the-origin; incomplete * d. linear; complete

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Chapter 03 - The Classical World of David Ricardo and Comparative Advantage

11.

Which one of the following is NOT an assumption contained in the Classical/Ricardo trade model? a. Factors of production (labor) are completely mobile within a country. * b. Factors of production (labor) are completely mobile between countries. c. Marginal costs are constant as production increases for a firm/industry. d. Transportation costs of goods between countries are zero.

12.

Given the following Ricardo-type table shows the labor input required per unit of output in each of the two industries in each of the two countries: SteelCloth United Kingdom Germany

4 days 6 days

8 days 9 days

Which one of the following statements is true? a. The United Kingdom has an absolute advantage in both goods and a comparative advantage in cloth. b. The pretrade price ratio in the United Kingdom is 1 steel:2 cloth. c. The United Kingdom has an absolute advantage in neither good but a comparative advantage in steel. * d. The pretrade price ratio in Germany is 1 cloth:1.5 steel. 13.

Given the information in Question #12 above, suppose that Germany is a much larger country in terms of production and income than is the United Kingdom. In this situation, other things equal, when the countries engage in trade, the posttrade price ratio (terms of trade) would tend to settle __________, and __________ would therefore tend to have relatively large gains from trade. a. toward a value of 1 cloth:2 steel; the United Kingdom b. toward a value of 1 cloth:2 steel; Germany * c. toward a value of 1 cloth:1.5 steel; the United Kingdom d. toward a value of 1 cloth:1.5 steel; Germany

14.

In the Classical (Ricardo) analysis, a. if a country has an absolute advantage in a good, it also has a comparative advantage in the good. b. if a country has a comparative advantage in a good, it cannot have an absolute advantage in the good. * c. a country can have a comparative advantage in a good at the same time that it has an absolute advantage in that good. d. a country with an absolute advantage in all goods cannot gain from trade.

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Chapter 03 - The Classical World of David Ricardo and Comparative Advantage

15.

Given the following Ricardo-type table showing the amount of labor input needed to get one unit of output in each industry in each country:

Malaysia India

Wheat

Chairs

3 days 10 days

2 days 8 days

a. Terms of trade of 1 wheat:1.25 chairs is not a feasible equilibrium terms of trade. * b. Terms of trade of 1 wheat:1.5 chairs would give all the gains from trade to India. c. Malaysia has an absolute advantage in both goods and a comparative advantage in wheat. d. India has an absolute advantage in both goods and a comparative advantage in wheat. 16.

If a country’s relative price of X (compared to Y) in autarky is greater than the same relative prices on the world market, then the country has a comparative advantage in good __________, and it will __________. a. X; export Y and import X b. X; export X and import Y * c. Y; export Y and import X d. Y; export X and import Y

17. As a country moves from autarky to trade, the relative price of the country’s import good will __________ for home consumers, and the relative price of the country’s export good __________ for home consumers. * a. fall; will rise b. fall; also will fall c. rise; also will rise d. rise; will fall 18.

Suppose that, in a Classical constant-opportunity-costs framework, country I can produce 15 units of wheat if it devotes all of its resources to wheat production and 45 units of clothing if it devotes all of its resources to clothing production. In a trading situation for this country, if the world price ratio is Pwheat/Pclothing = ⅓ (or Pclothing/Pwheat = 3), country I would a. export wheat and import clothing. * b. export clothing and import wheat. c. be indifferent to trade. d. export either clothing or wheat and import either wheat or clothing – cannot be determined without more information.

19.

Suppose that, with constant opportunity costs, Spain can produce 2,000 units of clothing

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Chapter 03 - The Classical World of David Ricardo and Comparative Advantage

if it devotes all of its resources to clothing production and 8,000 units of wheat if it devotes all of its resources to wheat production. If Spain is opened to trade at a world price ratio of 1 wheat:0.4 clothing (or 1 clothing:2.5 wheat), Spain will export __________; if the world price ratio were 1 wheat:4 clothing (or 1 clothing:2.5 wheat), Spain would __________. * a. wheat; also export wheat b. wheat; would export clothing c. clothing; also would export clothing d. clothing; would be indifferent to trade 20.

Given the following constant-cost production-possibilities frontiers for Pakistan and India:

Pakistan has an autarky relative price of __________; if trade begins with India, then Pakistan would produce at point __________, assuming complete specialization. * a. 1 cloth:0.5 wheat (i.e., Pcloth/Pwheat = 0.5); A b. 1 cloth:0.5 wheat (i.e., Pcloth/Pwheat = 0.5); B c. 1 cloth:2 wheat (i.e., Pcloth/Pwheat = 2); A d. 1 cloth:2 wheat (i.e., Pcloth/Pwheat = 2); B 21.

Suppose that a country in the Classical model has the following production-possibilities frontier (PPF):

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Chapter 03 - The Classical World of David Ricardo and Comparative Advantage

If, in autarky, the country is producing 700 computers and is located at point M on the PPF, the country would be producing __________ autos. If the country is now opened to trade at a terms of trade of 1 auto: 2 computers (or 1 computer: 0.5 auto), it would export __________. a. 120; autos * b. 120; computers c. 280; autos d. 280; computers 22.

In Question #21 above, suppose that the country, when it is opened to trade, did not change its production combination from the production combination at point M. In this situation, how many units of its import good could the country obtain if it exported all of the export good that it produced? a. 240 units * b. 350 units c. 500 units d. 800 units

23.

If, in a two-commodity, two-country Classical world, Sweden can make a unit of furniture with 10 days of labor and a unit of steel with 15 days labor, while Germany can make a unit of furniture with 12 days of labor and a unit of steel with 12 days labor, then a. Sweden has an absolute advantage in steel and Germany has an absolute advantage in furniture. b. Sweden has a comparative advantage in steel and Germany has a comparative advantage in furniture. * c. the pretrade price ratios indicate that Germany will export steel if trade takes place. d. the pretrade price ratio in Sweden is 1 furniture:1.5 steel.

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Chapter 03 - The Classical World of David Ricardo and Comparative Advantage

24.

Given the following Ricardo-type table showing the amount of labor input required to produce one unit of output of each of the two goods in each of the two countries:

United Kingdom United States

Wheat

Clothing

6 days 4 days

5 days 3 days

* a. The United Kingdom has an absolute advantage in neither good. b. The United States has a comparative advantage in wheat. c. The United States has a comparative advantage in both goods. d. A post-trade price ratio (terms of trade) of 1 wheat:1.5 clothing is a feasible equilibrium post-trade price ratio. 25.

In Question #24 above, a. if the United Kingdom were a much larger country than the United States, then, other things equal, the terms of trade would tend to be located more toward the U.S. pre-trade price ratio than toward the U.K. pre-trade price ratio. b. if world demand (the sum of U.S. demand and U.K. demand) were directed more toward clothing than toward wheat, other things equal, then the terms of trade would tend to be located more toward the U.K. price ratio than toward the U.S. pre-trade price ratio. c. a post-trade price ratio (terms of trade) of 1 clothing:0.75 wheat would mean that the United Kingdom did not gain from trade. * d. a post-trade price ratio (terms of trade) of 1 wheat:1.2 clothing would give all the

gains from trade to the United States. 26.

Given the following Ricardo-type table showing the amount of labor input required to produce one unit of output of each of the two goods in each of the two countries:

France Germany

Shirts

Machines

3 days 2 days

5 days 4 days

France has an absolute advantage in __________ and a comparative advantage in __________. a. both goods; machines b. both goods; shirts * c. neither good; machines d. neither good; shirts

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Chapter 03 - The Classical World of David Ricardo and Comparative Advantage

27.

In Question #26 above,

a. a post-trade price ratio (terms of trade) of 1 shirt:0.75 machine is a feasible post-trade price ratio. b. a post-trade price ratio (terms of trade) of 1 machine:0.6 shirt is a feasible post-trade price ratio and it would give all the gains from trade to France. c. a post-trade price ratio (terms of trade) of 1 machine:0.55 shirt is a feasible post-trade price ratio and both countries would gain from trade at that price ratio. * d. other things equal, if world demand for shirts is much greater than world demand for machines, then the post-trade price ratio (terms of trade) will tend to settle toward or be located at 1 shirt:0.6 machine rather than settle toward or be located at 1 shirt:0.5 machine. 28.

Country A has the following constant-opportunity-costs production-possibilities frontier (PPF):

Suppose that this country in autarky is located at point R on its PPF, where it is producing 300 units of good Y and __________ of good X. Suppose that country A is now opened to trade and can trade at a terms of trade of 1X:3Y. Assuming complete specialization in production, the country will now produce at __________. * a. 50 units; point N and will export good X and import good Y b. 150 units; point N and will export good X and import good Y c. 50 units; point M and will export good Y and import good X d. 150 units; point M and will export good Y and import good X

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Chapter 04 - Extensions and Tests of the Classical Model of Trade

CHAPTER 4 EXTENSIONS AND TESTS OF THE CLASSICAL MODEL OF TRADE Learning Objectives: ■ ■ ■ I.

Demonstrate how wages, productivity, and exchange rates conceptually affect comparative advantage and international trade patterns. Examine the implications of extending the basic model of comparative advantage to more than two countries and/or commodities. Show that real-world trade patterns are consistent with underlying comparative advantages. Outline Introduction - Trade Complexities in the Real World The Classical Model in Money Terms Wage Rate Limits and Exchange Rate Limits Multiple Commodities - The Effect of Wage Rate Changes - The Effect of Exchange Rate Changes Transportation Costs Multiple Countries Evaluating the Classical Model Summary Appendix: The Dornbusch, Fischer, and Samuelson Model

II.

Special Chapter Features

Concept Box 1: Wage Rate Limits and Exchange Rate Limits in the Monetized Ricardian Framework In the Real World: The Size of Transportation Costs In the Real World: Labor Productivity and Import Penetration in the U.S. Steel Industry In the Real World: Exporting and Productivity III.

Purpose of Chapter

The purpose of this chapter is to present several extensions of the Classical Ricardian model in order to demonstrate more fully the factors that influence international trade beyond the simple two country-two commodity labor requirement barter model developed in Chapter 3. IV.

Teaching Tips

A. This chapter begins with a look at the real-world complexities of trade that are omitted from the previous chapter’s discussion. This should help the students to understand the need to 4-1 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 04 - Extensions and Tests of the Classical Model of Trade

examine the extensions of this chapter. B. The key to using this chapter is to make certain that the student can work with and understand the Classical model in money terms. This provides a framework for demonstrating not only additional microeconomic aspects of international trade but also the important role of the exchange rate. The monetized model incorporating the exchange rate makes the international terms of trade explicit and does not just indicate the limits to the terms of trade. C. It is useful to make students comfortable with the idea that the international (barter) terms of trade are simply the reciprocal of the ratio of international prices expressed in a common currency. This will be of value later when working graphically with the neoclassical model. D. Instructors teaching a one-semester course have indicated that they limited the use of this chapter, in particular the discussion of the DFS model. As a result, the DFS model is in an appendix. We have found, however, that working with the remaining extensions helps students develop some good intuition about the nature of international trade. E. We think that the effects of productivity improvement in the DFS model as discussed in the appendix are important for students to grasp. Whether the appendix is used or not, it is useful to stress that productivity improvements in one country do get transmitted to trading partners. The students should be disabused of the zero-sum notion that productivity increases in other countries mean that our country “loses”; rather, real income gains arise not only in the country experiencing the productivity improvement but also in its trading partners. V.

Answers to End-of-Chapter Questions and Problems

1. As a result of the trade surplus, France experiences, under a fixed exchange rate, a net gold inflow and the United Kingdom experiences a net gold outflow. Assuming that the pricespecie-flow mechanism is in operation, these gold movements will result in an increase in prices and wages in France and a decrease in prices and wages in the United Kingdom. Because the demand for traded goods is assumed to be price-elastic, this will cause the expenditures for U.K. goods by France to rise and the expenditures for French goods by the United Kingdom to fall. These adjustments will take place until trade is balanced. The changes in prices in the two countries will lead to a change in the terms of trade that will move them closer to those of the United Kingdom in autarky, i.e., the terms of trade will deteriorate for the United Kingdom and improve for France. 2.

(a) There is a basis for trade here because the relative labor costs for the two commodities are different in autarky, i.e., 6/8 is not the same as 4/4. From another perspective, the individual price ratios in autarky are different between the two countries, i.e., they are 1 wine:0.67 shoes (or 1S:1.5W) in Italy and 1 wine:0.5 shoes (or 1S:2W) in Switzerland. (b) Italy should export shoes and Switzerland should export wine because the relative labor cost of shoes is less in Italy relative to wine. From Switzerland’s point of view, its

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Chapter 04 - Extensions and Tests of the Classical Model of Trade

absolute disadvantage is less in wine compared to shoes. (c) The international terms of trade must lie between 1 wine:0.67 shoes and 1 wine:0.5 shoes (or 1S:1.5W and 1S:2W). (d) The commodity terms of trade = 1 wine:(Pwine/Pshoes) shoes [or 1 shoe:(Pshoes/Pwine) wine], which results in 1 wine:(14/24) shoes, i.e., 1 wine:0.583 shoes [or 1 shoe:(24/14) wine, i.e., 1 shoe:1.714 wine]. 3. Given the Swiss wage rate of 3.5 francs per hour and the 1:1 exchange rate, the limits to the wage in Italy are 4⅔ and 3½ euros/hr. Given the Italian wage rate of 4 euros per hour and the 1:1 exchange rate, the limits to the wage in Switzerland are 3 and 4 francs/hr. Given the Italian wage rate of 4 euros/hour and the Swiss wage rate of 3.5 francs/hour, the limits to the exchange rate are 7/8 and 1 1/6 francs/euro. 4. Italy will export shoes and import clothing, wine, cutlery, and fish. Switzerland will export clothing, wine, cutlery, and fish and import shoes. With the inclusion of transportation costs, clothing, wine, and fish become nontraded goods, Switzerland maintains its comparative advantage in cutlery and continues to export it, and the cost of shoes is exactly equalized between the two countries (shoes thus may or may not be traded). The trade pattern changes because the relative costs of the products change when transportation costs are included and assumed to be paid by the importer. In the cases of clothing, wine, and fish, transportation costs exceed the difference in product costs between the two countries and thus cause them to become nontraded goods. 5. There is a basis for trade for all three countries since all three autarky price ratios are different from each other and from the international terms of trade. With an international terms of trade of 1 fish:0.5 potatoes, Sweden and Poland will export potatoes and import fish, and Denmark will export fish and import potatoes.

6. Yes. Since productivity in U.S. manufacturing is considerably higher than in Mexican manufacturing, one would expect the level of wages to be considerably higher in the United States than in Mexico. For traded goods, if U.S. productivity is five times as high but U.S. wages are less than five times as high, U.S. manufactured goods prices would tend to be lower priced than Mexican goods. The relatively great demand for U.S. goods (relatively small demand for Mexican goods) would therefore drive up U.S. wages (and drive down Mexican wages) until the wage difference roughly matches the productivity difference. Similarly, if U.S. wages are more than five times Mexican wages, Mexican goods would be in relatively great demand (and U.S. goods in relatively small demand). Mexican wages would then rise (and U.S. wages would fall) until the wage difference again is roughly equal to the productivity difference.

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Chapter 04 - Extensions and Tests of the Classical Model of Trade

In practice, the matter is made more complicated by such factors as nontraded goods and a different composition of goods in the two countries. However, the general principle of the link between relative wages and relative productivity differences still holds. 7.

(a) The relative wage ratio is (WU.S./WU.K.) = [$20/(£8$2/£1)] = 5/4. Thus the United Kingdom exports bread and books; the United States exports VCRs, rugs, and lamps. (b) The upper limit to U.K. wages is found by setting 2/3 = $20/(WU.K.$2/£1); therefore the upper limit to WU.K. is £15 per day. By setting 4/2 equal to $20/(WU.K.$2/£1), the lower limit to WU.K. of £5 per day is obtained. (c) The upper limit to the exchange rate is found by setting 2/3 = $20/(£8e), which yields the result of $3.75/£1. By setting 4/2 = $20/(£8e), the lower limit of $1.25/£1 is obtained.

(a) The new U.K. labor times are: bread - 1.6 days; VCRs - 6.4 days; lamps - 3.2 days; rugs - 2.4 days; books - 1.6 days. With these numbers and the original wage ratio of 5/4, the United Kingdom will export bread, VCRs, rugs, and books; the United States will export lamps. (b) The new upper limit to U.K. wages is found by setting (1.6)/3 = $20/(WU.K. $2/£1); therefore the upper limit to WU.K. is £18.75 per day. By setting (3.2)/2 equal to $20/(WU.K.$2/£1), the lower limit to WU.K. of £6.25 per day is obtained. Thus, with the U.K. productivity improvement, both the upper limit and the lower limit to U.K. wages are higher than prior to the improvement.

9. This is to some extent an opinion question, but deficiencies of the Classical model that could be indicated clearly include the use of the labor theory of value, the constant cost assumption, and the assumption of a smooth monetary adjustment mechanism. The labor theory of value obviously ignores the role of other factors of production in the determination of production cost and hence of pretrade price ratios; the constant cost assumption typically yields the unrealistic situation of complete specialization by both countries; and the lack of a smooth monetary adjustment mechanism in practice means that the actual trade pattern can differ from the comparative advantage pattern. Other deficiencies that could be mentioned that result in a lack of complete realism are the specific assumption that the quantity theory of money holds and the general assumption of the existence of perfect competition. 10. Increases in foreign country productivity will cause the A = a2/a1 curve to shift downward as a2/a1 falls for each good. This will lead to a fall in home country export goods (an increase in foreign country export goods) since the boundary good shifts to the left in the DFS diagram. There will be a decline in the wage level in the home country relative to the foreign country. In addition, following the analysis in the appendix, the foreign country will experience a gain in real income in terms of both home country goods and foreign country goods, and the home country will experience a gain in real income when income is expressed in foreign goods and no change in real income when income is expressed in home goods. Since the home country in fact consumes both home and foreign goods, it thus attains a higher real income. 4-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 04 - Extensions and Tests of the Classical Model of Trade

VI.

Sample Exam Questions

Essay Questions

1. In the monetized Classical model, if trade is not balanced, the international terms of trade will deteriorate for the country with the trade deficit. Explain why this is so. 2. In the basic Classical model, only the limits to the international terms of trade can be specified. If the two country-two commodity model is monetized using an exchange rate and a wage rate for each country, the international terms of trade are implicitly specified. Explain why this is so. 3. In a two-country Classical model of trade with many commodities, briefly explain what would happen to the structure of trade in each of the following cases: (a) an increase in wages in one country; (b) a change in the exchange rate; (c) an improvement in productivity (lowering of the labor requirements/product) in one country; and (d) an increase in transportation costs. 4. In a five country-two commodity Classical model of trade, where the autarky price ratios in all five countries are different, can you conclude a priori that all five countries will desire to trade? Why or why not? Between which of the five countries is trade certain? What will determine which of the remaining countries will trade? 5. It is common to read statements to the effect that domestic inflation or production cost increases hinder our ability to export and also stimulate imports. Is this consistent with the Classical view of international trade? What effects would such an event have on the overall economy according to Classical thinking? 6.

(a) Set up a Ricardo-type comparative advantage numerical example with two countries and two goods. Distinguish “absolute advantage” from “comparative advantage” in the context of your example. Then explain how trade between the two countries benefits each of them in comparison with autarky. (b) For your numerical example in part (a) of this question, assign a wage rate to one of your countries and a fixed exchange rate between the two currencies. Then, using your wage rate and the exchange rate, indicate the upper and lower limits to the wage rate in the other country that are consistent with two-way trade between the countries, and explain why these are the upper and lower limits.

In the context of the Classical (Ricardo) model, explain, for each of the following two statements, why the statement is either TRUE or FALSE.

Chapter 04 - Extensions and Tests of the Classical Model of Trade

(a) “If country A can produce all goods with less labor time per unit of output than can country B, then there can be no reason for country A to trade with country B – country A would always maximize its own welfare by satisfying its consumption desires for all goods from its own production.” (b) “If country I’s workers have greater productivity in all industries than country II’s workers, then workers in country I will be paid a higher wage rate than workers in country II.” 8. Set up a Ricardo-type comparative advantage numerical example with two countries and two goods. Explain how trade between the two countries can benefit each of them in comparison with autarky. Then indicate a situation in which only one of the two countries would gain from trade and carefully explain why only one country gains. (Question 9 pertains to appendix material.) 9.

(a) Explain the Dornbusch-Fischer-Samuelson (DFS) model of Classical-type trade between two countries in a very large number of goods. Be sure to describe why each curve slopes as it does, and indicate the trading pattern at the equilibrium position. (b) Now suppose that, from your equilibrium position in part (a) above, there is a uniform improvement in labor productivity in one of the two countries in all industries. (You can choose either country.) Illustrate and explain what happens to the trading pattern and to relative wage rates. Then explain the impact of the productivity improvement on real income in each country.

Multiple-Choice Questions

10.

You are given the following Classical-type table indicating the number of days of labor input needed to make one unit of output of each of the five commodities in each of the two countries. Assume that the wage rate in England is £20 per day, that the wage rate in Portugal is 40 euros per day, and that the fixed exchange rate is £1 = 3 euros.

England Portugal

Good A

Good B

Good C

Good D

Good E

1 day 4 days

5 days 4 days

2 days 1 day

1 day 2 days

4 days 5 days

With the given information, what will be the trade pattern if the two countries engage in trade? a. England will export good A and import goods B, C, D, and E. * b. England will export goods A and D and import goods B, C, and E. c. England will export goods A, B, and E and import goods C and D. d. England will export goods A, B, D, and E and import good C. 4-4 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 04 - Extensions and Tests of the Classical Model of Trade

11.

In Question #10 above, suppose that one-half day of labor must be used to transport a good internationally, no matter which good is considered and which country is doing the exporting. With this addition of transportation costs, England will export good(s) __________ and will import good(s) __________. a. A; B, C, D, and E b. A and D; B, C, and E * c. A; B, C, and E d. A; B and C

12.

Suppose that the wage rate in country A is three times the wage rate in country B. In this situation, in the context of the Classical/Ricardo trade model, country A would be able to export goods to country B in industries where a. A’s workers were less than one-third as productive as B’s workers. b. A’s workers were equally as productive as B’s workers. c. A’s workers were less than three times as productive as B’s workers. * d. B’s workers were less than one-third as productive as A’s workers.

13.

You are given the following Classical-type table showing the output of 10 days labor in the production of each of the two commodities in each of the two countries. Assume that the U.K. worker’s wage is £30 per day and that the fixed exchange rate is $2 = £1.

United States United Kingdom .

Food

Clothing

30 units 20 units

30 units 15 units

If trade is taking place between the two countries, what is the “upper limit” to the U.S. worker’s wage per day? a. $30 b. $40 c. $90 * d. $120

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Chapter 04 - Extensions and Tests of the Classical Model of Trade

14.

In the situation in Question #13 above, if trade is taking place, what is the lower limit” to the U.S. worker’s wage per day? a. $30 b. $40 * c. $90 d. $120

15.

Given the following Classical-type table shows the number of days of labor input required to obtain one unit of output of each of the three commodities in each of the two countries:

United Kingdom United States

good T

good X

good Y

4 days 4 days

5 days 4 days

3 days 2 days

Suppose that the wage rate in the United Kingdom is £30 per day, the wage rate in the United States is $40 per day, and the exchange rate is £1 = $1. In this situation, the United Kingdom will a. export good T and import goods X and Y. b. export good Y and import goods T and X. * c. export goods T and X and import good Y. d. export goods X and Y and import good T. 16.

In Question #15 above, if the U.S. wage rate is $40 per day and the exchange rate is £1 = $1, what is the upper limit to the wage rate in the United Kingdom that is consistent with two-way trade between the countries? a. £26⅔ per day b. £30 per day c. £32 per day * d. £40 per day

17.

The following Classical-type table shows the number of days of labor input required to obtain one unit of output of each of the two commodities in each of the three countries:

Spain United States England

clothing

wheat

3 days 2 days 4 days

6 days 5 days 6 days

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Chapter 04 - Extensions and Tests of the Classical Model of Trade

Given this information, the United States has an absolute advantage over Spain in * a. both goods, and the United States also has an absolute advantage over England in both goods. b. both goods, but the United States has an absolute advantage over England in neither good. c. neither good, but the United States has an absolute advantage over England in both goods. d. neither good, and the United States also has an absolute advantage over England in neither good. 18.

In the three-country world in Question #17, which one of the following statements is TRUE? a. Posttrade prices (terms of trade) of 1 wheat:2.5 clothing (or 1 clothing:0.4 wheat) would give all the gains from trade to the United States. b. Posttrade prices (terms of trade) of 1 wheat:3 clothing (or 1 clothing:⅓ wheat) are possible. * c. At posttrade prices (terms of trade) of 1 wheat:1.6 clothing (or 1 clothing:0.625 wheat), England would export wheat and Spain and the United States would export clothing. d. At posttrade prices (terms of trade) of 1 wheat:2.25 clothing (or 1 clothing:0.44 wheat), Spain would export clothing and import wheat.

19.

In the table in Question #17 above, when trade is taking place among the three countries, __________ will always be exporting wheat and __________ will always be exporting clothing. a. the United States; England * b. England; the United States c. England; Spain d. Spain; the United States

(Questions 20-24 draw on Appendix material.) 20.

You are given the following Dornbusch-Fischer-Samuelson (DFS) graph, where a1 = the labor-time needed per unit of output in any given industry in the home country, a2 = the labor-time needed per unit of output in any given industry in the foreign country, W1 = the wage rate in the home country, and W2 = the wage rate in the foreign country. The exchange rate e is assumed = 1.

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Chapter 04 - Extensions and Tests of the Classical Model of Trade

FIGURE 1 In this Dornbusch-Fischer-Samuelson graph, moving to the right along the A line indicates goods in which the __________ country has greater relative efficiency; further, the introduction of technical progress in the foreign country would, other things equal, be reflected in __________ shift of the curve. a. home; an upward b. home; a downward c. foreign; an upward * d. foreign; a downward 21.

In the Dornbusch-Fischer-Samuelson graph in Question #20 above, a good that is located on the horizontal axis to the left of the point directly below the intersection of the A curve with the C curve will be exported by the __________ country, and, for this good, __________. a. home; a2/a1 < W1/W2 (or a1/a2 > W2/W1) * b. home; a2/a1 > W1/W2 (or a1/a2 < W2/W1) c. foreign; a2/a1 < W1/W2 (or a1/a2 > W2/W1) d. foreign; a2/a1 > W1/W2 (or a1/a2 < W2/W1)

22.

In the Dornbusch-Fischer-Samuelson model of Question #20 above, a uniform improvement in labor productivity in all of the home country’s industries would shift the A schedule __________ and would lead to the export of a __________ number of goods by the home country than the number exported before the productivity improvement. * a. upward and to the right; greater b. upward and to the right; smaller c.. downward and to the left; greater d. downward and to the left; smaller

In the Dornbusch-Fischer-Samuelson model of Question #20 above, a rise in labor productivity in the home country would cause real national income to __________ in the home country and __________ in the foreign country. a. increase; to decrease * b. increase; also to increase c. decrease; to increase 4-8

Chapter 04 - Extensions and Tests of the Classical Model of Trade

d. decrease; also to decrease 24.

In the Dornbusch-Fischer-Samuelson model of Question #20 above, a shift in tastes and preferences towards home country goods will cause the __________ schedule to pivot __________. a. A; downward and to the left b. A; upward and to the right c. C; downward and to the right * d. C; upward and to the left

25.

In the context of the Classical/Ricardo model, suppose that, in an industry X, the productivity of U.S. workers is three times the productivity of Chinese workers. At the same time, suppose that the wage rate paid to Chinese workers is 20% of the wage rate paid to U.S. workers. In this situation, the unit labor cost of producing good X would be __________ in China than in the United States and therefore, in this two-country Classical/Ricardo context, __________. * a. lower; China would export good X to the United States b. lower; the United States would export good X to China c. higher; China would export good X to the United States d. higher; the United States would export good X to China

26.

In a Ricardo-type model, if Portuguese workers can produce three times as much wine per day as English workers but only twice as much cloth per day as English workers, then, if Portuguese wages are 30 euros per day, the upper limit to English wages per day is __________. (Assume 1 euro = £1.) a. £10 * b. £15 c. £60 d. £90

27.

Suppose that the labor requirements per unit of output in each of the two industries in each of three countries are as follows:

Spain France United States

Wheat

Cloth

2 days 2 days 1 day

3 days 2 days 3 days

In this situation, with an international terms of trade of 1 cloth:2 wheat (or 1 wheat:½ cloth), __________ would export cloth and import wheat; if the terms of trade were, instead, 1 wheat:¾ cloth (or 1 cloth:1⅓ wheat), __________ would export cloth and 4-9 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 04 - Extensions and Tests of the Classical Model of Trade

import wheat. a. France and the United States; Spain * b. Spain and France; France c. France and the United States; Spain and the United States d. Spain and France; Spain and the United States

28.

Given the following Ricardo-type table showing the amount of labor input required to produce one unit of output of each of the two goods in each of the two countries:

France Germany

Shirts

Machines

3 days 2 days

5 days 4 days

If the wage rate in France is €60 per day (i.e., 60 euros per day), what is the upper limit to the wage rate per day in Germany (which also uses the euro) that is compatible with twoway trade between the countries? a. €40 b. €48 c. €75 * d. €90 29.

Suppose that, in a Classical model with two goods, Germany can produce 50 units of steel with one day of labor and 30 units of textiles with one day of labor; Switzerland can produce 45 units of steel with one day of labor and 45 units of textiles with one day of labor. If the exchange rate is fixed at 1 Swiss franc = 1 euro and if the Swiss wage rate is 10 francs per day, then, in trading equilibrium, German wages a. must be greater than 10 euros per day. b. must be less than 10 euros per day. c. must be equal to 10 euros per day. * d. can be above, below, or equal to 10 euros per day – cannot be determined without more information.

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Chapter 04 - Extensions and Tests of the Classical Model of Trade

30.

Given the following Classical-type table showing the fixed money prices of each good in each of the two countries: Shoes Wine United States Switzerland

$20/pair 100 francs/pair

$10/bottle 40 francs/bottle

If the exchange rate is flexible, the upper limit to the price of the dollar (i.e., the number of Swiss francs per dollar above which there is export of both goods by Switzerland) is * a. 5 francs = $1. b. 4 francs = $1. c. 0.25 francs = $1. d. 0.20 francs = $1. 31.

Given the following Classical-type table showing the number of days of labor input required to obtain one unit of output of each of the two commodities in each of the three countries: wine clothing Denmark Germany Portugal

4 days 3 days 5 days

6 days 3 days 9 days

Which one of the following statements is correct? a. If trade is taking place, Germany will always be exporting wine. b. If trade is taking place, Denmark will always be exporting clothing. * c. If trade is taking place, Portugal will always be importing clothing. d. If trade is taking place and the terms of trade are 1 clothing:1.6 wine, Germany will be exporting clothing and Denmark and Portugal will be importing clothing. 32.

Given the following Ricardo-type table showing the amount of labor input required to produce one unit of output of each of the two goods in each of the two countries:

United Kingdom United States

Wheat

Clothing

6 days 4 days

5 days 3 days

Suppose that the U.S. wage rate is $60 per day and that the exchange rate is $2 = £1 (or £0.5 = $1). In this situation, the lower limit for the U.K. wage rate in order to have twoway trade would be __________ per day.

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Chapter 04 - Extensions and Tests of the Classical Model of Trade

* a. £18 b. £20 c. £45 d. £50

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Chapter 05 - Introduction to Neoclassical Trade Theory: Tools to Be Employed

CHAPTER 5 INTRODUCTION TO NEOCLASSICAL TRADE THEORY: TOOLS TO BE EMPLOYED Learning Objectives: ■ ■ ■

Review the microeconomic principles of consumer and producer behavior. Explain the concept and limitations of a community indifference curve. Examine the underlying basis for a production-possibilities frontier with increasing opportunity costs.

Outline Introduction The Theory of Consumer Behavior - Consumer Indifference Curves - The Budget Constraint - Consumer Equilibrium Production Theory - Isoquants - Isocost Lines - Producer Equilibrium The Edgeworth Box Diagram and the Production-Possibilities Frontier - The Edgeworth Box Diagram - The Production-Possibilities Frontier Summary

II.

Special Chapter Features Titans of International Economics: Francis Ysidro Edgeworth (1845-1926) In the Real World: Consumer Expenditure Patterns in the United States

III.

Purpose of Chapter

Since neoclassical trade theory at the undergraduate level relies heavily on a few basic graphical micro tools, we think it useful to gather these tools into one convenient place early in the book. The purpose of the chapter is to re-introduce the student to thinking in marginal terms and to re-emphasize principles of maximization. The student should become aware early in the course that the conceptual precision of economic analysis to which he or she was exposed in earlier work is going to be employed in the international trade course as well.

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Chapter 05 - Introduction to Neoclassical Trade Theory: Tools to Be Employed

IV.

Teaching Tips

A. In classes where the prerequisite for the international economics course(s) consists only of introductory economics, some of the tools will be new and this chapter should be required reading. If intermediate micro is a prerequisite, this chapter can be made optional, but it may still serve as a worthwhile reference point if difficulty is encountered in later chapters. Even then, however, the material on community indifference curves is likely to be new to the students. B. Our less-than-complete discussion of relative factor intensity of production processes can be given more precision in class here rather than waiting until that material is more fully developed in Chapter 8. C. In the discussion of consumer and producer maximization we think that the student’s grasp of the material is improved if the tangencies and equalities and the movements to them are not thought of as relationships to be memorized but rather as processes to be understood in economic terms. Thus, we stress that, with a disequilibrium such as (MUX/PX) > (MUY/PY), it is simple common sense to reallocate the consumption bundle toward more of good X and less of good Y because total utility is enhanced through spending the last dollar on a good that brings greater utility at the margin. D. The material on the derivation of the PPF from the Edgeworth box at the end of the chapter seems particularly useful to us when we teach the course, and we recommend that special emphasis be put upon it. This material is helpful for the later discussion in Chapter 8 of the Heckscher-Ohlin trade pattern when using the physical definition of factor abundance. E. If students have a ready grasp of the Edgeworth box and if time permits in a one-semester trade course, you might want to derive a community indifference curve from a consumption Edgeworth box by selecting a starting point on the contract curve and “sliding” one consumer’s individual curve along the other’s curve so that the origin that is changing traces out a community curve. Different starting points can then be shown to yield intersecting curves unless assumptions are made that both consumers have: (a) the same (or proportional) incomes and identical tastes; (b) identical and homothetic tastes; or (c) the same (or proportional) incomes and homothetic tastes.

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Chapter 05 - Introduction to Neoclassical Trade Theory: Tools to Be Employed

Answers to End-of-Chapter Questions and Problems

In the graph below,

the initial equilibrium is at point E1 with relative prices (PX/PY)1. If the price of good X falls while the price of good Y remains constant, then a new flatter price line (PX/PY)2 line emerges from the original intercept at point A on the vertical axis. Because MUX/PX is now greater than MUY/PY at E1, the consumer will substitute toward greater consumption of the X good and less consumption of the Y good in order to increase total satisfaction. Equilibrium will move from E1 to E2, and the consumer will be on a higher indifference curve and will have increased the relative consumption of good X. Only if good X is a sufficiently “inferior” good will the relative increase in the quantity of X consumed not occur. 2. Consider an indifference curve diagram such as Figure 3 in the text. A shift in the income distribution toward consumers with a relatively stronger preference for good Y than in the original distribution (the distribution with the solid lines) will make each curve “flatter” and will shift each curve leftward toward the vertical axis. The curves become flatter because, for any total amount of Y taken away from consumers at the margin in proportion to their incomes, more X must be given to the community as a whole in order to restore each consumer to his or her original level of satisfaction. The leftward shift occurs because, at each given total amount of good Y consumed (which is now more preferred), less X is necessary in order for the community as a whole to attain a given utility level. 3. In Figure 8 in the text, consider the lower intersection point (not labeled) of isoquant Q0 with budget line B1. At that point, MPPL/MPPK is less than w/r because the isoquant is flatter than the isocost line. This indicates that MPPL/w < MPPK/r, or that, at the margin, the output obtained per dollar spent on labor by the firm is less than the output obtained per dollar spent on capital. The profit-maximizing entrepreneur will therefore, with the given budget, reallocate spending toward capital and away from labor. The reallocation will stop at point E, where, at the margin, the output per dollar spent on capital is equal to the output per dollar spent on labor. The higher isoquant Q1 will have been reached, and equality between MPPL/MPPK has been achieved by a rising MPPL as less labor is utilized and a falling MPPK as more capital is utilized. 4. No, it cannot be unambiguously determined. With capital on the vertical axis and labor on the horizontal axis, the new flatter isocost line will have a vertical-axis intercept lower than originally and a horizontal-axis intercept to the right of the original intercept. If this new isocost line passes above the original equilibrium point, the new level of output will be greater than it was before the factor price changes; if it passes below the original point, output will have fallen. 5-3 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 05 - Introduction to Neoclassical Trade Theory: Tools to Be Employed

5. With labor on the horizontal axis and capital on the vertical axis, the original isocost line has a vertical-axis intercept of 300 hours of capital usage and a horizontal-axis intercept of 3,000 hours of labor usage. The slope of this isocost line is (-)1/10 or 0.10. With the specified changes in factor prices, the isocost line shifts inward on both axes because the prices of both inputs have increased. The new intercepts are at 250 hours of capital and 2,000 hours of labor, and the new isocost line is slightly steeper [having a slope of (-)12.5/100 or 0.125] than the old one. The equilibrium level of output has fallen because all inputs have risen in price; the firm has also shifted toward using more capital relative to labor because w/r has risen. 6. The PPF would exhibit constant opportunity costs. Suppose that the employment of all of the economy’s capital and labor in the X industry (an endpoint of the Edgeworth box diagonal) yields 100 units of X output (and 0 units of Y output). Alternatively, suppose that employment of all capital and labor in the Y industry yields 200 units of Y output (and 0 units of X output). With constant returns to scale in both industries, production at the midpoint of the diagonal (using one-half of the economy’s capital and labor in each industry) would therefore yield 50X and 100Y. Employment of one-fourth of the economy’s capital and labor in the X industry and three-fourths of the economy's capital and labor in the Y industry (i.e., at a point one-fourth of the distance along the diagonal from the X origin to the Y origin) would yield 25X and 150Y. Plotting these various output combinations (and the output combinations of all other production points on the diagonal) yields a straight-line PPF. This PPF would be analogous to the dashed line RTMWQ in Figure 13(b) in the text. 7. This statement is incorrect. The discussion in the text regarding the productionpossibilities frontier indicates that a PPF with increasing opportunity costs emerges when constant returns to scale exist in each industry, provided that the industries have different factor intensities. Thus, neither industry needs to be operating in a context of decreasing returns to scale in order to generate an increasing-opportunity-cost PPF. 8. The country is producing less of the capital-intensive good and more of the laborintensive good. The overall demand for labor would rise and the overall demand for capital would fall as the industry with the higher K/L ratio (lower L/K ratio), industry Y, contracts, while the industry with the lower K/L ratio (higher L/K ratio), industry X, expands. Hence, relative factor prices w/r will rise (or r/w will fall). No, the (absolute values of the) isoquant slopes at V’ will be higher than at S’ because, in equilibrium, these (absolute values of the) slopes are equal to the now-higher w/r. An alternative geometric explanation is that, with homothetic isoquants, a ray from 0X (0Y) through S’ would hit isoquant x2 (y4) at a point below and to the right (above and to the left) of V’, a point that would have the same slope as isoquant x1 (y6) at S’. Given the convex shapes of isoquants, V’ would then have a steeper slope than S’. 9. The Edgeworth box would become “taller” because the vertical capital axes become longer and the horizontal labor axes stay the same length. The PPF will also become “taller” because the good Y intercept shifts upward by a greater percentage than the good X intercept shifts rightward. Note, however, that the good X intercept does shift to the right because, with a larger capital stock, more X can be obtained when all resources are devoted to X production.

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Chapter 05 - Introduction to Neoclassical Trade Theory: Tools to Be Employed

10. If the price of labor rises with no change in the price or rental rate of capital, w/r increases (r/w decreases). Producers in both industries would respond by using relatively less labor and relatively more capital, and the K/L ratio would rise in both industries. Note that, in this question, we do not specify the cause of the rise in the price of labor – the effects on output of each good and on total output would depend on this cause and would be different, for example, if the cause were technological change that increased the demand for labor rather than a desire on the part of labor to take more leisure time. VI.

Sample Exam Questions

Essay Questions

1. Suppose that, from an initial individual consumer equilibrium position in the indifference curve-budget line diagram, the prices of both goods rise by 10 percent. What happens to the position and slope of the budget line? Why does the consumer’s level of satisfaction from a given money income fall? Illustrate and explain. Would it be acceptable for an economist to say that the level of satisfaction of the consumer fell by exactly 10 percent? Why or why not? 2. Suppose that, from an initial individual consumer equilibrium position in the indifference curve-budget line diagram, the price of good X rises while the price of good Y falls. What will happen to the relative consumption of the two goods by the consumer and why? Can it be specified whether the consumer’s level of satisfaction has increased or decreased because of this change in absolute and relative prices? Why or why not? Could the satisfaction level of some consumers increase and the satisfaction level of other consumers decrease because of the price changes? Explain. 3. “If constant returns to scale exist for a firm, then a 10 percent rise in all factor prices will lead to a 10 percent decline in the equilibrium quantity of output for a given budget. However, if increasing returns to scale exist, a 10 percent rise in all factor prices will lead to a less than 10 percent decline in the equilibrium quantity of output for a given budget.” Assess the validity of this statement. 4. Explain, using the isoquant-isocost diagram, why a rise in the rental rate of capital coupled with no change in the wage rate will lead to a rise in the price of the capital-intensive good relative to the price of the labor-intensive good. 5. Explain why any point on an economy’s PPF must be associated with a point on the production efficiency locus in the Edgeworth box diagram.

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Chapter 05 - Introduction to Neoclassical Trade Theory: Tools to Be Employed

6. The textbook has developed the Edgeworth box diagram and the concept of the production efficiency locus or contract curve in the context of the production of two goods with two factors. Apply the Edgeworth box apparatus to the context of consumption of two goods by two consumers, and, in particular, explain how welfare for the two consumers as a whole when on the contract curve relates to welfare when the consumers are not on the contract curve. B.

Multiple-Choice Questions

In the following Edgeworth box diagram for a country’s production,

* a. point T has greater output of the A good than does point R. b. output of the A good is greater at point S as at point R. c. a plotting of the output combinations along the “diagonal” results in the productionpossibilities frontier for this country. d. good A is the relatively labor-intensive good and good B is the relatively capitalintensive good. 8.

In the diagram in Question #7 above, a. a movement from point S to point T involves an increase in the capital/labor ratio used in the production of good A. b. if the PPF is plotted from the “contract curve” (or “production efficiency locus”), the production combination of goods A and B associated with point R is on the PPF. c. if the PPF is plotted from the “contract curve” (or “production efficiency locus”), with good A on the vertical axis and good B on the horizontal axis, the production combination of goods A and B associated with the 0B origin is at the origin of the PPF graph. * d. if the PPF is plotted from the “contract curve” (or “production efficiency locus”), with good A on the vertical axis and good B on the horizontal axis, the production combination of goods A and B associated with point T is further up the vertical axis than the production combination associated with point S.

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Chapter 05 - Introduction to Neoclassical Trade Theory: Tools to Be Employed

In the diagram in Question #7 above, a movement from point S to point T will lead to __________ in the capital/labor ratio used in the production of good A and __________ in the capital/labor ratio used in the production of good B. a. an increase; will lead to a decrease b. an increase; also will lead to an increase * c. a decrease; also will lead to a decrease d. a decrease; will lead to an increase

10.

If, for a consumer, (MUA/PA) is greater than (MUB/PB), then the consumer a. has an incentive to consume relatively more of good A, which will increase his/her MUA. * b. has an incentive to consume relatively more of good A, which will decrease his/her MUA. c. has an incentive to consume relatively more of good B, which will increase his/her MUB. d. has an incentive to consume relatively more of good B, which will decrease his/her MUB.

11.

In the following table of production possibilities for a country, Good X

Good Y

0 units 1 unit 2 units 3 units

13 units 10 units 6 units 0 units

there are __________ opportuninferior inity costs in the production of good X, and there are __________ opportunity costs in the production of good Y. * a. increasing; increasing b. increasing; constant c. constant; increasing d. constant; decreasing 12.

Two indifference curves for an individual consumer __________ intersect; two community indifference curves for a country __________. a. cannot; also cannot intersect * b. cannot; can intersect under some circumstances c. can; can also intersect under some circumstances d. can; cannot intersect

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Chapter 05 - Introduction to Neoclassical Trade Theory: Tools to Be Employed

13.

Which one of the following sequences of specifications of relative preferences for bundles of goods A, B, and C by a consumer indicates the property of transitivity (where “>” indicates that the preferred bundle is on the left, “<” indicates that the preferred bundle is on the right, and “=” means indifference between the bundles)? a. A > B; B > C; C > A b. A > B; B = C; C = A * c. A < B; C < A; B > C d. A = C; B > C; A > B

14.

In the following table of production possibilities for a country, Good X

Good Y

400 units 300 units 200 units 100 units 0 units

0 units 100 units 180 units 240 units 280 units

there are __________ opportunity costs when moving to greater production of good X and __________ when moving to greater production of good Y. a. increasing; decreasing b. decreasing; constant c. constant; increasing * d. increasing; increasing 15.

Suppose that, in the isoquant-isocost diagram, with given relative factor prices, an equilibrium input combination of 10 units of capital and 30 units of labor yields an output level for the firm of 120 units. Suppose that, for this firm, at the same relative factor prices but with a larger budget, an equilibrium input combination of 15 units of capital and 45 units of labor yields an output level of 160 units. Viewing these input-output relationships, an economist would say that, in its production process, this firm experiences a. increasing returns to scale. b. constant returns to scale. * c. decreasing returns to scale. d. increasing returns to scale, constant returns to scale, or decreasing returns to scale – cannot be determined without more information.

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Chapter 05 - Introduction to Neoclassical Trade Theory: Tools to Be Employed

16.

In the Edgeworth box diagram for production, a. a point off the “contract curve” (or “production efficiency locus”) cannot have more production of one of the goods than can some point on the curve. b. a point off the “contract curve” (or “production efficiency locus”) can involve more production of both goods than can any point on the curve. * c. a movement from autarky to trade can be associated with a movement along the “contract curve” (or “production efficiency locus’). d. the “contract curve” (or “production efficiency locus”) will always be the “diagonal” of the box.

17.

In the following graph showing an isoquant and an isocost line, at point X,

MPPL/MPPK is __________ w/r and the producer has an incentive to use relatively more __________ in producing the given output. a. greater than; capital b. greater than; labor * c. less than; capital d. less than; labor 18.

In the Edgeworth box diagram in production with two goods and two factors of production, a. a movement from any point off the “production efficiency locus” (“contract curve”) to any point on the locus must involve greater production of one good and less production of the other good. b. a movement from any point on the “production efficiency locus” (“contract curve”) to any point off the locus must involve less production of both goods. c. a point that is off the “production efficiency locus” (“contract curve”) must be associated with unemployment of at least one of the factors of production. * d. a movement from any point on the “production efficiency locus” (“contract curve”) to another point on the locus must involve greater production of one good and less production of the other good.

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Chapter 05 - Introduction to Neoclassical Trade Theory: Tools to Be Employed

19.

The equilibrium condition for consumer behavior pertaining to goods A and B is __________. a. (MUB/PA) = (MUA/PB) b. MUB = MUA c. (MPPB/MPPA) = (PB/PA) * d. (MUB/MUA) = (PB/PA)

20.

You are given the following two possible community indifference curve maps for a country, where curves S1 and S’1 pertain to income distribution #1 and curves S2 and S’2 pertain to income distribution #2:

The differing shapes of the curves in these two maps could reflect the fact that in income distribution #2, in comparison with income distribution #1, a greater share of total income is held by individuals who value __________. In addition, in this diagram, point B is preferred to point A __________. a. good X relatively more highly than good Y; on the basis of income distribution #2 but not on the basis of income distribution #1 b. good X relatively more highly than good Y; on the basis of income distribution #1 but not on the basis of income distribution #2 c. good Y relatively more highly than good X; on the basis of income distribution #2 but not on the basis of income distribution #1 * d. good Y relatively more highly than good X; on the basis of income distribution #1 but not on the basis of income distribution #2

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Chapter 05 - Introduction to Neoclassical Trade Theory: Tools to Be Employed

21.

A production isoquant shows the various combinations * a. of two factors of production that can produce the same amount of output of a good. b. of two factors of production that can be hired by a firm for the same cost. c. of two goods that can be produced by the firm with the same quantity of the factors of production. d. of two goods that bring an equivalent satisfaction level to an individual consumer.

22.

The slope of a consumer indifference curve at any given point on the curve reflects (ignoring the negative sign) a. the marginal rate of transformation (MRT) in production of one commodity into the other commodity. b. the marginal rate of technical substitution (MRTS) between the factors of production. c. the relative prices of the commodities in the consumption bundle of goods. * d. the marginal rate of substitution (MRS) of the consumer between the two goods.

23.

The equilibrium condition for producers (i.e., the condition that exists when the isocost line is tangent to an isoquant) is __________. a. (MPPL/r) = (MPPK/w) * b. (MPPL/MPPK) = (w/r) c. (MUB/MUA) = (PB/PA) d. (MUB/PA) = (MUA/PB)

24.

Given the following table showing various combinations of goods X and Y that bring equal satisfaction to an individual consumer: good X

good Y

2 units 3 units 4 units 5 units

10 units 9 units 6 units 2 units

In this table, as the individual consumes a greater amount of X, a __________ amount of good Y is given up for each additional unit of good X. This pattern suggests that, as more of good X is consumed and less of good Y is consumed, the ratio MUX/MUY is __________. * a. larger; increasing, which contradicts economists’ usual expectations b. larger; decreasing, which conforms to economists’ usual expectations c. smaller; increasing, which contradicts economists’ usual expectations d. smaller; decreasing, which conforms to economists’ usual expectations 25.

The curve in the following diagram is called an __________, and its slope (ignoring the 5-2

Chapter 05 - Introduction to Neoclassical Trade Theory: Tools to Be Employed

negative sign) indicates the ratio __________.

a.. isoquant; w/r * b. isoquant; MPPL/MPPK c. isocost line; w/r d. isocost line; MPPL/MPPK 26.

Suppose that, in the context of the Edgeworth box diagram in production, there are constant returns to scale in each of the two industries and that one good is relatively labor-intensive in its production process and the other good is relatively capital-intensive in its production process. In considering this Edgeworth box diagram and the PPF that can be derived from it, a. all points on the “diagonal” of the Edgeworth box diagram will have corresponding points on the PPF. b. no point on the “diagonal” of the Edgeworth box diagram will correspond to a point on the PPF. * c. the PPF will show increasing opportunity costs. d. the PPF will show constant opportunity costs.

5-3

Chapter 06 - Gains from Trade in Neoclassical Theory

CHAPTER 6 GAINS FROM TRADE IN NEOCLASSICAL THEORY Learning Objectives: ■ ■ ■ ■

Describe economic equilibrium in a country that has no trade. Discover the welfare-enhancing impact of opening a country to international trade. Demonstrate that either supply differences or demand differences between countries are sufficient to generate a basis for trade. Discuss the implications of key assumptions in the neoclassical trade model.

Outline Introduction - The Effects of Restrictions on U.S. Trade Autarky Equilibrium Introduction of International Trade - The Consumption and Production Gains from Trade - Trade in the Partner Country Minimum Conditions for Trade - Trade between Countries with Identical PPFs - Trade between Countries with Identical Demand Conditions - Conclusions Some Important Assumptions in the Analysis - Costless Factor Mobility - Full Employment of Factors of Production - The Indifference Curve Map Can Show Welfare Changes Summary Appendix: “Actual” versus “Potential” Gains from Trade

II.

Special Chapter Features In the Real World: Changes in Income Distribution with Increased Trade

III.

Purpose of Chapter

The purpose of this chapter is to build the case, using familiar microeconomic tools, for a country to participate in international trade rather than to remain in autarky. The chapter thus uses more modern or updated analysis, compared to the Classical model, to evaluate the impact of trade. The chapter also attempts to acquaint the student with some of the important underlying assumptions in this neoclassical analysis. IV.

Teaching Tips

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Chapter 06 - Gains from Trade in Neoclassical Theory

A. The chapter begins with an analysis of the costs of trade restrictions in terms of lost imports and exports. This provides students with a real-world estimate of the potential gains from free trade as a motivation for the theoretical discussion in this chapter. B. We find it useful to dwell on the production equilibrium material, since students don’t usually seem to have an economic grasp of why the equilibrium production point on the PPF emerges in the standard competitive framework. C. When introducing the effects of international trade it is worthwhile to stress that the “trading line” is in fact the consumption-possibilities frontier (CPF) with trade. This CPF is outside the economy’s CPF in autarky (which is identical to the PPF), except at the point of tangency to the PPF. D. The consumption gain from trade sometimes puzzles students. It can be useful to explain this gain as the natural result of receiving a relatively higher price for the good now sold on the world market, coupled with paying a relatively lower price for the good now bought on the world market. E. It can be helpful in discussing the case of identical PPFs and different tastes to emphasize that the gains for each country occur because they are each getting more of the good for which they have relative preference. However, note that trade does not occur because of the different tastes per se but rather because of the different opportunity costs resulting from the different tastes in the increasing-opportunity-cost framework. F. The discussion in the last section regarding underlying assumptions seems to be of interest to students. It is useful to stress that policies that facilitate mobility and adjustment to trade (such as trade adjustment assistance), as well as possible compensation measures, can help to ensure that the actual gains from trade are maximized in practice. V.

Answers to End-of-Chapter Questions and Problems

1. Figures 1 and 2 in the text are the relevant diagrams. Point E is the production equilibrium position because the marginal rate of transformation in production (= marginal cost of X/marginal cost of Y) is equal to the relative commodity price ratio PX/PY at that point. For the given relative prices, production at any other point would have PX/PY unequal to MCX/MCY, or PX/MCX unequal to PY/MCY. Hence, firms would have an incentive to shift resources until point E was attained. For consumers, point E in Figure 2 is the equilibrium position because, at that point, the marginal rate of substitution in consumption (= marginal utility of X/marginal utility of Y) is equal to PX/PY. Consumption on the PPF at any other point would be on a lower indifference curve, and, for the given prices, MUX/MUY would be unequal to PX/PY (or MUX/PX would be unequal to MUY/PY). Because consumption of one good at the margin brings less utility per dollar spent than on the other good, consumers will change their consumption bundle until point E is attained.

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Chapter 06 - Gains from Trade in Neoclassical Theory

In order for the country to gain from trade, the world PX/PY must be different from the autarky PX/PY. With different relative prices on the world market, a reallocation of production and consumption will enable the country to move to a higher indifference curve. 2. Yes, the country should trade. It should export cloth because that is the good of comparative advantage, and producers will have a profit incentive to sell cloth at its relatively higher price on the world market. The country will gain from trade because its trading line (CPF with trade) will permit larger consumption bundles than are possible in autarky, since the exported cloth allows for the purchase of relatively cheaper machines than in autarky. As long as world prices differ from autarky prices, the country can move to a higher indifference curve by participating in trade. 3. The “gains from exchange” (“consumption gain”) occur because of the opportunity to consume at different relative goods prices, even though production does not change. The higher relative price for the export good on the world market permits consumption of the now-relatively lower priced import good, and consumers will substitute toward the import good and will move to a higher indifference curve than was possible in autarky. The “gains from specialization” (“production gain”) reflect the enhanced real income possible for the economy because the economy is now using resources more efficiently by concentrating its production to a greater extent on its comparative advantage good. 4. Yes. Even though unemployment may not fall with the opening of the country to trade, the country can still be reallocating production (increasing the proportion of employed workers in the export industry and decreasing the proportion in the import-substitute industry) and can trade along a CPF different from the CPF being attained in autarky. The consumption and production gains from trade can still be realized. In fact, consumption could now even occur outside (rather than inside) the PPF with a sufficient volume of trade. Further, even if no workers can be shifted to the export industry from the import-substitute industry (or from the unemployment pool) because of rigidities, the consumption gain from trade will still occur. 5. The statement is incorrect. This is the case of trade with a “right-angle” PPF. The consumption gain from trade will still be realized because trade has exposed the country to a different set of relative commodity prices. 6. Without getting into material generally beyond the scope of the undergraduate course (such as the conditions discussed in the Tower article cited in the text or in Miltiades Chacholiades, International Trade Theory and Policy, Chapter 5), the general statements regarding the indifference curve map and welfare changes found in the section entitled “The Indifference Curve Map Can Show Welfare Changes” can be used to answer this question. 7. This position reflects a misunderstanding of the nature of the gains from trade. With trade, both countries become better off in that movement can take place to a higher community indifference curve in each nation. Certainly U.S. producers in industries that would now compete with Cuban exports (principally sugar) would be injured, but U.S. consumers of sugar would gain, as would U.S. producers of new exports to Cuba (such as machine tools). As this

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Chapter 06 - Gains from Trade in Neoclassical Theory

chapter has explained, if the compensation principle is employed, those who gain from trade can fully compensate all losers and still be better off because a larger quantity of goods is available. Of course, relaxation of the embargo involves political dimensions as well as economic dimensions, and these noneconomic aspects need to be taken into account when deciding upon the most desirable course of action. 8. It is not likely that trade would cease even if production conditions were to become identical (identical technologies and relative factor endowments). This is because there would still be a basis for trade as long as demand conditions (as reflected in the two community indifference maps) continued to be different for the two countries. 9. While the opening of trade improves the overall well-being of a country, it can affect the distribution of real income and leave certain individuals less well off. This result occurs because the price of the export good is rising, the price of the import good is falling, and factor prices are changing. In this case, Ms. Jones is correct about her situation but not about the situation of the country. Also, as will be seen in Chapter 8, if Ms. Jones owns the abundant factor used intensively in food production (the export), her real income should be rising because the price of the abundant factor rises to a greater relative extent than does the price of the export good (via the Stolper-Samuelson theorem and the magnification effect). In this instance, her conclusion about her own situation is incorrect. If, however, she owns the scarce factor of production, she will be strictly worse off since she will be faced with both an increased price of food and a falling income due to the decline in the price of the scarce factor. If Ms. Jones falls into the latter category, she should lobby for “compensation” from those whose real income has clearly increased from trade rather than for the imposition of trade restrictions which would lead to a fall in real income for the economy as a whole. 10. Even though a change in the indifference map makes it impossible to compare the new and old indifference curves in a meaningful way, it is still possible that a conclusion regarding the gains from trade can be reached by comparing the old consumption bundle with the new consumption bundle. If a country is consuming more of both goods after trade or the same amount of one good and more of the other it can be concluded that the country is better off with trade. This conclusion rests on the long-held axiom that more is preferred to less. However, if trade involves moving to a consumption point which involves having more of one good and less of the other, a clear ambiguity exists. Such an ambiguity can potentially be removed, however, if by changing the trade bundle, the country can move to a consumption situation where winners could compensate losers and where no one is worse off and at least one person is better off. See the appendix for more discussion.

Chapter 06 - Gains from Trade in Neoclassical Theory

VI.

Sample Exam Questions

Essay Questions

1. In the equilibrium trading position in a two-country model of trade, why must the trade triangles of the two countries be congruent (identical)? What role does the slope of the world price line play in making the triangles congruent? 2. The text has demonstrated that, even if a country’s production does not change with the opening of the country to trade, a gain (the “consumption gain”) can still occur even though there is no “production gain.” Is the reverse situation possible – that is, can there be a “production gain” without there being a “consumption gain” for the country? Why or why not? 3.

“In a situation of increasing opportunity costs, trade can be beneficial to both countries if they have identical PPFs or if they have identical tastes. However, trade cannot be beneficial to either country if the countries have identical PPFs and identical tastes.” Is this statement correct or incorrect? Illustrate and explain.

4. (This question pertains to material in the appendix.) Explain the economist’s distinction, in discussion of the compensation principle, between “potential” gains from trade and “actual” gains from trade. Why are the gains only “potential” when that word is used? 5. Suppose that the trade pattern of a country is that it exports foodstuffs and imports fancy sports equipment. Can you make a case that trade acts like a regressive tax in its impact on the distribution of real income and welfare within the country? Explain. 6. Explain, using the PPF-indifference curve diagram, how a change in tastes can cause a country to shift from being an exporter of a good to being an importer of that same good. (Assume that world prices are constant.) 7. (a) Using the neoclassical model, build the case why it is beneficial for a country to move from a situation of autarky to a situation of free trade. (b) Briefly, why can the neoclassical model of trade be regarded as “better” in some respects than the Classical model of trade?

8. Illustrate and explain, for each statement below, why the statement is either TRUE or FALSE. Assume a two-commodity world in each case. (a) “If a country has an absolutely fixed production pattern, i.e., resources used in each industry are completely specific to their respective industry, then this

Chapter 06 - Gains from Trade in Neoclassical Theory

country cannot experience any welfare gain when moving from autarky to free trade.” (b) “It is possible that, even if two countries have identical productionpossibilities frontiers, trade between the countries can enhance the well-being of each country, in comparison with well-being under autarky.” 9.

(a) Suppose that two countries have identical increasing-opportunity-costs productionpossibilities frontiers (PPFs). Illustrate and carefully explain why, under certain conditions, the two countries can have an incentive to trade with each other. In addition, illustrate and explain how they can therefore both gain from trade. (b) Suppose that two countries, in a situation where they each have an increasingopportunity-costs production-possibilities frontier (PPF), have identical tastes and preferences (demands). Illustrate and carefully explain why, under certain conditions, the two countries can have an incentive to trade with each other. Why can they gain from trade?

10.

(a) Using the neoclassical production-possibilities frontier/indifference curve approach, build the case that free trade is preferable to autarky for a country. Then explain how an economist could still say that trade can be beneficial to the country even if trade causes the community indifference curve map to change such that the country appears to lose welfare on the basis of the original autarky income distribution. (b) It has often been pointed out in this course that, within a country, a movement to freer trade, while helping some people, can hurt other people. Thinking over various parts of this course, indicate two groups of people within a country who can have their well-being reduced because of the opening of the country to trade and very briefly explain why their welfare can be reduced.

Multiple-Choice Questions

11.

Which of the following does not contribute to a basis for trade between two countries? a. different tastes and preferences b. different technologies c. different relative factor endowments * d. different absolute factor endowments, but the same relative endowments

12.

Given the following graph showing production-possibilities frontiers for country A and country B in a situation where both countries are on the same community indifference curve S1 in autarky:

Chapter 06 - Gains from Trade in Neoclassical Theory

Prior to trade, PX/PY in country A is __________ PX/PY in country B, and, when trade begins, country A will import good __________. * a. greater than; X b. greater than; Y c. less than; X d. less than; Y 13.

Given the production-possibilities-frontier/community-indifference-curve diagram below, where P is the autarky production point, C is the free trade consumption point, P1 represents autarky prices, and P2 represents free-trade prices, the free-trade production point is __________ and the autarky consumption point is __________.

a. R; G * b. R; P c. P; G d. G; P 14.

In the diagram in Question #13 above, as the country moves from autarky to free trade, the difference between the S0 and S1 satisfaction levels is called the * a. “consumption gain” (or “gains from exchange”). b. “production gain” (or “gains from specialization”). c. “total gains from trade (both “consumption gain” and “production gain”). d. “lost tariff revenue effect” from removing protective tariffs.

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Chapter 06 - Gains from Trade in Neoclassical Theory

15.

In the following graph showing indifference curves for country A (a1) and for country B (b1) in a situation where both countries have the same production-possibilities frontier, in autarky, PX/PY in country A is __________ PX/PY in country B, and, if trade begins, country A will export good __________.

* a. less than; X b. less than; Y c. greater than; X d. greater than; Y 16.

If country A’s (PX/PY) in autarky is greater than the (PX/PY) on the world market, then, as the country moves from autarky to trade, the relative price of good X facing A’s producers will __________, and A’s producers will hence want to shift their production toward producing __________. a. decrease; more of good X and less of good Y * b. decrease; more of good Y and less of good X c. increase; more of good X and less of good Y d. increase; more of good Y and less of good X

17.

If two countries with increasing opportunity costs have identical PPFs but different tastes,

a. the countries will have identical relative commodity prices under autarky, and therefore there is no incentive to trade. b. the countries will have different relative commodity prices under autarky, but there will still be no incentive for them to trade. c. the countries will have different relative commodity prices under autarky, and each country can gain by exporting the good for which its consumers have the higher relative preference. * d. the countries will have different relative commodity prices under autarky, and each country can gain by exporting the good for which its consumers have the lower relative preference.

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Chapter 06 - Gains from Trade in Neoclassical Theory

18.

Given the diagram below, which shows country A in its autarky position at point E [where the price line labeled p0 is tangent to both country A’s production-possibilities frontier (PPF) and country A’s indifference curve S0]:

If country A now is opened to international trade in a situation where the price of bread relative to the price of meat is lower on the world market than it is in A’s autarky position, then __________; with international trade, country A will be __________. a. country A will face a steeper price line than p0 and will change production to a point on the PPF that is downward and to the right from point E; exporting meat and importing bread b. country A will face a steeper price line than p0 and will change production to a point on the PPF that is downward and to the right from point E; exporting bread and importing meat * c. country A will face a flatter price line than p0 and will change production to a point on the PPF that is upward and to the left from point E; exporting meat and importing bread d. country A will face a flatter price line than p0 and will change production to a point on the PPF that is upward and to the left from point E; exporting bread and importing meat 19.

In the neoclassical model of trade, the movement of a country from autarky to free trade generally results in __________ specialization in production, __________ the situation in the Classical model. a. complete; unlike b. complete; as was also * c. partial; unlike d. partial; as was also

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Chapter 06 - Gains from Trade in Neoclassical Theory

20.

Given the following diagram showing a fixed-quantity production-possibilities frontier, a community indifference curve, and the associated autarky price line, if this country is opened to trade through exposure to different relative prices, the country can attain

a. both a “production gain” (“gains from specialization”) and a “consumption gain” (“gains from exchange”). b. neither a “production gain” (“gains from specialization”) nor a “consumption gain” (“gains from exchange”). * c. a “consumption gain” (“gains from exchange”) but not a “production gain” (“gains from specialization”). d. a “production gain” (“gains from specialization”) but not a “consumption gain” (“gains from exchange”). 21.

In the diagram in Question #20 above, suppose that this country is opened to trade from this initial situation where the dashed line indicates autarky prices [(PX/PY)autarky]. With this opening to trade, a. the country can gain from trade if PX/PY on the world market is less than (PX/PY)autarky but cannot gain from trade if PX/PY on the world market is greater than (PX/PY)autarky. b. the country can gain from trade if PX/PY on the world market is greater than (PX/PY)autarky but cannot gain from trade if PX/PY on the world market is less than (PX/PY)autarky. * c. the country can gain from trade if PX/PY on the world market is less than (PX/PY)autarky and also can gain from trade if PX/PY on the world market is greater than (PX/PY)autarky. d. the country cannot gain from trade if PX/PY on the world market is less than (PX/PY)autarky and also cannot gain from trade if PX/PY on the world market is greater than (PX/PY)autarky.

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Chapter 06 - Gains from Trade in Neoclassical Theory

22.

If a country’s PX/PY in autarky is less than the PX/PY on the world market, then this country has a comparative advantage in the __________ good, and, if the country now engages in international trade and moves along its production-possibilities frontier, its production of the X good will __________. a. Y; increase b. Y; decrease c. X; decrease * d. X; increase

23.

If a country’s PX/PY in autarky is less than the PX/PY on the world market, then, as the country moves from autarky to trade, the relative price of good Y will __________ for home consumers. Thus, consumers with a strong relative preference for good __________ would tend to oppose the movement to trade. a. increase; Y b. increase; X c. decrease; Y * d. decrease; X

24.

If two countries have identical production-possibilities frontiers but different tastes, it is possible for each country to gain from trade with the other country a. in the Classical model but not in the neoclassical model. * b. in the neoclassical model but not in the Classical model. c. in both the Classical model and the neoclassical model. d. in neither the Classical model nor the neoclassical model.

25.

In the neoclassical (or modern) theory, two countries with identical productionpossibilities frontiers (PPFs) * a. can gain from trade with each other if demand conditions (tastes) differ in the two countries and the identical PPFs demonstrate increasing opportunity costs. b. can gain from trade with each other if demand conditions (tastes) differ in the two countries and the identical PPFs demonstrate constant opportunity costs. c. can gain from trade with each other even if demand conditions (tastes) are identical in the two countries as long as the identical PPFs demonstrate constant opportunity costs. d. cannot gain from trade with each other under any circumstances.

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Chapter 06 - Gains from Trade in Neoclassical Theory

26.

As a country moves from autarky to trade, the relative price of the country’s export good will __________ for home consumers, and the relative price of the country’s import good __________ for home consumers. a. fall; will rise b. fall; also will fall c. rise; also will rise * d. rise; will fall

27.

In the following graph, at point W (and ignoring the negative signs), the marginal rate of transformation (MRT) in production __________ the marginal rate of substitution (MRS) in consumption.

a. is greater than b. is equal to * c. is less than d. has no determinate relationship to 28.

Suppose that a country’s factors of production are “completely specific” to the industries in which they are located (i.e., factors in the X industry would contribute nothing to Y output if they were employed in the Y industry and factors in the Y industry would contribute nothing to X output if they were employed in the X industry). In addition, suppose that the country has an autarky PX/PY that is greater than the world PX/PY. In this situation, if the country is opened to international trade, it will

a. export good X and will obtain “gains from specialization” (a “production gain”) but not “gains from exchange” (a “consumption gain”). b. export good X and will obtain “gains from exchange” (a “consumption gain”) but not “gains from specialization” (a “production gain”). c. export good Y and will obtain “gains from specialization” (a “production gain”) but not “gains from exchange” (a “consumption gain”). * d. export good Y and will obtain “gains from exchange” (a “consumption gain”) but not “gains from specialization” (a “production gain”).

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Chapter 06 - Gains from Trade in Neoclassical Theory

29.

Given the diagram below, in which country A is producing at point P and consuming at point C:

Country A is __________, and the ratio of the price of food relative to the price of books [i.e., (Pfood/Pbooks)] reflected by price line P0 is __________ than the (Pfood/Pbooks) ratio that existed when country A was in autarky. a. exporting food and importing books; lower * b. exporting food and importing books; higher c. exporting books and importing food; lower d. exporting books and importing food; higher

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Chapter 07 - Offer Curves and the Terms of Trade

CHAPTER 7 OFFER CURVES AND THE TERMS OF TRADE Learning Objectives: ■ ■ ■ ■

Define a country’s offer curve and show how it is obtained. Identify how the equilibrium international terms of trade are attained. Explain how changes in both supply and demand conditions influence a country’s international terms of trade and volume of trade. Demonstrate the usefulness of different concepts of the terms of trade.

Outline Introduction - Terms-of-Trade Shocks A Country’s Offer Curve Trading Equilibrium Shifts of Offer Curves Elasticity and the Offer Curve Other Concepts of the Terms of Trade - Income Terms of Trade - Single Factoral Terms of Trade - Double Factoral Terms of Trade Summary Appendix A: Derivation of Import-Demand Elasticity on an Offer Curve Appendix B: Elasticity and Instability of Offer Curve Equilibria

II.

Special Chapter Features Concept Box 1: The Tabular Approach to Deriving an Offer Curve Concept Box 2: Measurement of the Terms of Trade In the Real World: Terms of Trade for Major Groups of Countries, 1973-2010 In the Real World: Income Terms of Trade of Major Groups of Countries, 1973-2010

III.

Purpose of Chapter

The purpose of this chapter is to introduce students to the concept of the offer curve and to the determination of the equilibrium international terms of trade. A general overview of the chapter is that, until this point in the book, the establishment of the equilibrium terms of trade has not been analyzed: now the student can see how the terms of trade result from the interaction of supply and demand in the world market.

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Chapter 07 - Offer Curves and the Terms of Trade

IV.

Teaching Tips

A. Offer curves are often viewed by students as difficult and theoretical. The introduction to this chapter presents the impact of changes in the supply of exports or demand for imports on terms of trade for a group of African nations. The impact of these changes in terms of trade on real income is also presented. This is designed to provide additional motivation for the students to understand how terms of trade are determined and why they change. B. The offer curve and the terms of trade are used extensively in later chapters, so the foundation established in this chapter is very important. We find it useful to stress that, unlike other concepts to which the students have been exposed, the offer curve is both a supply curve (of exports) and a demand curve (for imports). C. The “tabular approach” to deriving an offer curve developed in Concept Box 1 seems to be interesting to students. It is also useful because it drives home the point about the offer curve being both a supply curve and a demand curve. In addition, adding another row or two to the table with appropriately-chosen numbers can yield a “backward-bending” offer curve that is understandable. D. The nature of the shifts in Country II’s offer curve discussed and illustrated on page 113 should be emphasized. For some unknown reason, students often seem to think that an “increased willingness to trade” by the country whose exports are on the vertical axis means a pivot of that country’s curve downward and to the right. E. The use in class of the latest export and import price indexes from the IMF’s International Financial Statistics to demonstrate calculation of the commodity terms of trade seems to be of interest to students. F. We’ve never quite puzzled out why, but some students often seem to confuse “terms of trade” with “balance of trade.” It is useful to distinguish between these very different concepts. V.

Answers to End-of-Chapter Questions and Problems

1. A change in tastes by the home country’s consumers toward greater relative preference for the import good would increase the willingness of the country to trade. In addition, a rise in income (provided that imports as a whole are not “inferior goods”) would also make the country more willing to trade at each terms of trade. Other events leading to greater willingness to trade would be, for example, increased productivity in the export industry and trade negotiations that resulted in a lowering of trade barriers by the home country. 2. If the demand increase for the export good is by the foreign country, the terms of trade will improve by an equal amount in either instance. If the country is large, the normal upward shift in the foreign offer curve occurs; if the country is small, the straight-line offer curve by the foreign country pivots to higher terms of trade for the home country. If the demand increase for the export good is by home country citizens, the home country’s offer curve pivots inward. If the

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Chapter 07 - Offer Curves and the Terms of Trade

country is large, the terms of trade will improve, but, if the home country is small, there will be no impact on the terms of trade since a small country faces a foreign offer curve that is a straight line from the origin. 3. The terms of trade for country I will definitely deteriorate, since both shifts are working in that direction. However, the impact on the volume of trade is indeterminate without more information. Assuming that country I is operating in the “elastic” portion of its offer curve, the increased willingness to trade by I will lead to an expansion of both its exports and imports (if country II is operating on the “elastic” portion of II’s curve) and to an expansion of I’s exports and a contraction of I’s imports (if country II is operating on the “inelastic” portion of II’s curve). The reduced willingness to trade by country II will lead to a contraction of both the exports and imports of country I regardless of the elasticity range of II’s curve. The net effect on I’s exports is indeterminate always and depends on the relative extent of the offer curve shifts; the net effect on I’s imports is indeterminate if country II is operating in its “elastic” range and a decline if II is operating in its “inelastic” range. If country I is operating in the “inelastic” portion of its offer curve both before and after the two shifts, the result will be a greater volume of exports by I if II’s curve is “elastic” but export volume could be less if II is in its “inelastic” range; the volume of I’s imports can either increase or decrease with either range of II’s curve. (We assume that the equilibrium positions are “stable” equilibria and, of course, that both countries are “large” countries. You may also wish to assume for your class, as we usually do, that both countries always operate in the “elastic” ranges of their offer curves, which makes the answers to this question and to Question #4 below considerably simpler.) 4. With both countries operating in the “elastic” ranges of their offer curves, the volume of country I’s exports and imports will definitely decrease. However, the terms of trade impact (under all elasticity assumptions) is indeterminate without more information. Country I’s decreased willingness to trade will improve its terms of trade, but country II’s decreased willingness to trade will cause deterioration in I’s terms of trade. The net impact therefore depends on the relative extent of the offer curve shifts. If country I is operating in the “inelastic” portion of its offer curve, the volume of its imports decreases but the volume of its exports can increase if country II is in its “elastic” range. If country II is also operating in the “inelastic” portion of its offer curve, the volume of I’s exports will decrease but the volume of I’s imports can actually increase. 5. The excess supply of exports of one good (say good X) means that, at the given terms of trade, one country (say country I) is willing to provide a greater quantity of good X on the world market than country II is willing to purchase at those terms of trade. PX/PY (with Y being II’s export good) is thus higher than the equilibrium terms of trade. Because PX/PY is “too high,” this must mean that PY/PX is “too low” or below the equilibrium level. A relative price of good Y below the equilibrium level means that there is excess demand for good Y. Alternatively, because a supply of exports reflects a demand for imports in the offer curve analysis, a supply of good X from I that exceeds the demand for good X by II must be associated with a demand for good Y by I that exceeds the supply of good Y coming forth from country II at the given terms of trade.

Chapter 07 - Offer Curves and the Terms of Trade

6. In the offer curve diagram below, the initial trading equilibrium between Iraq and the rest of the world (ROW) results in terms of trade TOT1. With the greatly reduced willingness to trade by ROW, the ROW offer curve shifts downward to ROW’. The terms of trade for Iraq deteriorate to TOT2, and the volume of Iraq’s exports and imports falls dramatically. If Iraq is in the “inelastic” portion of its offer curve both before and after the ROW curve shift, Iraq could actually end up exporting a larger volume, but this situation is highly unrealistic.

7. With relatively slow growth in demand for developing countries’ products by developed countries, the developed countries’ offer curve shifts only slightly upward. With relatively rapid growth in demand by the developing countries for developed countries’ export goods, the developing countries’ offer curve shifts rightward to a relatively large extent. The terms of trade deteriorate for the developing countries. If it were postulated that the developed countries were in the “inelastic” range of their offer curve, the developing countries would experience an even greater deterioration in their terms of trade. (It is highly unlikely that the developing countries have an inelastic demand for developed countries’ goods, so that case does not need to be considered.)

8. The offer curves of the oil-importing countries were likely inelastic because the rise in the price of oil exports by OPEC resulted in greater “revenue” (export quantity in the offer curve diagram) being spent on the crude petroleum imports by any given importing country. Hence, the oil importers were in the “backward-bending” portions of their offer curves. 7-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 07 - Offer Curves and the Terms of Trade

9. “Behaving rationally” occurs even with a “backward-bending” offer curve. The underlying economic purpose of exports is to obtain imports for enhancing utility, and a rise in the relative price of exports constitutes a fall in the relative price of imports. With this fall in the price of imports, there will rationally be a rise in the quantity of imports purchased, and the exporting country will export a smaller quantity if the demand for imports is inelastic. Alternatively, the rise in the price of exports would lead to the export of a smaller quantity if the “income effect” (or “terms-of-trade effect”) of the price increase outweighs the “production effect” and the “substitution effect.” 10. The commodity terms-of-trade ratio for 2010 is 92.3 [= (120/130)100]; the income terms of trade for 2010 are 106.2 [= (120115)/130]. Thus the commodity terms of trade deteriorated from 2000 to 2010 while the income terms of trade improved. This could certainly occur if the relative decline in export prices stimulated an elastic response of quantities demanded of the country’s exports. VI.

Sample Exam Questions

Essay Questions

1. Suppose that a home country is contemplating the imposition of a tariff in order to improve its terms of trade by a given amount. How would the decision as to the size of the tariff to impose depend on the elasticity of the foreign country’s offer curve? Explain. 2. Suppose that, from an initial equilibrium position in the offer curve diagram, country I imposes a tariff on country II’s export good at the same time that consumers in country II change their tastes toward wanting more of II’s export good. Illustrate and explain the impact of these two simultaneous events on country I’s volume and terms of trade. (Assume that both countries’ offer curves are “elastic” throughout.) 3. When Spain and Portugal joined the European Community (EC) in 1986, the United States feared that a result of this change might be a shift in demand for agricultural products by Spain and Portugal away from the United States and toward other Community members. In response, the United States threatened to impose stiff tariffs on a variety of exports of the rest of the EC to the United States. Using offer curve diagrams for (a) the United States and Spain/ Portugal, (b) Spain/Portugal and the rest of the EC, and (c) the United States and the rest of the EC, illustrate and explain the effects of these potential events on the terms of trade and volume of trade for the various economic units.

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Chapter 07 - Offer Curves and the Terms of Trade

4. Given the following table showing possible terms of trade for country I and country I’s corresponding demand for imports of good Y at each terms of trade: possible terms of trade

I’s quantity demanded of imports of Y

(a)

1X:1Y or PX/PY = 1

20 units

(b)

1X:2Y or PX/PY = 2

46 units

(c)

1X:3Y or PX/PY = 3

69 units

(d)

1X:4Y or PX/PY = 4

84 units

Calculate the supply of exports of good X by country I at each terms of trade and plot the resulting offer curve. What is the nature of the elasticity of demand for imports between [i] points (a) and (b); [ii] points (b) and (c); and [iii] points (c) and (d)? How do you know? What might account for these respective elasticities? 5.

Given the following indexes for country I in 2012, with 2005 = 100: price of exports = 108

quantity of exports = 116

price of imports = 120

quantity of imports = 102

(a) Calculate country I’s net barter or commodity terms of trade for 2012 (round to nearest one decimal place if necessary). (b) Calculate country I’s income terms of trade for 2012 (round to nearest one decimal place if necessary). (c) Explain your differing results for (a) and (b) and briefly explain the significance of each terms-of-trade movement for country I. 6.

“If we observe that a home country’s volume and terms of trade are both moving in the same direction (i.e., either both increasing or both decreasing), then we can surmise that the home country’s offer curve is shifting. However, if we observe that the home country’s volume and terms of trade are moving in opposite directions (i.e., one is increasing and the other is decreasing), then we can surmise that the foreign offer curve is shifting.” Is this statement correct or incorrect? Illustrate and explain your answer. (Assume “elastic” offer curves throughout.)

Chapter 07 - Offer Curves and the Terms of Trade

7. (a) Define the “offer curve” (or “reciprocal demand curve”) of a country. If an offer curve is drawn as an upward-sloping curve, what is being assumed about the value of the country’s elasticity of demand for imports and why does this assumption yield the upward-sloping curve? (b) Using the usual two-good, two-country offer-curve diagram, identify the equilibrium position and state why the position is one of equilibrium. Then suppose that, from this initial equilibrium position, one country now experiences an increase in productivity in its export industry at the same time that the other country imposes an import tariff. Illustrate and explain the combined or overall impact of these two events on the equilibrium terms of trade and on the quantity traded of each of the two goods. If a combined impact is uncertain, briefly indicate why it is uncertain. 8.

(a) Define the theoretical concept of a country’s “offer curve” (or “reciprocal demand curve”). Then, using a numerical example, construct three points on a country’s offer curve, assuming that the country (call it “country A”) exports wheat and imports clothing. (b) Put the offer curve of country A [you do not need to use your specific numbers from part (a) of this question in this part (b)] together with the offer curve of trading partner country B. Explain how the equilibrium position is attained if the countries initially are in a situation that is not a position of equilibrium. (You can assume that the countries are always operating in the “elastic” portions of their offer curves.) (c) Finally, suppose that country B’s consumers change their tastes so that they now have greater preference for country A’s export good than they did previously. Illustrate and carefully explain the movement from the old equilibrium position to the new equilibrium position because of this change in tastes, assuming other things equal. Be sure to include an indication of the impact on country A’s terms of trade and volume of trade.

(a) Define the concept of a country’s (call it country A’s) offer curve. Will this curve always be upward-sloping? Briefly, why or why not? (b) Put country A’s offer curve together with the offer curve of a trading partner country (call it country B) and indicate the equilibrium position. Then suppose that, from this equilibrium position, country A’s consumers now change their tastes toward wanting relatively more of A’s export good at the same time that country B reduces its tariff on A’s export good. Explain the impact of each event separately on the volume of trade of each good and on the terms of trade. Then indicate whether it is possible to assess, when the new equilibrium position is attained, the net results of the two shifts together on the volume of trade of each good and on the terms of trade (in comparison with the initial equilibrium). (Assume that the offer curves are “elastic” throughout.)

Chapter 07 - Offer Curves and the Terms of Trade

Multiple-Choice Questions

10.

The “income terms of trade” index would be calculated by which one of the following formulas (where PX = price index of exports, PM = price index of imports, QX = quantity index of exports, and QM = quantity index of imports)? a. (PX/PM)100 b. (QM/QX)100 * c. (PXQX)/PM d. (PXQX)/(PMQM )100

11.

In deriving an offer curve for a country, if a higher price of exports/price of imports leads to a reduction in the quantity of exports which the country is willing to supply, then, in this range of the offer curve, the offer curve is said to be __________. * a. inelastic b. unit-elastic c. elastic d. inelastic, unit-elastic, or elastic – cannot be determined without more information

12.

If country I is trading in the inelastic range of country II’s offer curve, then the imposition of a tariff by country I, which still leaves country I in the inelastic range of country II’s curve, will (assuming no retaliation) lead to __________ in country I’s terms of trade and to __________ in the volume of imports of country I. a. a deterioration; a decrease b. a deterioration; an increase c. an improvement; a decrease * d. an improvement; an increase

13.

In the following partially-completed table showing country I’s demand for import good Y and supply of export good X at various terms of trade, TOT

Y demanded

X supplied

4Y:1X 3Y:1X 2Y:1X

400Y v 300Y

100X 120X w

a. v = 40Y; w = 600X * b. v = 360Y; w = 150X c. v = 350Y; w = 140X d. v = 360Y; w = 140X

Chapter 07 - Offer Curves and the Terms of Trade

14.

In an offer curve graph with country A’s exports on the horizontal axis and country B’s exports on the vertical axis, which one of the following events will shift or pivot country A’s offer curve to the right? a. the imposition of a tariff by country B b. a decrease in demand by A for B’s products * c. a tariff reduction by A on B’s products d. an increase in demand by B for A’s products

15.

Suppose that country I is importing good Y and exporting good X. At a terms of trade of 1X:4Y, country I is willing to import 60 units of Y and to export 15 units of X in exchange; at a terms of trade of 1X:5Y, country I is willing to import 70 units of Y and to export 14 units of X in exchange. Considering just these two offer curve points, country I’s demand for imports between the two points is __________. a. elastic b. unit-elastic * c. inelastic d. elastic, unit-elastic, or inelastic – cannot be determined without more information

16.

In an offer curve graph with country A’s exports on the horizontal axis and country B’s exports on the vertical axis, which one of the following events will shift or pivot country B’s offer curve downward (or to the right)? a. decreased demand by A for B-goods b. technological improvement in B’s industries c. imposition of a tariff by A * d. imposition of a tariff by B

17.

International Monetary Fund data indicate that, with 2005 = 100.0, Thailand’s export price index for 2011 was 104.7 and Thailand’s import price index for 2011 was 111.1. Further, with 2005 = 100.0, the export price index for 2011 for the United Kingdom was 118.5 and the import price index for 2011 for the United Kingdom was 121.0. With this information, an economist would say that, from 2005 to 2008, Thailand experienced __________ in its commodity terms of trade and the United Kingdom __________ in its commodity terms of trade. * a. a deterioration; also experienced a deterioration b. a deterioration; experienced an improvement c. an improvement; experienced a deterioration d. an improvement; also experienced an improvement

Chapter 07 - Offer Curves and the Terms of Trade

18.

In the following offer curve diagram,

at TOT1, there is excess demand for __________, and the movement to equilibrium will result in better terms of trade for __________. *a. wine; France b. wine; Korea c. clothing; France d. clothing; Korea 19.

In the graph in Question #18 above, suppose that, when trade is taking place at the equilibrium position, consumers in France now change tastes and shift their demand more toward clothing and away from wine. This change in tastes would * a. cause France’s offer curve to shift or pivot downward and to the right. b. cause France’s offer curve to shift or pivot upward and to the left. c. cause Korea’s offer curve to shift or pivot upward and to the left. d. cause Korea’s offer curve to shift or pivot downward and to the right.

20.

Suppose that a country is exporting good X and importing good Y. Suppose also that, in a particular range of the country’s offer curve, a rise in the relative price of X causes the country to export less of X and to import more of Y. Then, in this range, a. with respect to good Y, the “income effect” of a rise in the terms of trade outweighs the “substitution effect” and the “production effect.” b. with respect to good X, the “substitution effect” of a rise in the terms of trade outweighs the “income effect” and the “production effect.” c. with respect to good X, the “production effect” of a rise in the terms of trade outweighs the “substitution effect” and the “income effect.” * d. with respect to good X, the “income effect” of a rise in the terms of trade outweighs the “substitution effect” and the “production effect.”

Chapter 07 - Offer Curves and the Terms of Trade

21.

In the following offer curve diagram,

if, starting from the initial equilibrium point E, countries A and B both increase their demand for computers, then country A’s terms of trade will __________ and the volume of A’s exports will __________. a. improve; fall * b. improve; rise, fall, or stay the same (cannot be determined without more information) c. deteriorate; rise d. improve, deteriorate, or stay the same (cannot be determined without more information); rise 22.

A “small” country in international trade is defined as a. a country that can influence its volume of trade. b. a country that can influence its terms of trade. c. a country that cannot influence its volume of trade. * d. a country that cannot influence its terms of trade.

23.

In an offer curve diagram with country A’s export good (country B’s import good) on the horizontal axis and country B’s export good (country A’s import good) on the vertical axis, which one of the following events will shift or pivot country B’s offer curve upward (or to the left)? a. increased demand by A for B’s export good b. technological improvement in A’s export industry c. imposition of a tariff by B * d. a change in tastes by B’s consumers toward wanting more of A’s export good and less of B’s export good

24.

Suppose that country I is importing good Y and exporting good X. At a terms of trade of 1X:4Y, country I is willing to import 60 units of Y and to export 15 units of X in exchange; at a terms of trade of 1X:5Y, country I is willing to import 75 units of Y and to export 15 units of X in exchange. Considering just these two offer curve points, country I’s demand for imports between the two points is __________. 7-4

Chapter 07 - Offer Curves and the Terms of Trade

a. elastic * b. unit-elastic c. inelastic d. elastic, unit-elastic, or inelastic – cannot be determined without more information 25.

In the following offer curve diagram, showing one normally-shaped offer curve and one straight-line offer curve,

Germany is exporting good __________, and __________ is a “small country” in this particular situation. a. X; France b. X; Germany c. Y; France * d. Y; Germany 26.

In a two-commodity, two-country trading world (as in the offer curve diagrams), if, at a given terms of trade (price of good X ÷ price of good Y), there is an excess demand for good X, then there must __________ and the price of good X relative to the price of good Y will therefore __________. a. also be an excess demand for good Y; rise b. also be an excess demand for good Y; rise, fall, or not change – cannot be determined without more information * c. be an excess supply of good Y; rise d. be an excess supply of good Y; fall

27.

International Monetary Fund data indicate that, with 2005 = 100.0, Sweden’s export price index in 2011 was 129.7, its import price index in 2011 was 133.3, its export quantity index in 2011 was 115.9, and its import quantity index in 2011 was 129.0. Given this information, a calculation of Sweden’s “income” terms of trade for 2011 would give a result of __________. a. 87.4 * b. 112.8 7-2

Chapter 07 - Offer Curves and the Terms of Trade

c. 119.1 d. 132.6 28.

Suppose that country I is importing good Y and exporting good X. At a terms of trade of 1X:3Y, country I is willing to import 90 units of Y and to export 30 units of X in exchange; at a terms of trade of 1X:4Y, country I is willing to import 128 units of Y and to export 32 units of X in exchange. Considering just these two offer curve points, country I’s demand for imports over the range between these two points is __________. a. inelastic b. unit elastic * c. elastic d. inelastic, unit elastic, or elastic – cannot be determined without more information

Chapter 08 - The Basis for Trade: Factor Endowments and the Heckscher-Ohlin Model

CHAPTER 8 THE BASIS FOR TRADE: FACTOR ENDOWMENTS AND THE HECKSCHER-OHLIN MODEL Learning Objectives: ■ ■ ■ ■

Examine how relative factor endowments affect relative factor prices. Demonstrate how different relative factor prices generate a basis for trade. Explain how trade affects relative factor prices and income distribution. Analyze how real-world phenomena can modify Heckscher-Ohlin conclusions.

Outline Introduction - Do Labor Standards Affect Comparative Advantage? Supply, Demand, and Autarky Prices Factor Endowments and the Heckscher-Ohlin Theorem - Factor Abundance and Heckscher-Ohlin - Commodity Factor Intensity and Heckscher-Ohlin - The Heckscher-Ohlin Theorem - The Factor Price Equalization Theorem - The Stolper-Samuelson Theorem and Income Distribution Effects of Trade in the Heckscher-Ohlin Model - Conclusions Theoretical Qualifications to Heckscher-Ohlin - Demand Reversal - Factor-Intensity Reversal - Transportation Costs - Imperfect Competition - Immobile or Commodity-Specific Factors - Other Considerations Summary

II.

Special Chapter Features In the Real World: Relative Factor Endowments in Selected Countries In the Real World: Relative Factor Intensities in Selected Industries, 2006 Titans of International Economics: Paul Anthony Samuelson (1915-2009) In the Real World: The Effects of International Cartels Concept Box 1: The Specific-Factors Model and the Real Wage of Workers

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Chapter 08 - The Basis for Trade: Factor Endowments and the Heckscher-Ohlin Model

III.

Purpose of Chapter

The purpose of this chapter is to explain the underlying bases for trade, i.e., to explain the existence of different relative autarky prices in different countries. Particular attention is paid to factor endowments, factor intensities, the Heckscher-Ohlin theorem, the factor-price equalization process, and qualifications to the Heckscher-Ohlin explanation. IV.

Teaching Tips

A. The chapter begins with an examination of labor standards in developing countries. The article chosen investigates the possibility that a developing country can increase its relative abundance of unskilled labor by lowering labor standards, thereby enhancing a comparative advantage. This is a nice starting point for students because it uses a relatively controversial current issue to expose them to the concept of relative factor abundance and examines its potential impact on comparative advantage. B. In teaching the Heckscher-Ohlin paradigm and the resulting trade theorems, it is extremely important to lay out carefully the central assumptions of the model. In particular, it is crucial that students understand the concept of relative factor abundance from both the physical and price perspectives. It is useful to emphasize that the two definitions will necessarily give the same ranking of factor abundance only when demand is identical in the two countries. C. The second critical assumption to emphasize is the assumption of identical relative factor intensity across commodities. Students often do not grasp the idea that according to this assumption, commodities have the same relative factor intensity regardless of where they are produced in the world. D. Once the basis for trade (the Heckscher-Ohlin theorem) has been established, focus on the nature of the adjustment process that will accompany the opening of trade between the two countries. In discussing the factor-price equalization theorem, we have found it useful to point out that goods movements between countries substitute for factor movements, with the same impact on factor prices. E. We encourage you to spend some time on the income distribution effects of trade. Students not only find it interesting, but it is necessary to understanding much of the political economy of trade policy. We have found it effective to begin with the Stolper-Samuelson theorem, and then contrast it with the results of the specific-factors model. We have taken special care in the text to consider the case of specific factors inasmuch as factors appear to be less than perfectly mobile in the short run. F. The material that examines the impact of relaxing several of the H-O assumptions should not be slighted. We think that it provides a good background for Chapter 9’s focus on empirical tests of the H-O model.

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Chapter 08 - The Basis for Trade: Factor Endowments and the Heckscher-Ohlin Model

G. In Figure 15 on page 152, we have shown the price effect of the opening of the country to trade – a rise is PX/PY of 10 percent – as a shift upward of DLX (= MPPLX·PX) of 10 percent. Thus we are attributing the rise in PX/PY of 10 percent entirely to a 10 percent rise in PX. This is clearly a simplification; the actual PX/PY change of 10 percent would consist of a combination of a rise in PX and a fall in PY. To have PX shift up by, say, 6 percent and PY shift down by 4 percent could also accomplish the main point of this diagram – that the real wage falls for someone who consumes mostly the export good and rises for someone who consumes mostly the import good – but in a much more cumbersome way. You can certainly make the point by shifting the DLX curve upward and the DLY curve downward simultaneously, of course, as that is technically more accurate. V.

Answers to End-of-Chapter Questions and Problems

1. The physical definition of factor abundance is based on the relative physical amounts of the factors present in the country, e.g., the difference in the capital/labor ratios. The country whose K/L ratio is the largest is defined to be the capital-abundant country. The price definition is based on relative prices of the factors rather than on measurements of their presence in the country. It is hypothesized that the relatively-abundant factor in a country should be relatively cheaper compared to a second country. Thus, according to this definition, if the ratio of the price of capital to the price of labor is lower in one country (A) compared to a second country (B), country A is said to be the capital-abundant country. Under the assumptions of H-O, the two definitions should give the same result. However, if tastes differ between the two countries, then factor prices will not only reflect different supply conditions but also different demand conditions. In this instance the price definition and the physical definition could give conflicting conclusions about relative factor abundance. For example, if consumers in a physically capital-abundant country strongly prefer the capital-intensive product, this would bid up the price of the capital-intensive good and hence would bid up the price of capital. Therefore, other things equal, w/r would fall and could become lower than in the second country. Hence, the physically capital-abundant country could become labor abundant by the price definition. 2. According to the H-O theorem, countries should specialize in and export the product that uses relatively intensively the relatively-abundant factor. Therefore, Belgium should export capital-intensive goods to France because, by the physical definition, Belgium is the capitalabundant country. 3. The wages in the capital-abundant country should fall and the wages in the laborabundant country should rise with trade according to the factor price equalization theorem. Therefore, French wages should fall. 4. Assuming that the owners of capital are worried that the distribution of income will turn against them with trade, one concludes that the country in question must be a labor-abundant country. This follows from the Stolper-Samuelson theorem, which indicates that international trade will increase the real income of the owners of the abundant factor and lower the real

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Chapter 08 - The Basis for Trade: Factor Endowments and the Heckscher-Ohlin Model

income of the owners of the scarce factor. 5. Assuming that the country in question is a small country, the opening of the country to international trade will force the monopolist to become a price taker, i.e., to sell the product in question at the prevailing international price or lose its domestic sales. This will cause the monopolist to reduce price and expand output. Even if the country is not a small country, there would be downward price pressure as imports come into the country. In either case, if the international price were below the firm’s shutdown point (minimum average variable cost), the firm would stop producing immediately and go out of business unless it was able to become competitive internationally (reduce its cost of production). 6. If demand conditions are different between the two countries and sufficiently oriented toward the product using relatively intensively the physically relatively-abundant factor in at least one country, the relative autarky prices will be just opposite to what H-O would predict. That is, the price of the capital-intensive good will be relatively higher in the physically capitalabundant country and the price of the labor-intensive good will be relatively higher in the physically labor-abundant country. Consequently, the opening of trade will lead to a pattern of trade just opposite to that predicted by H-O, i.e., the physically capital-abundant country will export the labor-intensive good and import the capital-intensive good. If such extreme differences in demand are possible, then the H-O paradigm can no longer predict the pattern of trade between two countries when using the physical definition of relative factor abundance. Note, however, that the trade pattern still conforms to Heckscher-Ohlin when using the price definition of relative factor abundance. 7. Assume that capital is a specific factor of production, i.e., that it cannot move from the production of one product to the production of the other. As trade opens in the capital-abundant country, the country will attempt to expand production of the capital-intensive good (and export it) and contract production of the labor-intensive good (and import it). Because capital cannot move, the change in production takes place by the movement of labor from labor-intensive production to capital-intensive production. This increases the demand for labor and hence the wage rate. Owners of capital in the contracting (labor-intensive) industry find themselves with excess capacity and a falling return to capital. In the capital-intensive industry, the productivity of capital and hence the real return to capital are rising. Although the wage rate is also rising, it is not rising as fast as the price of the export (K-intensive) good due to the declining marginal productivity of labor in the production of the K-intensive good. Consequently, workers who consume only the K-intensive good will find themselves worse off. Thus, those who unambiguously stand to benefit from trade are workers who consume only the cheaper laborintensive good and the owners of capital used in the expanding capital-intensive industry (whose real income is rising). Those who unambiguously stand to lose are workers who consume only the capital-intensive good and owners of capital used in the production of the labor-intensive product (whose real income is falling). 8. You should not be surprised if the composition of trade changed. Before the upheavals in Eastern Europe and the Soviet Union, the majority of trade of most of the Eastern European countries was with each other and with the Soviet Union through a managed and negotiated 8-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 08 - The Basis for Trade: Factor Endowments and the Heckscher-Ohlin Model

framework. With the dissolution of the Soviet Union and the opening of trade with the West, prices began to reflect more accurately the true scarcity values of goods, and the Eastern European countries were also exposed more fully to a new set of potential trading partners. Hence, the relative factor endowments of the Eastern European countries vis-à-vis trading partners and the ability to respond to those endowments changed. Given the new relative scarcities, Heckscher-Ohlin analysis would tell us that new comparative advantages and hence a new pattern of exports and imports would emerge. For example, Hungary is most likely capital abundant relative to Romania but labor-abundant relative to Austria; a change in trading partners from Romania to Austria would clearly affect Hungary's trade pattern. 9. Given that the specific-factors PPF intercepts the good X axis at a point to the left of the point where the “normal” PPF intercepts the axis, that the economy is characterized by increasing costs, and that only labor is being transferred from industry Y to industry X in the movement from A’ to C’, the slope of the specific-factors PPF at C’ is necessarily steeper than the slope of the “normal” PPF at B’. Consequently, a change in relative prices that would lead to optimal production at B’ where [(PX/PY) = (MCX/MCY)] will be tangent to the specific-factors PPF at a point somewhere between C’ and A’. The presence of factor immobility increases the relative marginal cost of increasing production of good X and, hence, reduces the production response to the relative increase in PX. 10. This statement is correct because complete factor-price equalization can take place in the Heckscher-Ohlin framework only if product prices are the same in the two countries with trade. In the presence of transportation costs, the price of any good will differ between two countries by the amount of transportation costs. Hence, because product prices are not the same, factor-price equalization will not take place. 11. In this case, the apparent contradiction of the Heckscher-Ohlin model could be explained by factor-intensity reversal. In the United States, agricultural production utilizes considerable capital and, thus, many agricultural commodities such as rice are relatively capital-intensive. In India, however, agricultural production uses relatively much more labor than capital and, in all likelihood, is a labor-intensive product. Since there is considerable substitutability between capital and labor in the production of, for example, rice, it would not be surprising to find that rice is a labor-intensive product in a labor-abundant country such as India and capital-intensive in a capital-abundant country such as the United States. Consequently they both end up exporting the product because it is intensive in their respective abundant factors. 12. The specific-factors model makes it clear why, for example, if capital is immobile owners of capital in an import-competing product in a capital-abundant country would oppose the initiation of international trade. This is because owners of capital in a contracting industry unambiguously are worse off with trade. Improving the mobility of capital in this instance could enable the owners of capital in these declining industries to benefit from trade instead of finding themselves strictly worse off, as they would if their capital could not be easily adapted to production of the comparative advantage good. In graphical terms, improving factor mobility would move the factor-specific PPF (Figure 14) outwards towards the “normal” PPF. Such a change would lead to greater specialization, increased real income (a consumption-possibilities 8-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 08 - The Basis for Trade: Factor Endowments and the Heckscher-Ohlin Model

frontier “farther out” from the origin), and increased trade. VI.

Sample Exam Questions

Essay Questions

1. Will the price definition of factor abundance produce the same conclusion as the physical definition of factor abundance in the presence of demand reversal? Why or why not? 2. Explain how relative factor abundance can determine the nature of trade flows between countries, making certain to point out any needed assumptions. Then, state the Heckscher-Ohlin theorem and discuss at least two situations that could lead to contradictions to this theorem. 3. Will the gains from trade be larger or smaller if one of the factors is not mobile in production? Why? Demonstrate your conclusion graphically. Is it true that if neither factor is mobile the country will receive no gains from trade? Explain. 4. It has been argued that the effect of trade in goods and services has the same effect on factor income distribution in a country as would be the case if factors were completely mobile internationally. What is the reasoning behind this argument? 5. Domestic pressures for trade protection appear to stem importantly from the expected income distribution effects of trade. What theorems or concepts would you use from this chapter to explain why we find both various labor groups and capital owners pressuring the U.S. Congress for trade protection? Explain. 6. Two of the strong assumptions underlying the H-O model are zero transportation costs and perfect competition. Explain how the presence of each might alter any of conclusions reached in the basic H-O approach. 7. Carefully explain, for each of the following two statements, why the statement is either TRUE or FALSE. (a) “In a 2x2x2 Heckscher-Ohlin context, when a relatively labor-abundant country moves from autarky to trade, the real return to capital in the importcompeting industry decreases and the real return to capital in the export industry also decreases.” (b) “In the ‘specific-factors model,’ with capital fixed in each sector, when a relatively labor-abundant country moves from autarky to trade, the real return to capital in the import- competing industry decreases and the real return to capital in the export industry also decreases.” 8. In the context of the “specific-factors model,” explain the income distribution impacts within a relatively labor-abundant country of a movement from autarky to a situation of free 8-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 08 - The Basis for Trade: Factor Endowments and the Heckscher-Ohlin Model

trade. How and why are these impacts at variance with the impacts that would occur according to the Stolper-Samuelson theorem? Carefully explain. 9.

(a) State the Heckscher-Ohlin theorem. Then, in the context of a 2x2x2 model and using the “price definition” of relative factor abundance, illustrate and explain how this theorem is obtained. (b) Continuing with the “price definition” of relative factor abundance in the 2x2x2 context, carefully explain what happens (and why) to the relative factor price difference between the two countries as the countries move from autarky to free trade.

10.

(a) Assume a two-country world with two factors of production (capital and labor) and two goods. In this context, state the Heckscher-Ohlin theorem. Then indicate the two definitions of relative factor abundance. In addition, spell out what is meant by the assumption that one good is always relatively capital-intensive in its production process and the other good is always relatively labor-intensive in its production process. (b) Illustrate and carefully explain the complications that are generated for the predictive ability of the Heckscher-Ohlin theorem regarding trade patterns when (i) the phenomenon of “demand reversal” exists and (ii) the phenomenon of “factor-intensity reversal” exists.

11.

(a) In a 2x2x2 context, state the Heckscher-Ohlin theorem. Then indicate how this theorem can be obtained, utilizing the physical definition of relative factor abundance.

(b) When a country enters into trade in accordance with the Heckscher-Ohlin theorem, what happens to the real income of the country’s relatively abundant factor of production and what happens to the real income of the country’s relatively scarce factor of production? Carefully explain. B.

Multiple-Choice Questions

12.

If relatively capital-abundant country A opens trade with relatively labor-abundant country B and the trade takes place in accordance with the Heckscher-Ohlin theorem, what would be the consequence for factor prices (w/r) in the two countries? a. (w/r) rises in A and falls in B b. (w/r) rises in A and also rises in B * c. (w/r) falls in A and rises in B d. (w/r) falls in A and also falls in B

13.

An implication of the Heckscher-Ohlin theorem is that a. if two countries have identical tastes, then no trade will occur between them. b. the relative price of a country’s scarce factor of production will rise when the country is opened to trade. 8-2

Chapter 08 - The Basis for Trade: Factor Endowments and the Heckscher-Ohlin Model

c. income distribution in a country does not change when a country is opened to trade. * d. two countries with identical tastes can still have a basis for trade if factor endowments of the countries differ and if factor intensities of the commodities differ. 14.

If a commodity is classified as “labor-intensive” at one set of relative factor prices but “capital-intensive” at another set of relative factor prices, this situation is known as a. demand reversal. * b. factor-intensity reversal. c. balance-of-payments reversal. d. factor price reversal.

15.

In the situation of “demand reversal” in a 2x2x2 context where all the assumptions of the Heckscher-Ohlin analysis hold except for the assumption of identical demands across countries, and when the countries are trading with each other, a. one country will be conforming to the trade pattern predicted by the Heckscher-Ohlin theorem but the other country will not be conforming to that pattern. * b. both countries will be conforming to the trade pattern predicted by the HeckscherOhlin theorem if the “price” (or “economic”) definition of relative factor abundance is used but not if the “physical” definition of relative factor abundance is used. c. both countries will be conforming to the trade pattern predicted by the HeckscherOhlin theorem if the “physical” definition of relative factor abundance is used but not if the “price” (or “economic”) definition of relative factor abundance is used. d. factor price equalization across the two countries cannot occur.

16.

In the following diagram showing the relationship between the price of good X relative to the price of good Y, (PX/PY), and the wage rate relative to the return to capital or rental rate on capital, (w/r),

good X is the relatively __________ good at (w/r) values less than (w/r)*, and good X is __________ good at (w/r) values greater than (w/r)*. [Note: The (PX/PY) associated with (w/r)* is the highest (PX/PY) on the graph.] a. labor-intensive; also the relatively labor-intensive * b. labor-intensive; the relatively capital-intensive 8-3 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 08 - The Basis for Trade: Factor Endowments and the Heckscher-Ohlin Model

c. capital-intensive; the relatively labor-intensive d. capital-intensive; also the relatively capital-intensive 17.

Which one of the following is NOT an assumption in the Heckscher-Ohlin analysis? a. constant returns to scale * b. imperfect competition c. identical production functions across countries d. identical tastes across countries

18.

If good A costs $10 per unit in country A and $12 per unit in country B, and if transport costs between A and B for the good are $3 per unit, an economist would say that a. the good will be exported from A to B. b. the good will be exported from B to A. c. intra-industry trade will occur in the good. * d. the good will be a “nontraded good.”

19.

The “magnification effect” refers to the fact that, when a country is opened to trade, a. the price of the export good rises. b. real income is magnified even though the PPF does not change. * c. the price of the abundant factor rises faster than does the price of the export good. d. the price of the scarce factor rises.

20.

Suppose that a firm is maximizing profit in its home market at output Q1 and price P1 in the following graph:

If the firm now has the opportunity to sell overseas at given world price P2 and the firm can practice “dumping,” which one of the following will NOT happen? a. Total output of the firm will become greater than Q1. b. Home market price will rise above P1. c. The firm will increase its profits by engaging in “dumping.” * d. The firm will maintain its home market price at P1 and will sell abroad at price P2. 21.

The Stolper-Samuelson theorem suggests that, when a country is opened to international trade, the real income of the country’s abundant factor of production will __________ 8-4

Chapter 08 - The Basis for Trade: Factor Endowments and the Heckscher-Ohlin Model

and the real income of the country’s scarce factor of production __________. a. rise; also will rise * b. rise; will fall c. fall; will rise d. fall; also will fall 22. In a two-country world, if country A is the relatively labor-abundant and country B is the relatively capital-abundant country by the “price” definition of factor abundance (and where w is the wage rate and r is the return to capital), then __________. When the countries move from autarky to Heckscher-Ohlin-type trade, the result will be that __________. * a. (w/r)A < (w/r)B; (w/r)A will rise and (w/r)B will fall b. (w/r)A < (w/r)B; (w/r)A will fall and (w/r)B will rise c. (w/r)A > (w/r)B; (w/r)A will rise and (w/r)B will fall d. (w/r)A > (w/r)B; (w/r)A will fall and (w/r)B will rise 23.

Given the following diagram that shows the relationship between the price of good X relative to the price of good Y (PX/PY) and the wage rate relative to the return to capital or rental rate on capital (w/r), and also indicates relative factor prices in country A [(w/r)A], relative factor prices in country B [(w/r)B], relative autarky goods prices in country A [(PX/PY)A], relative autarky goods prices in country B [(PX/PY)B], and (w/r)* [where the (PX/PY) associated with (w/r)* is the highest (PX/PY) on the graph]:

At (w/r) values less than (w/r)*, __________ is the relatively labor-intensive good and, at (w/r) values greater than (w/r)*, __________ the relatively labor-intensive good. * a. good X; good Y is b. good X; good X also is c. good Y; good Y also is d. good Y; good X is 24.

In the graph in Question #23 above, if the two countries are opened to trade with each 8-5

Chapter 08 - The Basis for Trade: Factor Endowments and the Heckscher-Ohlin Model

other, country A will export __________ and country B __________. a. good X; will export good Y b. good X; also will export good X because there has been a factor-intensity reversal c. good Y; also will export good Y because there has been a factor-intensity reversal * d. good Y; will export good X 25.

In the following diagram,

at factor prices (w/r)I, good X is the __________, and, at factor prices (w/r)II, good Y is the __________. * a. labor-intensive good; labor-intensive good b. labor-intensive good; capital-intensive good c. capital-intensive good; labor-intensive good d. capital-intensive good; capital-intensive good 26.

If skilled labor is physically more abundant relative to unskilled labor in country I than in country II, but yet skilled labor is relatively higher-priced in comparison to unskilled labor in country I than in country II, this phenomenon could be accounted for by a. factor-intensity reversal. b. the “specific factors” model. * c. demand reversal. d. factor-price equalization between the two countries.

27.

Which one of the following is NOT an assumption made in the standard 2x2x2 Heckscher-Ohlin analysis? a. The production function for a given good is the same in both countries. b. If a particular good is the relatively labor-intensive good at one set of relative factor prices, then it is also the relatively labor-intensive good at any other set of relative factor prices. * c. A given relative commodity price ratio, say (PX/PY)1, can be associated with more than one relative factor price ratio, e.g., say with (w/r)1 as well as with (w/r)2. d. Tastes and preferences (i.e., the community indifference curve maps) are identical in the two countries. 8-6

Chapter 08 - The Basis for Trade: Factor Endowments and the Heckscher-Ohlin Model

28.

In the “specific-factors” model where capital in each sector is fixed but labor can move freely between the two sectors, the opening of the country to trade will increase the real return to capital in the __________ sector and will increase the real wage of a worker who __________. * a. export; consumes mostly the import good b. export; consumes mostly the export good c. import-competing; consumes mostly the import good d. import-competing; consumes mostly the export good

29.

Suppose that we are in a two-factor, two-country world where the factors of production are labor (L) and land (T), the returns to the factors are the wage rate (w) and the rental rate on land (t), and the countries are country A and country B. In this situation, country A is land-abundant relative to country B by the physical definition of relative factor abundance if __________, and country A is land-abundant relative to country B by the price (or economic) definition if __________. * a. (L/T)A < (L/T)B; (w/t)A > (w/t)B b. (L/T)A < (L/T)B; (w/t)A < (w/t)B c. (L/T)A > (L/T)B; (w/t)A > (w/t)B d. (L/T)A > (L/T)B; (w/t)A < (w/t)

30.

If country I is defined as “relatively capital-abundant” in relation to country II by the “price” (or “economic”) definition of factor abundance, then the price of labor relative to the price of capital is __________ in country I than in country II, and the HeckscherOhlin theorem would suggest that country I would export relatively __________ goods to country II. * a. higher; capital-intensive b. higher; labor-intensive c. lower; capital-intensive d. lower; labor-intensive

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Chapter 08 - The Basis for Trade: Factor Endowments and the Heckscher-Ohlin Model

31.

In the 2x2x2 Heckscher-Ohlin analysis, if an relatively labor-abundant country is opened to trade, then, as the movement to trade takes place, the capital/labor ratio used in the country’s export industry will __________ and the capital/labor ratio used in the country’s import-competing industry __________. a. increase; will decrease * b. increase; also will increase c. decrease; also will decrease d. decrease; will increase

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Chapter 09 - Empirical Tests of the Factor Endowments Approach

CHAPTER 9 EMPIRICAL TESTS OF THE FACTOR ENDOWMENTS APPROACH Learning Objectives: ■ ■ ■ ■

Analyze the failure of U.S. trade patterns to conform to Heckscher-Ohlin predictions. Examine possible explanations for the U.S. trade paradox. Describe issues arising from multi-country Heckscher-Ohlin tests. Assess the role of trade in generating growing income inequality in developed countries.

Outline Introduction - Theories, Assumptions, and the Role of Empirical Work The Leontief Paradox Suggested Explanations for the Leontief Paradox - Demand Reversal - Factor-Intensity Reversal - U.S. Tariff Structure - Different Skill Levels of Labor - The Role of Natural Resources Other Tests of the Heckscher-Ohlin Theorem - Factor Content Approach with Many Factors - Technology, Productivity, and “Home Bias” Heckscher-Ohlin and Income Inequality Summary

II.

Special Chapter Features In the Real World: Capital/Labor Ratios in Leading Export and Import Industries – Leontief Test In the Real World: Heckscher-Ohlin and Comparative Advantage In the Real World: Trade and Income Inequality in a Less Developed Country: The Case of Mozambique In the Real World: Outsourcing and Wage Inequality in the United States

III.

Purpose of Chapter

The main purpose of this chapter is to summarize various tests of the Heckscher-Ohlin theorem as a predictor of trade patterns among countries, in order to acquaint students not only with the applicability/non-applicability of Heckscher-Ohlin in practice but also with relevant testing techniques. In addition, we have included material on the growing income inequality in the United States and other countries so as to make students aware of the potential causal role of Heckscher-Ohlin trade in the phenomenon. As with the H-O theorem itself as the underlying basis of trade, there is also considerable controversy pertaining to the empirical importance of H-O trade in leading to the increased inequality. After digesting this chapter, students should 9-1 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 09 - Empirical Tests of the Factor Endowments Approach

have developed an appreciation of the difficulties of testing hypotheses in economics, as well as recognition that H-O has not been conclusively demonstrated to be empirically valid and that other factors besides trade may have played a role in the emergence of the greater inequality. IV.

Teaching Tips

A. The chapter begins with a discussion of a broader role for empirical work in international trade. Davis and Weinstein (Eastern Economic Journal, Fall 1996) suggest that empirical work can be a key to analyzing the assumptions associated with different theories. This is exactly what students need to be doing in this chapter. Through examining the various tests of the Heckscher-Ohlin theorem, the students will increase their understanding of the strict assumptions made in the model and can determine which assumptions are crucial. B. Very few undergraduates seem familiar with input-output analysis. If time permits, elaboration of that valuable analytical technique can be useful. C. The material in the first “In the Real World” box is not usually covered in textbook discussions of the Leontief paradox. Several of our referees found it interesting and worth including, and you might want to discuss it to some extent since it tends to buttress the conclusion about a “paradox.” D. Students always seem to have trouble understanding the Minhas test of factor-intensity reversals. You should explain this carefully, emphasizing how strong the assumption of “no factor-intensity reversals” really is. E. Because there are continuing tests of Heckscher-Ohlin appearing in the literature, we suggest that you supplement the “more recent tests” section of the chapter with later work as it comes out. This section of the text can become outdated rather quickly. A useful book is Robert E. Baldwin, The Development and Testing of Heckscher-Ohlin Trade Models: A Review (Cambridge, MA: The MIT Press, 2008). F. The issue of inequality is one that excites interest, perhaps because it is one that students seem not to have thought about in any systematic way. In addition, our experience is that many of our students come from families well above the median income level and don’t really realize it, so discussion of inequality is eye-opening to them. We suggest that you have students find data on inequality (say, for the United States, from the Census Bureau’s Current Population Reports or Statistical Abstract of the United States, or, for many other countries, from the World Bank’s World Development Indicators) and present them to the class. Further, a mini-debate on the role of trade in inequality can be very worthwhile, if time permits. G. The material in the fourth “In the Real World” box provides a nice opportunity to examine the (politically-sensitive) issue of outsourcing with students.

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Chapter 09 - Empirical Tests of the Factor Endowments Approach

Answers to End-of-Chapter Questions and Problems

1. The Leontief paradox was the finding by Wassily Leontief in 1953 that the capital/labor ratio utilized in U.S. import-substitute industries when weighted by import importance was greater than the capital/labor ratio utilized in U.S. export industries when weighted by export importance. This finding suggested that the United States was importing relatively capitalintensive goods on average and was exporting relatively labor-intensive goods on average. This result was contrary to the trade pattern expected from the Heckscher-Ohlin theorem, since the United States was generally thought to be a relatively capital-abundant country. 2. This is a judgmental question because several explanations involving demand reversal, factor-intensity reversals, the U.S. tariff structure, labor skills, and natural resources have been offered to account for the paradox. In general, however, the major defect seems to be that the Leontief test utilized a two-factor model, that is, it failed to differentiate labor according to various skill categories and to allow for the role of natural resources. Subsequent studies have suggested that U.S. exports might be relatively “skilled labor-intensive” or “human capitalintensive,” and that imports may be relatively intensive in natural resources as well as in relatively unskilled labor. 3. With factor-intensity reversal, suppose U.S. exports that would be produced abroad by relatively capital-intensive techniques are produced with relatively labor-intensive techniques in the United States. In addition, suppose that U.S. imports that are relatively labor-intensive in production in the supplying countries are produced in relatively capital-intensive fashion in the United States. If the United States is relatively capital-abundant, it is thus importing goods that would be classified as relatively capital-intensive in the United States and exporting goods that would be classified as being produced relatively labor-intensively in the United States. Because Leontief’s test utilized the U.S. input-output table and U.S. techniques, this yields the paradox. In the presence of demand reversal, the relative price of the good intensive in the abundant factor is higher (the relative price of the good intensive in the scarce factor is lower) compared to the relative international price. Consequently, the country will export the good that is intensive in the scarce factor and import the good that is intensive in the abundant factor. A capital- abundant country (in this case the United States) will thus be importing the capitalintensive good and exporting the labor-intensive good (using the price definition of relative factor abundance), contrary to the H-O prediction. This appeared to be the case for the United States in the initial Leontief study (hence the Leontief paradox). 4. The answers to this question will vary with student experiences. When traveling in developed countries, the students will most likely not have observed demand patterns to vary much across countries, with an emphasis on goods that are relatively “high tech” in nature or relatively capital-intensive in production (such as DVD players, automobiles, cell phones, personal computers). In developing countries, some of these same items will be observed in urban areas, but food and simple clothing items (more labor-intensive goods) will be more noticeable outside the urban centers. These observations may suggest to the students that some tendency toward demand reversal exists, but travelers are not usually exposed to the capital goods and intermediate goods imports of developing countries.

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Chapter 09 - Empirical Tests of the Factor Endowments Approach

5. These barriers may reflect the desire to engage in import substitution, with the laborabundant low-income developing countries in particular feeling threatened by perceived higher quality labor-intensive products from newly-industrializing countries and developed countries. There is no necessary contradiction here with Heckscher-Ohlin if the potential imports reflect product differentiation and intra-industry trade (to be discussed in Chapter 10). Also, in light of the Stolper-Samuelson theorem, the owners of capital (the relatively-scarce factor in developing countries) may be seeking protection since freer trade will reduce the return to capital. These capital owners may also have disproportionately heavy influence in the policy-making process. 6. This answer requires some judgment on the part of the student as to the relative success of the Heckscher-Ohlin tests discussed in the chapter. Certainly the two-factor Heckscher-Ohlin model is a good candidate for being discarded in empirical work, but the multifactor approach has promise. In view of the findings of Bowen, Leamer, and Sveikauskas, and more recently Daniel Trefler and others, however, the search for other theories of trade can be useful for supplementing Heckscher-Ohlin with such influences as demand patterns, technological change, and changing comparative advantage. (These kinds of influences are discussed in Chapter 10.) Hence, perhaps a multifactor Heckscher-Ohlin approach and a “newer theories” approach should both be pursued, and an “either-or” question may not be appropriate. 7. A sample answer: The rise in income inequality in the last 10-25 years has occurred at the same time that the U.S. economy has experienced a substantial rise in its imports/GDP ratio. Because many of these imports have come from relatively labor-abundant developing countries and are relatively unskilled labor-intensive goods that were manufactured or assembled in these countries, there has been relatively less demand for domestic unskilled labor and hence downward pressure à la Stolper-Samuelson on the wages of that part of the U.S. labor force. At the same time, the United States has been exporting high-tech products that require relatively skilled labor, and thus there has been relatively increased demand for the services of this kind of labor with a consequent rise in the relative return of skilled labor. Therefore, from both the export and the import side, there has been rising inequality within the U.S. labor force. While technological change, the weakening of labor unions, and other such factors have been responsible for some of the relative factor price rise of skilled labor compared to unskilled labor, these phenomena also can be traced back to trade because the threat of global competition has induced the technological change, reduced labor union strength, and so forth. The empirical work of Adrian Wood in particular lends credence to the view that trade has been the principal mechanism that has generated the rising inequality.

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Chapter 09 - Empirical Tests of the Factor Endowments Approach

8. A sample answer: While it is clear that increased income inequality and increased U.S. openness to imports have occurred at the same time, trade is but one of several factors in today’s rapidlychanging world that have led to the greater inequality. The nature of technological change seems to be the most important factor, because the increased demand for skilled labor to work with the new technology has led to a rise in the skilled labor/unskilled labor ratio in all industries, not just in traded goods industries. Further, there is little evidence that the relative prices of unskilled labor-intensive goods to skilled labor-intensive goods have fallen, which is necessary for the Stolper-Samuelson mechanism to occur. Other factors have also played a role in the increased inequality, such as a decline in the importance of unions and a fall in the real minimum wage, and these factors are likely due to the political climate and/or to the changing structure of the American economy from manufacturing to services, rather than to trade itself. VI.

Sample Exam Questions

Essay Questions

1. How can it be said that the factor-content approach “reveals” a country’s factor abundance? What assumptions seem crucial for making this inference? Explain. 2. The text notes that, if demand reversal were the cause of the Leontief paradox, then labor would be relatively cheap in the United States. Explain the reasoning behind this statement. 3. If economists wish to determine relative factor abundance across countries, why don’t they simply calculate w/r ratios across countries and then compare these ratios? 4. The European Union has heavily protected its farm sector through import duties; in addition, the Union subsidizes its exports of agricultural products. If “cropland” is regarded as a factor of production and is included in the Leontief statistic (along with, say, labor), how would the presence of these agricultural policies affect the results of such tests? Explain. 5. If factor-intensity reversals were indeed prevalent in the real world, how might this fact be used to explain the Leontief paradox? If this explained the paradox, would it suggest that any given U.S. trading partner stood a better chance of conforming to Heckscher-Ohlin than did the United States (i.e., will a factor intensity reversal yield “incorrect” H-O results for both countries)? Why or why not? 6. Why can it be suggested that the fact that the ratio of skilled labor/unskilled labor has risen in almost all U.S. industries in recent years (and not just in traded goods industries) lends support to the view that increased inequality in the United States is not primarily due to increased Heckscher-Ohlin-type trade? How might you counter this suggestion?

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Chapter 09 - Empirical Tests of the Factor Endowments Approach

7. Explain the economic process by which it can be hypothesized that increased participation in international trade by the United States in the last several decades has led to increased income/wage inequality in the United States. Then indicate why some economists doubt that the increased trade has been such an important factor, and explain other influences that economists think might have been important. Finally, if you were to pass judgment on this matter, what would be your view of the source(s) of the increased inequality and how would you defend your view? 8.

(a) Explain how the Heckscher-Ohlin theorem is obtained, using either the “physical” definition or the “price” (or “economic”) definition of relative factor abundance. (b) Illustrate and explain the phenomenon of a “factor intensity reversal.” If two countries are trading in a situation where such a reversal has occurred, can the Stolper-Samuelson theorem still be valid for both of the countries? Briefly explain.

Multiple-Choice Questions

Suppose that, in a real-world situation, a labor-abundant country’s tariffs and nontariff barriers are levied relatively more heavily on labor-intensive goods than on capitalintensive goods. In this situation, a Leontief two-factor test would, other things equal, be __________ the country’s adherence to the Heckscher-Ohlin trade pattern, in comparison with a situation where trade barriers were absent.

* a. biased toward confirming b. biased against confirming c. unbiased in its finding concerning d. biased toward confirming, biased against confirming, or unbiased in its finding concerning – cannot be determined without more information 10.

In the production process of a final good industry, the direct factor requirements per unit of output will be __________ the total factor requirements per unit of output; if the industry is relatively capital-intensive when classified by direct requirements, it __________ be relatively capital-intensive when classified by total requirements. a. greater than; must also b. greater than; may not necessarily c. less than; must also * d. less than; may not necessarily

11.

If the capital/labor ratio in import-competing industries in country A is $8,000 per worker and the capital/labor ratio in A’s export industries is $4,000 per worker, then country A’s “Leontief statistic” is __________.

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Chapter 09 - Empirical Tests of the Factor Endowments Approach

a. 0.50 b. 0.67 c. 1.00 * d. 2.00 12.

Since about 1970, in both developed and developing countries, the ratio of trade to GDP has __________; over the same time period, in the United States and the European Union, the ratio of imports from developing countries to total imports __________. a. increased; has decreased * b. increased; also has increased c. decreased; also has decreased d. decreased; has increased

13.

The “Leontief paradox” refers to the empirical finding obtained by Wassily Leontief that, even though the United States was generally thought to be a relatively __________ country, it was found to be __________. * a. capital-abundant; exporting relatively labor-intensive goods and importing relatively capital-intensive goods b. labor-abundant; exporting relatively capital-intensive goods and importing relatively labor-intensive goods c. skilled-labor-abundant; exporting relatively unskilled-labor-intensive goods and importing relatively skilled-labor-intensive goods d. capital-abundant; exporting relatively skilled-labor-intensive goods and importing relatively unskilled-labor-intensive goods

14.

If increased Heckscher-Ohlin-type trade were the major factor leading to increased income inequality in the United States, then one would expect that the relative prices of skilled labor-intensive goods to unskilled labor-intensive goods would have __________ and that nontraded goods industries would have __________ their use of unskilled labor relative to skilled labor. a. risen; decreased * b. risen; increased c. fallen; decreased d. fallen; increased

15.

If demand reversal is the explanation for the Leontief paradox, this would imply that the demand by the United States for labor-intensive goods is relatively __________ and therefore that U.S. wages would be relatively __________ in comparison to wages in U.S. trading partners. * a. low; low b. low; high

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Chapter 09 - Empirical Tests of the Factor Endowments Approach

c. high; low d. high; high 16.

If relatively labor-abundant country A has a “Leontief statistic” greater than 1.0 and relatively capital-abundant country B has a “Leontief statistic” less than 1.0, this suggests that a. neither country is conforming to the prediction of the Heckscher-Ohlin theorem. * b. both countries are conforming to the prediction of the Heckscher-Ohlin theorem. c. country A is conforming to the prediction of the Heckscher-Ohlin theorem but country B is not. d. country B is conforming to the prediction of the Heckscher-Ohlin theorem but country A is not.

17.

A 1974 empirical study (by Steven Rosefielde) found that the “Leontief statistic” for the Soviet Union in its trade with Western industrialized nations was 1.44, and its “Leontief statistic” for its trade with developing countries was 0.43. If the Soviet Union was trading in accordance with the Heckscher-Ohlin theorem, these results suggest that the Soviet Union was relatively __________ compared to its Western trading partners and __________ compared to developing countries. a. capital abundant; was relatively labor abundant b. capital abundant; also was relatively capital abundant c. labor abundant; also was relatively labor abundant * d. labor abundant; was relatively capital abundant

18.

In roughly the last three decades, the traditional measures of income inequality (such as the Gini coefficient) have shown that the degree of inequality in the United States has __________. However, if it were the case over that time period that the prices of goods primarily consumed by high-income individuals have increased more rapidly than the prices of goods primarily consumed by low-income individuals, then “real income” inequality in the United States over that same time period would likely have been _________ than suggested by the traditional measures. a. decreased; decreased to a lesser extent b. decreased; decreased to an even greater extent * c. increased; increased to a lesser extent d. increased; increased to an even greater extent

19.

If the U.S. trade pattern is as indicated by the Leontief test, this would suggest that participation in trade rather than in autarky by the United States has __________ the real return to U.S. capital and __________ the real wage of U.S. labor. a. increased; also has increased b. increased; has decreased * c. decreased; has increased

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Chapter 09 - Empirical Tests of the Factor Endowments Approach

d. decreased; has decreased 20.

Which one of the following could NOT theoretically be offered to help in explaining the “Leontief paradox?” * a. a relatively strong U.S. demand for relatively labor-intensive goods b. relatively high U.S. tariffs on relatively labor-intensive imports c. U.S. importation of goods that are relatively natural resource-intensive in their production processes d. a relatively strong U.S. demand for relatively capital-intensive goods and/or a relatively strong foreign demand for relatively labor-intensive goods

21. In the United States, in approximately the last 2-3 decades, the supply of highly-skilled (HS) labor relative to less-highly-skilled (LS) labor has been rising. At the same time, the ratio of wages of HS labor relative to LS labor has been __________, and, therefore, the demand for HS labor relative to LS labor must have been increasing __________ than the supply of HS labor relative to LS labor. a. falling; less rapidly b. falling; more rapidly c. rising; less rapidly * d. rising; more rapidly 22.

A criticism of the argument that trade has been an important cause of increased U.S. wage inequality in recent decades is that, if trade were an important cause, the nontraded goods industries would have responded to the __________ in the price of skilled labor relative to unskilled labor by using skilled labor relative to unskilled labor. a. rise; more * b. rise; less c. fall; more d. fall; less

23.

If, as is suggested by some recent research, a country’s consumers have a preference for home goods over foreign goods that is not accounted for in the analysis, then this __________ will lead to a prediction of trade volume that is __________ than the actual amount of trade volume of the country. a. “foreign bias”; larger b. “foreign bias”; smaller * c. “home bias”; larger d. “home bias”; smaller

24.

If the Heckscher-Ohlin theorem is valid in practice (and assuming that capital and labor are treated as the only two factors in the real world), then the “Leontief statistic” for a labor-abundant country would be __________.

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Chapter 09 - Empirical Tests of the Factor Endowments Approach

* a. greater than 1.0 b. equal to 1.0 c. less than 1.0 but greater than zero d. less than zero 25. Which one of the following has NOT been offered as a reason for increased wage inequality in the United States in recent decades? a. the increased adoption by firms of skill-biased technological change * b. an increase in the strength of labor unions c. a decline in the real minimum wage d. increased imports of labor-intensive goods from developing countries

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Chapter 10 - Post Heckscher-Ohlin Theories of Trade and Intra-Industry Trade

CHAPTER 10 POST HECKSCHER-OHLIN THEORIES OF TRADE AND INTRA-INDUSTRY TRADE Learning Objectives: ■ Explain the basis of trade in manufactures beyond Heckscher-Ohlin. ■ Discuss the roles of technology dissemination, demand patterns, and time in affecting trade. ■ Demonstrate how the presence of imperfect competition can affect trade. ■ Describe the phenomenon known as intra-industry trade. I.

Outline Introduction - A Trade Myth Post-Heckscher-Ohlin Theories of Trade - The Imitation Lag Hypothesis - The Product Cycle Theory - Vertical Specialization-Based Trade - Firm-Focused Theories - The Linder Theory - Economies of Scale - The Krugman Model - The Reciprocal Dumping Model - The Gravity Model - Multiproduct Exporting Firms - Concluding Comments on Post-Heckscher-Ohlin Trade Theories Intra-Industry Trade - Reasons for Intra-Industry Trade in a Product Category - The Level of a Country’s Intra-Industry Trade Summary Appendix A: Economies of Scale Appendix B: Monopolistic Competition and Price Elasticity of Demand in the Krugman Model Appendix C: Measurement of Intra-Industry Trade

II.

Special Chapter Features In the Real World: New Venture Internationalization In the Real World: Omitted-Country Bias in Testing the Linder Hypothesis In the Real World: Geography and Trade

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Chapter 10 - Post Heckscher-Ohlin Theories of Trade and Intra-Industry Trade

III.

Purpose of Chapter

The purpose of this chapter is to present some newer theories of trade that have emerged in the literature because of the failure of the Heckscher-Ohlin model to explain empirically important parts of world trade, specifically the growing trade in manufactured goods. In addition, because intra-industry trade emerges in some of these newer theories and because such trade is important in the real world, the last part of the chapter briefly surveys possible causes of this phenomenon. IV.

Teaching Tips

A. The chapter begins with an examination of the empirical evidence related to U.S. imports from Mexico. The initial thought is often that fruits and vegetables or clothing will top the list. In reality, electrical machinery and equipment ranks first and vehicles rank second. These same items top the list of U.S. exports to Mexico. This is certainly not the predicted trade patterns of the traditional models and provides a nice opening to discuss intra-industry trade and several elements of the newer trade theories that emphasize trade in manufactures. B. With respect to the product cycle theory (PCT), Vernon suggested in his original article that the PCT could help to explain the Leontief paradox because when the product was being imported into the United States in the standardized product stage it was more capital-intensive than when it was first introduced and exported by the United States. We have not utilized this point in our discussion because to us it seems incorrect. The relevant comparison would be between the capital intensity of imports and the capital intensity of exports at any given point in time. Thus the older (imported) product’s intensity should be compared with the intensity of the successive newer products. C. Another useful graph to employ in the presentation of Linder is one found in John Adams, International Economics: A Self-Teaching Introduction to the Basic Concepts, 2nd ed. (St. Martin’s Press, 1979), p. 95. Per capita incomes of a home country (say country A) and its trading partners are arrayed on the horizontal axis; the vertical axis measures the intensity of trade (average propensity to import) of A with the various trading partners. The conceptual result from Linder is a hill-shaped figure peaking at A’s per capita income, since the intensity of trade with any given partner is less the farther away that country’s per capita income is from A’s per capita income. D. A main point of the economies-of-scale discussion (introduced on page 190 and expanded in Appendix A) is that two countries identical in all respects can still receive gains from trade (although the precise pattern of trade may be a priori indeterminate). A further point to emphasize is the trade patterns become unpredictable from a Heckscher-Ohlin standpoint in the presence of economies of scale. E. The Krugman model (introduced on page 190 and expanded in Appendix B) may be difficult for the students. It is advisable to emphasize the general scenario while examining the details: that trade permits a larger market, which in turn permits internal economies of scale to

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Chapter 10 - Post Heckscher-Ohlin Theories of Trade and Intra-Industry Trade

be realized, which in turn permits lower consumer prices; in addition, a greater variety of differentiated goods is produced. The end result is that, again, identical countries can experience gains from trade, something not possible in Heckscher-Ohlin. V.

Answers to End-of-Chapter Questions and Problems

1. The length of the imitation lag would be influenced by barriers to obtaining information regarding the production process, the existence of patents, the length of time needed to learn the production process even after the information is obtained, or the extent to which multinational companies exist in the industry, for example. The demand lag would be influenced by the degree to which tastes are similar in the countries, the ease of communication, the amount of interaction between foreign consumers and the home country (e.g., via travel), product loyalty, and so forth. 2. Some examples would be automobiles, tractors, clothing, television sets, textile machinery, personal computers, and some sporting goods. 3. The Linder theory would suggest somewhat pessimistic prospects in that the per capita income levels and thus the overlapping demands differ widely between the two sets of countries. Indeed, Linder would suggest that the developing countries would trade most intensely with each other, which is not the case in practice. However, many labor-intensive goods sold to developed countries by developing countries (textiles, clothing, shoes) do have some overlap in demand, although the varieties exported may be of higher quality than those sold on developing countries’ home markets. Electronic goods that are assembled in developing countries for export to developed countries would not fit Linder well, since relatively small markets exist for those goods within the developing countries and the goods would not be classified as being “representative” of consumer demand in the developing countries. The Linder theory does not handle the phenomenon of production specifically for export very well. Also, of course, the theory does not embrace primary products (nor was it intended to). 4. The precise countries of export and import of any particular good may not be determinate a priori. The trade pattern may simply depend on which country first establishes a foothold in the market. 5. Before trade begins, many monopolistically-competitive firms producing differentiated goods are in equilibrium with zero profit. When the possibility of trade with other countries begins, export sales of firms increase production because the size of the market has increased and profit prospects have been enhanced. Firms experience reductions in unit costs as they expand, and new varieties of the differentiated goods also appear in the country because home consumers now have foreign varieties available to them. In the trading equilibrium, consumer prices have fallen, more varieties are available, and intra-industry trade in differentiated products is occurring. Because of the greater product variety and the increase in real income due to reduced product prices, consumers in all participating countries are better off than in autarky. 6. Greater choice for consumers may bring greater utility in and of itself. New varieties may initially provide more utility per dollar at the margin and lead to enhanced welfare as new 10-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 10 - Post Heckscher-Ohlin Theories of Trade and Intra-Industry Trade

equilibrium positions are sought by consumers. Disadvantages associated with greater product variety would be increased advertising costs of firms (which use resources) and the costs to consumers of obtaining information on the characteristics of the differentiated products. There may also be a greater time cost because of the more complicated decision-making process. 7. No. As pointed out in the text, geographical location and transport costs can lead to intraindustry trade in identical products. In addition, the degree of disaggregation in the product classification system may not be detailed enough to capture what are truly different products (e.g., different chemical compounds, special-use machinery). 8. It is a useful distinction if one grants that many differentiated varieties of a product are indeed the same general “product” (i.e., the cross elasticities of demand between the varieties are high). If such is granted, the analyst is forced to look beyond traditional trade theory when examining causative factors for trade patterns. If such is not granted, however, it becomes difficult to explain the U.S. export of Budweiser and import of Corona by relying only on different factor endowments and intensities. 9. The emergence of counterfeit goods suggests that the time lag between initial U.S. production and subsequent production abroad is being shortened. The product cycle is speeding up, and the displacement of U.S. exports in the “maturing product stage” is occurring more rapidly. In addition, unlike the situation in the traditional product cycle, some of the production abroad is not taking place in U.S.-owned facilities. Because the erosion of U.S. firms’ profits is occurring more quickly, there is less stimulus for U.S. R&D spending on new products to be undertaken than there would be if patents or proprietary knowledge could effectively protect against the counterfeit goods. Hence, while any given product cycle may be more rapid today, there may also be fewer future cycles. 150922560. In the “reciprocal dumping” model, each country’s consumers benefit from a flow of imports of the good coming into the country at a lower price than was initially being charged by the domestic monopolist. The lower import price and consequent increased consumption bring a welfare gain, as does the reduction of price by the monopolist in each country in order to meet the new foreign competition. However, there are welfare losses in the sense that resource costs are now being incurred to move the good (in both directions) between the countries, and these resources are being diverted from other welfare-creating activities. If the welfare gains offset the transport cost losses, the trade has been beneficial on balance. 11. The initial shift of athletic shoe production from the United States to South Korea is consistent with the product cycle theory’s suggestion of a shift, as the product becomes more standardized, to a new location with lower labor costs. However, it does not strictly fit the PCT’s suggestion of an initial shift to another developed country comprised of high-income consumers. The next shift in production from Korea to Indonesia and China, as wages rose in Korea, is also consistent with the PCT’s general emphasis on the role of lower wages in determining production location in the “standardized product stage” when the good is “older,” mass-produced, and sold worldwide. Indonesia and China have lower labor costs and living 10-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 10 - Post Heckscher-Ohlin Theories of Trade and Intra-Industry Trade

standards than South Korea, which has been rapidly moving toward “developed country” status. Obviously, Heckscher-Ohlin could also be of use in explaining the athletic shoe production shifts. In the H-O context, South Korea was labor-abundant relative to the United States and shoe production is a relatively labor-intensive process. However, the subsequent rise in Korean wages indicated a change toward less labor abundance in Korea. This gave an incentive for shoe production to shift toward Indonesia and China, which are relatively more labor-abundant than South Korea. 12.

The index (II) is equal to: │(100/500) - (20/400)│ + │(300/500) - (80/400)│ + │(100/500) - (300/400)│ 1 - _______________________________________________________________ (100/500) + (20/400) + (300/500) + (80/400) + (100/500) + (300/400) │0.20 - 0.05│ + │0.60 - 0.20│ + │0.20 - 0.75│ 1 - _______________________________________ = 1 - (1.10/2) = 0.45 2

VI.

Sample Exam Questions

Essay Questions

1. What features of the product cycle theory are at variance with the assumptions of the Heckscher-Ohlin model? Explain. 2.

How might the imitation lag hypothesis be incorporated into the product cycle theory?

3. Suppose that you test the Linder hypothesis by comparing Germany’s absolute difference in per capita income from each of its trading partners with the size of Germany’s total trade with each respective partner. You find a strongly negative correlation. Do you thus conclude that the Linder hypothesis must necessarily offer a good explanation of Germany’s trade? Why or why not? 4.

(This question pertains to material in Appendix A.)

Explain why, when a country is engaged in international trade as a result of economies of scale, production may move to an endpoint of the PPF. 5. Does the assumption in the Krugman model that demand becomes less elastic as consumption increases seem realistic to you? Why or why not? What would the PP schedule in Krugman’s basic diagram look like if demand became more elastic as per capita consumption increased?

Chapter 10 - Post Heckscher-Ohlin Theories of Trade and Intra-Industry Trade

6. Suppose someone stated that the Heckscher-Ohlin model is best-suited for explaining trade between developed countries and developing countries, while newer theories such as those of Linder and Krugman are best-suited for explaining trade among developed countries. Would you agree with this observation? Why or why not? 7. Why might it be hypothesized that a typical developed country is likely to have a greater relative amount of intra-industry trade than is a typical developing country? Explain. 8. (a) In what ways does the Krugman model of trade differ from the Heckscher-Ohlin model of trade? Carefully explain. (b) In what ways does the Linder theory of trade differ from the Heckscher-Ohlin model of trade? Carefully explain. 9.

(a) Define “intra-industry trade” and indicate several reasons why such trade can take place in any given product category. Then indicate the characteristics of a country that might lead you to expect that the country would have a substantial amount of intraindustry trade. (b) Thinking back over the various “post-Heckscher-Ohlin trade theories,” select one (1) such theory that contains intra-industry trade and present criticize the theory.

10. Present in detail the following two theories/models associated with “post-HeckscherOhlin” trade theory. In the case of each theory/model, be sure to indicate important characteristics of real-world international trade that the theory/model is attempting to explain. (a) the product cycle theory (b) the Krugman theory/model with economies of scale and monopolistic competition B.

Multiple-Choice Questions

11.

Which of the following findings would NOT be consistent with the product cycle theory? a. a finding that developing countries export “older” manufactured products b. a finding that the United States exports “new” products c. a finding that U.S. export industries are heavily engaged in research and development (R&D) activities * d. a finding that the United States exports goods catering mainly to “low income” tastes rather than “high income” tastes

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Chapter 10 - Post Heckscher-Ohlin Theories of Trade and Intra-Industry Trade

12.

The situation where a country both exports and imports goods in the same product classification category is known as __________ trade, and such a trade situation for countries in the real world is likely to be __________ associated with country per capita income levels. * a. intra-industry; positively b. intra-industry; negatively c. inter-industry; positively d. inter-industry; negatively

13.

In the Krugman model of trade where there are economies of scale and monopolistic competition, which one of the following indicates the situation for the typical firm in the long run (where P = price of output, Q = quantity of output, W = the wage rate, and a and b are constants that are > 0)? a. (a + bQ)∙W = P b. P∙(a + b) = W * c. (a + bQ)∙W = P∙Q d. (a + bQ)·W < P·Q

14.

The Linder theory of trade suggests that * a. a country with a per capita income of $15,000 is likely to have more intense trade with a country that has a per capita income of $16,000 than with a country that has a per capita income of $25,000. b. the most intense trade of low-income, developing countries will be with high-income, developed countries. c. countries will confine themselves to inter-industry trade. d. the exports of primary products of a country will mainly flow to other countries with per capita income levels similar to that of the exporting country.

15.

The situation where international trade occurs because various stages in the production process of a good are occurring in different countries is known as * a. vertical specialization-based trade. b. intra-industry trade. c. dumping or international price discrimination. d. gravity model-type trade.

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Chapter 10 - Post Heckscher-Ohlin Theories of Trade and Intra-Industry Trade

16.

(Questions 16 and 17 pertain to material in Appendix A.) Given the convex to-the-origin production-possibilities frontier (PPF):

Suppose that we envision a very slight movement of production away from the equilibrium point E toward point F (with unchanged goods prices). If this movement takes place, (PX/PY) will be __________ (MCX/MCY), and production will thus move __________. a. less than; back to point E b. less than; further away from point E c. greater than; back to point E * d. greater than; further away from point E 17.

Suppose that two countries each have the exact convex-to-the-origin productionpossibilities frontier (PPF) as in Question #16 above (i.e., the countries have identical PPFs like the Question #12 PPF) and the two countries also have identical tastes. In this situation, a. neither of the two countries could never gain from trade with each other. b. one country could gain from trade with the other but they could never both gain from the trade. c. both countries would go to the same endpoint of the PPF if the two countries engaged in trade with each other. * d. it is possible for the two countries to gain from trade with each other if one country produces at one endpoint of the PPF and the other country produces at the other endpoint of the PPF.

18.

Suppose that data are assembled on (1) research and development expenditures as a fraction of industry costs across U.S. industries (ranked from highest to lowest), and (2) the export success of U.S. industries (ranked from highest to lowest). If the “product cycle theory” is useful as an explanation for the pattern of U.S. exports, then an analyst would expect that statistical association (rank correlation coefficient) between these two series of data would be * a. positive. b. zero. c. negative d. positive, zero, or negative – cannot be determined without more information. 10-5

Chapter 10 - Post Heckscher-Ohlin Theories of Trade and Intra-Industry Trade

19.

In empirical tests of the Linder hypothesis for a given test country, a finding that conforms to the hypothesis would be that the test country trades more intensely with countries in which per capita income is __________ the per capita income of the test country. If the test country does not trade with some countries that have similar per capita incomes to the test country and these other countries are excluded from the empirical test, then the results of the empirical test will be __________ confirmation of the Linder hypothesis.

* 20.

a. different from rather than similar to; biased against b. different from rather than similar to; biased toward c. similar to rather than different from; biased against d. similar to rather than different from; biased toward Which expression below indicates the relationship between product price (P), marginal cost (MC), and the price elasticity of demand facing a firm (eD, which is negative) when the firm is pricing in order to maximize profit?

a. P = MC∙[(eD + 1)/(eD)] * b. P = MC∙[(eD)/(eD + 1)] c. MC = P∙[eD/(eD - 1)] d. P – MC = [eD/(eD + 1)] 21.

In the Linder theory of trade, a country sends goods to other countries which __________, and the greatest trade of a country is expected to be with countries which have per capita income levels __________ that of the original country. * a. also produce those goods; similar to b. also produce those goods; very different from c. do not produce those goods; similar to d. do not produce those goods; very different from

22.

(This question pertains to material in Appendix C.)

Suppose that country A has only three categories of traded goods and that A’s exports and imports in the three categories are as shown in the table below: exports

imports

good T good W good X

$ 30 60 60

$100 20 80

total

$150

$200

In this situation, country A’s index of intra-industry trade would have a value of 10-6 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 10 - Post Heckscher-Ohlin Theories of Trade and Intra-Industry Trade

__________. a. 0.3 b. 0.4 c. 0.6 * d. 0.7 23.

In the Krugman model with economies of scale and monopolistic competition (with L = amount of labor hired by the firm, Q = quantity of output of the firm, W = wage rate for labor, P = price of the firm’s product, and a and b are constants), the equation that states the labor requirement of the firm is __________. In the model, the existence of zero profits for the firm in long-run equilibrium can be stated as __________. a. L = bQ; P∙Q = W∙(a + bQ) b. L = bQ; P∙Q – (a + bQ) = 0 * c. L = a + bQ; P∙Q = W∙(a + bQ) d. L = a + bQ; P∙Q – (a + bQ) = 0

24.

Which one of the following statements pertaining to Vernon’s “product cycle theory” for explaining U.S. trade is INCORRECT? a. There is no international trade in the “new product” stage. * b. Throughout the “maturing product” stage, because the good is exclusively being produced abroad, the United States imports the good. c. In the “maturing product” stage, U.S. firms may start producing the good from an overseas location, and thus exports of the good from the United States may decrease. d. In the “standardized product” stage, the good is exported by developing countries.

25.

Empirical tests pertaining to the determinants of intra-industry trade at the country level tend to suggest that the amount of intra-industry trade a. of a country is negatively related to the country’s per capita income level. * b. between any two countries is negatively related to the geographic distance between the two countries. c. of a country is negatively related to the country’s total GDP level. d. between any two countries is negatively related to the average income level of the two countries.

26.

In the “imitation lag” hypothesis, a. the period of most intense export by the innovating country is the “imitation lag” period. b. the period of most intense export by the innovating country is the “demand lag” period. * c. the period of most intense export by the innovating country is the “net lag” period. 10-7

Chapter 10 - Post Heckscher-Ohlin Theories of Trade and Intra-Industry Trade

d. technology is identical in all countries at all times. 27.

The heavy export of a product by developing countries is most likely to occur in which of the following “stages” of the product cycle theory? a. “new product” stage b. “maturing product” stage * c. “standardized product” stage d. cannot be determined a priori – equally likely to occur in the “new product,” “maturing product,” and “standardized product” stages

28.

In the “imitation lag hypothesis,” the length of time that elapses between when a new product is introduced by innovating firms in country I and when consumers in country II decide that the new product is a good substitute for products in their current consumption bundle is known as the __________. a. “imitation lag” * b. “demand lag” c. “net lag” d. “product cycle lag”

29.

If the labor required per unit of output falls as output increases (such as is specified in the Krugman model), this can be thought of as a situation a. of constant returns to scale. b. of decreasing returns to scale. * c. of increasing returns to scale. d. that is exactly the same situation as was the case in Ricardo’s analysis.

30.

In the Krugman model, when a country is opened to international trade, the total output of each firm __________ and the real wage of workers in the country __________. a. increases; decreases * b. increases; also increases c. decreases; also decreases d. decreases; increases

31.

In the context of a country’s international trade, a “gravity model” is usually employed to investigate, for the country, *

a. the determinants of the amount or volume of the country’s trade with its trading partners. b. the determinants of the country’s terms of trade with its trading partners. c. the value of the country’s “Leontief statistic.” 10-8

Chapter 10 - Post Heckscher-Ohlin Theories of Trade and Intra-Industry Trade

d. whether the Stolper-Samuelson theorem is valid for the country. 32.

(This question pertains to material in Appendix C.) Given the following information on the exports of country A in 2009, and assuming that goods X and Y are the only goods in country A’s trade sector: exports

imports

good X good Y

$ 600 400

total

$1,000

$800

0 800

Country A’s “index of intra-industry trade has a value of __________. * a. 0.4 b. 0.6 c. 1.0 d. 200

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Chapter 11 - Economic Growth and International Trade

CHAPTER 11 ECONOMIC GROWTH AND INTERNATIONAL TRADE Learning Objectives: ■ ■ ■ ■

Distinguish the different ways in which growth can affect trade. Discuss how the source of growth affects the nature of production and trade. Summarize how growth and trade affect welfare in the small country. Assess how growth in a large country can have different welfare effects than growth in a small country.

Outline Introduction - China – A Regional Growth Pole Classifying the Trade Effects of Economic Growth - Trade Effects of Production Growth - Trade Effects of Consumption Growth Sources of Growth and the Production-Possibilities Frontier - The Effects of Technological Change - The Effects of Factor Growth Factor Growth, Trade, and Welfare in the Small-Country Case Growth, Trade, and Welfare: The Large-Country Case Growth and the Terms of Trade: A Developing-Country Perspective Summary

II.

Special Chapter Features In the Real World: Labor and Capital Requirements per Unit of Output In the Real World: “Spillovers” as a Contributor to Economic Growth Concept Box 1: Labor Force Growth and Per Capita Income Concept Box 2: Economic Growth and the Offer Curve In the Real World: Terms of Trade of Brazil, Jordan, Morocco, and Thailand, 19802010

III.

Purpose of Chapter

The purpose of this chapter is to demonstrate how economic growth affects international trade and the possible welfare effects that accompany growth in the open economy.

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Chapter 11 - Economic Growth and International Trade

IV.

Teaching Tips

A. The chapter begins with an examination of the huge increase in China’s international trade and its impact on economic growth. The interesting aspect is that the growth of Chinese trade is also having an impact on South Korea, Taiwan, and even Japan. This is an example of trade serving as a source of growth for an entire region. B. In discussing the production and consumption effects of growth on international trade, we distinguish between the normal protrade and antitrade effects and the more extreme ultraprotrade and ultra-antitrade effects. However, one can focus on just the pro and anti effects generally and ignore the further breakdown. What is important for the student to realize is that growth influences trade both from the supply side and from the demand side. C. We chose to analyze the influence of technological change on growth only from the standpoint of factor-neutral, commodity-specific change. If you have a special interest in growth and trade, you might find it useful to note that economywide technological change can be factorspecific as well. In this instance, the impact on the economy conceptually is analogous to that of a factor-neutral change plus growth in availability of the affected factor, and can be analyzed as such. D. Contrasting the impact of factor growth with that of changes in technology on income growth is effectively done with the PPF. At the end of this section, the student should be left with a clear impression of the different manner in which commodity-based technological change affects the PPF compared to that of growth in a single factor. E. The section of the chapter that presents the Rybczynski theorem and examines the impact of growth on welfare in the small-country case is clearly tougher material and may require more attention in class. F. Given the problems associated with reaching welfare conclusions in a dynamic setting, it is useful to introduce the student to the use of a proxy such as per capita income to draw a tentative conclusion. Although it is more rigorous, we have found the explanation of the decline in per capita income associated with growth in labor alone to be effective (Concept Box 1). G. Students find it surprising that only ultra-antitrade-biased growth shifts the offer curve to the left (Concept Box 2). This gives you an opportunity to distinguish relative effects on trade from absolute effects on trade. H. Although there has been a tendency to pay less attention to the terms-of-trade issue in recent years, this is still an important concern for many developing countries. The possibility of immiserizing growth developed by Jagdish Bhagwati is a very effective way to integrate growth and relative price effects, and the immiserizing growth concept seems of definite interest to students. There is little doubt that changes in developing countries’ terms of trade that are associated with world growth are still of concern to policymakers in developing countries. V.

Answers to End-of-Chapter Questions and Problems

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Chapter 11 - Economic Growth and International Trade

1. The growth in only one factor leads, according to the Rybczynski theorem, to the expansion of output in the good using intensively the growing factor and a contraction in output of the good using intensively the non-growing factor. If the growing factor is the abundant factor, then the result is an expansion in production of the export good and a decline in production of the import-competing good (an ultra-protrade production effect) because some of the scarce factor must be shifted away from import-competing production to export production in order to work with the new units of the abundant factor. If the growing factor is the scarce factor, then there will be an expansion in output of the import-competing good and a contraction in output of the export good (an ultra-antitrade production effect) since some of the abundant factor is shifted to work with the new units of the scarce factor. 2. Yes. Because growth in the abundant factor will result in an ultra-protrade production effect, the trading triangle will increase in size unless there is a sufficiently large ultra-antitrade consumption effect. Only if the absolute level of desired consumption of the import good declines sufficiently with growth will the trading triangle get smaller. 3. An inferior good is one whose consumption declines with growth in income. An absolute decline in desired consumption of the export good and an increase in desired levels of consumption of the import good characterizes an ultra-protrade consumption effect of growth. 4. The trading triangle could expand as in the small-country case as long as the Rybczynski production effect (expansion in production of the import-competing good and contraction of the export good) is more than offset by a sufficiently large ultra-protrade consumption effect (although this of course implies that the export good is an inferior good). In the large-country case it is also possible for an expansion of the trading triangle to take place with other consumption effects, due to the decline in world price of the import good as its demand declines in the country under consideration. It is certainly possible for the increased purchases of the import good due to the subsequent relative decline in the price of that good to more than offset the initial decline in the trading triangle due to the growth of the scarce factor. 5. This would be the case when the country in question is a large country in terms of the good in question. In this instance the bumper crop would lead to a fall in the relative world price of the export good. If this decline in relative price were sufficiently great, the country could well find itself worse off after the bumper crop. This is a case of immiserizing growth. 6. If constant or decreasing returns to scale characterize production of all commodities, then increasing only one of the inputs by a given percentage, e.g., 10 percent, will result in output rising by less than 10 percent. If the input in question is labor (population), then a 10 percent increase in labor will lead to a less than 10 percent increase in income, and per capita income [income/labor (population)] will decline since the numerator is growing less rapidly than the denominator (see Concept Box 1). If there were increasing returns to scale at least partly because of increasing marginal productivity of labor, then clearly per capita income could rise with an increase in the labor force. However, if the normal diminishing marginal productivity of labor exists, even with increasing returns to scale, per capita income will still fall with growth in the labor force because other factors of production are being held constant.

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Chapter 11 - Economic Growth and International Trade

7. The sluggish growth in the Japanese economy in the early 1990s meant that Japan’s production-possibilities frontier (and hence its consumption-possibilities frontier) was not shifting outward very rapidly. On the other hand, Japan’s major trading partners in Asia (e.g., China) were growing rapidly, and the United States (Japan’s largest overall trading partner) recovered relatively quickly from its 1990-91 recession. These trading partners also were growing in “protrade” fashion. Hence, for these trading partners, PPFs and CPFs on average shifted out more rapidly than for Japan. The partners were offering relatively more exports and demanding relatively more imports in their trade on the world market and with Japan, and this tended, other things equal, to cause deterioration in their terms of trade with Japan. With TOT deterioration for the partners, Japan’s terms of trade improved. 8. The PPF of the unified Germany would lie outside that of the former Federal Republic of Germany. In addition, since East Germany was relatively more labor-abundant than West Germany, the new unified PPF will not have shifted out proportionally, but will have shifted relatively more on the labor-intensive good axis. If international prices have remained unchanged, output of the labor-intensive good will clearly increase. However, output of the capital-intensive good could have increased, stayed the same or decreased depending on the relative increase in capital coming from East Germany. If West Germany was a capital-abundant country, according to Heckscher-Ohlin, it should have been exporting the capital-intensive good. Assuming that West Germany was initially exporting capital-intensive goods, the above production effect will fall into either the category of ultra-antitrade (when the production of the capital-intensive export good actually falls) or antitrade (when the growth in production of the labor-intensive import-competing good is greater than that of the export good). 9.

Because the innovation was restricted to manufactured goods, the intercept of the new PPF on the manufactured goods axis is farther out than on the original PPF. There is no change in the intercept on the services axis since no change in production conditions have occurred there. The change in production conditions will result in an expansion of output of manufactures and a contraction of services at constant international prices. Because this country was initially exporting manufactures, the above changes would produce an ultra-protrade production effect. 10.

(a) Volume of trade-2005: 20 units of exports of good X; 10 units of imports of good Y 11-4

Chapter 11 - Economic Growth and International Trade

Volume of trade-2010: 28 units of exports of good X; 14 units of imports of good Y Volume of trade-2015: 30 units of exports of good X; 15 units of imports of good Y (b) 2005-2010: There is a protrade production effect because although production of both goods increased, production of the export good (X) increased by 20 percent whereas the growth of production of the import good (Y) was only 10 percent. 2010-2015: There is an antitrade production effect because, although production of both goods increased, production of the import good (Y) increased by 30.30 percent whereas the growth of production of the export good (X) was only 16.67 percent. (c) 2005-2010: Since the growth in consumption of the export good (15 percent) is slightly greater than the growth in consumption of the import good (14.3 percent), the consumption effect is slightly antitrade. 2010-2015: Since the growth in consumption of the import good (26.25 percent) is greater than the growth in consumption of the export good (19.57 percent), the consumption effect is protrade. (d) 2005-2010: The overall effect is protrade. This is evident since the volume of trade at the constant terms of trade grew by 40 percent, while the growth in output in this twogood economy was between 10 percent (the growth rate of production of good Y) and 20 percent (the growth rate of production of good X). 2010-2015: The overall effect is antitrade. This is evident because the volume of trade at the constant terms of trade grew by 7.14 percent, while the growth in output was between 16.67 percent (in the X industry) and 30.30 percent (in the Y industry. 11. Even if small developing countries are truly “small” in the sense that they cannot by their own actions influence their own terms of trade, they can still experience a terms-of-trade decline because of developments in their trading partner countries (i.e., the partners’ offer curves toward the developing countries shift toward less willingness to trade). If demand shifts away from the developing countries’ products over time because of taste changes or because of the rise of substitutes or for other reasons, the developing countries’ terms of trade will deteriorate. Likewise, if supply developments in trading partners or in world markets in general raise the prices of goods imported by the small developing countries, the terms of trade will decline. Another possibility is the case where a physically small developing country may in fact be a sufficiently important supplier of some individual primary commodity so that expansion in the production of this particular commodity leads to adverse terms-of-trade movements (i.e., the country is actually not economically “small” in this commodity).

Chapter 11 - Economic Growth and International Trade

VI.

Sample Exam Questions

Essay Questions

1. In recent decades, trade has been growing faster than income for many countries. What combination of trade effects is sufficient for this to come about? Is this behavior consistent with the Rybczynski theorem? Under what circumstances? 2. Why is it difficult to analyze the welfare implications of growth in the neoclassical model? What proxy is often used to reach a conclusion about the effects of growth? What leads to the conclusion that, if welfare is to improve with growth in the labor force, there must be accompanying growth in the capital stock and/or improvements in labor productivity? 3. Is it possible that growth in the scarce factor can actually lead to expanded trade in the small-country case? Under what circumstances? 4. Developing countries often claim that growth and trade have left them no better off or perhaps worse off. How might you explain this result theoretically? Could this result obtain if the countries tended to be relatively small? Why or why not? 5. It is likely that a protrade production growth effect will lead to an expansion of trade since the presence of inferior goods is relatively rare. Explain. 6.

(a) Define the five types of “production effects” of economic growth in a country and the five types of “consumption effects” of the economic growth. Then define the types of possible “overall” or “net” effects of the country’s growth on the relative importance of the trade sector. (b) Developing countries are often concerned that their terms of trade might deteriorate as economic growth occurs. In terms of the analysis of part (a) of this question, other things equal, what type(s) of growth must occur and what type of country (“large” or “small”) must a developing country be in order for the country’s terms of trade to deteriorate as the country grows? Explain.

(a) State the Rybczynski theorem. Then, in a two-factor, two-good Heckscher-Ohlin context, illustrate and explain the “production effect” of growth in the labor force in a relatively capital-abundant country, other things equal.

(b) In the situation of the labor force growth in part (a) above, suppose that the country is a “large” country. Define the meaning of a “large” country in international trade. Then, and assuming that the “net” or “overall” effect of the labor force growth in part (a) is of the same type as the “production effect,” illustrate and explain, other things equal, the impact of that labor force growth on the country’s willingness to trade and the country’s terms of trade. (c) Finally, define “immiserizing growth.” Then very briefly explain how “immiserizing 11-3 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 11 - Economic Growth and International Trade

growth” could or could not happen in the situation of part (b) above. 8.

(a) Define the five types of “production effects” of economic growth in a country. Other things equal, if one factor of production in a country (either labor or capital) grows, what are the only two types of production effects that are possible because of the growth in this factor? Briefly explain. (b) Define the five types of “consumption effects” of economic growth in a country? Why can economists usually rule out two of these types when discussing likely possibilities in the “real-world” growth of countries? (c) Define the five types of possible “net” or “overall” effects of the country’s growth on the importance of the trade sector and indicate which types would, other things equal, lead to a deterioration of the growing country’s terms of trade (assuming that the country is a “large” country).

Multiple-Choice Questions

9. In the analysis of growth and trade, if a country's national income growth leads to an absolute increase in imports but to a slower relative growth in imports than in national income, this growth pattern is called __________ growth. * a. antitrade biased b. protrade biased c. ultra-antitrade biased d. neutral 10.

In a Heckscher-Ohlin context, other things equal, growth of the relatively-abundant factor of production in a country that is a “large” country will lead to __________ willingness

to trade and to __________ in the country’s terms of trade. * a. an increased willingness; a deterioration b. an increased willingness; an improvement c. a decreased willingness; a deterioration d. a decreased willingness; an improvement 11.

Growth of the scarce factor in the large-country case will, other things equal, a. always expand trade and improve the terms of trade. b. expand both exports and imports and lead to an improvement in the terms of trade. c. result in a protrade production effect and a deterioration in the terms of trade. * d. result in an ultra-antitrade production effect and an improvement in the terms of trade.

12.

In the two-commodity context, you are given the following information pertaining to 11-4

Chapter 11 - Economic Growth and International Trade

country I in the year 2009 and the year 2014: production of good X in 2009 = 200 units production of good X in 2014 = 198 units consumption of good X in 2009 = 160 units consumption of good X in 2014 = 176 units production of good Y in 2009 = 100 units production of good Y in 2014 = 120 units consumption of good Y in 2009 = 120 units consumption of good Y in 2014 = 131 units Given this information, this country, in 2009, is __________ and, in 2009, the country is __________. a. exporting good Y and importing good X; exporting 20 units of good Y and importing 40 units of good X b. exporting good Y and importing good X; exporting 11 units of good Y and importing 16 units of good X * c. exporting good X and importing good Y; exporting 40 units of good X and importing 20 units of good Y d. exporting good X and importing good Y; exporting 16 units of good X and importing 11 units of good Y 13.

Given the information in Question #12 above, it can be validly concluded that the type of “production effect” that takes place between 2009 and 2014 in country I is __________ production effect. * a. an ultra-antitrade (UA) b. an antitrade (A) c. a protrade (P) d. an ultra-protrade (UP)

14.

Given the information in Question #12 above, it can be validly concluded that the type of “consumption effect” that takes place between 2009 and 2014 in country I is __________ consumption effect. a. an ultra-antitrade (UA) * b. an antitrade (A) c. a protrade (P) d. an ultra-protrade (UP)

15.

With economic growth (where the growth reflects the “net” or “overall” effect of the 11-5

Chapter 11 - Economic Growth and International Trade

production and consumption effects), a country’s offer curve (with the export good on the horizontal axis) a. will always shift or pivot outward. b. will shift or pivot outward in the cases where the growth is “protrade” or “ultraprotrade” in nature and will shift or pivot inward in the cases where the growth is “antitrade” or “ultra-antitrade” in nature. * c. will shift or pivot inward in the case where the growth is “ultra-antitrade” in nature. d. will not shift or pivot in the case where the growth is “neutral” in nature. 16.

Assuming a two-country world, suppose that country I’s income elasticity of demand for imports is 1.2 and that country II’s income elasticity of demand for imports is 0.9. Suppose also that, during 2010, country I’s GDP grows by 5 percent and country II’s GDP grows by 6 percent. Given these income elasticities of demand for imports and these growth rates and with other things equal, the terms of trade of country I with country II during 2010 would __________. a. improve b. remain the same as before the growth in the two countries took place * c. deteriorate d. improve, remain the same as before the growth in the two countries took place, or deteriorate – cannot be determined without more information 17.

If the “net” or “overall” effect (which is the net result of the production and consumption effects) of a country’s growth is “protrade” in nature, then the country’s offer curve (with the export good on the horizontal axis) will shift or pivot __________; if the “net” or “overall” effect is “antitrade” in nature, then the country’s offer curve (with the export good on the horizontal axis) __________. a. outward (or to the right); will shift or pivot inward (or to the left) * b. outward (or to the right); also will shift or pivot outward (or to the right) c. inward (or to the left); also will pivot inward (or to the left) d. inward (or to the left); will shift or pivot outward (or to the right)

18.

If population growth is taking place, a. one can no longer meaningfully compare community indifference curves to evaluate the impact of growth and trade. b. the growth in population must be accompanied by increased capital stock or changes in technology if social welfare is to increase (if increasing returns to scale are not present). c. the production-possibilities frontier will shift out relatively more for the laborintensive good than for the capital-intensive good. * d. all of the above.

19.

Suppose that country I’s income elasticity of demand for imports (YEM) is 0.8. This 11-6

Chapter 11 - Economic Growth and International Trade

YEM means that, as country I’s national income rises, the “overall” or “net” effect of its growth on its trade sector is an __________ overall or net effect. In the context of the offer curve diagram, if country I is a “large” country and it grows (and assuming no growth occurs in its trading partner), this type of net effect means that country I’s terms of trade, other things equal, will __________. a. ultra-antitrade; improve (rise) b. ultra-antitrade; deteriorate (fall) c. antitrade; improve (rise) * d. antitrade; deteriorate (fall) 20. Other things equal, which one of the following types of growth in a large country will have the most adverse impact upon that country's terms of trade? a. ultra-antitrade growth b. antitrade growth c. protrade growth * d. ultra-protrade growth 21.

Suppose that, prior to a technological change (innovation) in an industry, at existing factor prices, it takes 30 units of capital and 100 units of labor to produce 500 units of good X. (Assume that capital and labor are the only two factors of production.) After the innovation, it takes 25 units of capital and 50 units of labor to produce 500 units of good X (at the same factor prices as before the innovation). In this situation, the technological change would be classified as a __________ technological change. a. capital-saving * b. labor-saving c. neutral d. capital-saving and labor-saving

22.

If, when a country grows, its home production of its export good increases by 10 percent and its home consumption of its export good also increases by 10 percent, then, with the economic growth and with other things equal, the country’s absolute quantity of exports will __________. * a. increase b. decrease c. remain constant d. increase, decrease, or remain constant – cannot be determined without more information. (Note: The answer is “a” because the good is being exported and therefore a 10 percent increase in home production is absolutely greater than a 10 percent increase in home consumption.) 11-7

Chapter 11 - Economic Growth and International Trade

23.

Suppose that country I’s income elasticity of demand for imports is 0.8 and that country II’s income elasticity of demand for imports is 1.5. These income elasticities indicate that growth in country I would be classified as __________ and that growth in country II would __________. a. “antitrade” growth; also be classified as “antitrade” growth * b. “antitrade” growth; be classified as either “protrade” growth or “ultra-protrade” growth c. either “protrade” growth or “ultra-protrade” growth; be classified as “antitrade” growth d. either “protrade” growth or “ultra-protrade” growth; also be classified as either “protrade” or “ultra-protrade” growth 24.

If a country's total output grows by 10 percent and its imports fall by 6 percent because of the growth, this growth pattern would be classified as __________ growth. * a. ultra-antitrade b. antitrade c. protrade d. ultra-protrade

25. If, at constant relative prices in a two-commodity and two-factor world, growth in a country’s labor force causes an expansion in output of the labor-intensive good and a contraction in output of the capital-intensive good, this situation is an example of the

26.

a. Stolper-Samuelson theorem. * b. Rybczynski theorem. c. Heckscher-Ohlin theorem. d. Leontief paradox. If a country grows such that, at constant relative prices, the production of its export good rises by 5 percent and the production of its import-competing good rises by 15 percent (and these are the only two goods produced in the economy), this production pattern would be called __________ production effect. a. a “neutral” b. a “protrade” * c. an “antitrade” d. an “ultra-antitrade”

27. If technological change in an industry results, at given relative factor prices, in a reduction in the amount of both capital and labor used to produce a given amount of output, but the reduction in labor requirements is greater than the reduction in capital requirements, this technological change would be called __________ in nature. a. neutral 11-8 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 11 - Economic Growth and International Trade

* b. labor-saving c. capital-saving d. both labor-saving and capital-saving 28.

In the new endogenous growth models a. growth can occur due to “spillover” effects of research and development. b. investment and growth are linked to acquisition of human capital. c. growth does not necessarily converge to that of the growth rate of population. * d. all of the above

29. If growth in national income is due entirely to growth in the labor force, under the Heckscher-Ohlin assumptions, * a. there will be a decline in per capita income. b. there will be an increase in per capita income. c. it is impossible to determine the direction of impact on per capita income without more information. d. there will be an increase in trade and welfare. 30.

In the analysis of growth and trade, growth in the labor force (coupled with no growth in the capital stock) in a relatively capital-abundant country would lead to what type of “production effect” in the country? * a. ultra-antitrade production effect b. antitrade production effect c. protrade production effect d. ultra-protrade production effect

31.

With economic growth, a country’s offer curve (with the export good on the horizontal axis) a. will always shift or pivot outward. b. will always shift or pivot inward. * c. will shift or pivot inward in the case ultra-antitrade growth. d. will not shift or pivot in the case of neutral growth.

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Chapter 11 - Economic Growth and International Trade

32.

If, when a country grows, its home production of its import good increases by 15 percent and its home consumption of the import good also increases by 15 percent, then, with the economic growth, the country’s absolute quantity of imports will __________. * a. increase b. decrease c. remain constant d. increase, decrease, or remain constant – cannot be determined without more information. (Note: The answer is “a” because the good is being imported and therefore a 15 percent increase in home consumption is absolutely greater than a 15 percent increase in home production.)

33.

Suppose that the “net” or “total” effect of the consumption and production effects of a country’s growth is that the country’s offer curve shifts or pivots outward (i.e., the country is more willing to trade). In this situation, it can validly be concluded that this country’s growth can be characterized as __________ (where UP = ultra-protrade growth, P = protrade growth, N = neutral growth, A = antitrade growth, and UA = ultraantitrade growth). * a. UP, P, N, or A but not UA b. UP, P, or N but not A or UA c. UP or P but not N, A, or UA d. UP but not P, N, A, or UA

34.

Other things equal, which one of the following factors would likely NOT contribute to a worsening of the terms of trade of developing countries? a. heavy reliance on primary product exports b. the differing price effects of technological change compared to developed countries * c. developing countries’ attempts to diversify their exports and to include more manufactured goods in their export bundle d. differences in the demand characteristics of the developing countries’ exports and imports

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Chapter 12 - International Factor Movements

CHAPTER 12 INTERNATIONAL FACTOR MOVEMENTS Learning Objectives: ■

■ ■

Identify the different types of foreign investment and the welfare effects of capital movements. Summarize the determinants of foreign direct investment and the associated costs and benefits. Explain the motivation for labor migration and its effects on participating countries. Describe the size and importance of international remittances.

Outline

■

Introduction International Capital Movements through Foreign Direct Investment and Multinational Corporations - Foreign Investors in China: “Good” or “Bad” from the Chinese Perspective? - Definitions - Some Data on Foreign Direct Investment and Multinational Corporations - Reasons for International Movement of Capital - Analytical Effects of International Capital Movements - Potential Benefits and Costs of Foreign Direct Investment to a Host Country Labor Movements between Countries - Seasonal Workers in Germany - Permanent Migration: A Greek in Germany - Economic Effects of Labor Movements - Additional Considerations Pertaining to International Migration - Immigration and the United States – Recent Perspectives Summary II.

Special Chapter Features In the Real World: Determinants of Foreign Direct Investment In the Real World: Host-Country Determinants of Foreign Direct Investment Inflows In the Real World: Migration Flows into the United States, 1986 and 2010 In the Real World: Immigrant Remittances In the Real World: Immigration and Trade In the Real World: Immigration into the United States and the Brain Drain from Developing Countries

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Chapter 12 - International Factor Movements

III.

Purpose of Chapter

In the theoretical analysis to this point it has been assumed that factors are immobile between countries. Because this is clearly not the case, the purpose of this chapter is to examine the reasons for and the trade and income implications of movements of capital and labor between countries. IV.

Teaching Tips

A. With the current attention being paid to foreign investment and migrant workers, students should find the issues covered in this chapter contemporary and interesting. The discussion of the impact of foreign direct investment in China may be of particular interest. The Chinese case is controversial in the United States and many other countries that trade with China, and it serves as a very intriguing case study for this class. We want students to see the real-world application of these issues before they move into the graphical analysis of capital and labor movements. B. It is important to make certain that the students understand the capital market equilibrium concept that is developed early in the chapter and presented graphically in Figure 1. Once the analytics have been grasped, then summarizing the overall costs and benefits of foreign investment logically follows. C. Note that the labor market equilibrium paradigm in Figure 2 (page 250), which is analogous to the capital market paradigm developed earlier in Figure 1, is expanded in Figure 3 (page 251) to examine the implications of labor movements from a labor surplus country with an institutionally-determined wage (developing country) to a country where labor markets are in fact clearing. Although this is a more involved case, it allows one to demonstrate how the impact of factor movements is altered in the presence of factor price distortions. D. In teaching this chapter, it is important that class time be devoted to presenting the analytics of the chapter and any new information on current or “hot button” issues. Much of the descriptive material can be left to the students to read on their own. V.

Answers to End-of-Chapter Questions and Problems

1. At the end of December 2010, the direct investment position of the United States was a positive $1,565.4 billion, as foreign direct investment in the United States was $2,342.8 billion and U.S. direct investment abroad was $3,908.2 billion. Countries in Europe (especially) were the major recipients of U.S. investment with Latin America and Asia/Pacific a distant second and third. By destination, the Netherlands was the largest recipient, followed by the United Kingdom, Canada, Luxembourg, Bermuda, Ireland, Switzerland, and Australia. The investment tends to be concentrated in finance (except depository institutions) and insurance, manufacturing, and (with considerably less investment) wholesale trade, mining, and information. The five largest investor countries in the United States were the United Kingdom, Japan, the Netherlands, Germany, and Canada. Foreign investment in the United States is concentrated in manufacturing (heavily), wholesale trade, and finance (except depository institutions) and insurance.

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Chapter 12 - International Factor Movements

2. In 2011, three of the top ten industrial corporations by revenue were U.S. firms, and three of the ten largest banks were U.S. banks. Three of the largest corporations were Chinese, two were Japanese, and there was one each from the Netherlands and the United Kingdom. In 2011, besides the U.S. banks, three of the top ten banks were from the United Kingdom, two were French, one was German, and one was Chinese. 3. Foreign direct investment takes place to earn a higher rate of return. This can result from specific market conditions abroad, from the access to foreign raw material sources, from the attempt to avoid tariffs, quotas, or nontariff barriers by producing abroad, or from taking advantage of cheaper foreign labor costs. 4. Assuming that capital is the scarce factor, foreign investment would lead to expansion of the capital-intensive import-competing good and contraction of the labor-intensive export good. This would be an ultra-antitrade production effect that would tend to reduce trade unless it was offset by a sufficiently strong ultra-protrade consumption effect accompanying growth (which requires that the import bundle is “inferior”). 5. The capital stock in the capital-abundant country would be larger and the capital stock in the capital-scarce country would be smaller. Consequently, output in the capital-abundant country would be larger, output in the capital-scarce country would be smaller, and their combined output would be smaller if capital controls were in place that kept the productivity of capital from equalizing. 6. Assuming that the developing country is a labor-abundant country and that the United States is the capital-abundant country, the movement of unskilled labor should tend to have an ultra-antitrade production effect in both countries. Inasmuch as skilled labor is more properly treated as a form of human capital, then the movement of skilled labor from the developing country to the United States would have an ultra-protrade production effect in both countries. 7. Voters would see the immigration of these skilled workers as increasing the availability of the goods or services which they produce and perhaps lowering the price. Skilled workers see the immigrants as potentially lowering their wage and real income. Congress should weigh the aforementioned costs and benefits of such migration flows and enact legislation consistent with the expected net welfare impact on the country. 8. If both factors of production and goods are free to move, it is difficult to predict the ultimate pattern of production and trade because factor movements substitute for goods movements. The ultimate pattern of trade will depend upon the degree to which factors move to equalize the returns to factors or goods are traded to accomplish the same end (through the factor-price equalization process). 9. With high Mexican tariffs in place, potential U.S. exporters (presumably of capitalintensive goods) found it difficult to compete price-wise with similar Mexican products. As Mexico has welcomed foreign investment in recent years, capital flows substituted for U.S. exports that had been kept out by the high tariffs. As trade restrictions are reduced under NAFTA, U.S. capital-intensive exports will become competitive in Mexico, reducing the need to

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Chapter 12 - International Factor Movements

invest in Mexico in order to sell in Mexican markets. Thus, the expected trade adjustments that should occur under NAFTA could actually work to reduce U.S. investment in Mexico. 10. Many U.S. citizens have expressed concern over U.S. immigration policy because of their belief that large numbers of current migrants are contributing both to the presence of low wages and to the increased cost of public expenditures, particularly for social programs and education. The fact that the education/skill levels of immigrants appear to be declining contributes to this concern. To the extent that these workers are, however, taking on jobs that U.S. citizens do not wish to and are, in fact, providing unskilled labor at wages lower than most U.S. labor would accept means that U.S. consumers are able to purchase these goods and services at a lower price than would be the case in the absence of this immigration. This is particularly true with respect to many food products that utilize migrant labor during planting and harvesting as well as other services that utilize unskilled labor. To the extent that this is true, reducing migration flows will lead to higher prices of some goods and reduced real income of people for whom those products are important parts of their consumption bundle. VI.

Sample Exam Questions

Essay Questions

1. Explain the underlying basis for foreign direct investment, and discuss several factors that may contribute to it. What factors have likely contributed to the current U.S. net direct investment position? 2. Direct investment inflows by foreigners into the United States have been sizable in recent years. How might this net inward movement of capital affect the level and pattern of U.S. trade according to the Heckscher-Ohlin model? The level of world output? 3. Because real investment by foreigners expands a country’s capital stock and hence presumably its output and income, why should any country consider restricting foreign investment? 4. The recent immigration of labor into the United States from Mexico has led to increased calls for new restrictions on this movement of labor (including greater enforcement of existing restrictions). What would be the costs and benefits to the United States of such restrictions? 5. Many industrialized countries such as the United States attempt to seriously restrict immigration of production workers, but are more open to immigrants who are highly-skilled. Why might this be the case? Why is this a problem for developing countries and how might they deal with the problem? 6. The impact of labor migration on patterns of international trade depends on the characteristics of the labor migrants. In which cases might migration expand trade? World income? In which cases might it reduce trade and world income?

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Chapter 12 - International Factor Movements

7. Economists frequently point out that factor movements between two countries can be a substitute for goods movements between the countries in terms of the impact on relative factor prices in the countries. Explain why the two types of movements can be substitutes. B.

Multiple-Choice Questions

In the graph below, without capital movements between countries I and II, the capital stock in country I is 0K1 and the capital stock in country II is K10’. The return to capital in country I is thus __________ and the return to capital in country II is __________.

a. 0r1; 0’r’1 b. 0r3; 0’r’1 * c. 0r1; 0’r’3 d. 0r2; 0’r’3 9.

In the diagram in Question #8 above, if restrictions on capital flows were removed, capital would move from__________, and this movement would reduce the return to capital in __________. a. country I to country II; country I * b. country I to country II; country II c. country II to country I; country I d. country II to country I; country II

10.

In the diagram in Question #8 above, if restrictions on capital flows were removed and capital was allowed to flow freely from the low-return country to the high-return country, then world output would rise by the amount of area __________. a. EAF b. EFG * c. EAG d. K2EAK1

11.

In the diagram in Question #8 above, if restrictions on capital flows were removed and 12-2

Chapter 12 - International Factor Movements

capital was allowed to flow from the low-return country to the high-return country, then total output in country II would rise by area __________. a. 0’r’3AK1 * b. K1AEK2 c. K1FEK2 d. K1GEK2 12.

In the diagram in Question #8 above, if restrictions on capital flows were removed and capital was allowed to flow from the low-return country to the high-return country, then total output in country I __________. a. would increase by the amount of area K2EAK1 b. would decrease by the amount of area K2EFK1 * c. would decrease by the amount of area K2EGK1 d. would decrease by the amount of area EFG.

13.

In the diagram in Question #8 above, if restrictions on capital flows were removed and capital was allowed to flow from the low-return country to the high-return country, then national income (i.e., GNP) in country I would __________ by the amount of area __________. a. decrease; K2EFK1 b. decrease; K2EGK1 c. increase; AEF * d. increase; EFG

14.

In the diagram in Question #8 above, if restrictions on capital flows were removed and capital was allowed to flow freely from the low-return country to the high-return country, then national income (i.e., GNP) in country II would rise by the amount of area __________. * a. EAF b. EFG c. EAG d. K2EAK1

Chapter 12 - International Factor Movements

15.

Suppose that, other things equal, labor moves from country A to country B. In a twofactor world (capital and labor), this labor movement will lead to a. an increase in the total return to owners of capital in country A. * b. a decrease in the total return to owners of capital in country A. c. a decrease in the wage rate in country B. d. a decrease in total wages paid in country B.

16. If there is diminishing marginal productivity of labor in production (with other inputs held constant), an outmigration of labor from low-wage country A to higher-wage country B will lead, other things equal, to a __________ in per capita income in country B and __________ in per capita income in country A. a. rise; also to a rise b. rise; to a fall c. fall; also to a fall * d. fall; to a rise 17.

Consider a situation where a foreign investor firm in country A wishes to move recorded profits out of country A to another plant location in country B. If the firm wants to utilize transfer pricing, it would want to record the prices of its exported goods from country A to country B at a __________ value than would be the case in an ordinary market transaction, and the firm would, when recording the prices of goods that it imports into country A from country B, __________ value than would be the case in an ordinary market transaction. a. higher; want to record the prices at a lower b. higher; also want to record the prices at a higher c. lower; also want to record the prices at a lower * d, lower; want to record the prices at a higher

18.

According to the Department of Commerce information given in the textbook, the country which is the recipient of the largest amount of U.S. foreign direct investment (FDI) is __________. a. Canada * b. the Netherlands c. Saudi Arabia d. the United Kingdom

Chapter 12 - International Factor Movements

19.

Labor immigration a. always produces a net social cost to society. b. clearly appears to result in a net cost to government in the United States. * c. in the United States appears to be of relatively less-skilled workers on average than in the past. d. almost always has a positive effect on the country of origin since it is usually the less-skilled worker who migrates.

20. Foreign investment such as the purchase of foreign bonds or the deposit of funds in a bank account in another country is called __________ investment; this type of investment involves __________ control over production in the host country than does the other type of investment. a. direct rather than portfolio; more b. direct rather than portfolio; less c. portfolio rather than direct; more * d. portfolio rather than direct; less 21. In a perfectly-competitive world, restrictions placed by developing countries to halt a “brain drain” would lead to __________ in efficiency and world output in a static sense; over time, these restrictions might, other things equal, __________ in the per capita income differences between developing countries and developed countries if skilled labor has important production externalities. a. a decrease; lead to an increase * b. a decrease; also lead to a decrease c. an increase; lead to a decrease d. an increase; also lead to an increase 22.

According to the Department of Commerce information given in the textbook, the country which has made the largest amount of foreign direct investment (FDI) in the United States is __________. a. Canada b. Japan c. the Netherlands * d. the United Kingdom

23.

According to the Department of Commerce information given in the textbook, the industry in which the United States has made the largest amount of foreign direct investment (FDI) abroad is __________. * a. finance (except depository institutions) and insurance b. information c. manufacturing 12-5

Chapter 12 - International Factor Movements

d. mining 24.

If labor moves from a labor-abundant country to a capital-abundant country, other things equal, consideration of the Rybczynski theorem suggests that the labor movement will cause __________ production effect in the labor-abundant country. * a. an ultra-antitrade b. an antitrade c. neutral d. an ultra-protrade

25.

If there is diminishing marginal productivity of labor in production (with other inputs held constant), an outmigration of labor from low-wage country A to higher-wage country B will lead, other things equal and if trade is taking place in accordance with the Heckscher-Ohlin analysis, to __________ production effect in the capital-abundant country. * a. an ultra-antitrade b. an antitrade c. a neutral d. an ultra-protrade

26.

Consider the labor situation in countries I and II in a two-country world with the marginal physical product schedules MPPLI (= demand for labor schedule DI) for country I and marginal physical product schedule MPPLII (= demand for labor schedule DII) for country II shown in the graph below (where the vertical axes also represent real wages):

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Chapter 12 - International Factor Movements

Without any migration of labor between the two countries, the labor force is 0L1 in country I and (in the leftward direction) 0’L1 in country II. If labor is now allowed to flow freely between the two countries, labor would migrate __________. As a result of the migration, world output would increase by the amount of triangle __________. a. from country I to country II; CBA b. from country I to country II; FBA c. from country II to country I; CFA * d. from country II to country I; CBA 27.

In the graph in Question #26 above, the migration of labor would result in __________ in country I’s Gross Domestic Product of the amount of area __________ * a. an increase; L1CBAL2 b. an increase; L1CFAL2 c. a decrease; L1CAL2 d. a decrease; L1CFAL2

28.

In the graph in Question #26 above, the migration of labor would result in an increase in country I’s Gross National Product of the amount of area __________. a. L1CBAL2 b. L1CAL2 c. CFA * d. FBA

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Chapter 12 - International Factor Movements

29.

In the graph in Question #26 above, the migration of labor would result in __________ in country II’sGross Domestic Product and __________ in country II’s Gross National Product. a. an increase; would also result in an increase b. an increase; would result in a decrease * c. a decrease; would result in an increase d. a decrease; would also result in a decrease

30.

According to the Department of Commerce information given in the textbook, the industry in which the largest amount of foreign direct investment (FDI) in the United States has been made is __________. a. finance (except depository institutions) and insurance b. information * c. manufacturing d. wholesale trade

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Chapter 13 - The Instruments of Trade Policy

CHAPTER 13 THE INSTRUMENTS OF TRADE POLICY Learning Objectives: ■ ■ ■ ■

Describe the different tax instruments employed to influence imports. Discuss policies used to affect exports. Explain the problems encountered in measuring the presence of protection. Summarize the different nontariff policies used to restrict trade.

Outline Introduction - In What Ways Can I Interfere with Trade? Import Tariffs - Specific Tariffs - Ad Valorem Tariffs - Other Features of Tariff Schedules - Measurement of Tariffs Export Taxes and Subsidies Nontariff Barriers to Free Trade - Import Quotas - “Voluntary” Export Restraints (VERs) - Government Procurement Provisions - Domestic Content Provisions - European Border Taxes - Administrative Classification - Restrictions on Services Trade - Trade-Related Investment Measures - Additional Restrictions - Additional Domestic Policies That Affect Trade Summary

II.

Special Chapter Features In the Real World: U.S. Tariff Rates In the Real World: The U.S. Generalized System of Preferences In the Real World: Nominal and Effective Tariffs in the United States and the European Union In the Real World: Nominal and Effective Tariff Rates in Vietnam and Egypt In the Real World: Is It a Car? Is It a Truck? In the Real World: Examples of Control over Trade In the Real World: The Effect of Protection Instruments on Domestic Prices

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Chapter 13 - The Instruments of Trade Policy

III.

Purpose of Chapter

The purpose of the chapter is to introduce the wide variety of trade-distorting instruments that exist in practice, as well as to acquaint students with particular policy concepts such as most-favored-nation treatment (normal trade relations) and the effective rate of protection. Once the instruments are understood, the stage is set for the discussion of their market and welfare implications in Chapter 14. IV.

Teaching Tips

A. In this chapter we have refrained from saying much about welfare – reserving that discussion for Chapter 14. The chapter begins with four examples of the instruments of trade policy being used by industrialized nations. Hopefully, the students will be motivated to use this chapter to classify these instruments and to gain an understanding of how the instruments are used. If you don’t like our division of instruments and welfare effects, feel free to combine the two chapters if that helps. B. In the discussion of GSP, it is useful to spend more time than we do in the text on the fact that there are ceilings to the quantities of imports that can come into the United States (although not for the “least developed” countries) and that the range of goods permitted is rather limited. Also, the “graduation” issue seems of some interest to students. C. For some reason, students have trouble grasping the ERP concept. It helps to make clear at the outset that the discussion concerns protection for a home import-substitute industry and that the final good’s tariff, because of the reduction in overall supply on the home market, raises the price that domestic producers receive to the world price plus the tariff. D. In the discussion of ERP, it is important to note that the tariffs on inputs raise the domestic price of identical home-produced inputs, too. Some texts imply that the inputs used in the ERP formula are only the specific units of the inputs that are imported and not produced at home, but that is not a necessary condition – the inputs can be produced at home under a situation where imports of the goods also exist. E. Pertaining to the discussion of VAT, some students who have traveled in Europe may have received VAT rebates. Reference to this can help the class understand the discussion. F. The Scott Bradford study summarized on pages 284-85 provides a look at the impact of protection in a more practical, real manner than is perhaps provided simply by observing actual tariff rates. V.

Answers to End-of-Chapter Questions and Problems

1. Preferential duties discriminate by trade partner in the importation of any given product, while the objective of MFN treatment (or normal trade relations) is to be nondiscriminatory. Because, under MFN, any tariff reduction to one partner is extended to all others with whom MFN agreements exist, the reduction does not benefit only one or a few partners (as it would 13-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 13 - The Instruments of Trade Policy

under preferential duties) to the exclusion of other trading partners. 2. Those industries and residents of a country who can benefit from protection are continuously seeking mechanisms by which their well-being can be enhanced. As tariffs have been reduced through international negotiations, these economic agents have sought to preserve their protected status by pushing for legislation and regulations regarding other barriers (NTBs) not covered by the negotiations. 3. Value added under free trade is $1,000 - ($300 + $500) = $200. In the small country case, the price of good F becomes $1,000(1 + 0.20) = $1,200. The price of input A becomes $300(1 + 0.20) = $360, and the price of input B becomes $500(1 + 0.30) = $650. Value added under protection is thus $1,200 - ($360 + $650) = $190. The ERP is therefore ($190 - $200)/$200 = minus 5 percent. The meaning of this ERP result is that the returns to the factors of production in the F industry as a whole have actually been reduced by 5 percent by the tariff structure, and there would be an incentive for the factors to leave this industry. 4. Probably not. For nominal tariffs, the problem of under- (over-) representation of high(low-) tariff goods prevents precise measurement by a weighted-average tariff, and an unweighted-average tariff will obviously only be approximate. The use of world weights is not satisfactory conceptually, as it does not embody the country’s actual trade pattern. For effective tariffs, problems regarding the reliability of the relation of inputs to output occur (especially if the input coefficients are not fixed), in addition to the nominal tariff calculation problems. With respect to NTBs, these barriers would need to be identified clearly and then converted to tariff equivalents. This would require estimation of price and quantity impacts (that is, of demand and supply elasticities). Taking the various tariff and NTB problems together, the best efforts to calculate an average level of protection will only produce approximations. In addition, all tariff and nontariff barrier calculations are made more difficult if the importing country is a “large” country, for then an estimate must be made of the levels of world prices of the various imports if there were no import restrictions in place. Finally, if the various errors and omissions are roughly of the same relative magnitude over time, more certainty can be attached to the trends shown by the protection indexes than to the calculated levels of protection themselves. 5. The ERPs for the country’s final goods industries will increase, meaning that these production processes are protected to an even greater extent than previously. Trading partners sending final goods to the country would regard this action as a move in the direction of less willingness to trade rather than in the direction of greater willingness to trade. 6.

(a) The unweighted-average nominal tariff rate is equal to: 0.10 + 0.05 + 0 + 0.30 + 0.02 + 0.025 + 0.15 + ($0.50/$4.00) + 0.40 + ($2.50/$10.00) 10 = 1.42/10 = 0.142 or 14.2 percent

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Chapter 13 - The Instruments of Trade Policy

(b) The weighted-average nominal tariff rate is: (0.10)($400) + (0.05)($600) + (0)($500) + (0.30)($300) + (0.02)($200) + (0.025)($400) + (0.15)($100) + (0.125)($400) + (0.40)($200) +(0.25)($100) $400 + $600 + $500 + $300 + $200 + $400 + $100 + $400 + $200 + $100 = ($344/$3,200) = 0.1075 or 10.75 percent 7.

(a) The new unweighted-average nominal tariff rate is equal to: 0.10 + 0.05 + 0 + 0.30 + 0.02 + 0.025 + 0.15 + ($0.50/$5.00) + 0.40 + ($2.50/$12.50) 10 = 1.345/10 = 0.1345 or 13.45 percent (b) The new weighted-average nominal tariff rate is equal to: (0.10)($500) + (0.05)($750) + (0)($625) + (0.30)($375) + (0.02)($250) + (0.025)($500) + (0.15)($125) + (0.10)($500) + (0.40)($250) + (0.20)($125) $500 + $750 + $625 + $375 + $250 + $500 + $125+ $500 + $250 + $125 = ($411.25/$4,000) = 0.1028 or 10.28 percent

8. A tariff will clearly result in a domestic price that is higher than the world price, and any nontariff barrier will do the same thing. Although we do not have estimates of the size of the nontariff barriers and there may be a combination of a variety of different barriers, the ratio of the domestic price to the world price can serve as an indicator of amount of domestic interference because the restricted supply via any instrument directed toward imports will result in a higher price domestically than exists on the world market. An index greater than 1.0 would indicate that protection is being afforded the domestic industry. 9. Both claims were correct because different tariff rate concepts were being utilized in the statements. Evidence suggests that, at the time, the United States in general had higher effective tariff rates (ERPs) than did countries of the European Economic Community. However, evidence also suggests the opposite with respect to nominal tariff rates – EEC countries appeared to have higher nominal tariff rates than did the United States. VI.

Sample Exam Questions

Essay Questions

1. Although a given set of tariff rates exists for a given country, not all of its trading partners necessarily face the same tariff rate structure. Discuss several reasons why this is the case. 2.

Industries with the highest level of nominal tariff rates on their competing imports do not 13-2

Chapter 13 - The Instruments of Trade Policy

necessarily receive the greatest incentive to expand domestic production. Explain why this is so and how you might go about arriving at a more revealing measure of tariff-based incentives for expanding production. 3. If offshore assembly provisions were extended to include more goods, what would this do to the actual level of protection provided by a country’s nominal tariff schedule? Explain. If the extension of the provisions is made to final goods but not to intermediate goods, what would this do to the effective rate of protection (ERP) for the country provided by its tariff schedule? Explain. 4. Suppose that a country has a nominal tariff rate of 10 percent on good A and imports $100,000 of good A, has a nominal rate of 5 percent on good B and imports $120,000 of good B, has a nominal rate of 12 percent on good C and imports $80,000 worth of good C, and has a prohibitive tariff rate of 50 percent on good D. These are the only four goods in existence. Calculate the country’s unweighted-average nominal rate and its weighted-average nominal rate. Explain in economic terms the relationship you have found between the unweighted- and weighted-average rates. 5. There is often heated debate over what qualifies as a nontariff barrier to trade and how large any trade-distorting effects of NTBs are. Why might this be so? Why do you suppose such debate is less common for tariffs? 6. How would you go about calculating an “implicit” or “equivalent” nominal tariff rate on an imported good that faces a nontariff barrier such as an import quota? What difficulties would you encounter? 7.

(a) Suppose that a country has a nominal tariff rate of 10 percent on good A and imports $1,000 of good A, has a nominal rate of 5 percent on good B and imports $1,400 of good B, and has a nominal tariff rate of 15 percent on good C and imports $600 of good C. These are the only three goods in existence. Calculate the country’s unweighted-average nominal tariff rate and its weighted-average nominal tariff rate. Explain in economic terms the relationship you have found between the two rates. (b) Suppose that, for a country, the free trade price of good X is $1,000 and the free trade prices of the only two inputs (both of which are imported) to the production process of good X are $400 for good W and $200 for good Y. Assume that one unit each of good W and good Y is necessary for the production of one unit of good X. Suppose now that the country, which is a “small” country, introduces a tariff structure that imposes a 20 percent nominal tariff on good X, an 8 percent tariff on good W, and a 6% tariff on good Y. Calculate the Effective Rate of Protection (ERP), or “effective tariff rate,” that this tariff structure provides to the domestic producers of good X. Explain the economic meaning of your result. For what purpose might the ERP of an industry be more useful to an economist than the nominal tariff rate on imports of the industry’s product?

Chapter 13 - The Instruments of Trade Policy

Multiple-Choice Questions

8. Which of the following is NOT an example of a nontariff barrier to the free flow of goods and services in accordance with comparative advantage? a. import quotas b. government procurement provisions that favor home products * c. specific duty of $1.00 per unit on each imported item d. voluntary export quotas (VERs) 9.

The 2012 U.S. MFN/normal trade relations tariff on men’s knitted wool blazers was 38.6¢ per kilogram of weight plus 10 percent of the value of the blazer. This is an example of __________. a. a specific tariff b. an ad valorem tariff * c. a combination of a specific tariff and an ad valorem tariff d. a nontariff barrier

10.

Suppose that a country’s nominal tariff rate on imports of good X is 20% and that the country’s nominal tariff rate on good A [a raw material and the only input (an imported input) used in making good X] is 5%. In this situation, the Effective Rate of Protection (ERP or “effective tariff rate”) for the country’s domestic X industry will be __________, and this type of escalated tariff structure __________ the type of tariff structures that high-income, developed countries actually have in place on goods imported from lowincome, developing countries. a. less than 20%; characterizes b. less than 20%; does not characterize * c. greater than 20%; characterizes d. greater than 20%; does not characterize

11. An import quota specifies the __________ amount of a good that can be imported into a country; a step to becoming more protectionist would involve __________ in the quota. * a. maximum; a reduction b. maximum; an enlargement c. minimum; a reduction d. minimum; an enlargement 12.

Which one of the following is NOT an example of making a trade instrument more restrictive against imports, other things equal? a. a decrease in the size of an import quota * b. a shifting of an import good from an administrative classification category with a high tariff to an administrative classification category with a low tariff 13-4

Chapter 13 - The Instruments of Trade Policy

c. a withdrawal of GSP treatment for goods from a particular country d. a denial of most-favored-nation (MFN) treatment to a country that previously received such treatment 13.

Other things equal, which one of the following will cause an increase in the effective rate of protection (ERP) in the automobile industry? a. a decrease in the nominal tariff rate on automobiles b. an increase in the nominal tariff rates on imported inputs used in making automobiles c. an increase in the world price of imported inputs used in making automobiles * d. a decrease in the nominal tariff rates on imported inputs used in making automobiles

14. Given the following information for industry X in country A, and assuming that at least some of input Y is imported, that one unit of Y is required for each unit of X, and that country A is a “small” country: free trade price nominal tariff rate final product X input Y (only input to X)

$100 $ 70

19% 10%

The effective rate of protection (ERP) for industry X is __________ percent. a. 9 b. 19 c. 30 * d. 40 15.

The United States now gives China permanent most-favored-nation (MFN) treatment [or normal trade relations (NTR)]. This means that the tariff schedules applicable to U.S. imports from China a. have lower tariff rates than the rates applicable to other countries to which the United States grants permanent MFN treatment. * b. have the same tariff rates as the rates applicable to other countries to which the United States grants permanent MFN treatment. c. have lower tariff rates than the rates applicable to any other country sending goods to the United States. d. have tariff rates of zero percent.

13-5 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 13 - The Instruments of Trade Policy

16.

The situation in the United States (and other developed countries) whereby an import good faces a lower tariff if the good comes from a developing country than if the good comes from a developed country is known as __________. *

a. GSP treatment b. MFN (or NTR) treatment c. OAP treatment d. ERP treatment

17.

Suppose that the free-trade offer curve of country I is drawn with country I’s exports of good A on the horizontal axis and country I’s imports of good B on the vertical axis. If country I now places an import quota of 100 units of good B, country I’s offer curve

* a. will have its normal free-trade appearance up to 100 units on the vertical axis and then will become a horizontal line back to the vertical axis. b. will have its normal free-trade appearance up to 100 units on the horizontal axis and then will become a vertical line going upward and parallel to the vertical axis. c. will shift to the left or vertically upward by 100 units at each level of exports of good A. d. will shift to the right or vertically downward by 100 units at each level of exports of good A. 18.

In general, a country’s unweighted-average nominal tariff rate tends to be __________ than the country’s weighted-average nominal tariff rate. The difference between the two would be __________ if the goods with the highest tariffs became imported relatively more heavily. a. lower; smaller b. lower; larger * c. higher; smaller d. higher; larger

19.

Given the following information for industry X in country A, and assuming that input Y is imported, that one unit of Y is required for each one unit of X, and that country A is a “small” country: free trade price nominal tariff rate final product X input Y (only input to X)

$120 $ 80

10% 15%

The “effective tariff rate” or “Effective Rate of Protection (ERP)” for industry X in country A is __________ percent. * a. 0 b. 10 c. 12.5 13-6 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 13 - The Instruments of Trade Policy

d. 25 20.

Suppose that the offshore assembly provisions (OAP) of a country A are extended to a final good X that is imported as well as produced domestically. This action will most likely * a. stimulate production in country A of components to final good X. b. stimulate production in country A of final good X. c. raise the price of imports of final good X to consumers in country A. d. cause foreign assemblers of final good X to use relatively more components of X that are supplied by countries other than country A.

21.

Suppose that the nominal tariff rate on final good X is 8 percent and that the weighted average of the nominal tariff rates on the inputs used in producing good X is 12 percent. In this situation, the effective rate of protection (ERP) for final good industry X a. must be greater than 12 percent. b. must be between 8 percent and 12 percent. c. must be less than 8 percent and greater than zero percent. * d. must be less than 8 percent and can be negative.

22.

Suppose that the nominal tariff rate on final good X is 10 percent and that the weighted average of the nominal tariff rates on the inputs used in producing good X is 6 percent. In this situation, the effective rate of protection (ERP) for final good industry X * a. will be greater than 10 percent. b. will be greater than 6 percent but less than 10 percent. c. will be less than 6 percent but greater than zero percent. d. can be negative.

23.

The use of the most-favored-nation (MFN) principle [or normal trade relations (NTR)] is an attempt to attain __________ toward competing suppliers of imports to a country. Hence, the arrangement whereby developed countries permit duty-free entry on some goods coming from developing countries but levy tariffs on the same goods if coming from other developed countries is __________ the MFN [or NTR] principle. a. discrimination; a departure from b. discrimination; an example of * c. nondiscrimination; a departure from d. nondiscrimination; an example of

24.

Suppose that a country’s “unweighted-average (nominal) tariff rate” (call it “tU”) and “weighted-average (nominal) tariff rate” (call it “tW”) are calculated both with and without the inclusion of prohibitive tariffs, and that the country does in fact have some prohibitive tariffs. In this situation, the tU that includes the prohibitive tariffs __________ the same as the tU that excludes the prohibitive tariffs, and the tW that 13-2

Chapter 13 - The Instruments of Trade Policy

includes the prohibitive tariffs __________ the same as the tW that excludes the prohibitive tariffs. a. would not be; would not be b. would not be; would be * c. would be; would not be d. would be; would be 25.

Given the following information for industry X in country A, and assuming that input Y is imported, that one unit of Y is required for each unit of X, and that country A is a “small” country: free trade price nominal tariff rate final product X input Y (only input to X)

$200 $100

25% 15%

The effective rate of protection (ERP) for industry X is __________ percent. However, if the nominal tariff rate on input Y is eliminated (i.e., the 15% rate become 0%), the ERP for industry X would become __________ percent. a. 20; 25 * b. 35; 50 c. 40; 50 d. 35; 25 26.

Suppose that the nominal tariff rate on final good X is 7 percent and that the weighted average of the nominal tariff rates on the inputs used in producing good X is 10 percent. In this situation, the effective rate of protection (ERP) for final good industry X a. will be greater than 10 percent. b. will be less than 10 percent but must be greater than 7 percent. c. will be less than 7 percent but must be greater than 0 percent. * d. can be negative.

27.

Given the following information for industry X in country A, and assuming that input Y is imported, that one unit of Y is required for each unit of X, and that country A is a “small” country:

Chapter 13 - The Instruments of Trade Policy

final product X input Y (only input to X)

free trade price

nominal tariff rate

$100 $ 80

20% 15%

The effective rate of protection (ERP), or “effective tariff rate,” for industry X is __________ percent. However, if the nominal tariff rate on input Y is eliminated (i.e., the 15% rate becomes 0%), the ERP for industry X would become __________ percent. a. 17½; 25 b. 35; 25 c. 40; 20 * d. 40; 100

13-4 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 14 - The Impact of Trade Policies

CHAPTER 14 THE IMPACT OF TRADE POLICIES Learning Objectives: ■ ■ ■ ■

Illustrate how tariffs, quotas, and subsidies affect domestic markets. Identify the winners, losers, and net country welfare effects of protection. Explain how the effects of protection differ between large and small countries. Demonstrate how protection in one market can affect other markets in the economy.

Outline Introduction - Gainers and Losers from Steel Tariffs Trade Restrictions in a Partial Equilibrium Setting: The Small-Country Case - The Impact of an Import Tariff - The Impact of an Import Quota and a Subsidy to Import-Competing Production - The Impact of Export Policies Trade Restrictions in a Partial Equilibrium Setting: The Large-Country Case - Framework for Analysis - The Impact of an Import Tariff - The Impact of an Import Quota - The Impact of an Export Tax - The Impact of an Export Subsidy Trade Restrictions in a General Equilibrium Setting - Protection in the Small-Country Case - Protection in the Large-Country Case Other Effects of Protection Summary Appendix A: The Impact of Protection in a Market with Nonhomogeneous Goods Appendix B: The Impact of Trade Policy in the Large-Country Setting Using Export Supply and Import Demand Curves - The Impact of an Import Tariff - The Impact of an Import Quota - The Impact of an Export Tax - The Impact of an Export Subsidy

II.

Special Chapter Features In the Real World: Real Income Gains from Trade Liberalization in Agriculture In the Real World: Welfare Costs of U.S. Import Quotas and VERs In the Real World: Domestic Effects of the Sugar Quota System

14-1

Chapter 14 - The Impact of Trade Policies

III.

Purpose of Chapter

The purpose of this chapter is to explain how trade restrictions affect a country so that the costs and benefits of this type of policy action can be more fully understood. IV.

Teaching Tips

A. The chapter begins with the example of the 2002 U.S. steel tariffs. This case provides a clear indication that there are both winners and losers from this type of trade barrier. In addition, the students will see that losers are not only the foreign exporters that have a tariff applied to their product but also actors within the domestic economy. B. The partial equilibrium analysis relies upon the concepts of producer and consumer surplus to demonstrate the costs and benefits of the various protection instruments. It is therefore important to review these two surplus concepts so that the students feel comfortable with them before they are used in the analysis. C. If you choose to use the large-country approach described on pages 299-311 and in Appendix B, it is worthwhile to stress that the demand for imports schedule is not the entire demand schedule for the product by domestic consumers. The demand for imports schedule is used when we discuss market effects, and the entire demand curve is primarily used when we discuss welfare effects – the two curves should not be confused. Analogous comments apply to the supply of exports schedule and the supply schedule of home producers. The former is used for discussing market effects and the latter for discussing welfare effects. D. We present several different instruments in a variety of settings. You may prefer not to examine all of them due to time constraints. E. We do recommend, however, that within the partial equilibrium model, care be taken to demonstrate the difference between import tariffs, quotas, and domestic subsidies; the effects of an export tax versus an import tariff; and the differing effects of a tariff or import quota in the large-country versus the small-country setting. Basic understanding of these differing situations is necessary for evaluating the effects of trade policy in general. F. It is important to spend some time discussing the general equilibrium effects of protection, even though it is, without a doubt, much tougher going. If you do not wish to spend the time working through the graphical depiction presented in Figure 14 (page 312), you can give students the intuition behind the effects by presenting it as a movement away from the free-trade equilibrium back towards the autarky position. (This just reverses what was done in Chapter 6, except that the country doesn't move all the way back to autarky). As a result, there will be welfare losses due to both a reduction in exchange and in specialization.

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Chapter 14 - The Impact of Trade Policies

G. We encourage the use of offer curves in discussing the impact of protection in the largecountry setting. Once the notion of how protection affects the offer curve is grasped, the diagram provides an excellent vehicle for examining not only the impact of home tariffs but also the impact of retaliatory protection, as well as the differing impact of tariffs, import quotas, and voluntary export restraints. Some students may have heard about the use of VERs and may be very interested in discussing the impact that they have had on the United States. V.

Answers to End-of-Chapter Questions and Problems

The winners are: Producers = (2,000)($1.20) + (0.5)(300)($1.20) = $2,580 Government = (200)($1.20) = $240 The losers are: Consumers = (2,500)($1.20) + (0.5)(100)($1.20) = $3,060 Society’s deadweight losses = (0.5)(300)($1.20) +(0.5)(100)($1.20) = $240; also = ($3,060 - $2,580 - $240) = $240

2. An equivalent subsidy would shift the supply curve down vertically by $1.20. Producers would thus be willing to supply 2,300 units at the world price of $12, consumers would continue to demand 2,600 units, and imports would fall from 600 to 300 units. In this instance, there would be no loss in consumer surplus because the consumer price does not change. Producers would again gain producer surplus equal to $2,580, there would be a deadweight production efficiency loss (society’s total deadweight loss) of $180, and the entire subsidy program would cost the taxpayers (consumers?) $2,760. If the consumers are the taxpayers, they should prefer the subsidy program at a cost of $2,760 in taxes to the loss of consumer surplus under the tariff of $3,060. 3. A quota differs from a tariff in that the quantity of imports is fixed and domestic price adjusts, whereas with a tariff, the domestic price is altered and quantity adjusts. The effects on consumers and producers of a quota are analogous to those of an equivalent tariff. However, there is no tariff revenue generated for the government. The equivalent of the tariff revenue that is generated with a quota (often referred to as the quota rent) can go to the government if the right to import (the quota rights) are auctioned off by the government. If the government does not sell the import quota rights, the quota rent can go to organized foreign producers in the form of higher selling prices, to domestic importing firms as they buy at the lower international price and sell at the higher market-clearing domestic price, or some combination of the two. Yet another possibility is that the governments of the exporting countries could obtain the rent if they auction off export licenses to the exporting firms. 4. You would prefer the quota because in this instance you would receive the benefits of the growth in demand via higher domestic prices and sales without any accompanying increase in imports. With the tariff or subsidy, at least some of the benefits of growth in the domestic 14-2

Chapter 14 - The Impact of Trade Policies

market would accrue to foreign producers in the form of increased foreign exports. A quota also provides greater market certainty for producers. 5. An export tax effectively lowers the price received by producers for their product. They are thus willing to sell at a lower price in the domestic market, as opposed to exporting the good and paying the tax, up to the point where the domestic price is equal to the international price less the export tax. This leads to an increase in domestic quantity demanded, a decrease in domestic quantity supplied, and a decrease in exports. An export subsidy, on the other hand, effectively raises the price received by producers for their exports. Producers consequently raise the domestic price until it is equal to the international price plus the subsidy per unit, which leads to a decrease in quantity demanded at home, an increase in home quantity supplied, and an increase in exports. Domestic consumers would clearly prefer the export tax to the export subsidy. 6. Use of trade restrictions for the small country clearly involves net social losses. The large country can, however, influence world price by its trade policy. The imposition of a tariff in the large-country case reduces the demand for the import good and hence world price, i.e., some of the tariff is passed on to foreign producers through lower international prices. Consequently, the deadweight losses for the tariff-imposing large country will be smaller than for the small country. It is possible that the large country might even experience a gain if the tariff revenue effectively paid by the exporting countries through lower prices is larger than the deadweight losses incurred in the tariff-imposing large country through higher domestic prices. 7. The relevant graph is Figure 14 (page 312) in the text. The loss in real income due to the tariff is shown by the inward shift of the consumption-possibilities frontier (the international terms-of-trade line) as a result of the tariff-induced change in domestic prices and production (the shift in the production point from B0 to B1). The accompanying loss in consumer well-being due to the tariff is shown by the movement from C0 on IC0 to C1 on IC1. Consumer loss would be reduced if an equivalent subsidy were used instead of the tariff. In this case consumers would continue to face international prices and would consume at point C2 on IC2. 8. The export subsidy is more costly in the case of the large country because it not only has to bear the cost of the subsidy, but also ends up exporting the good at a lower international price. The total welfare cost of the subsidy is thus larger than in the small-country case (where international prices remain constant). 9. Consumers pay twice for subsidized exports in that they not only pay a higher domestic price for the subsidized export good but also (as taxpayers) the higher taxes to pay the cost of the subsidy. They thus suffer both a loss in consumer surplus (through higher domestic prices) and a loss in after-tax income. 10. The changes in domestic quantity demanded and supplied can be calculated using the supply and demand elasticities and the increase in domestic price resulting from the 10 percent tariff. 14-3

Chapter 14 - The Impact of Trade Policies

The percentage change in quantity supplied = (0.10)·(elasticity of supply) = (0.10)(1.6) = 16 percent The change in quantity supplied = (0.16)(500) = 80 units The new quantity supplied = 500 + 80 = 580 units The percentage change in quantity demanded = (0.10)·(elasticity of demand) = (0.10)(-2.0) = -20 percent The change in quantity demanded = (800)(-0.20) = -160 units The new quantity demanded = 800 - 160 = 640 units The new domestic price = ($8.00)(1.10) = $8.80 Placing this information along with the initial market information provided in the question on a graph, the familiar partial equilibrium analysis can be carried out using an approach like that used in Figure 3 (page 292) in the chapter. The loss in consumer surplus = ($ 0.80)(640) + (½) ($0.80)(160) = $576 The gain in producer surplus = ($0.80)(500) + (½)($0.80)(80) = $432 The gain in government revenue = ($0.80)(60) = $48 The deadweight losses = (½)($0.80)(160) + (½)($0.80)(80) = $96 VI.

Sample Exam Questions

Essay Questions

“The imposition of a tariff on a good will always have a negative welfare effect on a country.” Agree? Disagree? Explain.

“Even if home consumers always have perfectly inelastic demand for a product, at least a portion of the demand curve by those consumers for imports of the product can have the normal downward slope. Further, even if the supply curve of domestic producers is everywhere perfectly inelastic, at least a portion of the supply curve of exports by those producers can have the normal upward slope.” Explain why these statements are true.

3. Discuss why an exporting country II, if faced with a choice between a 100-unit import quota by importing country I on a given product or a “voluntary” export restriction by II of 100 units of the product, would choose the VER. Might there be a larger import quota (for example, 120 units) that would be preferred by II to a 100-unit VER? In general terms, what considerations would be involved in this latter choice? 4. How would an export quota by a home country look in the offer curve diagram? How would a subsequent increase in foreign demand for the export affect the exporting country’s terms of trade and quantity of exports? 14-2

Chapter 14 - The Impact of Trade Policies

5. At the international price of $20/unit, domestic production is 5,000 units and domestic consumption is 6,000 units. With a 20 percent tariff, domestic production increases by 20 percent and domestic consumption decreases by 25 percent. What is the effect of this tariff on the affected parties? What is the net welfare effect on the country as a whole? 6. Demonstrate why economists argue that, from a country welfare perspective, a domestic subsidy is preferable to a tariff for assisting a particular industry. Use either a partial or a general equilibrium model to support your argument. 7. An import tariff has a similar impact on a country’s export good as an export tax. Explain. 8. Explain, using offer curves, how a tariff affects a large country in the context of general equilibrium. Can a tariff improve the welfare in the tariff-imposing country if both sets of offer curves are elastic in the relevant ranges? Explain. 9. If it has been decided that protection is to be given, industry usually prefers quotas and economic advisers to governments generally argue for subsidies or tariffs. Why might there be a difference of opinion between these two groups? Would it make any difference which was chosen if market demand was constant? 10.

“While the imposition by a country’s government of an import tariff on a good clearly injures the country’s domestic consumers of the good, the tariff helps domestic import-competing producers and enhances overall country welfare (i.e., the “net welfare effect” is positive). Similarly, the granting of an export subsidy by the country’s government to home producers of a good also injures home consumers of the good, but the subsidy helps home producers and enhances overall country welfare.”

Utilizing traditional supply/demand analysis, illustrate and explain the parts of the above statement that are TRUE (if any) and the parts that are FALSE (if any). (You can use a “smallcountry” case throughout your answer. Also, assume that there are barriers to the import of the good into the country granting the export subsidy.) 11.

(a) Using a demand/supply diagram, illustrate and explain the effects of the imposition of an export tax on a good Y by a home country’s government on (i) the home country’s consumers of Y, (ii) the home country’s producers of Y, and (iii) the home government’s tax revenues. (Assume that the country is a “small” country.) Then indicate the “net welfare effect” of the tax on the country. Why might a country want to impose an export tax? Briefly explain. (b) Suppose now that the country imposing the export tax in part (a) of this question is a “large” country rather than a “small” country. Is it an advantage or a disadvantage for a country to be “large” rather than “small” when it imposes an export tax? Briefly explain. (No diagrams are necessary in this part of the question.) 14-3

Chapter 14 - The Impact of Trade Policies

12.

(a) Suppose that country A wishes to restrict its imports of good X to 900 units per month, which is a reduction from the current quantity of imports. Assume that A also produces good X domestically. In this context, illustrate and explain why the following statement is either TRUE or FALSE. “The reduction in imports to 900 units per month will have identical effects on product price in A, quantity produced in A, and welfare in A whether the reduction is accomplished by the imposition of an import tariff by country A or by country A’s officials persuading foreign governments to ‘voluntarily’ restrict their exports to A to 900 units per month.” (b) Suppose that country A wishes to expand its home production of good Y (as well as employment in country A’s Y industry) by 10 percent, and country A is an importer of good Y. In this context, illustrate and explain why the following statement is either TRUE or FALSE. “The 10 percent increase in home output and employment in the Y industry will be associated with identical effects on product price, quantity of imports of good Y, and welfare in country A whether the 10 percent increase is accomplished by the imposition of an import tariff or by the granting of a subsidy for production and employment to home producers of good Y.”

13.

For each of the three statements below, illustrate and explain why the statement is either TRUE or FALSE. (a) “Other things equal, the imposition of a tariff by a (small) country on an imported good will have a less negative net welfare effect on the country than would the use of a ‘voluntary’ export restraint (VER) by supplying countries of the import, even if the effects on domestic price and the quantity of the good imported are the same in the two situations.” (b) “Other things equal, if a country imposes an export tax of a given amount on a good, then the country can potentially enhance its welfare if it is a ‘small’ country but cannot possibly enhance its welfare if it is a ‘large’ country.”

(c) “Other things equal, if a (small) country elects to assist an import-competing industry in expanding the industry’s output by a given amount, the net welfare effect on the country will be the same whether or not the assistance is given in the form of an import tariff or in the form of a production subsidy to the industry.”

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Chapter 14 - The Impact of Trade Policies

Multiple-Choice Questions

14.

In the following import graph, if horizontal supply line Sm shifts to horizontal line S’m because of the imposition of a tariff,

a. the situation must be one of a “large” importing country. b. the tariff must be a specific tariff. c. the tariff must be an ad valorem tariff. * d. the tariff can be either a specific or an ad valorem tariff. 15.

The presence of an export subsidy (assuming that foreign demand is not perfectlyinelastic) * a. will increase the price of the export good in the home market and decrease the wellbeing of home consumers. b. will decrease the price of the export good in the home market and increase the wellbeing of home consumers. c. will lead to a net gain in welfare in the home country since producer surplus is enhanced. d. can lead to a higher import price in the importing country in the large-country case.

16.

The imposition of an export tax by a home country will lead to __________ in home country consumer surplus and will __________ in home country producer surplus. a. a decrease; also lead to a decrease b. a decrease; lead to an increase * c. an increase; lead to a decrease d. an increase; also lead to an increase

17.

In the large-country case, an export tax * a. leads to an increase in the price of the good in the importing country. b. leads to no change in the price of the good in the importing country. c. is absorbed totally by the exporting country. d. increases consumer welfare in both the exporting and the importing country.

18.

The diagram below shows the situation of a small country with free-trade in an imported 14-5

Chapter 14 - The Impact of Trade Policies

product (at a price of $10) and the situation with a tariff on the product (at a price of $11). In this graph, the net welfare loss (or total deadweight loss) to the country from the imposition of the tariff is __________.

a. $2 * b. $6 c. $32 d. $44 19.

In the diagram in Question #18 above, what is the amount of tariff revenue collected by the government when the tariff is in place? a. $3 * b. $6 c.. $18 d. $40

20.

In the diagram in Question #18 above, suppose that a subsidy to import-competing producers is given instead of a tariff being imposed. The subsidy is set to generate the same amount of domestic production of the good as occurred under the tariff. What would be the net welfare loss to the country in this situation? * a. $2 b. $6 c. $12 d. $34

21.

Given the following information for (small) country A concerning a good X: free trade price in A tariff rate price in A, with tariff consumption in A, free trade consumption in A, with tariff production in A, free trade production in A, with tariff

$20 per unit 20 percent $24 per unit 1,000 units 900 units 600 units 800 units 14-6

Chapter 14 - The Impact of Trade Policies

a. The government revenue generated by the tariff is $800. b. The decrease in consumer surplus because of the tariff is $4,000. c. The increase in producer surplus because of the tariff is $3,200. * d. The net welfare loss for A from the tariff is $600. 22.

Other things equal, a country’s consumers’ “demand for imports” schedule for a good tends to be __________ than the country’s consumers’ overall demand schedule for the good. In addition, other things equal, a country’s producers’ “supply of exports” schedule of a good tends to be __________ than the country’s producers’ overall supply schedule of the good. * a. more elastic; more elastic b. more elastic; less elastic c. less elastic; more elastic d. less elastic; less elastic 23.

In the large country case, the imposition of an import quota a. will always produce a net loss for the imposing country. * b. can result in a net gain for the importing country if the government employs an auction quota system to allocate the restricted imports. c. will produce a net gain for the exporting country. d. will have no predictable effect on the exporting country.

24. In the general equilibrium graph with a production-possibilities frontier (PPF) and consumer indifference curves, a. a tariff has the same welfare impact as a subsidy to the import-competing industry (provided domestic production is the same with each alternative instrument). * b. a tariff reduces both real income and the gains from exchange. c. a tariff reduces consumer welfare only if the tariff is a prohibitive tariff (i.e., eliminates all imports). d. protection shifts the PPF outward but reduces consumer welfare. (Questions 25 and 26 draw on Appendix B material.) 25.

Given the following diagram showing country A’s demand for imports schedule for good X (Dimports), the supply of exports schedule to A from the rest of the world of good X (SROW), and the supply of exports schedule to A from the rest of the world of good X when country A has imposed a specific tariff on imports of good X (S’ROW):

14-7

Chapter 14 - The Impact of Trade Policies

price

quantity a. The total tariff revenue collected by country A is indicated by the rectangle P0P1E’H. * b. Distance OP2 indicates the net price received by the foreign suppliers after payment of the tariff. c. The loss of consumer surplus in country A because of the imposition of the tariff is indicated by rectangle P2P0HG. d. Country A is a “small” country. 26.

In Question #25 above, country A a. can never improve its welfare by the imposition of this tariff. b. gains welfare from the imposition of this tariff if the area of triangle GHE is larger than the area of rectangle P0P1E’H. * c. gains welfare from the imposition of this tariff if the area of rectangle P2P0HG is larger than the area of triangle HE’E. d. gains welfare if the area of rectangle P0P1E’H is larger than the area of rectangle P2P0HG.

27.

You are given the following information pertaining to large country B with respect to good W (which is produced at home and also imported), both under free trade and with a $10.00 import tariff in place: domestic price of W under free trade world price of W (i.e., price of W from rest-of-theworld) under free trade domestic price of W after imposition of tariff world price of W (i.e., price of W from rest-of-theworld after imposition of tariff

$40 $40 $44 $34 14-8

Chapter 14 - The Impact of Trade Policies

domestic production of W under free trade domestic production of W after imposition of tariff domestic consumption of W under free trade domestic consumption of W after imposition of tariff

80 units 94 units 120 units 112 units

Given this information, and assuming that demand and supply curves are straight lines, what is the loss of consumer surplus in country B that occurs because of the imposition of the tariff? a. $44 b. $72 c. $448 * d. $464 28.

Given the information on prices, production, and consumption in Question #27 above, and assuming that demand and supply curves are straight lines, what is the gain in producer surplus in country B that occurs because of the imposition of the tariff? a. $56 b. $140 * c. $348 d. $376

29.

Given the information on prices, production, and consumption in Question #27 above, and assuming that demand and supply curves are straight lines, the impact of the imposition of the tariff is that tariff revenue of the government increases by __________. Further, the “net welfare effect” of the imposition of the tariff is a __________. a. $72; loss of $44 b. $72; gain of $64 c. $180; loss of $44 * d. $180; gain of $64

30. Other things equal, a larger share of a tariff is more likely to be “paid” by the foreign exporting country B rather than the domestic importing country A if * a. the supply curve of B’s producers is very inelastic. b. the supply curve of A’s producers is very inelastic. c. the demand curve of B’s consumers is very elastic. d. the demand curve of A’s consumers is very inelastic. 31.

In the following offer curve diagram, OCA is the free-trade offer curve of country A, OCB is the free-trade offer curve of country B, and OC’A (which starts at the origin O, goes to point M and then comes back horizontally to point Y’) is the offer curve of country A when it has a restrictive trade policy instrument in place (while country B continues with free trade). In this situation, the restrictive instrument that country A has employed is 14-9

Chapter 14 - The Impact of Trade Policies

__________, and the resulting equilibrium position E’ is __________ equilibrium position.

a. a “voluntary” export restraint (VER) on its exports to country B; an unstable b. a “voluntary” export restraint (VER) on its exports to country B; a stable c. an import quota; an unstable * d. an import quota; a stable (Question 32 draws Appendix A material.) 32.

In the case of nonhomogeneous goods, the imposition of an import tariff * a. produces a transfer from consumers to producers in the domestic market. b. taxes the domestic product as well as the import product. c. has no impact on the price of the domestic substitute. d. results in deadweight losses in both the domestic market and the import market.

33.

If a (large) country B puts an export tax on a good, and assuming that world demand for the export from B is not perfectly inelastic, then, because of the tax, the price of the good in country B will __________ and the price of the good on the world market __________. a. increase; also will increase b. increase; will decrease * c. decrease; will increase d. decrease; also will decrease

34.

Given the following information pertaining to large country A with respect to good X under free trade and with a tariff in place: domestic price of X under free trade world price of X under free trade domestic price of X with tariff in place world price of X with tariff in place domestic production of X under free trade

$100 $100 $103 $ 98 40 units 14-10

Chapter 14 - The Impact of Trade Policies

domestic production of X with tariff in place consumption of X under free trade consumption of X with tariff in place

50 units 100 units 80 units

What is the loss of consumer surplus in country A that occurs because of the imposition of the tariff? a. $45 b. $150 * c. $270 d. $300 35.

The imposition of an export tax on good X by country A, other things equal, a. will improve the terms of trade of country A if A is a “small” country. b. will lead to a lower price of good X in country A’s home market if A is a “large” country but will not affect the price of good X in A’s home market if A is a “small” country. c. will always lead to an improvement in country A’s welfare if A is a “large” country. * d. will lead to an increase in consumer surplus in country A.

36. If a small country produces 100 units of product X and consumes 140 units at a price of $2 under free trade, but the imposition of a tariff leads to a situation where domestic price is $2.20, domestic production is 120 units, and domestic consumption is 125 units, then the gain in producer surplus in this country because of the tariff is __________. a. $1.00 * b. $22.00 c. $24.00 d. $26.50

14-11

Chapter 14 - The Impact of Trade Policies

37.

$100 $100 $103 $ 98 40 units 50 units 100 units 80 units

What is the impact of the tariff upon country A's welfare? a. loss of $15 b. loss of $45 * c. gain of $15 d. gain of $60.

14-12

Chapter 15 - Arguments for Interventionist Trade Policies

CHAPTER 15 ARGUMENTS FOR INTERVENTIONIST TRADE POLICIES Learning Objectives: ■

Explain how trade policy instruments are often part of broader social policy and why other policy instruments might be less costly. ■ Evaluate the effectiveness of trade policy in the presence of market imperfections. ■ Identify and assess invalid economic arguments for protection. ■ Analyze the role of trade policy in promoting strategic industries and dynamic comparative advantage. I.

Outline Introduction Trade Policy as a Part of Broader Social Policy Objectives for a Nation - Trade Taxes as a Source of Government Revenue - National Defense Argument for a Tariff - Tariff to Improve the Balance of Trade - The Terms-of-Trade Argument for Protection - Tariff to Reduce Aggregate Unemployment - Tariff to Increase Employment in a Particular Industry - Tariff to Benefit a Scarce Factor of Production - Fostering “National Pride” in Key Industries - Differential Protection as a Component of a Foreign Policy/Aid Package Protection to Offset Market Imperfections - The Presence of Externalities as an Argument for Protection - Tariff to Extract Foreign Monopoly Profit - The Use of an Export Tax to Redistribute Profit from a Domestic Monopolist Protection as a Response to International Policy Distortions - Tariff to Offset Foreign Dumping - Tariff to Offset a Foreign Subsidy Miscellaneous, Invalid Arguments Strategic Trade Policy: Fostering Comparative Advantage - The Infant Industry Argument for Protection - Economies of Scale in a Duopoly Framework - Research and Development and Sales of a Home Firm - Export Subsidy in Duopoly - Strategic Government Interaction and World Welfare - Concluding Observations on Strategic Trade Policy Summary

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Chapter 15 - Arguments for Interventionist Trade Policies

II.

Special Chapter Features In the Real World: The Relative Importance of Trade Taxes as a Source of Government Revenue In the Real World: Industry Employment Effects of Trade Liberalization In the Real World: Costs of Protecting Industry Employment In the Real World: Antidumping Actions in the United States In the Real World: Countervailing Duties in the United States In the Real World: U.S. Motorcycles – A Successful Infant Industry? In the Real World: Airbus Industrie

III.

Purpose of Chapter

The purpose of this chapter is to present and assess various arguments for protection. It is particularly hoped that students will learn to think in terms of benefits and costs and in terms of “who gains?” and “who loses?” when encountering these and other arguments in the media and in everyday discussion. A special effort is made to acquaint students with several recent approaches to protection, approaches that are cast in a framework where departures from the competitive trade model exist. Because many industries are clearly not “competitive” in the traditional microeconomic sense and since the newer approaches have received some attention in the press, an understanding of the arguments can be of practical use. IV.

Teaching Tips

A. The chapter begins with a number of statements in support of protection. Evaluating the merit of the arguments is a nice place to begin the discussion in this chapter. B. The macroeconomic interpretation of a trade deficit interests students. It is sometimes helpful also to make the point in terms of S + (T - G) - I = (X - M), in order to focus directly on relatively low saving in the United States and on the U.S. federal budget deficit as being related to the trade deficit. [Note that, strictly speaking, (X - M) is the current account balance, not just the trade balance. However, this distinction isn’t introduced until Chapter 19 (“Balance-ofPayments Accounts”) so we haven’t noted the difference in this chapter.] C. It is useful to stress that the optimum tariff rate can only occur in the elastic range of the foreign offer curve. Only in that range will the imposition of a higher tariff have its positive terms-of-trade impact potentially more than offset by the negative impact of the reduction in the quantity of imports. Hence, only in that range can country welfare start to decrease with a higher tariff, implying that the higher tariff is too high for attaining the “optimum” position. D. In presenting the argument for a “tariff to increase employment in a particular industry,” it is useful to repeat the partial equilibrium graph from Chapter 14 (Figure 4) showing that the home country welfare loss is less with a production subsidy than with a tariff. Students seem to have difficulty accepting that conclusion. E.

Because antidumping claims are filed regularly in the United States and are reported in

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Chapter 15 - Arguments for Interventionist Trade Policies

the press, you should have no trouble in providing more current examples than are provided in the “In The Real World” box on page 343. Students seem to like these specific examples. F. In fairness to the authors of the various “strategic trade policy” approaches, it should be pointed out to the students that the authors of the theories do not necessarily advocate protection. G. An exercise of interest to the students is to work through a situation like Figure 8 (or Figure 11), but where the home firm’s reaction function is “flatter” than the foreign firm’s reaction function. The equilibrium position is an unstable one. The rationale for the relative slopes drawn in the text is the observation (made by Krugman) that the instability associated with the opposite relative slopes does not appear to characterize these imperfect-competition situations in the real world. H. In covering the material related to Figures 12 and 13, it is useful to stress that the profit of the home firm being greater than the size of the subsidy can mean that home country welfare increases because of the subsidy. This possibility is more certain with the standard assumption that there is no home consumption of the good, since then there is no offsetting loss in home consumer surplus due to the export subsidy’s impact on the domestic price of the good. In general, however, you might want to indicate to the students that welfare impacts are uncertain not only because of possible retaliation and the opportunity cost of the resources used in the export industry, but also because the pre-protection framework in all of these theories is one where market distortions exist. In other words, the beginning situation is one of second-best. I. We have found the Krugman 1987 Journal of Economic Perspectives article to be an excellent outside reading to accompany the material of this chapter. V.

Answers to End-of Chapter Questions and Problems

1. Consider Figure 2 in the text. For a given tariff t and a given starting point, the transfer of foreign profit will be less if demand is more elastic, since distance c1c2 will be the same but the new quantity of imports (0q2) will be smaller. Other things equal, this would diminish the size of any home country welfare improvement because of the tariff. The loss in consumer surplus will also be smaller and, at the limit (perfectly elastic demand), equal to zero. However, since greater elasticity reduces both the transfer of profit and the loss in consumer surplus, it is not possible to determine any general relationship of demand elasticity to the net welfare gain of the home country from the tariff. 2. No, Krugman’s results would not follow. Turn to Figure 9 in the text. In Figure 9(a), the MM curve would slope upward. Protection would cause QQ to shift to the right and would lead to an increase in marginal cost. In Figure 9(b) the result would be a shift of home firm reaction function HH to the left and, with no change in foreign firm reaction function FF, the home firm’s sales in the export market would fall and the foreign firm’s sales would rise. If the foreign firm’s counterpart schedule to MM also sloped upward, the home protection would also lead to an upward shift in FF, which would reinforce these export market share results.

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Chapter 15 - Arguments for Interventionist Trade Policies

3. No. The reduced costs per unit and ultimately lower consumer prices can then potentially be realized (if they have not already been realized) by the foreign producer as that producer sells to the domestic market (and other markets) under a free-trade regime. Protection for the home firm would achieve no greater cost reductions than would free trade. In fact, protection could reduce world welfare by generating excess capacity in the industry for the world as a whole. Although the protection might result in a shift of any possible “external” benefits from the foreign country to the home country, this would not necessarily improve world welfare. 4. The negative effects on domestic employment caused by foreign retaliation, reduced national income abroad, home currency appreciation, and so forth could, if strong enough, outweigh any immediate positive domestic employment effects. 5. The use of a tariff will raise the price of imports of the good, and the price of the domestically-produced good will also rise as home demand switches toward it. Thus consumers will have their well-being reduced because they will be paying more for each unit of the good and will be buying a smaller quantity because of the higher price. A subsidy given to domestic producers, equal to the per-unit difference between home cost of production and the world price of imports, will cause the domestic industry to expand and provide jobs without having to raise price, and imports will not go up in price because there is no tariff. Consequently, consumers are not injured. Although taxes will need to be levied to finance the subsidy, the taxes are only paid on the units of the good that are produced at home, while the higher price paid when the tariff was used applied both to domestic production and imports. 6. No. The dumping can simply reflect price discrimination by the foreign producer, whereby a lower price is being charged in the importing (home) country than in the foreign exporting country. If the foreign firm is not a price taker, if demand is more elastic in the home country than in the foreign country, and if the markets can be kept separate (e.g., by transportation costs), then such price discrimination maximizes profits. There is no necessary reason for a foreign government subsidy to occur. 7. This statement can be evaluated in the framework of the discussion at the end of the chapter. Exports would be very unlikely to remain unaffected. Further, in the context of the macroeconomic interpretation of a trade deficit, there would not be an improvement in the trade balance unless the tariff increased income relative to spending (C + I + G). 8. Consider Figure 8 in the text and suppose that the H and F labels are switched. If point C is the starting point, the foreign firm is satisfied but the home firm is not since, with 0X2* of foreign sales, the home firm only wants to sell quantity 0X1 (instead of 0X2). The sales combination of the two firms will then move from point C to point B, where the home firm is at its profit-maximizing level, given 0X2* of foreign sales. However, at B, the foreign firm will want to sell the larger quantity 0X1* rather than 0X2*, so movement takes place to point A. This process continues, driving the firms farther away from the equilibrium position E.

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Chapter 15 - Arguments for Interventionist Trade Policies

9. Yes, the foreign firm will always produce because it makes a profit by doing so, no matter what the home firm does. No, the home firm will not produce the good. Since the foreign firm always produces, the home firm will elect zero profit rather than a $30 million loss. 10. Yes, the production pattern will change. The home firm will now receive $20 million profit if it produces at the same time that the foreign firm produces, and $150 million profit if it produces and the foreign firm does not. Since the foreign firm will still produce despite its reduction in profit from $140 million to $20 million, the production pattern is that both firms are now engaged in supplying the good to the market. However, the subsidy reduces welfare in the home country, since the home firm’s $20 million profit is financed by a $50 million subsidy, implying a $50 million burden on home country taxpayers. 11.

(a) $19. (b) $21. (c) Home country consumer surplus falls by ($21 - $19)(10) + (½)($21 - $19)(14 - 10) = $24 or (½)($21 - $19)(14 + 10) = $24 (d) ($16 - $12)(10 - 0) = $40. (e) The home country “gains” welfare of ($40 - $24) = $16.

12. In Figure 14, the reaction curves for each country show the various tariff rates that maximize that country’s welfare, given different tariff rates for the other country. If the countries find themselves at point F, only country II is on the reaction curve that maximizes its welfare. As country I attempts to maximize its welfare, given that country II has a tariff rate of t*2, it will need to raise its tariff to place itself on the TI tariff reaction function. This movement horizontally to the right of point F will mean that country I is now maximizing its welfare, given country II’s tariff rate of t*2. However, country II will now be off its reaction function, and it will lower its tariff rate until it is back on the function TII. This moves the position downward. Country I will now be off its reaction function and will raise its rate, II will then lower its rate, and so forth, and convergence takes place to point E. Once at E, the chosen tariff rates are such that both countries are simultaneously on their reaction functions and so the countries will stay there. If country I unilaterally moved away from point E by raising or lowering its tariff rate while country II did nothing, country I’s welfare must fall by definition since it no longer has in place the tariff rate that maximizes its welfare given the tariff rate of country II. Analogously, country II’s welfare would fall if it altered its tariff rate from the rate in place at point E and there were no change in country I’s tariff.

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Chapter 15 - Arguments for Interventionist Trade Policies

VI.

Sample Exam Questions

Essay Questions

1. Illustrate and explain how a country could attain its optimum tariff position (optimum terms of trade) on the foreign offer curve by using an import quota rather than a tariff. Could this position also be attained by negotiation of a “voluntary” export restraint (VER) with the foreign country rather than by the use of a tariff? Why or why not? 2. Remembering micro theory, why can it be assumed that home demand for the product of a foreign monopoly supplier (at the initial as well as the post-tariff point) is elastic? Even if the net welfare impact of the “tariff to extract foreign monopoly profit” is uncertain, why is it certain that home consumers will incur less total spending on the good after the imposition of the tariff than before the imposition of the tariff? 3. How would you respond to an argument to impose a tariff on imports arriving from a particular country in order to improve the balance of trade with that particular country? Do the criticisms of the tariff to improve the overall trade balance with all partners apply in this bilateral context? Why or why not? Are there additional considerations to be taken into account? Explain. 4. In the situation of the “tariff to extract foreign monopoly profit,” do you think that the existence of a home producer of the good would strengthen or weaken the case for protection from the standpoint of the impact on home country welfare? Explain. 5. Why might a foreign export subsidy decrease welfare in the foreign country? Why might the foreign country provide such a subsidy despite the adverse welfare effect? 6. Would it be possible for the infant industry argument to be applicable to a perfectlycompetitive industry? Why or why not? 7. It is noted in the text that the infant industry argument is more frequently used in developing countries than in developed countries. Why might this be the case? Does this necessarily have to be the case? 8. Suppose that a relatively capital-abundant country is exporting the capital-intensive good and importing the labor-intensive good, but that the “specific-factors” model of Chapter 8 applies rather than the Heckscher-Ohlin model. Assess the effect on the return to labor of the imposition of a tariff on the labor-intensive good. 9. In the model relating R&D spending to output and output to R&D spending, suppose that, for whatever autonomous reason, the home firm desires to spend more on R&D at each level of output. In this model, what does this greater R&D spending by the home firm do to R&D spending by the foreign firm? Why? Does this result conform to your expectation of foreign firms’ reactions in practice to increased R&D spending by home firms? Explain.

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Chapter 15 - Arguments for Interventionist Trade Policies

10. Why do you suppose that “reaction functions” are not used in analyzing the market structure of perfect competition (or even monopolistic competition)? If you were to draw reaction functions for any home firm and any foreign firm engaged in perfect competition, what would the functions look like? 11.

(a) Assume that there are only two firms in an industry – a home firm and a foreign firm – and that the firms are competing in third-country markets. (You can have them competing in each other’s domestic markets if you wish.) Explain a “reaction function diagram” for the two firms, including the definition of a “reaction function” in this context and a brief discussion of why the reaction functions slope as they do (although you do not need to derive the functions formally). Then use a reaction function diagram (possibly along with other diagrams) to explain how a “strategic trade policy” action by the home firm’s government can potentially enhance the home firm’s market share in third-country markets. (b) Briefly explain, in a two-country setting, how tariff reaction functions of the two governments can be constructed. Then, in a broader context, briefly indicate why this type of “game” can lead to a need for multilateral trade negotiations (such as those sponsored by GATT/WTO).

Multiple-Choice Questions

12.

In a two-country world, the terms-of-trade impact of a tariff will definitely improve the welfare of the tariff-imposing country (assuming no retaliation) if the tariff-imposing country a. is a small country. b. already has a tariff rate that is greater than the “optimum” tariff rate. c. is situated in the “elastic” portion of its trading partner’s offer curve. * d. is situated in the “inelastic” portion of its trading partner’s offer curve.

13.

In the case of the economist’s definition of “dumping,” an exporting firm is selling its product at a __________ price in the importing country than in the exporter’s home country, and this suggests that demand for the exporter’s product is __________ in the exporting country than in the importing country. a. higher; more elastic b. higher; less elastic * c. lower; less elastic d. lower; more elastic

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Chapter 15 - Arguments for Interventionist Trade Policies

14.

The following diagram shows the demand and marginal revenue curves facing a foreign monopoly supplier of a good to the home country, as well as the firm’s horizontal marginal cost curve when there is no tariff by the home country (MC) and the marginal cost curve when a specific tariff is imposed by the home country (MC + T). (Assume that average cost (AC) equals marginal cost.) In this situation, the price to home country consumers after the tariff has been imposed is __________.

a. $10 b. $14 c. $25 * d. 27 15.

In the situation in the diagram in Question #14 above, the loss of consumer surplus for home consumers because of the imposition of the tariff is __________. a. $4 * b. $56 c. $121 d. $224

16.

In the situation in the diagram in Question #14 above, the amount of former foreign monopoly profit that has been transferred as revenue to the home country’s government because of the imposition of the tariff is __________. a. $52 * b. $104 c. $120 d. $390

17.

A tariff placed upon a product in order to offset a foreign export subsidy is called a. an antidumping duty. * b. a countervailing duty. c. a predatory duty. d. a specific duty. 15-8

Chapter 15 - Arguments for Interventionist Trade Policies

18.

The following diagram shows a “reaction function” graph for two firms selling in an export market, where HH is the home firm’s reaction function and FF is the foreign firm’s reaction function. Reaction function HH reflects the fact that, if the foreign firm increases its quantity sold in this market, then the home firm will __________ its sales level in the market; reaction function FF reflects the fact that, if the home firm increases its quantity sold in this market, the foreign firm will __________ its sales level in the market.

* a. decrease; decrease b. decrease; increase c. increase; decrease d. increase; increase 19.

In the “reaction function” diagram of Question #18 above, if the firms are at point A and if both firms are seeking to maximize profit, the foreign firm wants to __________ its sales in this market, and the home firm __________its sales in this market. a. decrease; also wants to decrease * b. decrease; wants to increase c. increase; wants to decrease d. increase; also wants to increase

20.

In the “reaction function” diagram of Question #18 above, if economies of scale exist for both firms, then protection instituted in the home market to keep out the foreign firm’s product will, other things equal, cause HH to shift to the __________. a. left (or downward) and also will cause FF to shift to the left (or downward) b. left (or downward) and will cause FF to shift to the right (or upward) c. right (or upward) and also will cause FF to shift to the right (or upward) * d. right (or upward) and will cause FF to shift to the left (or downward)

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Chapter 15 - Arguments for Interventionist Trade Policies

21.

Given the following “payoff matrix” for two interdependent firms in duopoly, where the figure in the lower left of each box shows Firm H's profit and the figure in the upper right of each box shows Firm F's profit:

In this situation Firm F will __________. * a. always produce b. never produce c. produce only if its cost of production is less than $120 d. never produce if its cost of production exceeds $10 22.

In the “payoff matrix” in Question #21 above, Firm H __________ a “dominant strategy” and Firm F __________ a “dominant strategy.” a. has; also has b. has; does not have * c. does not have; has d. does not have; also does not have

23.

Starting from the “payoff matrix” situation in Question #21 above, suppose that a subsidy of $40 is now given to Firm H. Other things equal, with this subsidy, Firm H will __________. *

a. always produce b. never produce c. only produce if Firm F does not produce d. only produce if Firm F produces

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Chapter 15 - Arguments for Interventionist Trade Policies

24.

If the United States government imposes a “countervailing duty,” this duty is being imposed to offset * a. a foreign subsidy to a good exported to the United States. b. a foreign tariff on U.S. exports of a good. c. a foreign “voluntary” export restraint (VER) on a good exported to the United States. d. a foreign import quota on U.S. exports of a good.

25.

In the game-theoretic analysis of tariff reaction functions of two governments, suppose that the equilibrium position has been attained (i.e., the countries are located at the intersection of their respective tariff reaction functions). If, from this equilibrium position, one country reduces its tariff rate while the other country does not change its tariff rate, the result, other things equal, is that the country that has reduced its tariff will experience __________. a. an increase in its welfare b. no change in its welfare. * c. a decrease in its welfare. d. an increase, no change, or a decrease in its welfare – cannot be determined without more information.

26.

The argument that a tariff can provide temporary protection to an industry so that the industry can expand, realize economies of scale, and eventually become an export industry is known as the a. antidumping argument. b. national defense argument. * c. infant industry argument. d. terms of trade argument.

27.

In world of two “large” countries, if one country imposes a tariff, the welfare of the tariff-imposing country will definitely improve (assuming no retaliation) if, the tariffimposing country a. is trading, both before and after the imposition of the tariff, in the “elastic” portion of its trading partner’s offer curve. * b. is trading, both before and after the imposition of the tariff, in the “inelastic” portion of its trading partner’s offer curve. c. is putting the new tariff on top of an already existing tariff rate that is greater than the optimum” tariff rate. d. puts on a prohibitive tariff.

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Chapter 15 - Arguments for Interventionist Trade Policies

28.

In the following diagram, offer curve 0A0 of country A is the free-trade offer curve, and the other four offer curves represent A’s offer curves under four different tariff rates. Of these four other curves, only one of them can possibly be an offer curve which is associated with A’s “optimum tariff.” Which one?

a. 0A1 b. 0A2 c. 0A3 * d. 0A4

29.

The diagram below shows the demand curve (D) facing a foreign monopoly supplier of a good to home country I, the associated marginal revenue curve (MR), and the foreign monopolist’s marginal cost curve (MC), which equals the average cost curve (AC). If country I places a tariff of the amount T on the import of the foreign firm’s product, the MC curve shifts vertically upward by the amount of the tariff to (MC + T), which is also (AC + T). Given this situation, which one of the following statements is TRUE?

a. The price of the product when there is no tariff is P2. 15-12 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 15 - Arguments for Interventionist Trade Policies

b. The imposition of the tariff must lead to a net decrease in welfare in country I. c. The imposition of the tariff leads to a net increase in welfare in country I if area C1C2FG exceeds area P1P2AB. * d. The imposition of the tariff leads to a net decrease in welfare in country I if area P1P2AB exceeds area C1C2HJ. 30.

If tariffs are used in an attempt to improve country A’s balance of trade, and if exchange rates are flexible, the imposition of the tariffs will cause __________ in the value of A’s currency relative to other currencies and, as a consequence, A’s exports will __________. a. a decrease; decrease b. a decrease; increase * c. an increase; decrease d. an increase; increase

31.

The “optimum tariff rate” for a country is that rate which, assuming no retaliation, a. maximizes the country’s terms of trade. b. maximizes the country’s quantity of imports. c. maximizes the country’s balance of trade * d. maximizes the country’s welfare.

32.

The macroeconomic interpretation of a trade deficit for a country utilizes which one of the following expressions (where Y = national income, C = consumption, I = investment, G = government spending on goods and services, X = exports, and M = imports)? a. Y + (C + I + G) = (X - M) b. (C + I + G) - Y = (X - M) c. (C + I) - G - Y = (M - X) * d. Y - (C + I + G) = (X - M)

33.

The existence of which type of dumping most likely constitutes the weakest argument for the imposition of an antidumping duty? a. predatory dumping * b. persistent dumping c. sporadic dumping d. none of the above – predatory, persistent, and sporadic dumping all generate equivalent-strength arguments for the imposition of an antidumping duty

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Chapter 15 - Arguments for Interventionist Trade Policies

34.

The macroeconomic view of a trade deficit implies that, other things equal, the imposition of a tariff will reduce the country’s trade deficit a. because imports will be reduced and exports cannot possibly change. b. only if the tariff has no impact on the country’s spending or income. * c. only if the tariff leads to increased income in the country relative to the country’s spending. d. only if the tariff leads to increased spending by the country relative to the country’s income.

35. The general policy rule that states that the appropriate policies for alleviating a problem are those policies aimed directly at the source of the problem is called * a. the specificity principle. b. the “beggar-my-neighbor” rule. c. the “opportunity cost” principle. d. the law of diminishing returns. 36.

The Krugman economies-of-scale “strategic trade policy” model stresses that protection given to a home firm will, other things equal, __________ the marginal cost of producing each level of home output and will __________ the marginal cost of producing each level of foreign output. a. decrease; also decrease * b. decrease; increase c. increase; also increase d. increase; decrease

37.

If, in a tariff game between two governments, both countries are on their tariff reaction functions, then each country __________ maximizing its welfare given the tariff of the other country. In this situation, there __________ incentive for each country to reduce its tariff unilaterally. a. is; is an * b. is; is no c. is not; is an d. is not; is

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Chapter 16 - Political Economy and U.S. Trade Policy

CHAPTER 16 POLITICAL ECONOMY AND U.S. TRADE POLICY Learning Objectives: ■ ■ ■ ■

Examine several basic concepts of the political economy of economic policy. Summarize critical developments in the history of multilateral trade negotiations. Analyze recent trade policy issues. Describe ongoing U.S. trade policy developments.

Outline Introduction - Contrasting Vignettes on Trade Policy The Political Economy of Trade Policy - The Self-Interest Approach to Trade Policy - The Social Objectives Approach - An Overview of the Political Science Take on Trade Policy A Review of U.S. Trade Policy - Reciprocal Trade Agreements and Early GATT Rounds - The Kennedy Round of Trade Negotiations - The Tokyo Round of Trade Negotiations - The Uruguay Round of Trade Negotiations - Trade Policy Issues after the Uruguay Round - The Doha Development Agenda - Recent U.S. Actions Concluding Observations on Trade Policy - The Conduct of Trade Policy Summary

II.

Special Chapter Features In the Real World: World Attitudes toward Foreign Trade In the Real World: U.S. Attitudes toward International Trade In the Real World: Politics Puts the Squeeze on Tomato Imports In the Real World: The Determinants of Trade Adjustment Assistance In the Real World: Tariff Reductions Resulting from the Uruguay Round In the Real World: National Sovereignty and the World Trade Organization In the Real World: Health, Safety, or Protectionism?

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Chapter 16 - Political Economy and U.S. Trade Policy

III.

Purpose of Chapter

The purpose of this chapter is two-fold. The first purpose is to introduce students to the political economy of trade policy, and the second is to provide an overview of contemporary U.S. trade policy, focusing on recent developments. IV.

Teaching Tips

A. We have found that students are very interested in the current politics of trade policy and in identifying which groups are currently actively lobbying for changes in trade policy. Beginning this section with a discussion of several of the current political issues and some of the underlying bases for the political economy of trade policy often will stimulate student interest in reading further about key economic and political issues that have influenced recent trade negotiations. B. It is worthwhile to spend some time brainstorming with the class on possible reasons why U.S. citizens’ support of international trade (as reflected in Tables 1 and 2 on pages 368-69) is relatively low. The recent decline in support shown in Table 2 can be tied in with the economic recession and with the point made in Chapter 15 that protectionist tendencies increase in times of relatively high unemployment. C. Since much of this chapter is primarily descriptive/historical in nature, it can be assigned to provide some institutional background to the course and can be left primarily for the students to read on their own. D. If you have a particular interest in this topic area and wish to devote class time to it, a more thorough and rigorous focus on one or two current trade policy issues will help the material become more alive to the students. We have also found that assigning different groups of students particular roles and then having them carry on a short trade policy debate in class is very effective way to stimulate interest in the topic. E. Supplementing the material in the chapter with current material from sources such as The Wall Street Journal, the New York Times, the Washington Post, and The Economist is also a good way to emphasize the relevance of the policy issues discussed in earlier chapters as they relate to the evolution of U.S. trade policy in recent years. V.

Answers to End-of-Chapter Questions and Problems

1. Legislation favored by a minority may in fact be enacted if the majority simply does not actively participate in the voting process. This may occur because the costs of acquiring information and voting are sufficiently great so that a large group of voters simply chooses not to participate. A second reason this result could come about is because a large number of voters feel that their one vote does not really make a difference or “swing” the outcome and are willing to accept the political result. In either case, the non-participating voter is acting as a “free-rider,” avoiding the costs of participation and accepting whatever result comes about based on those 16-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 16 - Political Economy and U.S. Trade Policy

who are actively participating. Because members of interest groups in the numerical minority often have more intense interest in and/or more to gain by influencing the political outcome, it is not uncommon to see an outcome that is not consistent with the median-voter approach. 2. Bilateral trade negotiations are superior in that there is greater likelihood of two countries reaching an agreement on reducing trade restrictions than for many countries reaching such an agreement. It is also easier to target certain commodities or policy objectives and/or tailor the trade package to the particular interests of the two countries involved. It makes equal policy reciprocity easier to put into play. On the other hand, the fact that successful multilateral negotiations represent a more significant move toward freer trade means that the potential welfare gains would be greater. There is also the possibility that certain countries might “go along” with the reduction in trade restrictions if every other member of the WTO is participating whereas they might be more reluctant on a bilateral basis, i.e., a “rules-based” trade policy is established with the multilateral negotiations. 3. The presence of protection on consumer goods such as textiles and clothing has continued over the years even though it has been extremely costly to the consumer. This has occurred for several reasons. First, the impact of protection on consumer prices is not transparent, i.e., not clearly apparent to the consumer. The average consumer has little idea of the higher price being paid for the merchandise because of the various instruments of protection on textiles and apparel. Secondly, not only are consumers not knowledgeable of the impact of protection, they also are not sufficiently organized as a group to influence the political process. Further, there is a strong regional aspect associated with this particular product that provides additional political leverage in Congressional negotiations. For example, the textile/apparel lobby is very well organized and strong, particularly on a regional basis. Thus, the potential winners, textile owners and textile labor, have successfully argued for protection over the years on a social objectives platform (personal and regional income) at the considerable expense of consumers at large. (Even with the formal quota removal in January of 2005, tariffs and other restrictions remain.) 4. Concern by the government for the relative income position of a particular group or segment of the economy can foster protection in several ways. First, the government may be less willing to reduce protection on the products that are central to the income of these groups. This is particularly true if there is little support for adopting a direct form of income transfers to these groups if increased trade and the resulting structural change threaten their relative economic well-being. Further, once it is observed that the government will step in with trade restrictions, members of this group will likely become less concerned with efficiency and quality considerations and require increasing amounts of protection to maintain their relative income position. In addition, the knowledge of how the government treats one group may well foster similar behavior on the part of other groups who feel threatened by increased trade. Thus, protection based on a social objective like income distribution not only can result in a short-run policy, but also produce an environment within which continued and often increasing protection will be a necessary norm. Concern with an issue like income distribution need not result in maintaining or even increasing protection and economic inefficiency. Rather than using an indirect method such as trade restrictions to influence the incomes of the groups under consideration, it is far better to adopt policy instruments that deal directly with those in need of 16-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 16 - Political Economy and U.S. Trade Policy

support. Direct income transfers to those truly in need will not only be a much more effective way to meet income needs, they would also be much less costly to the economy and consumers/ taxpayers than restricting trade. 5. (a) From an economic perspective, TAA should facilitate the movement of resources away from comparative disadvantage industries and towards comparative advantage industries. Since this would make factors less “specific” in nature, it should enhance the short/medium-term gains from trade. The difficulties include such things as funding for the program and being able to ascertain whether the unemployment or profitability problems are due to changes in the trade environment or are simply the results of poor firm management. (b) This should not rule out the use of TAA as a desirable policy. If funds for this type of adjustment, both domestic and trade-related, are insufficient, then the funds should be allocated between the two sources of factor rigidity based on a marginal cost/marginal benefit analysis with the available funds going where the potential net gains appear to be the greatest. In addition, a case can specifically be made for TAA because trade adjustment is distinct from domestic competition adjustment in that the government has changed the “rules of the game” for trade-related firms by altering trade barriers. 6. From a policy perspective, the impact of taxes such as tariffs is relatively well-known and quite easily understood. There tends to be more general support for policy changes that clearly reduce consumer prices. NTBs are, however, less well-understood by and less transparent to the public at large, and there is considerable industry pressure for trade policies (such as quotas or VERs) that seem to have a more certain outcome for the pressure groups. Also, in a growing domestic market, a quota is more appealing to the protected firm than is a tariff because, with the growth in demand, no additional imports are permitted with a quota whereas more imports come in with a tariff. 7. (a) The case for nonreciprocity for the developing countries would logically be built along the lines of an infant industry argument for protection. Until the industries gain experience and sufficient scale economies, they should receive preferential treatment by the developed countries and should be able to protect their own industries until they have attained a cost of production consistent with their comparative advantage. Of course, a normative case can also be built along the lines of giving assistance to poorer countries in the world economy. (b) The use of the nonreciprocity principle tends to maintain an inefficient world production structure. Developing countries, presumably for domestic policy reasons such as greater employment, will use the principle to foster production not only in their comparative advantage industries, but also in industries where they might clearly never have a comparative advantage. 8. If all intervention in agriculture were dropped, then trade and production would reflect comparative advantage. Food prices would decline in those countries that previously had protection and rise in free-trade countries. Agricultural income would decline in the protected countries and rise in the unprotected countries. To the extent that developing countries tax 16-3 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 16 - Political Economy and U.S. Trade Policy

farmers and developed countries subsidize farmers, a transfer of real income from developed countries to developing countries should also occur with removal of all agricultural restrictions in general. Finally, world welfare should rise with the movement to free trade. 9. With the imposition of the VER, product prices rise in the importing country. Consumers therefore suffer a loss in consumer surplus. In addition, with the VER, the quota rent (which would be received by the home government with the use of an equivalent tariff or with an auctioning of the quota rights under a domestically-imposed quota) goes to the exporting country. 10. If, for example, interest groups (such as a trade union) are better organized in a particular industry than in other industries, then there will be greater pressure on legislators to adopt trade restrictions favoring that particular industry. If the product in question (e.g., shoes) also constitutes a relatively small share of consumers’ budgets, then there will be little opposition to the imposition of tariffs and other restrictions because the time and money costs to households of gathering and analyzing relevant information may well be greater than the potential consumer benefits of free trade in the product. As another example, scarce factors of production have more incentive to oppose free trade than do abundant factors. If the scarce factors tend to be located in a particular region of the country, then that region’s political representatives, who wish to maximize their chances of staying in office, will push for the restrictive legislation and also may be willing to swap their support for legislation on other matters proposed by politicians from other regions in order to get the restrictive trade policies adopted. VI.

Sample Exam Questions

Essay Questions

1. Briefly describe the evolution of U.S. trade policy since the imposition of the famous Smoot-Hawley tariff. What has happened to the level of tariffs over the period? To the level of protection in general? 2. Compare and contrast “rules-based” trade policy with “results-based” trade policy. On which type is the GATT based? Which type is consistent with the “new reciprocity” approach to trade policy? 3. Briefly outline the focus of the Uruguay Round of trade negotiations, as well as the focus of the Doha Development Agenda. 4. Since 1993, the U.S. and the European Union have had a number of disagreements over trade policy. Discuss some of the major disagreements and identify the groups in the U.S. that stand to gain from the policies and those that stand to lose. 5. Do you think that the developing countries should be given special, favorable treatment in multilateral trade negotiations? Why or why not? Has such treatment been given to developing countries in the past? Explain.

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Chapter 16 - Political Economy and U.S. Trade Policy

Multiple-Choice Questions

The most recently successfully completed GATT/WTO “round” or set of multilateral trade negotiations was the a. Doha Development Agenda. * b. Uruguay Round. c. Tokyo Round. d. Kennedy Round.

The World Trade Organization a. prevents each member country from adopting its own trade policy objectives. * b. is charged with implementing the agreements reached in the Uruguay Round of trade negotiations. c. requires its member countries to eliminate all barriers to imports. d. requires its member countries to adopt common labor standards with respect to and wages working conditions.

8. Which of the following is generally thought to have established the highest tariffs in U.S. history? a. Trade Act of 1974 b. Reciprocal Trade Agreements Act of 1934 * c. Tariff Act of 1930 (Smoot-Hawley tariff) d. General Agreement on Tariffs and Trade 9.

The average level of tariffs in developing countries, which is __________ the average level of tariffs in the developed countries, __________ after the conclusion of the Uruguay Round of trade negotiations. a. lower than; did not change b. lower than; fell c. higher than; did not change * d. higher than; fell

10.

Recent polling work discussed in the text pertaining to attitudes toward international trade suggests that Americans have __________. Another finding is that greater inequality in a country seems to be positively associated with a greater desire __________.

a. a more favorable opinion of the overall benefit of international trade than do citizens of most other countries; to restrict rather than to expand international trade b. a more favorable opinion of the overall benefit of international trade than do citizens of most other countries; to expand rather than to restrict international trade * c. a less favorable opinion of the overall benefit of international trade than do citizens of 16-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 16 - Political Economy and U.S. Trade Policy

many other countries; to restrict rather than to expand international trade d. a less favorable opinion of the overall benefit of international trade than do citizens of many other countries; to expand rather than to restrict international trade 11.

The concept of “results-based” trade policy * a. is embodied in the “new reciprocity” approach to policy. b. is consistent with GATT codes and guidelines. c. is encouraged by policymakers who want the government to be less involved in managing trade. d. is encouraged by those who feel that government allocation of resources is less efficient than market allocation of resources.

12. The successful Uruguay Round of trade negotiations transformed the then-existing sponsoring agency into the __________, which began operation in __________. a. GATT; 1986 b. GATT; 1995 c. WTO; 1990 * d. WTO; 1995 13.

If some of a country’s resources are devoted to the provision of bribes and other incentives to legislators so as to influence voting behavior on particular policies, these actions __________; the actions are referred to by economists as __________.

a. lead to enhanced production of goods and services in the country rather than simply to a redistribution of income; “directly productive activity” b. lead to enhanced production of goods and services in the country rather than simply to a redistribution of income; “directly unproductive activity” c. simply lead to a redistribution of income in the country rather than to enhanced production of goods and services; “directly productive activity” * d. simply lead to a redistribution of income in the country rather than to enhanced production of goods and services; “directly unproductive activity” 14. The use of a bilateral, item-by-item approach best characterizes which period of trade negotiations? a. the Kennedy Round b. the Tokyo Round * c. Reciprocal Trade Agreements negotiations d. early GATT negotiations after World War II 15.

It is not uncommon to find a voting industry minority being able to put in place trade policies that benefit that minority at the expense of the majority

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Chapter 16 - Political Economy and U.S. Trade Policy

* a. because perceived consumer benefits are less than the “cost” of voting, leading to absenteeism of consumers at the polls. b. because politicians ignore the average voter. c. because politicians are very often bribed by big business and labor unions. d. because consumers prefer to “buy American” even if it costs them more. 16.

The longstanding arrangement for regulating the flow of imports of textiles and apparel into developed countries from developing countries was known as __________. a. the Generalized System of Preferences * b. the Multi-Fiber Arrangement c. a “fast-track” agreement d. an outsourcing/offshoring agreement

17. The first U.S. legislation to authorize “adjustment assistance” for workers displaced by tariff reductions was the a. Reciprocal Trade Agreements Act of 1934. * b. Trade Expansion Act of 1962. c. Trade Act of 1974. d. Omnibus Trade and Competitiveness Act of 1988. 18.

In the last 10-15 years, which one of the following sets of goods has NOT been subject to an agreement to limit the amount of imports into the United States? a. imports of softwood lumber from Canada b. imports of steel from China * c. imports of hormone-treated beef from the European Union d. imports of some textile goods from China

19.

In late 2003, the Bush administration unilaterally placed temporary import quotas on several textile items imported from __________. a. the European Union b. Japan c. Brazil * d. China

20. In the Uruguay Round of trade negotiations, the talks originally broke down in 1990 primarily because of the strong disagreement between the United States and the European Community with respect to a. service restrictions. b. antidumping provisions. c. treatment of intellectual property. 16-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 16 - Political Economy and U.S. Trade Policy

* d. subsidies and protection in agriculture. 21.

Small groups may gain at the expense of the majority when a. voters perceive that there are costs associated with voting. b. small group solidarity is high and there is little “free-riding” within the groups. c. the expected consumer benefits from the policies are small on an individual basis. * d. all of the above

22.

An early significant agreement in the negotiations of the Doha Development Agenda that is of importance to developing countries occurred in the area of a. agricultural protection. * b. pharmaceuticals pricing. c. antidumping provisions. d. environmental protection and sustainable development.

23.

The feature of U.S. trade legislation whereby a negotiated trade agreement (negotiated by the Executive Branch) can only be voted on in a “yea” or “nay” fashion (with no amendments) by the Congress is known as * a. “fast-track” (or Trade Promotion Authority). b. MFN treatment (or Normal Trade Relations). c. the Generalized System of Preferences (GSP). d. the Offshore Assembly Provisions (or “production sharing”).

24.

After the implementation of the tariff reductions agreed to in the Uruguay Round of multilateral trade negotiations, the average level of tariffs in developed countries was __________. a. 0 percent * b. between 0 percent and 5 percent c. between 5 percent and 10 percent d. greater than 10 percent

Chapter 16 - Political Economy and U.S. Trade Policy

25.

In 2011, final approval by the U.S. Congress was given to free-trade agreements with __________. * a. Colombia, South Korea (Republic of Korea), and Panama b. Canada, China, and Ecuador c. China, Dominican Republic, and Panama d. Colombia, Costa Rica, and South Korea (Republic of Korea)

Chapter 17 - Economic Integration

CHAPTER 17 ECONOMIC INTEGRATION Learning Objectives: ■ ■ ■ ■

Differentiate among the four basic levels of economic integration. Identify the static and dynamic effects of economic integration. Analyze the real-world impact of economic integration on countries in the European Union and the North American Free Trade Agreement. Summarize current economic integration efforts in the world.

Outline Introduction - An Expanded European Union Types of Economic Integration - Free-Trade Area - Customs Union - Common Market - Economic Union The Static and Dynamic Effects of Economic Integration - Static Effects of Economic Integration - General Conclusions on Trade Creation/Diversion - Dynamic Effects of Economic Integration - Summary of Economic Integration The European Union - History and Structure - Growth and Disappointments - Completing the Internal Market - Prospects U.S. Economic Integration Agreements - NAFTA - Effects of NAFTA - Recent U.S. Integration Agreements Other Major Economic Integration Efforts - MERCOSUR - FTAA - Chilean Trade Agreements - APEC - Trans-Pacific Partnership Summary

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Chapter 17 - Economic Integration

II.

Special Chapter Features In the Real World: Economic Integration Units In the Real World: Trade Creation and Trade Diversion in the Early Stages of European Economic Integration Concept Box 1: Trade Diversion in General Equilibrium In the Real World: The East African Community In the Real World: Canadian Regional Trade Agreements – Is the EU Next? In the Real World: NAFTA – Myths vs. Facts In the Real World: Asian Economic Interdependence Leads to Greater Integration

III.

Purpose of Chapter

The purpose of this chapter is to extend the study of trade policy to the situation of discriminatory policy regimes, exemplified by economic integration units such as free-trade areas and customs unions. To acquaint the student with real-world economic integration, considerable attention is devoted to the history of and the continuing liberalization in the European Union. Coverage is also given to integration in North America and other major integration units. IV.

Teaching Tips

A. The chapter begins with a brief look at the enlargement of the EU over time. This provides a nice opportunity to discuss the potential benefits to the EU and why nations would want to join (focusing on real economic benefits apart from the macro difficulties that some EU members are currently experiencing). The “In the Real World” box on pages 399-400 also provides a list of the members of all major integration units. This allows the discussion to move toward the common characteristics of members of integration units. B. In discussing Figure 2 on trade diversion, it is useful to stress that there is some trade creation going on in this “trade-diverting” customs union. The 30 units between 100 and 130 constitute creation in Viner’s sense, because those units represent previous domesticallyproduced units in country A that are now imported from lower-cost partner country B. In addition, the 20 units between 180 and 200 represent creation in a broader sense in that those units constitute trade that did not exist before the union. Only the 50 units between 130 and 180 constitute true trade diversion. The “In the Real World” box on pages 400-02 provides an opportunity to look at actual trade creation and diversion in the original European Community. C. The graph in Concept Box 1 on page 405 may be hard for the students to follow, but we think that its message is a good one. Emphasis on the graph can also test whether the students truly understand the neoclassical trade diagram.

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Chapter 17 - Economic Integration

D. With respect to the section on the European Union, we think that the referenced Hufbauer chapter (“An Overview”) is excellent background. It would be well worth assigning as an outside reading. E. Obviously you will want to keep the students current with developments regarding NAFTA and other economic integration efforts as such efforts are very prevalent in the world economy. V.

Answers to End-of-Chapter Questions and Problems

1. This customs union has no possibilities for trade creation in the Viner sense because the two countries have no common domestic industries for yielding displacement of a higher-cost domestic industry by a lower-cost partner supplier. However, there are great possibilities for trade diversion. Country A may switch its imports of raw materials and agricultural goods from a low-cost outside world producer to higher-cost B producers, and B may do likewise with respect to its imports of manufactured goods. The trade diversion could still be beneficial if consumption effects are strongly positive, say because of very high preunion tariffs on outsideworld products – although such tariffs would be unlikely in this situation. Of course, dynamic effects could be beneficial as the countries integrated into a larger, more diversified economic unit. 2. The reasoning behind this view is that, because the developing countries produce similar products, they are not likely to be sources for each other of new, different products vital to the development effort. Even granting the questionable assumption that the developing countries are “alike,” however, consideration of trade creation and trade diversion could lead to disagreement with this view of “little gain” from customs unions. Because similar items are being produced in the potential partners, there can be a likelihood of trade creation. In addition, trade diversion will be slight if the potential partners do not possess the capability for displacing the different products being supplied by the outside, developed world. Finally, there can be dynamic benefits from scale economies, etc., as well as potential collective terms-of-trade effects. All of these potential benefits assume, of course, that the developing countries can effectively agree on integration and can surmount the political and distributional difficulties associated with it. 3. The motivation was that the United States feared that Portugal and Spain would, through trade diversion, switch their purchases of some agricultural goods away from the United States and toward other EC members. The threatened U.S. duties were designed to get new exports from the United States to the EC to replace the diverted agricultural goods. The action could be supported on welfare grounds since it actually led to a reduction of some other EC trade barriers and hence to gains from the additional trade. If the action had not been successful and had led to retaliatory EC measures on the United States, welfare losses would have occurred. 4. By reducing (usually eliminating) tariffs only on developing-country goods coming into developed countries, the action is a discriminatory trade policy measure, as is the formation of an economic integration project. Trade can be “created” in that the new developing countries’ exports displace previous high-cost domestic production within any given GSP-granting developed country. The GSP also diverts imports from other developed countries into any given

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Chapter 17 - Economic Integration

developed country, switching imports from a lower-cost to a higher-cost source (the developing countries) that was not exporting as much to the developed country with the uniform tariff structure. 5. Trade diversion against U.S. exports could have occurred as barriers within Europe were dismantled. Further, dynamic effects such as enhanced technology and scale economies could have made the EU a more formidable export threat in third-country markets as well as in the U.S. market. However, if the EU grows more rapidly, it can be in a position to purchase more U.S. goods. Also, U.S. foreign investors expanding into Europe may source their inputs from the United States. Whether or not one should be enthusiastic or worried obviously depends on the size of the costs to the United States relative to the benefits. Certainly greater growth in Europe can potentially benefit U.S. welfare, but, if the result of the integration is the formation of two hostile trading blocs (Europe and North America), there can be overall detrimental impacts. 6. It can be argued that the development of APEC and the Trans-Pacific Partnership alongside the efforts in the Western Hemisphere (e.g., NAFTA) represent a movement toward world free trade in that there are several members (Canada, Chile, Mexico, and the United States) that are participants in both APEC and integration efforts in the Western Hemisphere. For these countries their simultaneous participation in both movements represents a significantly greater step towards worldwide free trade and increased benefits of integration than do either of the movements alone. This follows from the knowledge that the net effects of integration are greater, the larger are the number of participants in free trade agreements and the larger the economic size of the participants. 7. U.S. workers, especially in labor-intensive industries, worried that freeing up trade with labor-abundant Mexico would cause U.S. workers to lose their jobs or receive lower wages. These results were thought to be even more likely because U.S. firms will also switch production to Mexico because of the lower wages there. Hence, fears arose and continue to arise because of the perceived increased job/wage insecurity due to NAFTA. Other concerns have been raised about inadequate environmental protection and about “unfair” trade since Mexico’s labor standards are lower. In addition, with NAFTA, there is joint arbitration of some trade disputes by representatives of all three nations, and this feature led to U.S. fears of loss of national sovereignty. The second part of the question is clearly a judgment call on the part of the person answering the question. In the static sense, the trade creation effects of NAFTA must be compared to the trade diversion effects, taking into account any accompanying costs of adjustment. Of greater importance, however, are the dynamic effects that can accompany the increased trade among the three countries. Insofar as integration fosters greater efficiency and higher productivity through increased specialization, reduces problems of illegal migration with Mexico, increases consumer well-being through lower import prices, and is not accompanied by major structural adjustment problems, the benefits can clearly be positive. 8. (a) The basis for this statement is the fact that specific coalitions contain elements of both trade creation and trade diversion. The static effects of these coalitions can thus be negative if trade diversion effects are greater than trade creation effects, whereas no trade diversion

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Chapter 17 - Economic Integration

effects occur with a general lowering of protection by everyone. In addition, there is the fear that once members of the coalition(s) have reduced tariffs with each other they will be less interested in further reductions in protection with nonmembers. There is also the fear that the new coalitions may actually raise their external tariffs to nonmembers, generating a group of trading blocs that would represent a movement away from freer trade. (b) The establishment of new trading coalitions should be encouraged because they represent a clear first step towards freer world trade. This is particularly so if the coalitions adopt common external tariffs for nonmembers which are lower than those in existence in each country prior to their integration. Further, to the extent that there are economies of scale present, the larger coalition market will allow coalition members to produce goods more cheaply and thus have less need for protection in general. Finally, experiencing both the static and dynamic economic gains that accompany the smaller coalitions will make them more open to reducing trade barriers on a worldwide basis. VI.

Sample Exam Questions

Essay Questions

1. Jacob Viner originally envisioned a situation where, in the demand/supply graph of a trade-diverting customs union, the demand curve was vertical and all supply curves (including the supply curve of domestic producers) were horizontal. In this situation, could the tradediverting customs union ever enhance the home country’s (country A’s) welfare? Explain. 2.

(a) Define “trade creation” in the context of the formation of a customs union. Then, using a demand/supply diagram of a (small) home country for a good that is produced at home and would be imported if there were no tariff, illustrate and explain how the formation of a pure trade-creating customs union can enhance the country’s well-being. What factors would be conducive to a greater rather than a smaller gain from the trade creation? (b) Define “trade diversion” in the context of the formation of a customs union. Then, using a demand/supply diagram of a (small) home country for a good that is both produced at home and imported, illustrate and explain how the movement from a situation of a uniform tariff on imports of the good from all countries to a situation of a trade-diverting customs union with one particular country can affect consumer and producer surplus and government revenue in the home country. Why can we not be sure that welfare in the home country will rise? Under what general conditions would it be likely that this trade-diverting customs union would injure welfare in the home country?

3. Other things equal, would the formation of a customs union with many members be more likely or less likely to improve welfare for a given member country than the formation of a customs union with only a few members? Why or why not? Other things equal, would the formation of a customs union be more likely or less likely to enhance welfare for a given member country if that country had very high preunion tariffs than if it had very low preunion tariffs? Why or why not?

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Chapter 17 - Economic Integration

4. Conceptually, what would happen to relative factor prices in labor-abundant country A and capital-abundant country B if the two countries joined together into a customs union? Why? Conceptually, why could the additional step of moving from a customs union to a common market not result in any movement of labor and capital between the two countries? Explain. 5. How could the formation of an economic integration unit among several countries actually result in the countries trading to a greater extent in absolute terms with the outside world than before the union was formed? What factors would you consider in assessing whether this result would be likely to occur? Explain. 6. When the European Community was originally formed, it was determined that the common external tariff on outside world products should be equal to the average of the preunion tariffs of partner countries on the outside world. This rule was adopted so that there would not be a net increase in protection against the outside world. Thus some partners raised tariffs on some products and lowered them on others. Demonstrate how this “averaging” rule would complicate the process of making welfare judgments about the likely effects of the original formation of the EC on the member countries. B.

Multiple-Choice Questions

In a production-possibilities/indifference curve diagram depicting the movement of a country from a situation of a uniform tariff against all trading partners to a situation of a customs union with one trading partner, a. the country must necessarily move to a higher indifference curve after the formation of the customs union. b. the country must necessarily move to a lower indifference curve after the formation of the customs union. c. home production of the country’s export good will increase and home production of the country’s import good will also increase after the formation of the customs union. * d. home production of the country’s export good will increase and home production of the country’s import good will decrease after the formation of the customs union.

The following diagram pertains to good X for country A, where DA is the demand for X by A’s consumers, SA is the supply curve of X from A’s home producers, SB is the horizontal supply curve of X to country A from country B, SC is the horizontal supply curve of X to country A from country C, and S’B and S’C are the horizontal supply curves from B and C, respectively, with a tariff in place. With the tariffs in place for both countries B and C, imports of good X into country A are represented by distance __________.

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Chapter 17 - Economic Integration

a. OQ6 b. Q1Q6 c. Q2Q5 * d. Q3Q4 9.

In the diagram in Question #8 above, suppose that country A, from this initial situation where its tariff is applied to both countries B and C, now forms a customs union with country B. With this customs union in place, imports into country A are distance __________. a. Q2Q5, all of which constitute trade diversion from the non-customs union country. * b. Q2Q5, only part of which constitute trade diversion from the non-customs union country. c. Q3Q4, all of which constitute trade diversion from the non-customs union country. d. Q1Q6, all of which constitute trade diversion from the non-customs union country.

10.

In the diagram in Question #8 above, when the tariffs are in place for both countries B and C, the tariff revenue being collected by country A’s government consists of __________. a. area b b. area f * c. areas (b + f) d. areas (e + f + g)

11.

In the diagram in Question #8 above, suppose that country A, from this initial situation where its tariff is applied to both countries B and C, now forms a customs union with country B. The “net welfare effect” on country A from the formation of this customs union with country B would be __________. a. areas (a + b + c) minus area f b. areas (a + c) minus areas (b + f) * c. areas (a + c) minus area f d. areas (a + c + d + e + g + h) minus area f

12.

In the diagram in Question #8 above, suppose that country A, from this initial situation 17-7

Chapter 17 - Economic Integration

where its tariff is applied to both countries B and C, now forms a customs union with country C. With the formation of this customs union, the amount of imports of good X into country A would be represented by the distance __________. a. OQ6 * b. Q1Q6 c. Q2Q5 d. Q3Q4 13.

In the diagram in Question #8 above, suppose that country A, from this initial situation where its tariff is applied to both countries B and C, now forms a customs union with country C. The “net welfare effect” on country A from the formation of this customs union with country C would be __________. a. areas (a + c) minus area f b. areas (a + c + e + g) minus area f c. areas (a + c + d + e + g + h) minus areas (b + f) * d. a gain of areas (a + c + d + e + g + h)

14.

In considering “trade creation” and “trade diversion” in the formation of a customs union between countries and whether the customs union enhances welfare in a home country joining the union, two general conclusions that seem valid are that the customs union is less likely to enhance welfare, other things equal, (i) if the union contains a __________ number of countries and (ii) if costs of production in the partner countries in the case of trade diversion differ __________ from costs of production in the outside world (the nonmember countries). a. large rather than a small; greatly b. large rather than small; only slightly * c. small rather than a large; greatly d. small rather than a large; only slightly

15.

Which of the following is considered to be a positive dynamic effect of integration? * a. economies-of-scale effects b. reduced customs costs c. trade diversion d. increased monopoly power of firms

16.

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Chapter 17 - Economic Integration

* a. higher; more elastic b. higher; less elastic c. lower; more elastic d. lower; less elastic 17. Which one of the following sets of countries contains only members of the European Union? a. France, Spain, Switzerland, United Kingdom b. Germany, Italy, Portugal, Norway c. Denmark, Greece, the Netherlands, Russia * d. Belgium, Greece, Italy, Portugal 18. If good X from country C faces a 10 percent tariff in country A and a 20 percent tariff in country B, but if A and B have free trade between each other, then A and B are part of which one (and only one) of the following types of groupings? * a. free-trade area b. customs union c. common market d. economic union 19.

As of January 1, 2007, the number of countries belonging to the European Union increased to a total of __________ countries. a. 6 b. 15 c. 25 * d. 27

20.

If country A forms a customs union with country B, then a. country B continues to get tariff revenue from country A’s exports sent to B. b. all new trade between countries A and B because of the union is known as “trade creation.” c. the welfare of countries A and B must necessarily be enhanced, especially if A and B begin to buy many items from each other that they used to buy from the “outside world.” * d. countries A and B may especially benefit from the union if substantial economies of scale exist in some of the A and B industries.

21.

In a production-possibilities/indifference curve diagram, when a (small) country moves from a situation of a uniform ad valorem tariff on all trading partners to a situation of a trade-diverting customs union with one of its trading partners, the ratio of the domestic price of the country’s export good to the domestic price of the country’s import good __________.

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Chapter 17 - Economic Integration

* a. will increase b. will not change c. will decrease d. will increase, not change, or decrease – cannot be determined without more information 22.

In general, other things equal, trade creation is more likely to outweigh trade diversion for a home country forming a customs union with partner countries (i) if the total number of countries forming the union is __________, and (ii) if the level of tariffs in the home country prior to the formation of the union is __________. a. small rather than large; high rather than low b. small rather than large; low rather than high * c. large rather than small; high rather than low d. large rather than small; low rather than high

23.

In a production-possibilities/indifference curve diagram, when a (small) country moves from a situation of free trade to a situation of a uniform ad valorem tariff on imports from all trading partners, the ratio of the domestic price of the country’s export good to the domestic price of the country’s import good __________. a. will increase b. will not change * c. will decrease d. will increase, not change, or decrease – cannot be determined without more information

24. If two countries remove all tariffs on each other’s products and establish a common set of tariffs against the rest of the world, but take no further steps toward economic integration, these two countries have formed a. a free-trade area. * b. a customs union. c. a common market. d. an economic union.

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Chapter 17 - Economic Integration

25.

When the European Community began operation in 1958, how many countries belong to this union? * a. 6 b. 15 c. 25 d. 27

26.

If two countries remove all tariff and nontariff barriers to trade between them, adopt a common external tariff on imports from the outside world, and permit free factor movements between themselves, but take no further steps toward economic integration, this economic coalition that has been formed is a a. free-trade area. * b. common market.. c. economic union. d. customs union.

27.

To which one of the following agreements or groups is the United States NOT a signatory or member? a. APEC b. CAFTA-DR * c. MERCOSUR d. NAFTA

28.

The country that claims to have a greater number of economic integration trade agreements in place than any other country is * a. Chile. b. the Dominican Republic. c. Mexico. d. the United States.

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Chapter 18 - International Trade and the Developing Countries

CHAPTER 18 INTERNATIONAL TRADE AND THE DEVELOPING COUNTRIES Learning Objectives: ■ ■ ■ ■ I.

Identify the various characteristics of developing countries. Explain how greater openness to trade can potentially contribute to more rapid economic growth. Discuss the problems of export instability and terms-of-trade deterioration faced by developing countries. Analyze the nature of and potential solutions to the external debt problems of developing countries. Outline Introduction - Strong Recovery in East Asia An Overview of the Developing Countries The Role of Trade in Fostering Economic Development - The Static Effects of Trade on Economic Development - The Dynamic Effects of Trade on Development - Export Instability - Potential Causes of Export Instability - Long-Run Terms-of-Trade Deterioration Trade, Economic Growth, and Development: The Empirical Evidence Trade Policy and the Developing Countries - Policies to Stabilize Export Prices or Earnings - Problems with International Commodity Agreements - Suggested Policies to Combat a Long-Run Deterioration in the Terms of Trade - Inward-Looking versus Outward-Looking Trade Strategies The External Debt Problem of the Developing Countries - Causes of the Developing Countries’ Debt Problem - Possible Solutions to the Debt Problem Summary

II.

Special Chapter Features Titans of International Economics: Raul Prebisch (1901-1986) and Hans Wolfgang Singer (1910-2006) In the Real World: Managing Price Instability In the Real World: The Length of Commodity Price Shocks In the Real World: Comecon Foreign Trade Pricing Strategies In the Real World: Terrorism and Its Effect on Developing Countries In the Real World: Emerging Connections between Asia and Africa In the Real World: The Multilateral Debt Relief Initiative 18-1

Chapter 18 - International Trade and the Developing Countries

III.

Purpose of Chapter

The purpose of this chapter is to review the general links between international trade and economic development and to summarize key problems that exist (or are alleged to exist) with respect to developing countries and their trade sector. Possible causes and consequences of the potential trade difficulties are examined. Policy options are considered that might help to obtain a more favorable contribution of trade to development and to accelerate growth in the less developed countries (LDCs). The chapter concludes with a specific focus on the debt problem of the developing countries. Some possible solutions to this debt problem also are suggested. IV.

Teaching Tips

A. U.S. college students often have little conception of the vast differences between their own living standards and those in the LDCs. Table 1 provides data necessary to understand the economic conditions in developing nations. The chapter then takes a look at the least developed countries in the world and the myths associated with their trade. Anything you can do to supplement and to bring life to these data would be very helpful. B. Presentation of a numerical example can help the students in understanding how transfer pricing can work against the host developing country. C. There seems to be some feeling among economists that the terms-of-trade issue is a “dead issue.” However, we recommend dealing with it because it seems very much alive in political science courses that students may be taking. D. In discussing “inward-looking” versus “outward-looking” strategies, it is important to note that government played a large role even in the “strongly-outward-oriented” cases of South Korea and Singapore. Students should not conclude from this section that the public sector should always get out of the way. E. The IMF’s semi-annual publication World Economic Outlook (appearing in April and September) provides updated information on the debt situation as well as projections for future years. V.

Answers to End-of-Chapter Questions and Problems

1. According to trade theory, countries should specialize in and export those goods and services that use relatively-intensively their relatively-abundant factor. Because the LDCs are often labor/land-abundant, the static gains from trade would result from their expanded production and trade in goods intensive in these factors. Their trading partners, the industrialized countries (ICs), would, on the other hand, be specializing in goods that are relatively intensive in capital. Thus, the gains from trade and the relative income distribution effects accompanying trade would tend to reward labor/land in the LDCs and capital in the ICs. 2. This question is obviously focusing on the dynamic gains from trade that are discussed early in the chapter. The dynamic effects of trade are related to such phenomena as 18-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 18 - International Trade and the Developing Countries

demonstration effects associated with exposure to new products and cultures, possible increased international investment, exposure to new technologies, economies of scale associated with enlarged production, benefits of increased competition (reduction in monopoly market leverage), etc. 3. These arguments focus on the static effects of international trade discussed in the first question. Following the dictates of comparative advantage, many developing countries could find themselves specializing in labor/land-intensive production rather than more capital-intensive production. Such a situation could lead to several problems. First, labor/land-intensive products often have lower income elasticities of demand than do capital-intensive manufactures. Consequently, the demand for labor/land-intensive products grows relatively more slowly and the countries producing these goods find their growth in exports lagging behind export growth in the ICs. Further, the LDCs’ own demand for imports may outgrow their export growth leading to balance-of-payments and debt problems. In addition, the low price elasticities of LDC export products tend to make LDC annual export revenues more erratic. Because of these production effects they may find themselves increasingly dependent upon foreign technology and international financing. Finally, by not focusing more on the effective use of capital, the consequent increase in labor productivity (and hence wages) is retarded and, relatively speaking, the gap in per capita income between the ICs and the LDCs may widen. 4. Basic reasons why export price (and earnings) instability is judged to be a problem are indicated in the chapter. Price instability seems more likely to occur for LDCs than for ICs because demand and supply elasticities are lower in LDCs, because shifts in the curves may be more frequent for LDCs, and because LDC exports are more heavily concentrated by commodity. These features reflect the relatively greater reliance on the export of primary products by the LDCs than by the ICs. 5. The long-run deterioration of the commodity terms of trade suggests that, other things equal, welfare is less for the LDCs than would otherwise be the case; for the ICs, it is greater, so there has in effect been a transfer of welfare to the ICs from the LDCs. A “worst case” of deterioration would be represented by the immiserizing-growth situation, where the outward shift of the PPF from an LDC’s growth results in such a deterioration of the terms of trade that the country ends up on a lower indifference curve after growth. However, the income terms of trade might have improved. 6. The diversification could mean that the price instability would be less because demand and supply curves for manufactured goods are generally more elastic than for primary products. Also, the diversification by definition would mean less of an “eggs in one basket” phenomenon. Regarding the terms-of-trade deterioration, diversification would mean movement into products with higher income elasticities of demand in the buying countries, and perhaps a greater ability by LDCs to avert downward wage movements associated with the unorganized labor markets in the primary product sector. With respect to the terms of trade, protection against the new LDC manufactured products might arise, which could offset the favorable effects of the higher income elasticities of demand. 18-3 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 18 - International Trade and the Developing Countries

7. If the larger market size generated by an economic integration project permits scale economies and efficient production, the LDCs might consequently diversify by exporting to each other (or even to the outside world). There could also be other dynamic effects such as the attraction of direct foreign investment from the ICs. Further, if the same primary products are exported to the ICs by the member LDCs, some market power might now be exerted. With respect to static effects, trade diversion might outweigh trade creation if the LDCs began to produce some of the manufactured products formerly imported from ICs, but this may not be the result. (See the answer to End-of-Chapter Question #2 in Chapter 17 in this Instructor’s Manual.) The formation of the coalition might also mean lower quality, lower-tech manufactured goods imports than had previously been the case. Whether such LDC unions should be recommended depends on a more precise assessment of the effects in each situation, but a cautionary note is provided by past experience (such as happened historically with the original East African Common Market). 8. A reduction in the debt burden can make for greater stability and growth in the world as a whole, and it is in the interests of both the developed countries and the developing countries to seek solutions to the debt problems in LDCs. Some argue that a reduction in debt might in fact enhance the likelihood that the LDCs will repay debt and help the lending banks as well. In cases where the debt burden is so high that default is a real possibility, the forgiveness may be the key to preventing default. If the LDC has a smaller debt burden and reduced possibility of a future need to raise taxes to deal with debt service and repayment, foreign investment may also be more attracted to the LDC. 9. The developing countries are not blameless, because they have often pursued inappropriate domestic policies involving price distortions, rapid inflation (leading to capital flight), usage of loans for purposes other than development, etc. Since internal factors have been important in generating the problem, a case can be made that debt should not be relieved unless countries make changes that improve the long-term ability to service their debt. In fact, a potential moral hazard problem is created if improper use of funds and poor policy choices appear to be rewarded by debt forgiveness. VI.

Sample Exam Questions

Essay Questions

1. Would you prefer to receive a stable income of $20,000 per year for three years or an income of $15,000 in the first year, $40,000 in the second year, and $15,000 in the third year? Explain. What about $20,000 per year versus a $15,000-$50,000-$15,000 sequence? Why or why not? What about $20,000 per year versus a $15,000-$35,000-$15,000 sequence? Why or why not? 2. Remembering the optimum tariff analysis of Chapter 15, explain why it might be possible that the imposition of a tariff by an LDC to improve its terms of trade (and thus hopefully to be 18-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 18 - International Trade and the Developing Countries

in a better position at the start of any future deterioration) could reduce the LDC’s welfare. Build the reverse case that reduction of an LDC tariff might improve the LDC’s welfare at the present time, even though the terms of trade deteriorate because of the tariff reduction. 3. Utilizing material in this chapter as well as the trade theory developed in Chapters 6-8 (traditional neoclassical trade theory), develop a case that the developing countries should pursue an “outward-looking” rather than an “inward-looking” trade strategy. 4. Utilizing material in this chapter as well as arguments for protection in Chapter 15, develop a case that the developing countries should pursue an “inward-looking” rather than an “outward-looking” strategy. Are you really convinced by the case that you have built? Why or why not? 5. Using the debt-relief Laffer curve, make the case that debt relief can be in the best interest of both the developing and developed countries. 6. Despite the general agreement among economists on the benefits of moving to free trade, observers have noted that some developing countries may have “special” problems with regard to trade – the problems of export instability and a potential long-run deterioration of the terms of trade. Indicate the alleged nature of the problems and discuss potential causes for the problems. Then summarize and assess possible policies that could be utilized to deal with the problems. Finally, do you think that these countries should “turn inward” (i.e., become less open to trade) because of these problems? Briefly explain. B.

Multiple-Choice Questions

7. In the situation of transfer pricing by a multinational firm in its trade between plants located in less developed countries (LDCs) and industrialized countries (ICs), the firm, other things equal, will, if it wants to shift recorded profits from its LDC plants to its IC plants, record a price on goods sent from LDCs to ICs that is __________ than a comparable free-market price. For goods sent from ICs to the LDCs, the firm will __________ than a comparable free-market price. a. lower; also want to record a price that is lower * b. lower; want to record a price that is higher c. higher; want to record a price that is lower d. higher; also want to record a price that is higher

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Chapter 18 - International Trade and the Developing Countries

8. In international commodity agreements that specify a target range for the price of a product, if the world price of the good is above the “ceiling” price, then a buffer stock agreement would require that the international agency __________ the product and an export quota agreement would require that countries __________ their exports of the good. * a. sell; increase b. sell; decrease c. buy; increase d. buy; decrease 9.

In attempting to determine whether a developing country’s export price instability is caused by shifts in world demand for the country’s exports or by shifts in the supply curve of the country’s exports (along with corresponding shifts in the supply curves of competing exporters), a general rule is that, other things equal, if the demand curve is doing the shifting, then price and quantity will move __________; in addition, if the supply curve is shifting along a given demand curve, then, other things equal, price and quantity __________.

* a. directly with each other (i.e., when price rises, quantity rises, and when price falls, quantity falls); will move inversely with each other (i.e., when price rises, quantity falls, and when price falls, quantity rises) b. directly with each other (i.e., when price rises, quantity rises, and when price falls, quantity falls); also will move directly with each other c. inversely with each other (i.e., when price rises, quantity falls, and when price falls, quantity rises); will move directly with each other (i.e., when price rises, quantity rises, and when price falls, quantity falls) d. inversely with each other (i.e., when price rises, quantity falls, and when price falls, quantity rises); also will move inversely with each other 10.

In the following diagram, the curve 0ABC that relates the market value of LDC external debt to the face value of the external debt is known as

a. the Laffer curve. * b. the debt-relief Laffer curve. c. the Brady curve. d. the Prebisch-Singer curve. 18-3 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 18 - International Trade and the Developing Countries

11. In the diagram in Question #10 above, where curve 0ABC relates the market value of LDC external debt to the face value of the external debt, the range __________ indicates a situation where debt relief or forgiveness for LDCs would reduce the market value of commercial banks’ holdings of LDC debt but by less than the amount of debt forgiven. In this range, any one bank __________. * a. AB; would not want to forgive debt unless all other banks did also b. AB; would be willing to forgive debt even though other banks did not forgive debt c. BC; would not want to forgive debt unless all other banks did also d. BC; would be willing to forgive debt even though other banks did not forgive debt 12. In the diagram in Question #10 above, where curve 0ABC relates the market value of LDC external debt to the face value of the external debt, the range __________ indicates a situation where debt relief or forgiveness for LDCs would reduce amount of debt owed by developing countries and would also increase the market value of the debt. In this range, any one bank __________. a. AB; would lose by forgiving debt unless all other banks also forgave debt b. AB; could gain by forgiving debt even though other banks did not forgive debt c. BC; would lose by forgiving debt unless all other banks also forgave debt * d. BC; could gain by forgiving debt even though other banks did not forgive debt 13.

In the classification terminology of the World Bank, a “strongly-inward-oriented economy” is one that has __________ trade controls and consequently __________. a. extensive; discriminates against production for the home market rather than for export * b. extensive; discriminates in favor of production for the home market rather than for export c. extensive; does not discriminate between production for the home market and production for export d. few or no; discriminates in favor of production for the home market rather than for export

14. Developing countries often claim that their “commodity terms of trade” have fallen over the long run. This means that (with Px = export price index, Pm = import price index, Qx = export quantity index, and Qm = import quantity index) the developing countries think that there has been a decline in their __________. a. (Pm/Px)Qm b. Pm/Px * c. Px/Pm d. (Px/Pm)Qx

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Chapter 18 - International Trade and the Developing Countries

15.

Developing countries (or LDCs) tend to have a ratio of manufactured goods exports to total exports that is __________ than the corresponding ratio for high-income countries, and the LDCs also tend to have a __________ degree of commodity concentration in their exports than do the high-income countries. a. higher; higher b. higher; lower * c. lower; higher d. lower; lower

16.

The income elasticity of demand for manufactured goods is generally thought to be __________ than the income elasticity of demand for primary products, and the price elasticity of demand for manufactured goods (when the negative sign is ignored) is __________ than the price elasticity of demand for primary products. a. lower; also generally thought to be lower b. lower; generally thought to be higher c. higher; generally thought to be lower * d. higher; also generally thought to be higher 17.

Two characteristics of low-income countries as classified by the World Bank are that, in comparison with high-income countries, the low-income countries have a __________ rate of population growth and a __________ percentage of GDP accounted for by agriculture. a. slower; smaller b. slower; larger c. faster; smaller * d. faster; larger

18.

Other things equal, an export quota agreement to stabilize the price of a good on the world market will be more effective, the __________ the percentage of producer countries that take part in the agreement and the __________ it is for countries to store (or stockpile) the good. * a. larger; easier b. larger; more difficult c. smaller; easier d. smaller; more difficult

19. For the World Bank’s category of low-income countries, gross domestic product has been growing __________ rapidly in recent years than in developed countries. With regard to another characteristic of low-income countries, the ratio of their exports of goods and services to their GDPs has __________ in the last 15-20 years.

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Chapter 18 - International Trade and the Developing Countries

a. less; been increasing b. less; been decreasing * c. more; been increasing d. more; remained about the same 20.

If the supply curve of a good shifts increases and decreases cyclically along a relatively inelastic (or steep) demand curve, then, in this market, the size of price fluctuations will be __________ than the size of the quantity fluctuations. a. relatively less b. the same * c. relatively greater d. relatively less or the same but not relatively greater

21. Which one of the following has NOT been offered as a possible reason for instability in exports of less developed countries? a. high degree of commodity concentration of exports b. low export demand elasticity coupled with shifting export supply curve c. low export supply elasticity coupled with shifting export demand curve * d. high export supply elasticity coupled with shifting export supply curve 22.

If the demand curve for a good increases and decreases cyclically along a relatively inelastic (or steep) supply curve, then, in this market, the size of price fluctuations will be __________ than the size of quantity fluctuations. a. relatively less b. the same * c. relatively greater d. relatively less or the same but not relatively greater

23.

In the context of developing countries’ external debt, the “debt service ratio” of a country is the ratio of annual interest payments on the debt plus scheduled repayment of the debt (amortization) to the country’s __________. * a. exports of goods and services b. exports of services c. gross domestic product d. total external debt

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Chapter 18 - International Trade and the Developing Countries

24.

In the analysis of the “debt-relief Laffer curve” pertaining to the external debt of a developing country, a. the market value of the debt always equals the face value of the debt. b. the market value of the debt is sometimes greater than the face value of the debt. * c. in one portion of the curve, forgiveness of debt can benefit both the debtor country and the lenders to the country. d. in no portion of the curve can forgiveness of debt benefit both the debtor country and the lenders to the country.

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Chapter 19 - The Balance-of-Payments Accounts

CHAPTER 19 THE BALANCE-OF-PAYMENTS ACCOUNTS Learning Objectives: ■

■ ■

Explain what is meant by a country’s “balance-of-payments” statement and how it is constructed. Analyze the difference between alternative accounting balances within the balance of payments. Describe the recent balance-of-payments experience of the United States. Discuss the meaning of the international investment position of a country.

Outline

■

Introduction - China’s Trade Surpluses and Deficits Recent Growth of Trade and Capital Movements Credits and Debits in Balance-of-Payments Accounting Sample Entries in the Balance-of-Payments Accounts Assembling a Balance-of-Payments Summary Statement Balance-of-Payments Summary Statement for the United States International Investment Position of the United States Summary II.

Special Chapter Features In the Real World: Current Account Deficits In the Real World: U.S. Trade Deficits with Japan, China, OPEC, and Canada In the Real World: Trends in the U.S. International Investment Position

III.

Purpose of Chapter

The purpose of this chapter is to present the basic principles of balance-of-payments accounting and to discuss the several concepts of “balance” in a country’s balance of payments. With a working knowledge of balance-of-payments concepts in hand, students will be better able to understand the operation of foreign exchange markets, which are discussed in succeeding chapters. IV.

Teaching Tips

A. Students often find balance-of-payments accounting uninteresting. However, in recent years, U.S. trade deficits, and particularly the deficits with China, have been continuously in the news. The opening vignette in this chapter provides background on this issue and will hopefully get students thinking of the importance of understanding what BOP surpluses and deficits mean and when they might be of concern to policymakers. You can also use this case to illustrate the point that a trade surplus of a country with one trading partner does not always accurately reflect the overall situation – a surplus with one trading partner is often associated with deficits with 19-1 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 19 - The Balance-of-Payments Accounts

other trading partners. B. The financial account classifications in the debit and credit categories are often difficult for students to understand. Sometimes it is helpful to stress that debit items are items that, other things equal, reflect an increase in the net claims ( assets - liabilities) of the home country on foreign countries (increase in foreign assets owned by home country citizens or government, decrease in home country assets owned by foreign citizens or government). Credit items reflect, other things equal, an increase in net claims of foreign countries on the home country (decrease in foreign assets owned by home country citizens or government, increase in home country assets owned by foreign citizens or government). C. In the balance-of-payments sample transactions, transaction 7 was included in order to bring Category III into the examples. You may want to indicate that this type of transaction is unlikely to occur very often in a world of basically floating exchange rates, but that it can be common in a regime of fixed rates. D. In your discussion of the U.S. balance-of-payments material, point out that the U.S. Department of Commerce separates out “investment income” from “services.” However, investment income is economically a service payment for the use of capital, so it should logically be included in “goods and services” rather than presented in a separate category. E. In the discussion of the net international investment position, note that the U.S. Department of Commerce is currently using “replacement cost” rather than “original cost.” You may want to check the latest September issue of the Survey of Current Business for data using “original” or historical cost and compare this information with the replacement cost figures of the text (and which appear annually in the July issue of the Survey of Current Business). V.

Answers to End-of-Chapter Questions and Problems

1. The initiating entries would be as follows (not enough information is generally given to ascertain the accompanying offsetting debit or credit entry): wheat shipment – credit entry in category I under “exports of goods;” the accompanying debit entry would be in category I under “unilateral transfers made” textile machinery imports – debit entry in category I under “imports of goods” Zurich bank account – debit entry of $500 in category II, “increase in U.S. short-term private assets abroad” Japanese purchase of U.S. government bonds – credit entry of $1,000,000 in category II, “increase in foreign long-term assets in the United States” Geneva hotel expenses – debit entry in category I under “imports of services” purchase of BMW – debit entry in category I under “imports of goods” 19-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 19 - The Balance-of-Payments Accounts

interest earned in London – credit entry in category I under “exports of services” purchase of chemical plant – debit entry in category II, “increase in U.S. long-term assets abroad” lumber sales to Japan – credit entry in category I under “exports of goods” shipment of Fords from Mexico – debit entry in category I under “imports of goods;” profits earned in the Mexican plant – credit entry in category I, “exports of services” 2. The financial account in the balance of payments indicates the net asset transfers between the home country and foreign countries during the time period under consideration. A net debit balance (financial account deficit or net capital outflow) indicates that home country wealthholders increased their holdings of foreign assets relative to foreign wealthholders’ ownership of home country assets. A net credit balance (financial account surplus or net capital inflow) indicates the opposite. The current account reflects the net effect with respect to foreign countries of the sources and uses of home country current income during the time period. A net debit balance (current account deficit) indicates that current income used to purchase imports of goods and services and to make unilateral transfers abroad exceeded current income generated by exports of goods and services and the receipt of unilateral transfers from abroad. A net credit balance (current account surplus) reflects the opposite. 3. The “net international investment position” shows the total existing stock of foreign assets (physical and financial) owned by U.S. citizens and government minus the total existing stock of U.S. assets (physical and financial) owned by foreign citizens and governments. If the United States experienced a current account surplus, the U.S. net international investment position would increase. Foreign payments to the United States for exports of goods and services and for unilateral transfers would exceed U.S. payments for imports of goods and services and unilateral transfers. This would result in a net buildup of U.S. ownership of foreign assets relative to foreign ownership of U.S. assets. 4. A country can have an official reserve transactions surplus that is larger than its merchandise trade surplus if phenomena such as an export surplus in services, a net inflow of unilateral transfers, and a net private capital inflow occur. In China’s case, there has been a relatively small services surplus in some years but a small deficit in others. However, the official reserve transactions balance (overall balance) has been substantially larger than the merchandise trade surplus (and the current account surplus) because there has been a huge inflow of direct investment in particular. 5. Keeping track of the financial account provides information on the specific nature of developments in the relative holdings of foreign assets by domestic citizens and government and home country assets held by foreign citizens and government. For example, the analyst can examine the extent to which the asset changes have been concentrated in short-term assets, longterm assets (and direct versus portfolio assets), private assets, or official assets. Developments in these various asset categories have different implications as to the speed with which the financial account can change in the future and for the size of investment income flows that will occur in the future. In addition, since the financial account estimates never match the current account 19-3 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 19 - The Balance-of-Payments Accounts

figures in practice, examination of the magnitude of the resulting statistical discrepancy can be useful for assessing the size and nature of the gaps that exist in the data-collection network. 6. Since Y = C + I + G + (X - M), the current account balance can be defined as (X - M) = Y - (C + I + G). With a current account deficit, (X - M) < 0 or, therefore, Y < (C + I + G). Because Y indicates production in the economy and (C + I + G) indicates total spending by the country’s residents (or the use of goods and services), the fact that Y < (C + I + G) means that the country’s use of goods and services is greater than the country’s production. 7. When the initial investment is made, say the purchase of a foreign production facility by a Country A firm, there is a debit in the long-term financial account of country A (“increase in long-term assets abroad”) and a credit in A’s short-term financial account (either an “increase in foreign short-term assets in country A” if the foreign firm selling the facility is given a bank account in country A, or a “decrease in A’s short-term assets abroad” if payment is made from the A firm’s bank balance abroad). Over time, A’s current account can be affected in a variety of ways – for example, exports from A of components to the new facility can take place, final goods imports into A from the facility can occur, and profits may be repatriated to A. Of course, if A’s currency depreciates because of the initial capital outflow, this can alter A’s current account immediately. 8. In balance-of-payments accounting, the transactions would be recorded for country A as follows: ITEM (1): Credit: Category I, Exports of goods, + $1,000 Debit: Category II, Increase in short-term assets abroad, - $1,000 ITEM (2): Debit: Category I, Unilateral transfers made, - $500 Credit: Category II, Increase in foreign short-term assets in A, + $500 The merchandise trade balance improves by $1,000 (the credit entry for exports); the current account balance improves by $500 (the sum of the $1,000 export credit entry and the - $500 unilateral transfers entry); the official reserve transactions balance has a net effect of zero [the $500 improvement in the current account is matched by the - $500 change (- $1,000 + $500) in the short-term private assets account. 9. There is validity to this point because of the identity (X - M) = S + (T - G) - I. A reduction in the U.S. federal government budget deficit, assuming other right-hand-side variables are constant, would reduce (T - G) and therefore decrease (X - M).

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Chapter 19 - The Balance-of-Payments Accounts

VI.

Sample Exam Questions

Essay Questions

1. Why might detailed information on the state of the balance of payments be useful to economists and to policymakers? Which of the five “balances” discussed in the text does the U.S. Department of Commerce not publish, and what case can be made for not publishing those balances? What case can be made that those balances should be published? 2. Suppose that home country A has the following transactions with foreign countries (represented by foreign country B). For each transaction, indicate and explain the appropriate debit and credit entry in A’s balance-of-payments accounts. (a) A firm in country A sells $6,000 of steel to a country B firm. Payment is made by the firm in B drawing down its checking account in a country A commercial bank. (b) Country A citizens give $1,000-worth of cash to country B relatives by writing checks on A-citizen bank accounts in country B. (c) An importer in country A buys $8,000 of apparel from a country-B supplier, paying for the goods by writing a check to be deposited into the B firm’s bank account in a country A bank. (d) A citizen of country B buys a long-term bond of a company in country A. The buyer purchases the $5,000 bond by drawing down his/her checking deposit in a bank in A. (e) A firm in country A purchases $3,000 of shipping services from a country B ocean freight carrier, paying for the services by drawing down bank deposits in B owned by the A firm. (f) A’s central bank buys $2,000-worth of foreign currency holdings held in a B commercial bank by an A citizen. The central bank adds the foreign currency to its own commercial bank account in country B. Next, using the debit and credit entries that you have constructed, and assuming that these six transactions were the only international transactions during the time period, construct country A’s balance-of-payments summary statement for the time period. Indicate the size for country A and explain the meaning of the “balance of trade,” “balance on goods and services,” “current account balance,” “official reserve transactions balance,” and “financial account balance.” 3. Suppose that you had to explain to a person in the street (who is not an economist) why a current account deficit must be accompanied by a financial or capital account surplus. What would you say?

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Chapter 19 - The Balance-of-Payments Accounts

4. “Since the statistical discrepancy in the U.S. balance-of-payments accounts is so large, we cannot rely on the U.S. BOP statement to give information on the size of various ‘balances’ with any precision. Perhaps the U.S. BOP statement is essentially useless.” Discuss this statement. 5. How is a country’s net international investment position related to that country’s balanceof-payments accounts? When might the net international investment position not change from the end of one year to the end of the next year? Explain. 6. Identify and distinguish among, in balance-of-payments accounting, various “balances” that can appear in a country’s balance-of-payments statement. What must conceptually be the numerical relationship between a country’s “balance on current account” (or “current account balance”) and its “capital/financial account balance?” Why? Then, for each of the two statements below, explain why the statement is either TRUE or FALSE. (a) “A rise in interest rates in a country, such as occurred in the United States in the early 1980s, can lead to an increased deficit in the country’s merchandise trade balance.” (b) “A decrease in saving by households in a country can lead to a deterioration in that country’s balance on current account (i.e., can make the current account balance less positive or more negative).” 7.

For each of the statements below, explain why the statement is either TRUE or FALSE. (a) “If a country’s income is less than its spending, then the country will have a surplus in its current account.” (b) “If a country has a merchandise trade deficit, then the country must also have a current account deficit.”

(c) “If a country’s balance on current account is a net debit of $5,000, then the country’s capital/financial account balance (including all government capital/ financial flows as well as all private capital/financial flows) must show a net capital/financial inflow of $5,000.” (d) “If country A makes a unilateral transfer of $1,000 of goods to country B, then, in this time period and other things equal, country A’s merchandise trade balance will be $1,000 more positive than would otherwise have been the case. However, country A’s current account balance will be the same as would otherwise have been the case.” 8. When might a current account deficit be a reflection of the fact that “good things” are happening in the economy? B.

Multiple-Choice Questions

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Chapter 19 - The Balance-of-Payments Accounts

If a country has a current account deficit, which one of the following is true? a. Y – (C + I + G) > 0 b. S + (G - T) - I < 0 * c. S < I + (G - T) d. C - Y > 0

10. Which one of the following items would be a “debit” in a country’s balance-of-payments account? a. exports of merchandise * b. an increase in a domestic citizen’s bank account in a foreign bank c. increased holdings of domestic bonds by foreigners d. exports of services 11.

If a country has a current account deficit, this suggests that a. the country’s spending is less than its income. b. the country must also have a negative merchandise trade balance. c. the country’s capital/financial account must also be in a deficit position. * d. the country’s saving is less than its investment.

12.

Suppose that a country A individual investor receives a dividend payment from an investment made abroad, and the payment is made by a deposit of funds into the investor’s bank account in the country where the investment is made. The category for the credit entry in this situation would be __________, and the category for the debit entry would be __________. * a. “factor income received from abroad”; “increase in private short-term assets abroad” b. “decrease in private short-term assets abroad”; “service exports” c. “increase in private short-term assets abroad”; “factor income payment abroad” d. “factor income received from abroad”; “decrease in short-term assets abroad”

13.

Which one of the following “balances” in a balance-of-payments account has incorporated all private short-term asset changes before arriving at the measure of “balance?” a. merchandise trade balance b. balance on current account c. balance on goods and services * d. official reserve transactions balance

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Chapter 19 - The Balance-of-Payments Accounts

14.

Suppose that a U.S. exporter sells goods to a foreign firm and receives payment by the foreign firm drawing down its New York bank account and transferring the funds to the U.S. exporter’s New York bank account. In this situation, the debit entry in the U.S. balance of payments account is __________. a. “exports of goods” b. “increase in foreign short-term private assets in the United States” * c. “decrease in foreign short-term private assets in the United States” d. “increase in U.S. short-term private foreign assets abroad”

15. Which one of the following items is a “credit” item in a country’s balance-of-payments accounts? * a. unilateral transfers received from another country b. decrease in short-term home country assets owned by foreign private citizens c. imports of goods d. domestic purchase of a foreign corporation’s bond 16.

If a country has a current account deficit, then the country must also have a. a merchandise trade deficit. * b. a financial or capital account surplus. c. a financial or capital account deficit. d. an increase in its net international investment position.

17.

Suppose that, during 2012, country A had exports of goods of $50, imports of goods of $60, exports of services plus factor income receipts from abroad of $36, and imports of services plus factor income payments abroad of $30. In addition, during 2007, country A made $15 of unilateral transfers abroad and received no unilateral transfers from abroad. Given this information, country A’s “balance on current account” in 2007 was * a. a $19 deficit. b. a $10 deficit. c. a $4 deficit. d. a $6 surplus

18.

Suppose that a U.S. importer buys goods from a foreign firm and makes payment by drawing down its New York bank account and transferring the funds to the foreign exporter’s bank account in the foreign country. In this situation, the credit entry in the U.S. balance of payments account is __________. * a. “decrease in U.S. short-term private assets abroad” b. “increase in U.S. short-term private assets abroad” c. “decrease in foreign short-term private assets in the United States” d. “imports of goods”

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Chapter 19 - The Balance-of-Payments Accounts

19.

Suppose that country A’s citizens, firms, and governments own $750 billion of assets in other countries and that foreign citizens, firms, and governments own $850 billion of assets in country A. This situation indicates that country A has __________ of __________. a. an official reserve transactions deficit; $100 billion b. an official reserve transactions surplus; $100 billion * c. a net international investment position; minus $100 billion d. a net international investment position; plus $100 billion

20.

If, in a country’s balance of payments statement, the merchandise trade balance is $-100, services exports and factor income receipts from abroad in total exceed services imports and factor income payments abroad by $25, unilateral transfers made exceed unilateral transfers received by $15, and the long-term financial account has debits exceeding credits by $30, then the country's balance on current account is a. $-120. * b. $-90. c. $-75. d. $-60.

21.

If a U.K. citizen removes funds from a London bank and places them in his/her bank account in the United States, this deposit into the United States is recorded as a __________ item in the U.S. balance-of-payments accounts. If, in a different transaction, a U.K. firm sells a good to a U.S. citizen, this U.K. export (U.S. import) of the good is __________ item in the U.S. balance-of-payments accounts. a. debit; also recorded as a debit b. debit; recorded as a credit * c. credit; recorded as a debit d. credit; also recorded as a credit

22.

Which one of the following items would be classified as a “debit” in country A’s balance-of-payments accounts? a. the receipt of investment income from abroad by a country A corporation b. an increase in the size of a bank account held in a country A bank by a country B citizen c. consulting services provided by a country A citizen to a country B firm * d. an increase in size of a bank account held in a country B bank by a country A corporation

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Chapter 19 - The Balance-of-Payments Accounts

23. If a U.S. citizen gives $1,000 to a French citizen by writing a check on a New York bank for deposit to the French citizen’s New York bank account, the credit item in the U.S. balance-of-payments accounts is __________ and the debit item is __________. a. “exports”; “unilateral transfers made” b. “increase in foreign short-term private assets in the United States”; “exports” * c. “increase in foreign short-term private assets in the United States”; “unilateral transfers made” d. “unilateral transfers made”; “decrease in foreign short-term private assets in the United States” 24.

In balance-of-payments accounting, the acquisition of a foreign production facility by a U.S. firm is a __________ item in the U.S. balance of payments; the deposit of funds in a foreign bank account by a U.S. citizen __________ item in the U.S. balance of payments. * a. debit; also is a debit b. debit; is a credit c. credit; is a debit d. credit; also is a credit

25. In its international investment position in the 1980s, the United States moved from a position of a __________ at the beginning of the decade to that of a __________ at the end of the decade. a. small “net debtor”; very large “net debtor” b. “net debtor”; “net creditor” c. large “net creditor”; small “net creditor” * d. “net creditor”; “net debtor” 26.

Suppose that a developing country receives foreign aid in the form of a shipment of wheat. Balance-of-payments accountants in that country would record the “debit” item in their accounts as __________ and the credit item as __________. a. “exports of goods”; “unilateral transfers made” b. “unilateral transfers received”; “imports of goods” * c. “imports of goods”; “unilateral transfers received” d. “imports of goods”; “increase in short-term official assets” in the developing country’s banks

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Chapter 19 - The Balance-of-Payments Accounts

27. Other things equal, an export of goods from the United States as a gift to foreigners would lead to an improvement in the U.S. __________ and to no change in the __________. * a. merchandise trade balance; balance on current account b. balance on current account; merchandise trade balance c. financial account balance; merchandise trade balance d. merchandise trade balance; balance on goods and services 28.

If we compile data on a country’s exports and imports of goods and services, its unilateral transfers, and net factor income flows, the resulting net credit or net debit account would be called that country’s a. balance of trade. * b. balance on current account. c. financial account balance. d. official reserve transactions balance

29.

The country/group of countries with which the United States has had the largest merchandise trade deficits in the last several years is __________. a. Canada * b. China c. Japan d. the Organization of Petroleum Exporting Countries (OPEC)

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Chapter 20 - The Foreign Exchange Market

CHAPTER 20 THE FOREIGN EXCHANGE MARKET Learning Objectives: ■ ■ ■

Summarize fundamental underpinnings of the foreign exchange market. Explain the distinctions between various measures of the exchange rate. Differentiate among the roles of hedging, arbitrage, and speculation in foreign exchange markets. ■ Describe the links between the current spot rate and contracts to buy or sell foreign exchange in the future. I.

Outline

Introduction - The Yen Also Rises (and Falls) The Foreign Exchange Rate and the Market for Foreign Exchange - Demand Side - Supply Side - The Market The Spot Market - Principal Actors - The Role of Arbitrage - Different Measures of the Spot Rate The Forward Market The Link between the Foreign Exchange Markets and the Financial Markets - The Basis for International Financial Flows - Covered Interest Parity and Financial Market Equilibrium - Simultaneous Adjustment of the Foreign Exchange Markets and the Financial Markets Summary II.

Special Chapter Features In the Real World: Nominal and Real Exchange Rates of the U.S. Dollar In the Real World: Spot and PPP Exchange Rates Concept Box 1: Currency Futures Quotations Concept Box 2: Currency Futures Option Quotations

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Chapter 20 - The Foreign Exchange Market

III.

Purpose of Chapter

The purpose of this chapter is to introduce students to the nature, components, and functioning of the foreign exchange market. Special attention is focused on the links between the foreign exchange market and the money markets. IV.

Teaching Tips

A. Describing the relative movement of the dollar in recent years and its impact on U.S. consumers, firms, and citizens traveling abroad is a good way to generate interest in exchange rates. This chapter introduces some of the different factors that influence exchange rates and makes the student aware of the difficulties involved in predicting exchange rate movements. B. Students often have difficulty relating the terms “appreciation” and “depreciation” to the price of foreign exchange and the graphical analysis. It is therefore important to make them comfortable with changes in the market price and what it means in terms of the cost of foreign exchange. C. It is increasingly common to read about different exchange rate concepts in the news media. We therefore have devoted more space than is usual in texts to explaining what the various measures are and of what use they are to the international business person/traveler. If you are pressed for time, you may find it advantageous to leave this material for students to read on their own. We do, however, think that it is important that students be exposed to these different exchange rate concepts. D. We suggest that you take time to introduce the PPP concept at this point. Understanding this concept is critical for the discussion of the monetary approach to the balance of payments which follows in Chapter 22. E. In a one-semester course in trade and finance, it is unlikely that you will have the time in class to discuss the forward and futures markets and the futures options market in the detail presented in the text. However, if you are teaching a one-semester course in international monetary economics, it is a topic that students find interesting and worth spending time on. This material is especially important if you plan to cover part or all of the material on international financial derivatives which follows in Chapter 21. F. It is important to show how the foreign exchange markets are linked to the domestic money markets, particularly at this point in time when financial markets are becoming more completely integrated worldwide. Although there are a number of ways of doing this, we have found the method used in Figure 8 at the end of the chapter to be particularly effective. Establishing the link between the foreign sector and the money markets is a useful transition from the micro-trade section to the international macro section.

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Chapter 20 - The Foreign Exchange Market

Answers to End-of-Chapter Questions and Problems

1. If Japan were to reduce its investment in the United States, the supply of foreign exchange (Japanese yen) would be reduced, i.e., there would be a shift to the left from Stotal to S’ as indicated below. With the decrease in the total supply of foreign exchange, the U.S. dollar would depreciate, leading to a reduction in the current account deficit from AB to CD below.

2. No, there is not cross-rate equality, since ($.0075/yen)/ (£.005/yen) = $1.50/£, not $2.00/£. Consequently, arbitragers would use dollars to acquire yen, use yen to acquire pounds, and use pounds to acquire dollars, thus making a quick profit. In the process, the dollar price of the yen would rise, the yen price of the pound would rise, and the dollar price of the pound would fall (pound price of the dollar would rise). 3. This statement is true. Unless one knows what happened to relative prices in the two countries concomitantly with the appreciation of the dollar, it is impossible to evaluate the new purchasing power of the dollar. What is required in this instance is a real exchange rate. 4. The real exchange rate provides an estimate of the purchasing power of a currency relative to some previous period by removing the effect of price changes in each country by using their respective price indexes. Relative PPP, on the other hand, provides an estimate of the equilibrium exchange rate based on the change in relative country prices compared to some previous period. The PPP estimate is then compared to the current exchange rate to ascertain if the currency is currently overvalued or undervalued. (See the text for the calculation of each of these measures.) 5.

2008 PPPrelpeso/$ = [e2005peso/$][PI2008Mexico/PI2008US] = 12.2 peso/$(125.2/106.7) = 14.315 peso/$

Given the 2008 exchange rate of 13.9 peso/$, PPPrel would suggest that the peso is overvalued (the dollar is undervalued), since the peso commands more dollars than expected, given the relative change in prices in both countries since 2005. 6. The condition for equilibrium in this instance is that iNY ≈ iLondon + xa - RP [or (iNY iLondon) ≈ xa - RP]. In this example, the rate of return in New York is less than the expected rate of return in London after accounting for expected depreciation of the pound and the required 20-3 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 20 - The Foreign Exchange Market

payment for risk associated with the U.K. investment, i.e., 0.02 < 0.06 + (-0.01) - 0.02, [or (0.02 - 0.06) < (-0.01 - 0.02)]. As a result, investment funds should flow from the United States to the United Kingdom. This raises the spot rate on pounds and, other things equal, reduces xa since xa equals [E(e)/e] -1. In addition, there should be upward pressure on the interest rate in New York, downward pressure on the interest rate in the London, and a possible increase in the risk premium (due to the increased exposure in the United Kingdom). These adjustments should take place until iNY is approximately equal to iLondon after taking account of the expected depreciation of the pound and the required risk premium. 7. For the financial markets to be in equilibrium, the difference between the interest rates in the two countries should be approximately equal to the forward premium, after taking account of any financial transactions costs. In this problem, (0.038 - 0.025)/4 is compared to (1.8180 – 1.8034)/1.8034. Since the difference between the two, 0.00325 compared to 0.00810, exceeds the estimated transactions cost of 0.0020, one would conclude that the markets are not in equilibrium. 8. With an increase in the U.K. interest rate, there is an incentive for short-term financial investments to move from the United States to the United Kingdom. As these flows take place, they will lead to upward pressure on the interest rate in the United States, appreciation of the spot pound, depreciation of the forward pound, and downward pressure on the U.K. interest rate. Investments should continue to flow into the United Kingdom from the United States until the adjustments in the markets cause the appropriate interest rate differential between the two countries to be approximately equal to the forward discount in the foreign exchange markets. 9. (a) The Swiss franc was at premium with respect to the dollar since the forward rate is greater than the spot rate (in $/Swiss franc). The percentage premium is equal to [(efwd/espot) - 1] = [($1.0685/$1.0670) - 1] = 0.1406 percent. This result is reasonably consistent with covered interest parity. For covered interest parity to hold, (iUS - iSwitzerland)/4 ≈ (efwd - espot)/espot or (efwd/espot) - 1. In this instance [(0.0325 - 0.0052)/4] = 0.006825 > [($1.0685 - $1.0670)/$1.0670] = 0.001406. Strictly speaking, investment funds should thus be moving to the United States until the interest parity condition is realized. However, if transactions costs are in the neighborhood of 0.50 percent (or 50 basis points), this situation is already almost one of arbitrage equilibrium. (b) In this example the dollar is at discount relative to the yen (the yen is at premium relative to the dollar) because the forward rate on the dollar is less than the spot rate. The percentage discount is equal to [(¥79.24/¥79.31) - 1] or -0.0009 percent. If transactions costs are thought to be in the neighborhood of 0.50 percent, the result is consistent with covered interest parity. The difference between the forward discount and the interest rate differential {[(0.01475 - 0.0325)/4] = -0.0044 < [(¥79.24 - ¥79.31)/¥79.31] = -0.0009} equals 0.35 percent (or 35 basis points), and there should be little or no incentive to move funds between the two countries. In the absence of transactions costs, funds should move to New York from Japan until the parity condition is realized. (Note: Make sure that the students realize that a more negative number is a smaller number, i.e., -0.0044 is less than -0.0009.)

Chapter 20 - The Foreign Exchange Market

10. If all markets are working efficiently, then the 1.2 percent 3-months forward premium should equal the expected forward premium (and hence the expected appreciation of the Swedish krona) if the difference between a higher 3-months interest rate in the United States and the interest rate in Sweden, adjusted for the presence of any risk premium and transaction costs, approximately equals 1.2 percent. However, the existence of capital market imperfections, information costs, non-comparability of country assets, and political risk can make it difficult to strictly interpret the forward premium as being a good indication of expectations regarding the movement of the krona over the next three months. VI.

Sample Exam Questions

Essay Questions

1. Explain the difference between the spot rate, the forward rate, the real exchange rate, and the effective exchange rate. Then discuss a situation in which you would use each of these different exchange rates. 2. If interest rates differ between two countries, it is an indication that the financial markets are not in equilibrium, and that investment flows should be taking place between the two countries. Agree? Disagree? Explain. 3. Balance-of-payments accounting indicates that any surplus (deficit) in the current account must be offset by a deficit (surplus) in the financial account. Explain why this is so, using demand and supply curves of foreign exchange. Suppose that a country had a current account surplus. What would you expect to happen to the current account balance if there were a relative decline in the domestic interest rate? Why? 4. You note that over the last five years, the Swiss franc has appreciated from Sfr 1.60/$1 to Sfr 1.45/$1. During that same period, the U.S. consumer price index rose from 100 to 120 and the Swiss consumer price index rose from 100 to 105. On the basis of these movements, would you expect the Swiss to be buying more or less U.S. goods? Why? Would you advise a foreign exchange speculator to buy Swiss francs at this point or to change Swiss francs into U.S. dollars? Why or why not? 5. How do speculators and arbitragers affect the foreign exchange market? Briefly describe the different ways that arbitragers can “cover” themselves in the foreign exchange market. Finally, will speculation in foreign exchange always have a stabilizing effect on the foreign exchange market? Why or why not? 6. You and a friend get into a heated discussion about the value of the U.S. dollar in which you argue that the dollar is currently undervalued against the Japanese yen. Failing to resolve the issue, you decide to prove that your position has the greatest economic merit given what you have recently learned in your international economics class. How might you go about trying to demonstrate to your friend that you are correct and that, indeed, the dollar is undervalued?

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Chapter 20 - The Foreign Exchange Market

7. Indicate the meaning of the terms “covered interest parity” (CIP) and “uncovered interest parity” (UIP). Then, focusing on “covered interest parity,” explain by numerical example and with at least one graph how such parity is conceptually attained in the context of a home country and a foreign country if the short-term interest rate in the foreign country is greater than the short-term interest rate in the home country at the same time that the spot rate on the foreign currency equals the forward rate on the foreign currency. (Assume that the two interest rates are on comparable assets of the same risk.) 8.

(a) Why does a “demand for foreign exchange” exist by a country’s economic actors? Explain. Why does this demand curve have its downward slope? Briefly explain. (b) What economic actions give rise to a “supply of foreign exchange” to a country? Explain. Can we be sure that this supply curve will always have an upward slope? Briefly explain. (c) Finally, put a demand curve and supply curve of foreign exchange together and indicate the equilibrium exchange rate. Then explain how and why the equilibrium exchange rate would change if there were a sudden increase in the supply of foreign exchange to the country.

(a) Draw a demand curve for foreign exchange (spot foreign exchange) by a home country and briefly indicate why the curve has a downward slope. Then draw an upwardsloping supply curve of foreign exchange to that country. (You do not need to explain why it is upward-sloping.) Then indicate the equilibrium exchange rate in this spot market and briefly explain why the market moves to this equilibrium position. (b) Define the “forward market” for foreign exchange, draw a demand curve and supply curve for the forward market, and indicate the equilibrium forward exchange rate. Assume that the equilibrium forward exchange rate is identical to the equilibrium spot exchange rate in part (a) of this question. (c) Into this situation where the spot and exchange rates are equal, now suppose that, for whatever reason, short-term interest rates suddenly rise in the home country while they

do not change in foreign countries. In the context of covered interest arbitrage, what forces are set in motion and what will happen to the spot and forward exchange rates because of this change in domestic interest rates? Carefully explain. B.

Multiple-Choice Questions

10.

If a speculator observes that the current 3-months forward rate on Swiss francs is $1.05= 1 franc, but he/she expects that the spot rate in 3 months will be $1.10 = 1 franc, then this speculator would now a. buy dollars on the forward market. * b. buy francs on the forward market. 20-4

Chapter 20 - The Foreign Exchange Market

c. sell francs on the forward market. d. buy francs on the spot market and simultaneously sell francs on the 3-months forward market if the current spot rate is $1.07 = 1 franc. 11.

Which one of the following sets of exchange rates shows “cross-rate equality” (or “consistent cross rates”)? a. 50 Indian rupees = $1; $2 = ₤1; 25 Indian rupees = ₤1 b. 1 Indian rupee = 1.5 Pakistani rupees; 50 Pakistani rupees = 1 Singapore dollar; 1 Singapore dollar = 75 Indian rupees * c. 2 Swiss francs = $1; 1 Swiss franc = € ⅓; €1 = $1.50 d. $2 = ₤1; €1.5 = ₤1; €1 = $0.75

12. Other things equal, if exchange rates are flexible, and if U.S. consumers increase their demand for Japanese goods at the same time that Japanese consumers increase their demand for U.S. goods, then we would expect the dollar to a. appreciate relative to the yen. b. depreciate relative to the yen. c. remain unchanged in value relative to the yen. * d. appreciate, depreciate, or remain unchanged in value relative to the yen – impossible to determine without more information. 13.

In a setting of flexible exchange rates, suppose that the U.S. citizens decrease their import purchases from the United Kingdom at the same time that British citizens increase their purchases of stocks and bonds in the United States. The first action (the U.S. imports) by itself would lead to __________ of the dollar against the pound; the second action by itself would __________ of the dollar against the pound. a. an appreciation; lead to a depreciation * b. an appreciation; also lead to an appreciation c. a depreciation; also lead to a depreciation d. a depreciation; lead to an appreciation

14.

The Wall Street Journal indicated, in its issue of Friday, November 9, 2012, that, in late trading on Thursday, November 8, 2012, the spot U.K. pound was selling at a price of $1.5983 per pound. At the same time, the six-months forward U.K. pound was selling at a price of $1.5974 per pound. Observation of these rates indicates that the U.K. pound was selling at a six-months forward __________ against the dollar, and, if covered interest parity had indeed been attained at that time, the conclusion could validly be reached that interest rates in the United Kingdom were __________ than comparable interest rates in the United States. a. premium; lower b. premium; higher 20-5

Chapter 20 - The Foreign Exchange Market

c. discount; lower * d. discount; higher 15. If, in time period #1, the equilibrium value of the pound is $1.60, but then U.K. prices double between time period #1 and time period #2 while U.S. prices rise by 60 percent, then the (relative) purchasing power parity theory would say that the equilibrium value of the pound in time period #2 is a. $0.80. b. $1.25. * c. $1.28. d. $2.00 16. In which of the following relationships between the expected future spot rate [E(e)] of a foreign currency and the current forward rate (efwd) of a foreign currency would a speculator have an incentive to sell foreign currency in the forward market? * a. E(e) < efwd b. E(e) > efwd c. E(e) = efwd d. E(e) = (1/efwd) 17.

A simultaneous increase in U.S. demand for German products and decrease in the desire of German investors to send funds to the United States would, under a flexible exchange rate system and with other things equal, lead to __________ of the U.S. dollar against the euro and to __________ of the euro against the dollar. a. an appreciation; a depreciation b. an appreciation; an appreciation c. a depreciation; a depreciation * d. a depreciation; an appreciation

18.

Suppose that, in a system of floating or market-determined exchange rates, the equilibrium exchange rate is 80 Japanese yen = $1. If there is then a change in preferences of U.S. consumers such that they now prefer more Japanese goods in their consumption bundle, then, other things equal, the equilibrium exchange rate __________, which is __________. * a. will move toward a lower price for the dollar (e.g., 75 yen = $1); an appreciation of the yen relative to the dollar b. will move toward a lower price for the dollar (e.g., 75 yen = $1); an appreciation of the dollar relative to the yen c. will move toward a higher price for the dollar (e.g., 85 yen = $1); an appreciation of the yen relative to the dollar d. will move toward a higher price for the dollar (e.g., 85 yen = $1); an appreciation of 20-6

Chapter 20 - The Foreign Exchange Market

the dollar relative to the yen 19.

If U.K. interest rates are higher than Japanese interest rates, then the theory of covered interest arbitrage would suggest that, in the pound/yen exchange markets, the yen would be at a forward __________ and the pound would __________. a. discount; be at a forward premium b. discount; also be at a forward discount c. premium; also be at a forward premium * d. premium; be at a forward discount

20. If, because of Japan’s high saving rate (in excess of domestic investment spending), Japan invests overseas, then this investment can cause __________ of the Japanese yen and thus a consequent trade __________ for Japan. a. a depreciation; deficit * b. a depreciation; surplus c. an appreciation; deficit d. an appreciation; surplus 21. An exporter who is to receive payment in foreign currency in three months and who wants to engage in “hedging” would __________ the foreign currency on the threemonths forward market in order to protect himself/herself from __________ of the foreign currency. a. buy; an appreciation b. buy; a depreciation c. sell; an appreciation * d. sell; a depreciation 22. Suppose that the United States trades only with Germany and Japan. Suppose also that in 2005 the spot rates were 0.70 euro = $1 peso and ¥110 = $1, and that in 2010 the spot rates were 0.84 euro = $1 and ¥99 = $1 peso. If United States trade is 50 percent with Germany and 50 percent with Japan, calculation of the effective exchange rate for the United States indicates that the dollar * a. appreciated from 2005 to 2010. b. did not change in value from 2005 to 2010. c. depreciated from 2005 to 2010. d. appreciated, did not change in value, or depreciated from 2005 to 2010 – cannot be determined without more information. 23.

Suppose that the one-year interest rate in the United States is 6% and that the one-year interest rate in the United Kingdom is 3%. In the context of “uncovered” interest arbitrage and with other things equal, funds would tend to flow out of the United States and into the United Kingdom

Chapter 20 - The Foreign Exchange Market

a. if the British pound is expected to depreciate by 2% relative to the dollar during the coming year. b. if the British pound is expected to depreciate by 5% relative to the dollar during the coming year. c. if the British pound is expected to appreciate by 2% relative to the dollar during the coming year. * d. if the British pound is expected to appreciate by 5% relative to the dollar during the coming year. 24.

Given the following partially-completed table showing the quantity demanded of euros and the quantity supplied of dollars in exchange for the euros: exchange rate

euros demanded

dollars supplied

$2.00 = €1 $1.50 = €1

€600 y

x $1,500

The missing values are __________. a. x = $1,200, y = €2,250 * b. x = $1,200, y = €1,000 c. x = $300, y = €2,250 d. x = $300, y = €1,000 25.

A given exchange rate will be more or less the same in all of the world’s financial markets because of a. hedging. b. interest arbitrage. c. speculation. * d. currency arbitrage.

26.

Suppose that the three-months interest rate in New York is 4 percent and the threemonths interest rate in London is 3 percent, and that the spot rate is $2.00/£1 and the three-months forward rate is $2.10/£1. In this situation, there is an incentive for shortterm interest arbitrage funds to flow * a. from New York to London. b. from London to New York. c. neither from New York to London nor from London to New York. d. from New York to London, from London to New York, or in neither direction – cannot be determined without more information.

27.

If a PPP estimate of the dollar/pound exchange rate is $1.61/£ and the current spot rate is

Chapter 20 - The Foreign Exchange Market

observed to be $1.68/£, on the basis of these two rates you should, viewing the long run, a. expect the pound to appreciate against the dollar. * b. expect the dollar to appreciate against the pound. c. take a “short” position in dollars. d. have no expectation regarding the likely movement of the dollar/pound exchange rate. 28.

If ef = the forward rate on three-months Swiss francs, e = the current spot rate on Swiss francs, and E(e) = the expected future rate of the Swiss franc in three months, then the Swiss franc is said to be at a forward discount if __________ is negative. * a. ef - e e b. e - ef e c. E(e) - e e d. E(e) - ef ef

29.

The “Big Mac” Index

a. is a popular example of a relative PPP index of a particular commodity. * b. is an absolute PPP index of the international value of the U.S. dollar based on a single commodity. c. demonstrates the growth in international sales of the Big Mac starting in 1983. d. has proven to be totally inconsistent with other more sophisticated PPP measures of currency values. 30.

If a “Big Mac costs $4.00 in the United States and 200 yen in Japan, then the implied “purchasing-power-parity” exchange rate using the “Big Mac” is __________. If the actual exchange rate in the market is 120 yen = $1, then an economist would say that the actual Japanese yen is __________ in comparison with its “purchasing-power-parity” rate. a. 800 yen = $1; undervalued b. 800 yen = $1; overvalued * c. 50 yen; undervalued d. 50 yen; overvalued

31.

Suppose that a speculator notes that the current three-months forward rate on the euro is $1.36 and the speculator expects that, in three months, the euro will have a value of

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Chapter 20 - The Foreign Exchange Market

$1.40. In this situation, the speculator would __________ euros on the forward market, and this activity __________ for the speculator. * a. buy; involves risk b. buy; involves no possible risk c. sell; involves risk d. sell; involves no possible risk 32.

If a “Big Mac” costs $4.00 in the United States and 5 francs in Switzerland, then the implied “purchasing-power-parity” exchange rate using the “Big Mac” is __________. If the actual exchange rate in the market is 1 franc = $0.90, then an economist would say that the actual Swiss franc is __________ in comparison with its “purchasing-powerparity” rate. a. 1 franc = $1.25; overvalued b. 1 franc = $1.25; undervalued * c. 1 franc = $0.80; overvalued d. 1 franc = $0.80; undervalued

33.

Suppose that, in Year 1, the price of the U.K. pound is $1.44 = £1. In year 2, the price is $1.48 = £1. An economist would validly conclude that, from Year 1 to Year 2 and in nominal terms, the U.K. pound __________ relative to the U.S. dollar and, simultaneously, the U.S. dollar __________ relative to the U.K. pound. a. appreciated; appreciated * b. appreciated; depreciated c. depreciated; appreciated d. depreciated; depreciated

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Chapter 21 - International Financial Markets and Instruments: An Introduction

CHAPTER 21 INTERNATIONAL FINANCIAL MARKETS AND INSTRUMENTS: AN INTRODUCTION Learning Objectives: ■ ■ ■

Summarize the fundamental components of international financial markets. Illustrate how global money markets, interest rates, and foreign exchange markets are interdependent. Describe the types and roles of international currency and monetary derivatives.

Outline Introduction - Financial Globalization: A Recent Phenomenon? International Bank Lending The International Bond Market (Debt Securities) International Stock Markets Financial Linkages and Eurocurrency Derivatives - Basic International Financial Linkages: A Review - International Financial Linkages and the Eurodollar Market - Hedging Eurodollar Interest Rate Risk The Current Global Derivatives Market Summary

II.

Special Chapter Features In the Real World: Interest Rates across Countries In the Real World: U.S. Domestic and Eurodollar Deposit and Lending Rates, 1989-2011 Concept Box 1: Eurodollar Interest Rate Futures Market Quotations Concept Box 2: Eurodollar Interest Option Quotations

III.

Purpose of the Chapter

The purpose of this chapter is to introduce students to the characteristics and size of the many financial assets that are currently exchanged internationally. With the importance of international finance growing every day, it is important that students have a familiarity with the range of financial instruments available for transferring wealth across country borders and the nature of the investment decision that lies behind such movements.

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Chapter 21 - International Financial Markets and Instruments: An Introduction

IV.

Teaching Tips

A. Students today accept as conventional wisdom that globalization is a new phenomenon that will continue throughout their lifetimes. The opening vignette can be used to make the point that increased interdependence among nations has occurred in previous times and that various forces can slow down or sometimes even reverse the phenomenon. B. Since the first part of the chapter is primarily descriptive, much of it can be left to the students to read on their own. It is useful, however, to point out the various ways in which these financial assets can come about and their possible implications for the carrying out of economic policy. C. This material can be brought to life by discussing the pros and cons of having international financial instruments in one’s own portfolio, either directly or indirectly through mutual funds. A discussion of the impact of the increased internationalization of investing on the various stock and bond markets can also trigger student interest. D. If you plan to cover the latter part of the chapter on the various derivatives in any detail, we strongly encourage buttressing this introductory material with examples and problems from a text in international business/finance. E. If possible, invite an expert in international finance from a local bank or the finance department to give a guest lecture on this material. This would be especially useful for those students who might be considering investment banking as a career. V.

Answers to End-of-Chapter Questions and Problems

1. The growth in the eurodollar markets was the result of a number of factors. For example, on the supply side, the oil shock in the 1970s and the accompanying build up of petrodollars abroad was a key factor, as well as the sustained balance-of-payments deficits of the United States in the 1960s. In addition, European banks were able to offer relatively higher interest rates for eurodollar deposits because they did not face interest rate ceilings such as that produced by Regulation Q in the United States, and they were willing to offer a higher rate because eurodollar deposits were not subject to any legal reserve requirement and thus earned higher returns than other deposits. On the demand side, the tightening of the money supply in the United States in the 1960s made borrowing dollars in the United States more difficult for all, but especially for foreigners because of the foreign lending guidelines proposed by the Federal Reserve and the imposition of the interest equalization tax on loans made to foreigners. In addition, lending rates on eurodollars were less than lending rates in the United States. Consequently foreign demand for eurodollars increased. Finally, U.S. banks themselves contributed to the growth in demand for eurodollars as they attempted to obtain dollar funds from their overseas branches during the tight money period when borrowing rates on eurodollars were actually lower than borrowing rates at home.

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Chapter 21 - International Financial Markets and Instruments: An Introduction

2. Since the interest rate in the United States is less than that in England, the pound should be at discount (the U.S. dollar at premium) such that, in financial equilibrium, the difference in the two rates is exactly offset by the difference between the spot and the forward and/or expected exchange rate, leaving the investor indifferent between the two markets. 3. One would expect the eurodollar deposit rate to be above 6½ percent and the lending rate to be below 8½ percent. Because the eurodollar deposits are not subject to the reserve requirements and other possible bank regulatory controls, including state and local taxes faced by domestic banks, eurodollar deposits potentially earn more and therefore eurobanks are willing to pay higher deposit rates and charge lower loan rates compared to similar loans in the United States. If local taxes on international financial activity were reduced, the respective deposit and lending rates would be expected to move more closely together. 4. Because eurodollar accounts are not subject to a reserve requirement or the 10 basis points deposit insurance costs, they should be willing to pay a deposit rate that is larger than 6½ percent by the equivalent costs of these two items. That is, they should be willing to pay a rate equal to (.065 + .001)/(1- .02) = .0673, or 6.73 percent. (See footnote 12 in the chapter.) 5. Bonds are initially issued for a specific face value, with a specific maturity date and a specific annual interest rate. The bond thus earns an amount each year equal to the stated interest rate times the face value (the coupon payment). With an increase in interest rates, bonds (whose rate of interest is now below the current market rate) will be less attractive to investors and they will attempt to sell them and move into investments paying a higher rate of return. Because the bonds can only be sold at a lower price, bond prices will fall until the fixed coupon payment (as a percentage of the new lower price) represents a higher rate of return equal to that currently on the market. This activity could well lead to the newspaper headline cited in the question. 6. The nominal rate of interest can never be negative because that would indicate that people were willing to pay someone to have use of their money, i.e., they want the nominal value or absolute size of their savings to decline over time, not increase. On the other hand, the real interest rate (the nominal rate minus the rate of inflation) can be negative if the rate of inflation exceeds the nominal interest rate. In this case, the nominal value of savings is increasing, but the purchasing power of those savings is declining because prices are rising at a faster rate than the rate at which savings are growing, i.e., the interest rate. If there are money markets in other countries that are paying a positive real rate of interest, then individuals should be attempting to move their funds out of negative real return investments in the home country to investments with the more attractive real rates abroad. In an integrated financial environment with no barriers to capital movements, funds would be shifted out of the country, which would place upward pressure on the nominal rate at home. Such pressure should continue until real interest rates are equalized. If negative real rates persist, this is a sign that there are barriers to capital movements and that the country is not well integrated into the world financial markets.

Eurodollar interest rate futures are sold in $1 million units. Therefore if one wishes a

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Chapter 21 - International Financial Markets and Instruments: An Introduction

futures contract for more than $1 million, e.g., $10 million, one simply negotiates a contract containing 10 such units. If investors wish to hedge against interest rate changes for more than a three-month period, for example nine months, they would simply acquire a series of successive eurodollar interest rate futures contracts which would cover the nine months in question. This could be done for a nine-month period starting in December 2012 by acquiring a March 2013 futures contract, a June 2013 futures contract, and a September 2013 futures contract. When the March contract came to an end, it would be rolled over into the June contract. Similarly, when the June contract came to an end, it would be rolled over into the September contract. The individual in question would thus be hedged against changes in the interest rate for the ninemonth period ending on the September contract date. This type of collection of eurodollar interest rate futures contracts is referred to as a eurodollar strip. 8. A characteristic of any futures contract is that gains or losses of the contracting parties are settled on a daily basis, and not on the final maturity date. Thus, for example in a currency futures contract, if a particular currency begins to depreciate (move away from the contract rate) the party agreeing to supply (taking a short position) the other (appreciating) currency at the contract rate must make up any change in the difference between the current rate and the contract rate on a daily basis. When the contract comes due, the supplier will have paid enough into the account such that the holder of the contract will be able to acquire the needed foreign exchange from the market on the contract date by using a combination of funds at the contracted rate and the additional funds provided by the seller of the contract. Steady and large movements away from the contract rate can thus ultimately result in cash flow problems for the seller of the contract. Similar problems can occur in interest rate futures contracts as well, the principal difference being that the daily margin pertains to deviations of the market rate of interest from the contract rate (rather than deviations in the exchange rate.). 9. A eurodollar interest rate swap involves the exchange of interest rates by the two contracting parties for several periods in the future. This generally involves the exchange of a fixed rate by one party for a floating rate held by the other party, and is most often written in terms of LIBOR. This type of contract can benefit both parties in that a person holding a fixedrate loan cannot benefit from declines in the market rate of interest and thus might prefer to hold a variable-rate instrument. On the other hand, an individual with a flexible-rate loan might feel at risk because of potential increases in the interest rate and hence the cost of his loan. A swap thus enables the person who would prefer to take on more risk by switching from a fixed rate to a flexible rate to obtain the more preferred position and, at the same time, permits the holder of a floating-rate loan to reduce his interest rate exposure by obtaining a fixed rate without having to renegotiate the original loan. A “normal swap” involves the exchange of a fixed rate for a floating rate. A “basis swap” occurs when both sides are contracting a floating rate (a floating-floating swap). If the economic environment and or expectations should change, either or both contracting parties can contact a swaps trader and enter into a second swap arrangement. 10. In futures contracts, both the writer and the buyer of the contract can potentially lose, depending on what happens to the market interest rate. In the case of options contracts, the 21-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 21 - International Financial Markets and Instruments: An Introduction

writer of the options contract bears all the risk associated with interest rate changes. This asymmetry is dealt with through the size of the up-front cost of the futures contract (the option price), which is paid by the purchaser of the options contract. The greater the risk, the higher the option price. 11. The growth in loan syndicates has fostered growth in international lending by reducing the credit risk to any one single lender, particularly in the case of very large loans to sovereign borrowers. In addition, syndication has resulted in a reduction in the time for processing loans and a decrease in the costs associated with international lending, and has facilitated the contracting of very large loans. In a loan participation syndicate, the principal or lead bank negotiates the loan instrument with the borrower and then enters into participation agreements with other banks (syndicates the loan). In this case the participating banks are not viewed as co-lenders. In the case of the direct loan syndicate, all the bank participants sign a common loan agreement and are legal co-lenders. 12. In this case, you would purchase a “call” at the strike price of 9250, since 10,000-9250 (equivalent to 1.000 - 0.925) reflects a 7.5 percent rate of interest. For this contract you would have to pay 54 basis points. Since each basis point is worth $25, a $1 million contract would cost (54)($25) or $1,350. A $6 million contract would thus cost a total of $8,100. VI.

Sample Exam Questions

Essay Questions

1. Several people have argued that a surge in international lending and the increase in eurodollar accounts and derivatives will contribute to economic instability. Do you agree or disagree with their concerns? Why? 2. Discuss why an investor might be interested in foreign stocks and bonds instead of domestic financial instruments. What are the dangers of such purchases? 3. Why are investors interested in eurodollar interest rate futures and/or interest rate options? How do these instruments relate to financial risk? How might they be used in conjunction with exchange rate derivatives? 4. If, indeed, international financial markets are well-integrated, why do interest rates differ markedly between countries? 5. Present a brief overview of what has happened to financial markets over the past fifteen years. What factors contributed to this phenomenon? What are the implications, if any, for the developing countries? B.

Multiple-Choice Questions

If a French citizen places $100,000 in an Italian bank and an Italian citizen places 21-3

Chapter 21 - International Financial Markets and Instruments: An Introduction

$40,000 in a French bank, “international bank lending” has increased by __________. a. $40,000 b. $60,000 c. $100,000 * d. $140,000 7.

The “globalization of finance” in relatively recent years a. is an entirely new phenomenon in the world economy. b. is not an entirely new phenomenon because a similar expansion of financial flows occurred in the world economy in the 1930s. * c. is not an entirely new phenomenon because a similar expansion of financial flows occurred in the world economy in the 1870-1914 period. d. has been primarily associated with the flow of foreign direct investment across country borders rather than with growth in financial flows such as international bank lending.

Which one of the following is NOT a component of international bank lending? a. domestic bank loans in domestic currency to nonresidents b. domestic bank loans in foreign currency to domestic residents * c. domestic bank loans in domestic currency to a multinational corporation located in the domestic country d. domestic bank loans in foreign currency to nonresidents

Which one of the following gives rise to a new eurocurrency deposit? a. a U.S. exporter receives payment from a U.K. importer in U.S. dollars drawn on a New York bank and places dollars in a London bank b. a London bank loans out 90 percent of a eurodollar deposit to a firm which then deposits the eurodollars in a French bank account (in dollars) c. a French businessman opens up a bank account in Zurich, denominated in French francs * d. all of the above

10.

If a French citizen places $100,000 in an Italian bank and an Italian citizen places $40,000 in a French bank, “net international bank lending” increased by __________. a. $40,000 * b. $60,000 c. $100,000 d. $140,000

11.

The increasing importance of international stock transactions most likely will

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Chapter 21 - International Financial Markets and Instruments: An Introduction

a. result in international portfolio diversification. b. facilitate the movement of financial capital to its best use. c. possibly contribute to greater world volatility in world financial markets. * d. all of the above 12.

A London exporting firm’s dollar-denominated checking account in a New York bank __________ of the eurodollar market; a London exporting firm’s dollar-denominated checking account in a London bank __________ of the eurodollar market. a. would be counted as a component; also would be counted as a component b. would be counted as a component; would not be counted as a component * c. would not be counted as a component; would be counted as a component d. would not be counted as a component; also would not be counted as a component

13.

A surge in international bank lending could be potentially economically destabilizing because * a. it creates the possibility of reduced control of a country’s money supply. b. it directly contributes to destabilizing real investment flows. c. it results in too much control of world investment by a few large industrial countries. d. it results in inefficient use of financial capital, and hence reduces world growth rates.

14.

The eurodollar deposit rate would theoretically be expected to lie __________ the domestic U.S. deposit rate, and the eurodollar lending rate would theoretically be expected to lie __________ the U.S. domestic lending rate. a. below; below b. below; above * c. above; below d. above; above

15.

The growth in the last 10-20 years in international bond markets a. should result in exactly equal interest rates on two identical assets, even though the assets are located in different countries. b. should reduce exchange rate risk. c. will likely slow down, and may even become negative. * d. will likely result in a more efficient allocation of financial capital.

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Chapter 21 - International Financial Markets and Instruments: An Introduction

16.

A eurodollar interest rate swap a. is a type of future rate agreement that extends over several time periods. b. most often involves the exchange of a fixed rate for a floating rate. c. can be retraded on the futures market should either party desire to do so. * d. all of the above.

17.

An approximation to the “real” interest rate can be calculated by a. subtracting the nominal interest rate from the inflation rate. b. subtracting the price level from the nominal interest rate. c. dividing the nominal interest rate by the inflation rate. * d. subtracting the inflation rate from the nominal interest rate.

18.

A eurodollar interest rate put option, which was purchased at a strike price of 93, * a. would not be exercised if the market interest rate was 6½ percent on the contract date. b. gives the buyer the option of acquiring a lending rate of 9.3 percent on the contract date. c. gives the buyer the option of receiving a 7 percent deposit rate on the contract date. d. would cost the buyer 93 basis points.

19.

Suppose that short-term interest rates rise in the United States and, consequently, U.K. financial investors respond by sending funds to the United States (and cover those funds against any exchange rate change that might occur between the time of the investment and the time of returning the funds and interest to the United Kingdom). In this situation, which one of the following events will NOT occur? a. a rise in short-term eurodollar interest rates in London b. a fall in the dollar price of the British pound in the spot market c. a fall in the pound price of the U.S. dollar in the forward market * d. a fall in short-term interest rates on pound deposits in London

20.

Eurodollars __________ be borrowed by U.S. banks for use in the United States, and, because of this fact, the conduct of effective monetary policy in the United States is __________ than would otherwise be the case. a. cannot; more difficult b. cannot; easier * c. can; more difficult d. can; easier

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Chapter 21 - International Financial Markets and Instruments: An Introduction

21.

A U.S. mutual fund that purchases packages of equities that contain stocks of corporations both in the United States and in other countries worldwide is called a. an international fund. * b. a global fund. c. an emerging market fund. d. a regional fund.

22.

If an individual wished to lock in a future deposit rate of 8 percent in the eurodollar interest rate options market, she should * a. purchase a call at a strike price of 92. b. purchase a put at a strike price of 108. c. sell a put at a strike price of 8. d. sell a call at a strike price of 92.

23.

Global derivative instruments do NOT include which one of the following? a. interest rate futures b. stock market index futures c. currency options * d. checking accounts in commercial banks

24.

One hundred basis points in terms of dollars is equal to __________. a. $0.0001 * b. $0.01 c. $0.10 d. $1.00

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Chapter 22 - The Monetary and Portfolio Balance Approaches to External Balance

CHAPTER 22 THE MONETARY AND PORTFOLIO BALANCE APPROACHES TO EXTERNAL BALANCE Learning Objectives: ■

■

Show how the supply and demand for money can affect a country’s balance of payments and exchange rate. Describe how other financial assets besides money can influence exchange rates and international payments positions. Explain how a changing exchange rate can initially overshoot its new equilibrium value.

Outline

■

Introduction - The New Globalized Capital The Monetary Approach to the Balance of Payments - The Supply of Money - The Demand for Money - Monetary Equilibrium and the Balance of Payments The Monetary Approach to the Exchange Rate - A Two-Country Framework The Portfolio Balance Approach to the Balance of Payments and the Exchange Rate - Asset Demands - Portfolio Balance - Portfolio Adjustments Exchange Rate Overshooting Summary Appendix: A Brief Look at Empirical Work on the Monetary and Portfolio Balance Approaches - Empirical Testing on the Monetary Approach - Testing of the Portfolio Balance Model II

Special Chapter Features In the Real World: Relationships between Monetary Concepts in the United States In the Real World: Money Growth and Exchange Rates in the Russian Transition Titans of International Economics: Rudiger Dornbusch (1942-2002)

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Chapter 22 - The Monetary and Portfolio Balance Approaches to External Balance

III.

Purpose of Chapter

The purpose of this chapter is to consider the role played by money and asset relationships in establishing and maintaining equilibrium in the external sector. In particular, students should learn how money and asset markets influence and are influenced by the balance of payments and exchange rates. With this material in hand, the reader will be better able to understand why exchange rates change so frequently and sizably in situations where they are not pegged. IV.

Teaching Tips

A. From their study of Chapter 20 in particular, the students should now have grasped the ideas that exchange rates can change quickly and sizably and that such changes can have important effects. The opening paragraphs in this chapter reiterate these ideas and pave the way for exploration of the underlying causes and consequences of exchange rate changes. You should emphasize that this chapter and the next two are devoted to this exploration. B. In the discussion of the monetary approach, point out that a rise in income improves the balance of payments in this model (because of the resulting increase in the demand for money). This may seem peculiar to students who remember from the principles course that a rise in income in a Keynesian model worsens the current account because of induced imports. However, the situations are not really directly comparable, because the monetary approach is dealing not just with the current account but with the overall BOP (official reserve transactions balance). C. The point that, in the monetary approach, a fall in the interest rate leads to an improvement in the BOP (because the interest rate reduction increases money demand relative to money supply) needs to be stressed. Students (probably rightly so) will rebel against this, in that their intuition suggests that the lower interest rate will cause a financial capital outflow and a deterioration in the BOP. The students’ intuition is validated in the later discussion of the portfolio balance approach. D. The material on exchange rate overshooting will probably be difficult for many students to follow – if you can think of a better way to present it, by all means please do so. It may help to point out that the Dornbusch and Melvin models are very similar, with the only substantive difference being that Dornbusch uses the expected exchange rate and uncovered interest parity while Melvin uses the forward rate and covered interest parity. V.

Answers to End-of-Chapter Questions and Problems

1. The balance of payments will move toward surplus because the rise in income increases the demand for money and the money supply is unchanged. With excess demand for money, individuals attempt to build up their cash balances, causing a reduction in spending on goods and assets (including foreign goods and assets), a process that will move the BOP toward surplus. In the portfolio balance approach, the result of the rise in income will also be a movement toward surplus, but the role of bonds and the interest rate is more explicit. The increased demand for

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Chapter 22 - The Monetary and Portfolio Balance Approaches to External Balance

money raises the interest rate, foreign bonds are sold in the portfolio adjustment process, and there is a capital “inflow” into the home country. 2. The statement is true, as is explained in the section early in the chapter that discusses the demand for money. 3. From expression [12] in the chapter on page 560, it can be seen that a rise in k in country A leads to a proportional fall in e (an appreciation of A's currency). If, other things equal, people wish to hold more money, there is an excess demand for money. This excess demand leads to attempts to build up cash balances, an incipient surplus in the balance of payments, and an appreciation of the home currency. 4. PPP is more likely to hold in a hyperinflationary period because the money supply is usually out of control. With continual excess supply of money and expectations of continuing price rises, money “turns over” rapidly, bidding up the price level and driving down the international value of the home currency. All other determinants of the exchange rate are swamped by the extremely rapid price changes, so the exchange rate moves proportionately with the price level. In more “normal” periods, other influences (such as in the current account) on the exchange rate besides prices will have an important role. 5. This is obviously an opinion question. Utilizing Dornbusch’s sample and test (as discussed in the Appendix), only the interest rate variables were of the correct sign and statistically significant. However, during much of the 1973-1979 period that he was examining, the world economy was in disarray because of the first OPEC oil shock of 1973-1974 and the ensuing dislocations. For longer periods with very rapid inflation (such as in the Frenkel test), the monetary approach performs well. It would seem that further testing is necessary. Nevertheless, a point in favor of the monetary approach even in Dornbusch’s test is that the interest rate variables tested well. This is noteworthy because, in view of intuition and the portfolio balance approach, one might expect opposite signs for those variables. 6. The issuance of foreign government bonds will affect the perceived risk (and hence RP) associated with investment in the foreign country. The relationship between RP and the exchange rate can be seen by utilizing equations [13] and [14] in the chapter (page 562). Noting that xa = [E(e) - e]/e and substituting appropriately in [13] results in id = if + [E(e) - e]/e - RP. With an increase in already-risky foreign bonds, the risk premium will increase, effectively lowering the rate of return abroad, making the right-hand side of the equation smaller than the left, and stimulating domestic residents to decrease their holdings of foreign assets. Decreased demand for the foreign currency to make these asset purchases will cause an appreciation of the home currency (a decrease in e), and possibly an increase in E(e), due to the fact that home investors buying assets abroad will now demand less home currency in the future as their investments mature. Barring any changes in the interest rates in both countries, these exchange rate changes will take place until the increase in xa exactly offsets the initial increase in RP. Of course, if the interest rates also change in response to the short-term capital flows, if should increase and id should decrease, thus reducing the degree of change in the exchange rate.

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Chapter 22 - The Monetary and Portfolio Balance Approaches to External Balance

7. Following the framework used in Question #6 above, an increase in id will lead to an inflow of short-term capital into the home country. As investors acquire the domestic currency to make these investments, the demand for the home currency will increase and the exchange rate will appreciate (e gets smaller). This, of course, might be accompanied by an increase in E(e), a fall in id, an increase in if, and a decrease in RP. Should any of these occur, the degree to which e appreciates will be less. A monetarist would not come to the same conclusion. According to the monetarist approach, an increase in id will lead to a fall in the demand for money in the home country, causing the home country money supply to exceed home country money demand. In the open economy, this money market disequilibrium will lead to home country currency depreciation, not appreciation. 8. This statement can be defended using either the Dornbusch model or the Melvin model spelled out in the last section of the chapter. 9. With the huge volume of mobile short-term assets in existence, and with the huge amount of information available virtually immediately, actors in asset markets can respond quickly and sizably to any disequilibrium situation (such as a departure from uncovered or covered interest parity). Goods markets are slower in adjusting since the production process takes time and changes in it involve waiting to see if any change is truly a permanent change. Consumption and demand patterns also do not change rapidly because of inertia and because of less complete information than is available in financial markets. 10. The answer to this question is developed at the end of the chapter. The basic idea is that if E(e) is equal to efwd, then xa {= [E(e) - e]/e} is equal to (efwd - e)/e and there are no unexploited profit opportunities. The absence of such opportunities for profit in the market is the way that market efficiency is defined. 11. Students might respond to this question by indicating that the asset approach offers plausible explanations of instability in exchange rates and of overshooting, that it integrates financial markets with the exchange rate, that it reflects the reality of the large influence of interest rates and expectations on exchange rates, etc. On the other hand, the approach may underplay the role of changes in real factors in the economy on exchange rates and the balance of payments, particularly in countries (such as developing countries) where asset markets are thinly developed and/or financial capital is relatively immobile and subject to exchange control. Also, this approach to the exchange rate loses some relevance in a situation of relatively fixed rates, and many countries in the world have at least some element of “fixity” in their rates. Finally, the approach says little about the impact of exchange rate changes themselves on the economy, but it was not really designed to undertake that task.

Chapter 22 - The Monetary and Portfolio Balance Approaches to External Balance

VI.

Sample Exam Questions

Essay Questions

1. Explain the implication for a country’s exchange rate in the monetary approach and in the portfolio balance approach of (a) an autonomous decline in the demand for money at each interest rate by the country’s citizens, and (b) a change in expectations by the country’s citizens such that less inflation is expected in the future. 2. Why do the monetary approach and the portfolio balance approach have different expected signs for the impact of a change in the domestic interest rate on the exchange rate? Explain carefully. 3. In a situation of a fixed exchange rate, explain why, in the monetary approach, an excess supply of money leads to a balance-of-payments deficit. Why is the deficit only temporary? How might advocates of the monetary approach explain a long-lasting deficit in the balance of payments? 4. Describe a scenario that will make the current three-months forward rate on a foreign currency equal to the expected spot rate in three months for that currency. What might prevent this result from occurring? 5. (a) Could there be “overshooting” of the exchange rate in the Dornbusch model if goods markets adjusted as rapidly as asset markets? Why or why not? (b) What would be the analog to the general phenomenon of “overshooting” in a situation of fixed exchange rates? Explain. B.

Multiple-Choice Questions

6. In the monetary approach to the balance of payments and the exchange rate, if there is an excess demand for money, the result is a balance-of-payments __________ in a fixed exchange rate situation and __________ of the country’s currency in a flexible exchange rate situation. * a. surplus; an appreciation b. surplus; a depreciation c. deficit; an appreciation d. deficit; a depreciation 7. If id is the domestic interest rate, if is the foreign interest rate, xa is the expected rate of appreciation of the foreign currency (or the expected rate of depreciation of the home currency), and financial capital is mobile across countries (and assuming no risk premium), then equilibrium in international financial asset markets is indicated by the

Chapter 22 - The Monetary and Portfolio Balance Approaches to External Balance

expression a. xa = (id/if). b. xa = id + if. c. if = id + xa. * d. id = if + xa 8. If Ms is the money supply, BR = reserves of commercial banks (depository institutions), C = currency held by the nonbank public, and a = the money multiplier, then a. Ms = aBR + C * b. Ms = a(BR + C) c. BR = Ms - C d. aC = Ms - BR 9.

Because of widespread risk aversion in the financial sector in recent years, commercial banks in the United States have tended to hold __________ excess reserves than would otherwise have been the case. A result of this bank behavior is that the “money multiplier” in the U.S. economy is __________ than would otherwise have been the case. * a. a larger amount of; smaller b. a larger amount of; larger c. a smaller amount of; smaller d. a smaller amount of; larger

10.

Suppose that, for a country, its money supply (Ms) is at the moment equal to its demand for money (Md). Now suppose that the country’s central bank pumps new money into the economy. The result of this central bank action, other things equal, is that there will be __________ under flexible exchange rates and a consequent __________ of the country’s currency. a. an incipient balance-of-payments surplus for the country; appreciation b. an incipient balance-of-payments surplus for the country; depreciation c. an incipient balance-of-payments deficit for the country; appreciation * d. an incipient balance-of-payments deficit for the country; depreciation

11.

In the monetary approach to the balance of payments and the exchange rate, a. an increase in the demand for money (with a fixed supply) would cause a balance-ofpayments deficit under fixed exchange rates. b. an increase in the supply of money (with a fixed demand) would cause a balanceof-payments surplus under fixed exchange rates. * c. a decrease in the demand for money (with a fixed supply) would cause a balance-ofpayments deficit under fixed exchange rates. d. an increase in the supply of money (with a fixed demand) would cause the domestic currency to appreciate under flexible exchange rates.

Chapter 22 - The Monetary and Portfolio Balance Approaches to External Balance

12.

In the monetary approach to the balance of payments, under flexible exchange rates, an increase in the proportion of income that people in country A wish to hold as money would, other things equal, lead to an __________ in country A’s balance of payments and therefore to __________ of A’s currency in the foreign exchange markets. a. incipient surplus; a depreciation * b. incipient surplus; an appreciation c. incipient deficit; a depreciation d. incipient deficit; an appreciation

13.

The term xa in the textbook is defined as the expected rate of appreciation of the foreign currency. A mathematical way to express this definition [where e is the spot rate of the foreign currency and E(e) is the expected future spot rate of the foreign currency] is __________. a. E(e) - e b.

e ______ E(e)

* c.

E(e) _____ - 1 e

E(e) - e _________ e-1

14. In the asset market or portfolio balance approach, other things equal, a depreciation of the home currency would be caused by __________ in inflationary expectations in the home country and by __________ in real income in the home country. a. an increase; an increase * b. an increase; a decrease c. a decrease; an increase d. a decrease; a decrease 15.

Under a system of flexible exchange rates, the portfolio balance approach suggests that an increase in real income in a home country will lead to __________ of that country’s currency; under flexible rates, the monetary approach suggests that an increase in real income in a home country __________ of that country’s currency. a. a depreciation; will lead to an appreciation

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Chapter 22 - The Monetary and Portfolio Balance Approaches to External Balance

b. a depreciation; also will lead to a depreciation * c. an appreciation; also will lead to an appreciation d. an appreciation; will lead to a depreciation 16. In the portfolio balance approach, which one of the following, other things equal, will cause an increase in the demand for domestic bonds by home country citizens? a. a decrease in the home country interest rate b. a increase in the home country price level c. an increase in the home country real income level * d. a decrease in the expected rate of appreciation of the foreign currency (or a decrease in the expected rate of depreciation of the home currency) 17. In the portfolio balance model, other things equal, the issuance of new bonds by a home corporation will __________ the domestic interest rate and, especially if home and foreign bonds are very good substitutes for each other, will lead to __________ of the home currency. a. decrease; a depreciation b. decrease; an appreciation c. increase; a depreciation * d. increase; an appreciation 18.

If e is the current spot rate (units of home currency per unit of foreign currency), efwd is the current three-months forward rate, E(e) is the expected spot rate in three months, and xa is the expected rate of depreciation of the home currency in three months, then, in an efficient foreign exchange market, * a. E(e) = efwd. b. e = efwd. c. xa = efwd. d. E(e) = e.

19. In considering the demand for money in the monetary approach to the balance of payments, it can be said that the money demand would increase if home real income __________ and if the home interest rate __________. a. decreases; also decreases b. decreases; increases * c. increases; decreases d. increases; also increases 20. In the Dornbusch “overshooting” model, asset markets adjust __________ rapidly to disturbances than do goods markets, and therefore the exchange rate and the price level __________ proportionately to each other in the short run.

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Chapter 22 - The Monetary and Portfolio Balance Approaches to External Balance

a. more; move * b. more; do not move c. less; move d. less; do not move 21.

Which one of the following, other things equal, would NOT cause an increase in the amount of money demanded in country A? a. an increase in A’s national income b. an increase in the price level in country A c. a fall in interest rates in country A * d. an increase in the rate of expected inflation in A

22. In the monetary approach to the exchange rate, which one of the following will cause a depreciation of A’s currency relative to B’s currency? * a. an increase in the amount of money demanded at each income level in country B b. an increase in the money supply in country B c. a fall in real income in country B d. a decrease in the money supply in country A 23. In the portfolio balance model, other things equal, an increase in home country wealth because of a current account surplus a. will reduce home country demand for money. b. will reduce home country demand for foreign bonds. * c. will have an indeterminate effect on the domestic interest rate (without more information). d. will not affect the domestic demand for either foreign or domestic bonds. 24.

In the monetary approach to the exchange rate, a decrease in income in country I will, other things equal, lead to an __________ money in country I and therefore to __________ of country I’s currency against other currencies. * a. excess supply of; a depreciation b. excess supply of; an appreciation c. excess demand for; a depreciation d. excess demand for; an appreciation

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Chapter 23 - Price Adjustments and Balance-of-Payments Disequilibrium

CHAPTER 23 PRICE ADJUSTMENTS AND BALANCE-OF-PAYMENTS DISEQUILIBRIUM Learning Objectives: ■

Explain how changes in exchange rates affect the movement of goods and services and the trade balances of countries. ■ Discuss how price elasticity of demand relates to the stability of foreign exchange markets. ■ Summarize how the price adjustment mechanism functions under a system of fixed or pegged exchange rates. I.

Outline Introduction - Price Adjustment: The Exchange Rate Question The Price Adjustment Process and the Current Account under a Flexible-Rate System - The Demand for Foreign Goods and Services and the Foreign Exchange Market - Market Stability and the Price Adjustment Mechanism - The Price Adjustment Process: Short Run versus Long Run The Price Adjustment Mechanism in a Fixed Exchange Rate System - Gold Standard - The Price Adjustment Mechanism and the Pegged Rate System Summary Appendix: Derivation of the Marshall-Lerner Condition

II.

Special Chapter Features Concept Box 1: Elasticity of Import Demand and the Supply Curve of Foreign Exchange When Demand Is Linear In the Real World: Estimates of Import and Export Demand Elasticities In the Real World: Exchange Rate Pass-Through of Foreign Exports to the United States In the Real World: Japanese Export Pricing and Pass-Through in the 1990s In the Real World: U.S. Agricultural Exports and Exchange Rate Changes

III.

Purpose of Chapter

The purpose of this chapter is to introduce the students to the manner in which changes in the exchange rate affect the current account. The material forms a necessary foundation for the later macro policy chapters in the text.

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Chapter 23 - Price Adjustments and Balance-of-Payments Disequilibrium

IV.

Teaching Tips

A. It often appears that the prices of foreign goods do not change as expected with respect to changes in the exchange rate. It is useful to focus on the fact that this can be influenced both by market characteristics and by the nature of the foreign exchange rate regime that is in place. B. The characteristics of the foreign exchange market are critical to understanding the nature of the adjustment process. We have found that linking the foreign demand schedule for home goods and services to the supply schedule of foreign currency by numerical example is a useful way to demonstrate how an unstable foreign exchange market can result from inelastic demand for traded goods. A backward-sloping supply curve of foreign exchange is not necessarily an unlikely possibility in the short run. C. We do not feel that it is useful to expend too much effort on the Marshall-Lerner condition. Consequently, the derivation is in an appendix. The Marshall-Lerner condition is, however, a useful vehicle to drive home the basic idea that foreign exchange market stability properties are the consequence of both demand and supply considerations. Using estimates such as those found in Table 3, the Marshall-Lerner condition is useful for giving confidence to the likely existence of stable market equilibria, at least in the medium to long term. D. Given the continually-voiced interest in returning to a fixed exchange rate system, this is a good time to make the student aware of the different manner in which price adjustments take place under fixed rates as opposed to flexible rates. E. Make certain that students understand the link between gold flows or obligatory central bank interventions in the foreign exchange market and the domestic money supply under fixed rates. If students grasp this basic link at this point, it will make Chapter 25 containing analysis of economic policy under fixed exchange rates much easier to follow. V.

Answers to End-of-Chapter Questions and Problems

1. This is not valid. The existence of a downward-sloping supply curve of foreign exchange is not a sufficient condition for producing an unstable equilibrium. If the downward-sloping supply curve is steeper than the demand curve, the exchange market is stable. Only if the downward-sloping supply curve is flatter than the demand curve will the equilibrium position be an unstable one. 2. In the analysis of this chapter, it is necessary that the supply curve be downward-sloping in order for the equilibrium position to be unstable. However, if one were to get more exotic and specify that the demand curve could be upward-sloping, then an upward-sloping demand curve coupled with an upward-sloping supply curve that was steeper than the demand curve would generate an unstable equilibrium position. However, it is best to forget about this possibility in this class! 3.

According to the Marshall-Lerner condition, the current account balance will improve

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Chapter 23 - Price Adjustments and Balance-of-Payments Disequilibrium

because of currency depreciation if the sum of the absolute values of the elasticities of demand for imports and exports is greater than 1.0. In this problem the elasticity of demand for imports is equal to {(790 - 810)/[(790 + 810)/2]}/0.10 = - 0.25. The elasticity of demand for exports is equal to {(1,025 - 975)/[(1,025 + 975)/2]}/(-0.10) = - 0.50. The sum of the absolute values of these two elasticities is thus 0.75, which is strictly less than 1.0. One would therefore conclude that a depreciation of the home currency would cause the current account balance to worsen. 4. This could be explained in terms of a J-curve phenomenon. If the short-run elasticities of supply and demand for traded goods are sufficiently inelastic (producing a backward-bending supply curve of foreign exchange and a very steep demand curve such that the Marshall-Lerner condition is not met in the short run), then the foreign exchange market in the short run is unstable and an increase in the exchange rate (depreciation of the dollar) will lead to a worsening in the balance of trade. Of course, income growth in the United States and stagnation in Japan would have strengthened this result. 5. This question calls for the students to examine their own behavior. If the short-run response is different than the long-run response (e.g., more inelastic), and if enough people behave similarly so that the market elasticities are different in the short run than in the long run, the J-curve phenomenon can result. In the J-curve phenomenon, a depreciation of the home currency leads to a worsening of the current account in the short run but to an improvement in the long run as elasticities become greater. 6. If the Chinese are keeping their currency undervalued (below the market equilibrium price), it would decrease their own demand for foreign goods and services and hence their import outlays, as well as stimulate foreign purchases of Chinese goods and services and hence Chinese export revenues. There would thus be a smaller current account deficit, a current account surplus, or a larger current account surplus than would otherwise occur. This assumes that the Marshall-Lerner condition is met since the depreciation of the renminbi yuan leads to an improvement in the current account. 7. (a) The dollar/pound exchange rate is $40/£20 or $2/£1. Given the transactions cost of $1/oz., the gold export point is thus $41/£20 = $2.05/£, and the gold import point is $39/£20 = $1.95/£. (b) The peso/pound exchange rate is 60 pesos/£20 or 3 pesos/£1. Given the transactions cost of $1/oz. or 1.5 pesos/oz. (since 60 pesos = $40), the gold export point is 61.5 pesos/£20 = 3.075 pesos/£1, and the gold import point is 58.5 pesos/£20 = 2.925 pesos/£1. (c) The peso/dollar exchange rate is 60 pesos/$40 = 1.5 pesos/$1. Given the transactions cost of $1/oz. (1.5 pesos/oz.), the gold export point is thus 61.5 pesos/$40 = 1.5375 pesos/$1, and the gold import point is 58.5 pesos/$40 = 1.4625 pesos/$1. 8. The term “pass-through” refers to the degree to which changes in the exchange rate are realized in changes in the prices of goods. If the dollar depreciates by 10 percent against the Japanese yen, then the prices of Japanese goods to U.S. consumers should rise by 10 percent if 23-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 23 - Price Adjustments and Balance-of-Payments Disequilibrium

the entire impact of the exchange rate change is passed on in the form of increases in the prices of Japanese goods in the United States (a “pass-through” of 100 percent). Japanese exporters can offset the impact of the appreciating yen (depreciating dollar) by reducing their domestic prices, thus leading to an increase in the price of Japanese goods in the United States that is less than the depreciation of the dollar, i.e., reducing the degree of “pass-through.” VI.

Sample Exam Questions

Essay Questions

2. Suppose that there is an increase in the supply of foreign exchange due to an inflow of foreign investment in a flexible-rate system. Explain how this would affect the balance on current account, being careful to explain any assumptions about the foreign exchange market that are critical to your discussion. 3. “The J curve occurs because of differences of short-run elasticities from long-run elasticities.” Explain the reasoning behind this statement.

Chapter 23 - Price Adjustments and Balance-of-Payments Disequilibrium

4. Briefly compare and contrast the price adjustment mechanism under fixed exchange rates to that under flexible exchange rates. Why is a price adjustment necessary under a fixed-rate system? 5. Under either a gold standard or a pegged-rate system, what changes in the money supply are necessary in order for effective adjustment to take place? Why are these changes necessary? 6. Is the Marshall-Lerner condition of any relevance for the successful operation of the gold standard adjustment mechanism? Explain. 7. Assume a two-country world containing country A (whose currency is the dollar) and country B (whose currency is the peso). In this context, and using relevant graphs, explain how a depreciation of the dollar against the peso (for example, a 10% depreciation) conceptually affects the quantity of A’s exports to B and the quantity of A’s imports from B. (You can use either dollars or pesos on the vertical axes of your graphs. Also, assume that “pass-through” is complete.) Then carefully explain why economists say that such a depreciation could actually worsen the trade balance (or current account balance) of country A and indicate the MarshallLerner condition. Finally, define the “J curve” and give a very brief explanation of why it has the shape that it does. B.

Multiple-Choice Questions

8. Which of the following occurs if a country A depreciates its currency relative to country B’s currency? a. A’s export goods become cheaper to A’s residents. * b. A’s export goods become cheaper to B’s residents. c. B’s export goods become cheaper to A’s residents. d. B’s export goods become more expensive to B’s residents. 9.

Other things equal, which of the following occurs if a country A appreciates its currency relative to country B’s currency? a. A’s export goods become cheaper to B’s citizens. b. A’s export goods become more expensive to A’s citizens. * c. B’s export goods become cheaper to A’s citizens. d. B’s export goods become cheaper to B’s citizens.

10.

Suppose that a 5% depreciation of the U.S. dollar raises the dollar price of a U.S. import good by 5%. This situation would be characterized as a situation of __________ “passthrough” (or “exchange-rate pass-through”), and U.S. consumers of the imported good would spend a larger dollar amount on the imported good than they did before the depreciation of the dollar if their demand for the good is __________. * a. complete; inelastic b. complete; elastic 23-3

Chapter 23 - Price Adjustments and Balance-of-Payments Disequilibrium

c. incomplete or partial; inelastic d. incomplete or partial; elastic 11.

Given the following table showing various $/£ exchange rates and the respective quantities of pounds demanded by U.S. buyers: $/£

pounds demanded

$2.50/£1

£1,000

$2.00/£1

£1,500

$1.50/£1

£1,800

The demand for pounds between $2.00/£1 and $1.50/£1 is a. elastic. b. unit-elastic. * c. inelastic. d. elastic, unit-elastic, or inelastic – cannot be determined without more information. 12.

Using the information in the table in Question #11 above, the arc elasticity of demand for pounds between the $2.50/£1 exchange rate and the $2.00/£1 exchange rate is (ignoring the negative sign) __________. a. 0.56 b. 1.33 * c. 1.80 d. 2.50

13.

In the “gold standard” framework of the period 1880-1914, suppose that the par value exchange rate is $2.00/£1. If the market exchange rate rises to $2.12/£1 because of a rise in U.S. demand for British goods, and if it costs $0.05 to ship gold between the two countries, there would be __________. Then, if the “rules of the game” were being followed, the money supply in the United States would __________ after this movement of gold. a. an inflow of gold to the U.S. Treasury from the Bank of England; decrease b. an inflow of gold to the U.S. Treasury from the Bank of England; increase * c. an outflow of gold from the U.S. Treasury to the Bank of England; decrease d. an outflow of gold from the U.S. Treasury to the Bank of England; increase

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Chapter 23 - Price Adjustments and Balance-of-Payments Disequilibrium

14. In which of the following cases can we conclude, without any further information, that a depreciation of a country’s currency will worsen the country’s trade balance (or current account balance). a. demand curve for exports is horizontal; supply curve of imports is horizontal * b. demand curve for exports is vertical; demand curve for imports is vertical c. demand curve for exports is horizontal; demand curve for imports is horizontal d. supply curve of exports is horizontal; supply curve of imports is horizontal 15.

The simple Marshall-Lerner condition would suggest that one of the following cases would produce a worsening of the trade balance if the country’s currency depreciated. Which one? (The negative sign on elasticities is being ignored; also, assume that trade is initially balanced.) a. elasticity of demand for exports = 0.8; elasticity of demand for imports = 0.5 b. elasticity of demand for exports = 0.4; elasticity of demand for imports = 0.6 c. demand curve for exports is vertical; demand curve for imports is horizontal * d. elasticity of demand for exports = 0.8; elasticity of demand for imports = 0.1

16.

If, under the gold standard, the par value of the Swiss franc in terms of the dollar is $0.80, and if it costs $0.01 to move one franc’s worth of gold between the countries, then the “gold export point” from the United States is at __________, and the “gold import point” into the United States is at __________. a. $0.80 = 1 Swiss franc; $0.80 = 1 Swiss franc * b. $0.79 = 1 Swiss franc; $0.81 = 1 Swiss franc c. $0.81 = 1 Swiss franc; $0.79 = 1 Swiss franc d. $0.82 = 1 Swiss franc; $0.78 = 1 Swiss franc

17.

Which one of the following situations would represent a “small-country” case in the analysis of the elasticities approach to devaluation? a. demand for exports curve has normal downward slope, supply curve of imports is horizontal b. supply curve of imports has normal upward slope, demand curve for exports is horizontal c. supply curve of imports is horizontal, demand curve for exports is vertical * d. demand curve for exports is horizontal, supply curve of imports is horizontal

18. If depreciation of a home currency occurs, foreign exporters to the home country could offset some of the impact of the depreciation by __________ the price/cost ratio on goods sent to the home country; such a change in the price/cost ratio would mean that there was __________ “pass-through” of the exchange rate change to foreign export prices. a. decreasing; complete * b. decreasing; less-than-complete 23-5 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 23 - Price Adjustments and Balance-of-Payments Disequilibrium

c. increasing; complete d. increasing; less-than-complete 19. The shape of the curve that shows the effect of currency depreciation upon a country’s current account balance over time, with the curve itself being known as the __________, reflects the fact that short-run demand elasticities are sufficiently __________ than longrun elasticities to generate this particular shape. (Ignore the negative sign on the elasticities.) * a. J curve; lower b. J curve; higher c. supply curve of foreign exchange; lower d. supply curve of foreign exchange; higher 20. When considering the change in price of a country’s imports when foreign currencies depreciate by 10 percent relative to the home country, the “elasticity of exchange rate passthrough” would be equal to a. 1.0 if there were no “pass-through.” * b. 1.0 if there were complete “pass-through.” c. zero if there were complete “pass-through.” d. 10 percent if there were complete “pass-through.” 21.

If, in a demand curve/supply curve graph with the quantity of U.S. exports plotted on the horizontal axis and the price of U.S. exports in dollars plotted on the vertical axis, suppose that, from an initial equilibrium position, there is now a depreciation of the U.S. dollar relative to other currencies. (Assume that the supply curve is horizontal.) Other things equal, this depreciation of the dollar would cause the __________. a. demand curve to shift to the left (or vertically downward) * b. demand curve to shift to the right (or vertically upward) c. supply curve to shift vertically downward d. supply curve to shift vertically upward

22.

If, in a demand curve/supply curve graph with the quantity of U.S. imports plotted on the horizontal axis and the price of U.S. imports in dollars plotted on the vertical axis, suppose that, from an initial equilibrium position, there is now a depreciation of the U.S. dollar relative to other currencies. (Assume that the supply curve is horizontal.) Other things equal, this depreciation of the dollar would cause the __________.

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Chapter 23 - Price Adjustments and Balance-of-Payments Disequilibrium

a. demand curve to shift to the left (or vertically downward) b. demand curve to shift to the right (or vertically upward) c. supply curve to shift vertically downward * d. supply curve to shift vertically upward 23.

If country A depreciates its currency against country B’s currency, then, other things equal, * a. there should be “expenditure switching” towards A’s goods by residents of both countries. b. there should be “expenditure switching” towards A’s goods only by A’s residents. c. there should be “expenditure switching” towards B’s goods by residents of both countries. d. B’s goods become cheaper to country A’s residents.

24.

Which one of the following was NOT supposed to occur in the “gold standard” international monetary system? a. Countries were to specify their currency values in terms of gold. * b. Countries were to prevent gold movements from influencing their money supplies. c. Free movement of gold was to occur among countries. d. Countries were to have wage and price flexibility.

25.

If a home country depreciates or devalues its currency by 10 percent, and if there is “complete pass-through” as well as horizontal supply curves of exports and imports, then the price of the country’s exports in terms of foreign currency will __________ and the price of the country’s imports in terms of home currency will __________. a. not change; rise by 10 percent b. not change; not change * c. fall by 10 percent; rise by 10 percent d. fall by 10 percent; not change

Chapter 24 - National Income and the Current Account

CHAPTER 24 NATIONAL INCOME AND THE CURRENT ACCOUNT Learning Objectives: ■

■

Show how the incorporation of a foreign trade sector into a Keynesian income model alters the domestic saving/investment relationship and changes the multiplier. Demonstrate that national income equilibrium may not be consistent with equilibrium in the current account. Explain why income levels across countries are interdependent.

Outline

■

Introduction - Does GDP Growth Cause Trade Deficits? The Current Account and National Income - The Keynesian Income Model - Determining the Equilibrium Level of National Income - The Autonomous Spending Multiplier - The Current Account and the Multiplier - Foreign Repercussions and the Multiplier Process An Overview of Price and Income Adjustments and Simultaneous External and Internal Balance Summary Appendix A: The Multiplier When Taxes Depend on Income Appendix B: Derivation of the Multiplier with Foreign Repercussions II.

Special Chapter Features Titans of International Economics: John Maynard Keynes (1883-1946) In the Real World: Average Propensities to Import, Selected Countries In the Real World: Multiplier Estimates for India In the Real World: Historical Correlation over Time of Countries’ GDP In the Real World: Recent Synchronization of GDP Movements of Countries

III.

Purpose of Chapter

The purpose of this chapter is to introduce the students to the manner in which changes in the current account influence the aggregate macroeconomy and the mechanism by which changes in the macroeconomy influence the current account. The material forms a necessary foundation for the remaining chapters in the text.

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Chapter 24 - National Income and the Current Account

IV.

Teaching Tips

A. The opening vignette can be used to make sure that the students realize that the foreign trade sector of the economy is not something separate from the rest of the economy – rather, it is intricately interdependent with developments in the “internal” sector. B. The basic Keynesian model developed should be familiar to your students because most principles books now include the foreign sector in the model (although sometimes only in appendixes to chapters). Therefore, we recommend that you not devote too much class time to the purely mechanistic material in this model. C. Note that we make imports dependent on total income and not on disposable income. If you choose to make them dependent upon disposable income, you will end up with a different formula for the autonomous spending multiplier, as we indicate in expression [23] in Appendix A. D. Some international economics texts call the open-economy multiplier the “foreign trade multiplier.” We recommend that you not use that term, however, since we think that it is misleading – the multiplier does not apply only to autonomous changes in the foreign trade sector of the economy. E. Remind the students that prices are fixed in this chapter (except for reference to exchange rate changes). Price changes are considered later in the aggregate demand-aggregate supply material in Chapter 27. However, you may want to discuss possible effects here in a general way, although it is much easier to do in the IS/LM/BP framework which is presented in the following chapter. V.

Answers to End-of-Chapter Questions and Problems

1. An autonomous increase in saving at each income level is equivalent to an autonomous decrease in consumption at each income level. The autonomous decrease in consumption will decrease equilibrium national income by the autonomous consumption change times the openeconomy multiplier, 1/(1 - MPC + MPM), or if taxes depend on income, 1/(1 - MPC + MPCt + MPM). (Note that this assumes that the first round reduction in C impacts only on domestic goods; otherwise the numerator would be 1 - MPM.) 2.

(a) Y = C + I + G + (X - M) Y = 50 + 0.85Yd + 150 + 300 + 80 - (10 + 0.05Y) Y = 50 + 0.85(Y - 400) + 150 + 300 + 80 - (10 + 0.05Y) Y = 0.85Y - 0.05Y + 230 = 0.80Y + 230 Y = (1/0.2)(230) Y = 1,150

Therefore the equilibrium level of income is 1,150. (b) At the equilibrium level of income, because X = 80 and M = 10 + 0.05(1,150) = 67.5, there is a current account surplus of 12.5.

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Chapter 24 - National Income and the Current Account

(c) 1/[(1 – MPC) + MPM] = 1/[(1 - 0.85) + 0.05] = 1/(0.15 + 0.05) = 5. 3. Y would have to rise by 250, because this increase in Y would increase M by 12.5 with an MPM of 0.05. Because the multiplier is 5, autonomous investment would have to rise by 50 (= 250/5) in order to generate this increase in Y. 4. If a country has a current account surplus (X > M), then a reworking of the national income expression S + M + T = I + X + G to S + (T - G) - I = (X - M) indicates that saving (private plus government) exceeds investment by the amount of the current account surplus. In effect, the excess of saving over investment has been lent abroad to permit foreigners to purchase more of the home country’s exports than the home country buys in imports from foreign countries. Alternatively, the positive net exports generate, with no change in investment, a rise in income that yields saving (private plus government) greater than investment. 5. If Germany pursues a policy that results in a lower rate of growth, then its growth in demand for goods from its trading partners will also slow down. A slower rate of growth of German imports from its trading partners can not only contribute to balance-of-trade issues, but can also reduce the growth rate in these trading partners. Trading partners that were trying to reduce a trade deficit with Germany and/or attempting to grow at a faster rate than would be consistent with Germany’s performance would more than likely be frustrated with German economic policy. 6. Expansionary fiscal policy in Japan would lead to an expansion of Japanese income and thus increased imports, some of which would come from the United States. This expansion of Japanese imports from the United States would, other things equal, reduce the U.S. trade deficit with Japan. However, the increased U.S. exports would provide a stimulus to U.S. income, and this U.S. income growth would stimulate greater U.S. imports from Japan. This “foreign repercussion” would reduce the degree to which the growth in Japanese income would work toward eliminating Japan’s surplus with the United States. The overall result would be a reduction in the U.S. deficit with Japan, but not to the degree expected if foreign repercussions were not taken into account. 7. (a) Since E = Y in equilibrium, then Y = C + I + G + X - M. Substituting the equations and/or exogenous values for the various expenditure items into the income identity produces Y = 120 + .075(Y - 40 - 0.20Y) + 230 + 560 + 350 - 30 - 0.10Y Y - 0.75Y + 0.15Y + 0.10Y = 120 - 30 + 230 + 560 + 350 - 30 = 1,200 0.5 Y = 1,200 Y = 2,400 (b) T = 40 + 0.20Y T = 40 + 0.20(2,400) = 520 The government surplus (deficit) = T - G = 520 - 560 = - 40. Therefore the government is running a deficit of 40 at equilibrium.

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Chapter 24 - National Income and the Current Account

(c) M = 30 + 0.10Y = 30 + 0.10(2,400) = 270 Because the trade balance equals exports minus imports, it is equal to 350 - 270 = 80. The country is thus running a trade surplus of 80 at equilibrium. 8.

1 + (MPMII/MPSII) ΔY = ________________________________  ΔI MPSI + MPMI + MPMII(MPSI/MPSII) 1 + (0.2/0.2) ΔY = _________________________  35 = (2/0.7)35 0.3 + 0.1 + 0.2(0.3/0.2)

Therefore country I’s income will rise by $100 billion. VI.

Sample Exam Questions

Essay Questions

1. If a country has a current account deficit, this is often referred to as a situation where the country is “spending beyond its means.” What does this phrase mean in terms of the simple Keynesian model? Does the existence of the current account deficit imply that the country as a whole is a dissaver (i.e., that saving is actually negative)? Why or why not? 2. Suppose that autonomous consumption increases but that, unlike the situation in the simple Keynesian model of this chapter, some of this autonomous consumption increase is spent on imports (say an amount equal to MPM times the autonomous consumption increase) in the “first round” of the multiplier process. What would this mean for the size of the open-economy multiplier in comparison to the open-economy multiplier in the text? 3.

(This question pertains to Appendix B material.)

In the presence of “foreign repercussions,” why is the multiplier for an autonomous increase in home country exports smaller than the multiplier for an autonomous increase in home country investment? Explain in economic terms. 4.

Given the following Keynesian model: Y=C+I+G+X-M C = 80 + 0.75Yd Yd = Y - T T = 0.20Y

I = 250 G = 100 X = 200 M = 0.30Y

(a) Calculate the equilibrium level of income and indicate the value of the current

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Chapter 24 - National Income and the Current Account

account balance when the economy is at its equilibrium income level. (b) Suppose that all equations in the model above stay the same except the size of exports. Calculate the level of exports needed to yield an equilibrium income level that also has X = M, and indicate that resulting equilibrium income level. 5. In the context of a Keynesian open-economy income model for a country, carefully explain the impact of each of the following autonomous events upon equilibrium income in the country and upon the country’s current account balance: (a) an increase in domestic investment; (b) an increase in exports; and (c) a simultaneous and equal autonomous increase in exports and imports. B.

Multiple-Choice Questions

If expansionary aggregate demand-oriented macroeconomic policy is to be used to move the economy towards simultaneous external and internal balance, in which one of the following situations would the policy indeed move the economy towards the attainment of both goals? a. deficit in the current account; unacceptably high unemployment b. deficit in the current account; unacceptably rapid inflation * c. surplus in the current account; unacceptably high unemployment d. surplus in the current account; unacceptably high inflation

7. Other things equal, in a Keynesian income model, the autonomous spending multiplier will __________ if there is a decrease in the marginal propensity to consume, and the autonomous spending multiplier __________ if there is a decrease in the marginal propensity to import (MPM). a. decrease; also will decrease * b. decrease; will increase c. increase; will decrease d. increase; also will increase 8. If the consumption function in a Keynesian model is C = 60 + 0.7Y, then the associated saving function is __________. * a. S = - 60 + 0.3Y b. S = - 60 + 0.7Y c. S = 40 + 0.3Y d. S = - 40 + 0.3Y

Chapter 24 - National Income and the Current Account

9. If the “multiplier” in a Keynesian open economy is 2.0, this is consistent with which one of the following combinations of the marginal propensity to consume (MPC) and the marginal propensity to import (MPM)? (Assume that there is no government sector.) * a. MPC = 0.7, MPM = 0.2 b. MPC = 0.3, MPM = 0.2 c. MPC = 0.8, MPM = 0.2 d. MPC = 0.5, MPM = 0.2 10.

(This question pertains to Appendix A material.)

In which one of the following situations is the “multiplier” for a given autonomous change in investment spending the largest? a. MPS = 0.4, MPM = 0.2, t = 0.25 b. MPS = 0.4, t = 0.25 and the economy has no foreign trade. c. MPS = 0.25, MPM = 0.1, t = 0.2 * d. MPS = 0.25, MPM = 0.1, t = 0.2, and the economy has “foreign “repercussions.” 11. In an open-economy Keynesian income model of the sort used in Chapter 24, at the equilibrium level of income, a. S + X + T = Y + M + G b. S + I + (T - G) = M - X * c. S + M + T = I + X + G d. S + (G - T) - I = (X - M) 12.

If an economy has a marginal propensity to import of 0.3 and the economy’s balance-of-trade deficit is 15, how much must the economy contract its GNP if income contraction is to be the method of removing the balance-of-trade deficit? a. 4.5 b. 45 * c. 50 d. 200

13.

In a Keynesian open-economy income model, an increase in autonomous investment in a country is likely to lead to what impact (if any) on national income in a trading partner country? * a. an increase b. a decrease c. no change d. an increase, a decrease, or no change – cannot be determined without more information

Chapter 24 - National Income and the Current Account

14.

The income elasticity of demand for imports (YEM) is defined as a. the change in imports divided by the change in income. b. total imports divided by total income. c. the change in income divided by the change in imports. * d. the percentage change in imports divided by the percentage change in income.

15.

Given the following import function for a country in a Keynesian income model: M = 15 + 0.10Y

a. At an income level of 100, imports are 10. b. An increase in the 0.10 to a value of 0.15 would, other things equal, increase the size of the country’s open-economy multiplier (i.e., autonomous spending multiplier with a foreign sector) * c. At an income level of 200, the country’s average propensity to import would be 0.175. d. An increase in the 15 to a value of 20 would, other things equal lead to an increase in the country’s national income. 16.

(This questions draws on Appendix A material.) Other things equal, an increase in the marginal propensity to save will __________ the size of the “autonomous spending multiplier” (or “the multiplier”); other things equal, an increase in the marginal tax rate __________ the size of the “autonomous spending multiplier” (or “the multiplier”). a. increase; also will increase b. increase; will decrease c. decrease; will increase * d. decrease; also will decrease

17.

If national income is greater than spending by domestic residents, then the country will have, in its balance of trade (or balance on current account) a. a deficit. * b. a surplus. c. neither a deficit nor a surplus. d. either a deficit or a surplus – cannot be determined without more information.

Chapter 24 - National Income and the Current Account

18. In a Keynesian model, if MPM = 0.2, MPC = 0.8, and there is no government sector, what will be the ultimate effect of an autonomous increase in investment of 30 on the imports of the country, other things equal? a. increase by 6 * b. increase by 15 c. increase by 75 d. decrease by 30 19. If a country’s ratio of imports to national income rises as the country grows over time, this implies, other things equal, that the country’s marginal propensity to import is __________ the country’s average propensity to import and, consequently, that the country’s income elasticity of demand for imports (YEM) is __________. a. greater than; less than 1.0 * b. greater than; greater than 1.0 c. less than; less than 1.0 d. less than; greater than 1.0 20.

Other things equal, in a Keynesian income model with a foreign sector, the autonomous spending multiplier that applies to an autonomous increase in the country’s investment __________.

* a. is larger when “foreign repercussions” are included in the model than when such repercussions are not included in the model b. is of the same size when “foreign repercussions are included in the model as when such repercussions are not included in the model c. is smaller when “foreign repercussions” are included in the model than when such repercussions are not included in the model d. is larger than, is the same as, or is smaller when foreign repercussions are included in the model in comparison to when such repercussions are not included in the model – cannot be determined without more information 21.

(This question pertains to Appendix A material.) In a Keynesian open economy, suppose that the MPC = 0.8, the MPM = 0.10, and t = 0.25. If it is desired to increase national income by 125 through an increase in private investment, by how much will private investment have to increase in order to generate the 125 increase in income?

22.

a. 25 b. 31.25 c. 50 * d. 62.5 Suppose that a Keynesian import function is expressed as M = 20 + 0.25Y. With this

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Chapter 24 - National Income and the Current Account

function, a. if income = 1,000, imports = 250. * b. if income = 1,000, the average propensity to import is 0.27. c. the marginal propensity to import is greater at an income level of 1,000 than at an income level of 800. d. the average propensity to import is greater at an income level of 1,000 than at an income level of 800. 23.

Consider a Keynesian income model without a government sector. In a graph with national income (Y) on the horizontal axis and both (S - I) and (X - M) on the vertical axis, the graphical relationship between (S - I) and Y would be portrayed as __________, and the graphical relationship between (X - M) and Y would __________. a. a downward-sloping line; also be portrayed as a downward-sloping line b. a downward-sloping line; be portrayed as an upward-sloping line * c. an upward-sloping line; be portrayed as a downward-sloping line d. an upward-sloping line; also be portrayed as an upward-sloping line

24.

In a Keynesian income model, if a country’s actual level of income is above the equilibrium income level, then there will be an __________ of inventories of firms and, consequently, firms will __________ their level of output. a. unintended depletion; increase b. unintended depletion; decrease c. unintended accumulation; increase * d. unintended accumulation; decrease

25.

Suppose that, at the equilibrium level of income in a country, the country has a current account (X-– M) deficit of 60. The country’s marginal propensity to consume = 0.7, and the country’s marginal propensity to import = 0.2. If contraction in imports by means of reducing national income is the method to be used to eliminate the current account deficit, by how much must national income be reduced? a. 30 b. 60 c. 120 * d. 300

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Chapter 24 - National Income and the Current Account

26.

(This question pertains to Appendix B material.) Assume a two-country world (countries I and II) where taxes do not depend on income and where MPSI = 0.2, MPMI = 0.2, MPSII = 0.1, and MPMII = 0.3. In this situation, what is the numerical value of the autonomous spending multiplier that applies to a change in autonomous investment in country I on country I’s income, taking account of foreign repercussions? a. 1.0 b. 2.5 * c. 4.0 d. 5.0

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Chapter 25 - Economic Policy in the Open Economy under Fixed Exchange Rates

CHAPTER 25 ECONOMIC POLICY IN THE OPEN ECONOMY UNDER FIXED EXCHANGE RATES Learning Objectives: ■ ■ ■ ■ I.

Explain general equilibrium in the macroeconomy using the IS/LM/BP model. Describe the impact of changes in fiscal policy on income, trade, and interest rates under fixed exchange rates. Describe the impact of changes in monetary policy on income, trade, and interest rates under fixed exchange rates. Demonstrate how varying degrees of capital mobility alter the effectiveness of fiscal and monetary policy under a system of fixed exchange rates. Outline Introduction - The Case of the Chinese Renminbi Yuan Targets, Instruments, and Economic Policy in a Two-Instrument, Two-Target Model General Equilibrium in the Open Economy: The IS/LM/BP Model - General Equilibrium in the Money Market: The LM Curve - General Equilibrium in the Real Sector: The IS Curve - Simultaneous Equilibrium in the Monetary and Real Sectors - Equilibrium in the Balance of Payments: The BP Curve - Equilibrium in the Open Economy: The Simultaneous Use of the LM, IS, and BP Curves The Effects of Fiscal Policy under Fixed Exchange Rates The Effects of Monetary Policy under Fixed Exchange Rates The Effect of Official Changes in the Exchange Rate Summary Appendix: The Relationship between the Exchange Rate and Income in Equilibrium

II.

Special Chapter Features Titans of International Economics: Robert A. Mundell (born 1932) In the Real World: The Presence of Exchange Controls in the Current Financial System In the Real World: The Historical Rise and Fall of a Currency Board – The Case of Argentina

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Chapter 25 - Economic Policy in the Open Economy under Fixed Exchange Rates

III.

Purpose of Chapter

The purpose of the chapter is to develop the IS/LM/BP analysis and then to show how domestic macroeconomic policy influences the open economy under a system of fixed exchange rates. The policy material focuses on the impacts of monetary policy, fiscal policy, and expenditure-switching policies under different degrees of international capital mobility. IV.

Teaching Tips

A. In recent years various news sources have emphasized that the Chinese renminbi yuan has been pegged to the U.S. dollar since 1994 and that the Chinese trade surplus with the United States has grown steadily over this time. This has led to considerable pressure on the Chinese to revalue (appreciate) their currency to reduce this trade imbalance. (In fact, since 2005, the Chinese have allowed the yuan to appreciate somewhat against the dollar.) This chapter’s opening vignette points out that there are indeed different opinions on the need or desirability of this policy action by China and that such action can have far-reaching effects. This case can be used to generate interest in the policy implications of a fixed exchange rate in the open economy. B. The discussion of the Mundell model in the first section is essentially an introduction to macro policy in the open economy and can be left to a considerable degree to the students to read on their own. It is, however, useful to emphasize the policy degrees-of-freedom issue and the reason why monetary policy is usually assigned to the external target (which is handled nicely in the familiar Mundell-Fleming diagram). C. The IS and LM curves may be familiar to some of your students but probably not to all of them. The standard four-quadrant derivation of these curves is not done in the chapter, but you may want to do so to make the material clearer. D. It is a good idea to discuss the BP curve thoroughly, making certain that the students recognize the factors that shift the curve and the nature of the balance-of-payments disequilibrium if the intersection of the IS and LM curves does not occur on the BP curve. It is also important to make sure that the students recognize how the slope of the curve depends on the degree of international short-term capital mobility. E. If you are constrained by time, we suggest focusing primarily on the imperfectly mobile capital case where BP is flatter than LM, since it characterizes the U.S. situation. Given the number of countries with fixed exchange rates and strict capital controls, the perfectly immobile case is also of interest to students. F. A critical message of this chapter is that the effectiveness of a particular policy instrument is dependent upon the nature of the exchange rate system and the degree of capital mobility. The analysis, among other things, can help to explain why the U.S. economy relied more on fiscal policy under the Bretton Woods system than in the current flexible-rate system.

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Chapter 25 - Economic Policy in the Open Economy under Fixed Exchange Rates

G. You should make the point that sterilization operations by the central bank under a fixedrate system can at best delay the responses discussed in this chapter. V.

Answers to End-of-Chapter Questions and Problems

1. The system must come to rest at the combination of interest rate and income where all three sectors are simultaneously in equilibrium. If the domestic equilibrium (intersection of IS and LM) is above the BP curve, under fixed rates there will be a surplus in the balance of payments, a resulting inflow of foreign exchange, and a consequent expansion of the money supply. As this occurs, the LM curve will shift to the right (downward), lowering the interest rate and expanding domestic investment, income, and imports. This shift will continue to take place until the combination of the interest rate and income causes all sectors to be in equilibrium at the same time. Similarly, a combination of the interest rate and domestic income that lies below the BP curve will lead to a balance-of-payments deficit, an outflow of foreign currency, and a consequent contraction in the money supply and leftward shift in the LM curve. This will cause the interest rate to rise and income to fall until there is again simultaneous equilibrium in all three sectors. 2. Monetary policy is ineffective in this scenario because changes in the money supply trigger changes in the domestic rate of interest as the LM curve shifts along the IS curve. With a change in the interest rate, short-term capital movements take place that produce either a surplus or deficit in the balance of payments. As the central bank intervenes to maintain the pegged value of the currency (or the appropriate gold flows take place under a gold standard), there is a contrary change in the money supply exactly equal to the initial effect of the monetary action. The end result is a return to the initial equilibrium that existed prior to the monetary action. 3. With an increase in the money supply, the domestic rate of interest temporarily falls below the international rate of interest as the LM curve moves rightward along the IS curve. In the case of perfect capital mobility, this immediately causes domestic investors to shift shortterm capital holdings from domestic assets to foreign assets to maximize their financial returns. As they acquire the desired foreign exchange (with domestic currency) from the central bank, there is a reduction of the home country’s international reserves and a decline in the money supply. This will continue until the economy is once again back in the initial equilibrium position. 4. In the case of perfectly immobile capital, the level of income is determined by the balance-of-payments constraint, i.e., the vertical BP curve. Income can only be increased by shifting the BP curve to the right, since attempts to increase income with either domestic monetary or fiscal policy create a balance-of-payments deficit that leads to a decrease in the money supply and offsets the initial expansionary effort. Thus, income will only grow as there is an inflow of foreign currency due to increased exports, foreign investment, or foreign aid that shifts the BP to the right and thereby permits the attainment of a higher level of income.

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Chapter 25 - Economic Policy in the Open Economy under Fixed Exchange Rates

5. Fiscal policy is least effective when capital is perfectly immobile (see Question #4). It is the most effective when capital is perfectly mobile, since in this instance there is no accompanying increase in the interest rate and hence no crowding out of domestic investment. 6. A devaluation of the currency leads to an expansion of exports and a contraction of imports, which shifts the IS curve to the right and shifts the BP curve down (to the right). A surplus in the balance of payments results, which leads to an increase in the money supply as the central bank acts to maintain the new exchange rate. The increase in the money supply takes place until there is an equilibrium of the new IS, LM, and BP curves at a new, higher level of income. Devaluation is effective under perfectly immobile capital since it leads to a net increase in foreign exchange, thus allowing the economy to function at a higher level of income (i.e., it has the effect of shifting the vertical BP curve to the right). 7. Because capital is nearly, if not perfectly mobile between states in the United States, the appropriate BP curve would essentially be horizontal at the U.S. rate of interest. 8. Because, under a fixed exchange rate system, the central bank stands ready to support the currency at its pegged rate, the country must maintain sufficient foreign exchange reserves to meet any balance-of-payments deficits that occur at the stated rate. Because there may be situations of considerable excess demand for foreign exchange at the pegged rate and/or the fixed exchange rate may over time become structurally incorrect given other targets in the country, sizable foreign exchange reserves are necessary if the country is not to be constrained by the external balance requirement, e.g., by a reduction in the money supply and hence income. Countries that, for whatever reason, find themselves with persistent BOP deficits must maintain high levels of foreign exchange reserves if they wish to postpone the automatic adjustment that leads to a reduction in income. 9. Under a fixed exchange rate regime, expansionary fiscal policy would cause the IS curve to shift to the right, leading to an increase in the Japanese interest rate and income. Since the BP curve is flatter than the LM curve, the new IS-LM intersection will lie above the BP curve. In other words, for the new level of income, the interest rate is higher than that which is necessary to balance the balance of payments, and a surplus in the Japanese BOP occurs. (The Japanese current account has worsened, but short-term capital inflows have improved the capital/financial account by more than the current account deterioration.) The BOP surplus causes an expansion of the money supply as the Japanese central bank purchases the excess foreign exchange, and the LM curve shifts to the right until all three curves are again in simultaneous equilibrium. The expansionary fiscal policy is thus complemented by an expansion in the money supply, leading to an even greater expansion of income. The higher level of income will, of course, generate an increase in imports into Japan, some of which would come from the United States. Thus, other things equal, there would be a reduction in the U.S. trade deficit with Japan. If the BP curve were steeper than the LM curve, the initial fiscal expansion would still worsen the current account, but there would be a Japanese BOP deficit at the intersection of the original LM curve with the new IS curve. (The increased net capital inflows would be insufficient to offset the worsening of the current account.) Hence, the Japanese money supply 25-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 25 - Economic Policy in the Open Economy under Fixed Exchange Rates

would contract. The end result will still be a higher level of Japanese income and more imports into Japan than before the fiscal action, but the reduction in the U.S. current account deficit would be less than when the BP curve was flatter than the LM curve. 10. In this scenario, it is difficult if not impossible for a country to influence in any significant way the domestic interest rate and thereby to have much divergence from the international rate. Since the BP curve in this case would be nearly horizontal (slightly upwardsloping) and presumably flatter than the LM curve, any attempt to stimulate growth by increasing the money supply and lowering interest rates will simply result in an outward flow of short-term capital (reducing the domestic money supply) until the domestic interest rate again approximates the international (EU) rate. Similarly, an attempt to reduce inflationary pressures by reducing the money supply and placing upward pressure on the domestic interest rate will quickly lead to an inflow of capital and an increase in the money supply until the interest rate again approximates the international rate. Growth and/or inflation targets thus must be pursued through the use of fiscal policy in this economic environment. Fiscal policy can alter real GDP, but not through any interest-rate target mechanism. 11. This is one of the cases in the phenomenon known as the “impossible trinity.” If the country wishes to maintain a fixed exchange rate and it also permits free flows of short-term capital into and out of the country, then monetary policy cannot be independent because effective control of the money supply is lost. For example, contractionary monetary policy would raise interest rates and lead to a short-term capital inflow that would put pressure on the home currency towards appreciation. Under fixed rates, the central bank would have to purchase the excess supply of foreign currency with home currency, which would increase the domestic money supply and offset the initial contractionary policy action. Clearly, expansionary monetary policy would set the reverse forces into motion, and the resulting short-term capital outflows would require the central bank to purchase home currency to prevent depreciation; this action would reduce the money supply back to its original level. In either of these cases, if the central bank did not intervene, the exchange rate would change and there would be monetary independence but no longer a fixed exchange rate. Hence, in order to be able to influence the money supply as well as to maintain fixity in the exchange rate, the country has to institute controls on short-term capital flows so that those flows will not put the upward and downward pressures on the exchange rate. VI.

Sample Exam Questions

Essay Questions

1. “Attempts to stimulate an economy with expansionary monetary policy will lead only to a loss of some of the country’s international reserves and to no permanent change in income under a fixed-rate system.” Agree? Disagree? Explain. 2. Since under a fixed exchange rate system the exchange rate does not change, does this mean that the BP curve never shifts? Why or why not? If it in fact does shift, what effects do such movements have on the equilibrium interest rate and equilibrium income if financial capital is imperfectly mobile? Briefly explain.

Chapter 25 - Economic Policy in the Open Economy under Fixed Exchange Rates

3. “A country that must adopt foreign exchange controls because of a misaligned exchange rate sacrifices the use of both monetary and fiscal policy instruments to influence domestic income and the interest rate.” Explain. 4. Using the Mundell-Fleming diagram dealing with internal balance (IB) and external balance (EB), explain what is meant by effective policy instrument choice, being careful to identify clearly the critical elements of the diagram. Why is the EB curve postulated to be more interest-elastic than the IB curve? In what ways is the IS/LM/BP model preferable to the simple Mundell-Fleming diagram? 5. Fiscal policy is most effective in a fixed-rate system when capital is perfectly mobile because there is no domestic “crowding out.” Explain what is meant by the term “crowding out,” and then critically evaluate the previous statement using the IS/LM/BP model. 6. Explain, in the IS/LM/BP framework with fixed exchange rates, the impact of an autonomous increase in foreign demand for a country’s exports upon the country’s national income, money supply, and balance of payments. If there is no impact on a variable, explain why. B.

Multiple-Choice Questions

In the ordinary analysis of IS and LM curves (ignoring the BP curve), a. expansionary fiscal policy shifts the IS curve to the left. b. expansionary monetary policy shifts the LM curve to the left. * c. expansionary fiscal and expansionary monetary policy undertaken at the same time will lead to an increase in the level of equilibrium income. d. expansionary fiscal policy and contractionary monetary policy acting together will lead to a decline in the equilibrium interest rate.

8. In the Mundell prescription for monetary and fiscal policy under fixed exchange rates, expansionary fiscal policy and contractionary monetary policy would be recommended if a country were faced with * a. unemployment and a balance-of-payments deficit. b. unemployment and a balance-of-payments surplus. c. inflation and a balance-of-payments deficit. d. inflation and a balance-of-payments surplus.

Chapter 25 - Economic Policy in the Open Economy under Fixed Exchange Rates

In the graph below, if point W represents the income and interest rate targets under a country’s fixed exchange rate system, then the policy combination needed to reach point W consists of

* a. expansionary monetary policy and expansionary fiscal policy. b. expansionary monetary policy and contractionary fiscal policy. c. contractionary monetary policy and contractionary fiscal policy. d. contractionary monetary policy and expansionary fiscal policy. 10.

In the following diagram, with fixed exchange rates,

the economy is in domestic equilibrium at income level __________ and there is __________. a. Y1; a balance-of-payments surplus b. Y2; a balance-of-payments deficit * c. Y2; a balance-of-payments surplus d. Y3; equilibrium in the balance of payments 11.

In the situation pictured in Question #10 above, during the automatic adjustment process to the disequilibrium in the balance of payments, a. the BP curve will shift to the left (or vertically upward). b. the IS curve will shift to the left (or vertically downward). * c. the LM curve will shift to the right (or vertically downward). d. the IS curve will shift to the right (or vertically upward).

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Chapter 25 - Economic Policy in the Open Economy under Fixed Exchange Rates

12.

In a closed economy, an increase in the demand for money shifts the LM curve to the __________; other things equal, this will lead to __________ in national income. a. right; an increase b. right; a decrease c. left; an increase * d. left; a decrease

13. Under fixed exchange rates and a constant price level, the automatic adjustment process produces balance-of-payments equilibrium as * a. the LM curve shifts along the fixed IS and BP curves. b. the IS curve shifts along the fixed LM and BP curves. c. the IS, LM, and BP curves all shift. d. the BP curve shifts to the point where the IS and LM curves intersect. 14.

In the Mundell analysis in which, in a situation of fixed exchange rates, a country is using monetary and fiscal policy to attain “external balance” (i.e., balance-of-payments equilibrium) and “internal balance” (i.e., full employment without inflation), the country __________. In this context, if the country has a balance-of-payments surplus at the same time that it has inflation, the country should engage in __________. a. should assign monetary policy to the attainment of internal balance and fiscal policy to the attainment of external balance; expansionary (“easy”) monetary policy and contractionary (“tight”) fiscal policy b. should assign monetary policy to the attainment of internal balance and fiscal policy to the attainment of external balance; contractionary (“tight”) monetary policy and expansionary (“easy”) fiscal policy * c. should assign monetary policy to the attainment of external balance and fiscal policy to the attainment of internal balance; expansionary (“easy”) monetary policy and contractionary (“tight”) fiscal policy d. should assign monetary policy to the attainment of external balance and fiscal policy to the attainment of internal balance; contractionary (“tight”) monetary policy and expansionary (“easy”) fiscal policy

15. In a system of fixed exchange rates, the automatic balance-of-payments adjustment process for a country with a balance-of-payments deficit would theoretically involve, among other things, __________ in the interest rate and __________ in national income. a. a decrease; a decrease b. a decrease; an increase * c. an increase; a decrease d. an increase; an increase

Chapter 25 - Economic Policy in the Open Economy under Fixed Exchange Rates

16.

Other things equal, a rise in income in a country will lead to __________ in the demand for money in the country and consequently to __________ in the country’s LM curve. * a. an increase; a leftward (or vertically upward) shift b. an increase; a rightward (or vertically downward) shift c. a decrease; a leftward (or vertically upward) shift d. a decrease; a rightward (or vertically downward) shift

17.

The use of expansionary or “easy” fiscal policy by a country’s government in a situation of fixed exchange rates will, other things equal, initially lead to __________ of the country’s current account balance (or trade balance); if short-term financial capital is relatively mobile between countries (i.e., the BP curve is flatter than the LM curve), the policy initially __________ of the country’s capital/financial account balance. a. an improvement; also leads to an improvement b. an improvement; leads to a deterioration (or worsening) * c. a deterioration (or worsening); leads to an improvement d. a deterioration (or worsening); also leads to a deterioration (or worsening)

18.

Under fixed exchange rates, a. fiscal policy is ineffective in influencing national income with all degrees of international capital mobility. * b. fiscal policy is most effective in influencing national income when capital is perfectly mobile internationally. c. monetary policy is very effective in influencing national income if capital is perfectly immobile internationally. d. monetary policy is more effective when capital is perfectly mobile internationally than when capital is perfectly immobile internationally.

19.

Under a fixed exchange rate, a balance-of-payments surplus for a country will lead to a __________ in the money supply as the country’s central bank __________ in order to maintain the fixed exchange rate. a. rise; purchases domestic currency * b. rise; purchases foreign exchange c. fall; sells domestic currency d. fall; sells foreign exchange

Chapter 25 - Economic Policy in the Open Economy under Fixed Exchange Rates

20.

Assume an initial equilibrium position for the economy (at the three-way intersection of the IS, LM, and BP curves), and also assume that the BP curve is vertical. This situation is one where there is __________ of financial capital internationally, and, from this initial equilibrium, expansionary fiscal policy would initially lead to a balance-of-payments __________. a. perfect immobility; surplus * b. perfect immobility; deficit c. perfect mobility; surplus d. perfect mobility; deficit 21.

Suppose, in the basic Mundell-Fleming diagram that plots the internal balance (IB) and external balance (EB) schedules against the interest rate (i) and government spending minus taxes (G - T), that the economy is located at a point that is above (or to the left) of the IB schedule and also above (or to the left) of the EB schedule. In this situation the economy is experiencing a. unacceptably high unemployment and a balance-of-payments deficit. * b. unacceptably high unemployment and a balance-of-payments surplus. c. unacceptably rapid inflation and a balance-of-payments deficit. d. unacceptably rapid inflation and a balance-of-payments surplus.

22. In the IS-LM analysis (and ignoring the BP curve), if the economy is located at a point that is to the left (or below) the IS curve and also to the left (or above) the LM curve, there is __________ pressure in the real sector of the economy as well as an excess __________ money. a. expansionary; demand for * b. expansionary; supply of c. contractionary; demand for d. contractionary; supply of 23.

With imperfect capital mobility, the BP curve slopes upward because, starting from a given balance-of-payments equilibrium position, a rise in national income will tend to cause a __________, which must be counteracted by a rise in the interest rate in order to cause a __________ that will restore BOP equilibrium. * a. BOP deficit; short-term financial capital inflow b. BOP deficit; short-term financial capital outflow c. BOP surplus; short-term financial capital inflow d. BOP surplus; short-term financial capital outflow

Chapter 25 - Economic Policy in the Open Economy under Fixed Exchange Rates

24. In the diagram below, under fixed exchange rates, the automatic adjustment mechanism will lead to

a. a fall in the money supply, a fall in income, and a fall in the interest rate. b. a rise in the money supply, a fall in income, and a fall in the interest rate. c. a fall in the money supply, a rise in income, and a rise in the interest rate. * d. a fall in the money supply, a fall in income, and a rise in the interest rate. 25. From an initial equilibrium position for the economy (at the three-way intersection of the IS, LM, and BP curves), and if the LM curve is steeper than the BP curve, expansionary fiscal policy initially leads to a balance-of-payments (BOP) __________, and expansionary monetary policy __________. a. deficit; also initially leads to a BOP deficit b. deficit; initially leads to a BOP surplus * c. surplus; initially leads to a BOP deficit d. surplus; also initially leads to a BOP surplus 26.

Other things equal, if the if the demand for money becomes more elastic, then the LM curve will become __________, i.e., a given rise in the interest rate will, in order for money market equilibrium to be preserved, be associated with a __________ rise in income. a. less elastic; smaller b. less elastic; larger c. more elastic; smaller * d. more elastic; larger

27.

A general rule is that, as international capital mobility for a country increases, the country’s BP curve __________. a. becomes steeper (less elastic) b. maintains the same slope (or elasticity) * c. becomes flatter (more elastic) d. eventually will become downward-sloping

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Chapter 25 - Economic Policy in the Open Economy under Fixed Exchange Rates

28.

Other things equal, a fall in the marginal propensity to save will make the IS curve __________, and a rise in the responsiveness of short-term international financial capital to changes in the interest rate will make the BP curve __________. * a. flatter of more elastic; flatter or more elastic b. flatter or more elastic; steeper or less elastic c. steeper or less elastic; flatter or more elastic d. steeper or less elastic; steeper or less elastic

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Chapter 26 - Economic Policy in the Open Economy under Flexible Exchange Rates

CHAPTER 26 ECONOMIC POLICY IN THE OPEN ECONOMY UNDER FLEXIBLE EXCHANGE RATES Learning Objectives: ■ ■ ■ I.

Analyze the impact of fiscal policy on income, trade, and exchange rates under flexible exchange rates. Analyze the impact of monetary policy on income, trade, and exchange rates under flexible exchange rates. Show how external economic shocks affect the domestic economy under flexible exchange rates. Outline Introduction - Movements to Flexible Rates The Effects of Fiscal and Monetary Policy under Flexible Exchange Rates with Different Capital Mobility Assumptions - The Effects of Fiscal Policy under Different Capital Mobility Assumptions - The Effects of Monetary Policy under Different Capital Mobility Assumptions - Policy Coordination under Flexible Exchange Rates The Effects of Exogenous Shocks in the IS/LM/BP Model with Imperfect Mobility of Capital Summary Appendix: Policy Effects, Open-Economy Equilibrium, and the Exchange Rate under Flexible Rates

II.

Special Chapter Features Concept Box 1: Real and Financial Factors that Influence the BP Curve In the Real World: Commodity Prices and U.S. Real GDP, 1972-2011 In the Real World: European Instability and U.S. GDP In the Real World: Policy Frictions in an Interdependent World In the Real World: Macroeconomic Policy Coordination: The IMF, the G-7/G-8, and the G-20

III.

Purpose of Chapter

The purpose of this chapter is to introduce students to the adjustment mechanisms under a flexible exchange rate system and to make them aware of the implications of flexible exchange rates for the use of domestic policy instruments.

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Chapter 26 - Economic Policy in the Open Economy under Flexible Exchange Rates

IV.

Teaching Tips

A. The opening paragraph sketches some choices that have been made by several different countries regarding their exchange rate regimes. Students will be inclined to think that such choices affect principally the foreign sector, with some spillovers to the domestic economy. You should stress that the choice has much wider implications, however, because it conditions the overall relative effectiveness of different macroeconomic policy instruments for guiding the economy toward the country’s preferred goals. B. One of the keys to understanding the analysis in this chapter is grasping how changes in the exchange rate, along with other variables, shift the BP curve back and forth. It is important to review this (again) before you get into the content of the chapter. C. The various assumptions regarding capital mobility are more critical under flexible rates than under fixed rates. This point can be driven home in the case of fiscal policy actions that have less and less impact on income as capital becomes more and more mobile. Discuss the implications of this in today’s world where financial markets are becoming increasingly interdependent and capital more and more mobile among the major financial centers of the world. D. We find it useful to emphasize strongly the effects of exogenous international shocks such as relative price changes, foreign interest rate changes, etc., on the domestic economy. This makes the students aware of the difficulty of carrying out economic policy when one has to deal not only with domestic factors but also with events taking place in other countries. E. As part of the comparative statics exercises, examine the impact of a change in domestic prices on equilibrium income levels. Since this is the manner in which an aggregate demand curve is derived in Chapter 27, it is a good bridging technique between the content of the IS-LM analysis and the aggregate supply/demand model and gives the student some anticipation of what is coming. V.

Answers to End-of-Chapter Questions and Problems

1. If the intersection of the IS and LM curves is at a point below the BP curve, there will be an incipient BOP deficit and depreciation of the home currency. Assuming that the MarshallLerner conditions are met, as the currency depreciates exports expand and imports contract, leading to a downward shift in the BP curve and to a rightward shift in the IS curve. These adjustments continue until there again is equilibrium on all three curves at some point on the unchanged LM curve. 2. The position of the BP curve is influenced by any factor other than domestic income and the interest rate that impacts upon the capital/financial and current accounts in the balance of payments. Therefore, foreign and domestic prices, expected prices, foreign and domestic tastes and preferences for traded goods, foreign income, and foreign and domestic trade policy are examples of factors that influence the current account and hence the BP curve. The financial 26-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 26 - Economic Policy in the Open Economy under Flexible Exchange Rates

account is influenced by such phenomena as the foreign interest rate, expected exchange rates, domestic and foreign rates of return on investment, foreign and domestic tax policy, foreign and domestic financial reforms, and relative economic/political stability. 3. Fiscal policy is completely ineffective when capital is perfectly mobile. This result occurs because the upward pressure on the domestic interest rate generated by expansionary fiscal action (rightward shift in the IS curve) generates, because of large-scale capital inflows, an incipient BOP surplus and an appreciation of the currency. The appreciation leads to an increase in imports and a decrease in exports (leftward shift in the IS curve). The appreciation and trade (price) adjustment process will continue until the initial effect of the expansionary fiscal policy is exactly offset and any upward pressure on the interest rate is removed. 4. Under a fixed-rate system, the country is committed to maintain the exchange rate either through unobstructed gold movements or by appropriately buying or selling foreign exchange. As a result, the central bank loses control of the money supply as an instrument for meeting targets other than external balance. Even if the automatic money supply changes are sterilized by policy action, this can only be a temporary stopgap. Under a flexible-rate system, external balance is maintained automatically through changes in the exchange rate, assuming that the Marshall-Lerner condition holds. There is thus no constraint on the central bank regarding the size of the money supply necessary for maintaining relative currency value. In fact, as explained in the answer to Question #5 immediately below, the foreign sector relative price adjustments that accompany monetary policy actions tend to reinforce the intent of the policy. 5. Under a flexible-rate system, expansionary monetary policy puts downward pressure on the interest rate which, in turn, puts downward pressure on the value of the home currency as investors shift out of financial investments denominated in the home currency. Depreciation of the currency expands exports and reduces imports. There is thus a two-fold expansionary effect on the economy, a stimulus for greater real investment at lower interest rates and a greater demand for domestic goods and services as exports rise and imports fall. The price adjustment process thus complements the monetary action, whereas under fixed rates the adjustment process leads to a loss in reserves and a contraction in the money supply that offset the initial policy action. 6. Expansionary monetary policy will increase exports and decrease imports as downward pressure is put on the interest rate and, subsequently, the value of the home currency (assuming that the Marshall-Lerner conditions are met). Thus, one would expect those associated with export industries and import-competing industries to favor such a policy. On the other hand, those who consume relatively more imports and merchants involved in the retailing of imports would not favor such a policy. 7. Without additional information the precise impact of expansionary fiscal policy on the exchange rate is ambiguous because it depends on the interest-responsiveness of short-term capital internationally compared to the interest-responsiveness of the domestic money market (i.e., is the BP curve flatter or steeper than the LM curve?). In the case where the BP curve is 26-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 26 - Economic Policy in the Open Economy under Flexible Exchange Rates

flatter than the LM curve (relatively greater responsiveness internationally), there will be an appreciation of the home currency. This will offset at least some of the initial stimulus to income provided by the expansionary fiscal policy. In the case where the BP curve is steeper than the LM curve (relatively less responsiveness internationally), expansionary fiscal policy will lead to a depreciation of the home currency, and there will be additional income expansion beyond that provided by the initial expansionary fiscal policy. 8. If there is a rise in the expected appreciation of the foreign currency, there will be an incentive for investors to shift toward foreign currency-denominated financial assets. Thus, for every level of income, it will now take a higher domestic interest rate to balance the balance of payments, i.e., the BP curve will shift upward (to the left), and there will now be an incipient BOP deficit. The domestic currency will thus begin to depreciate (BP curve now begins shifting downward or to the right), stimulating exports and reducing imports. Assuming a normal price adjustment to the changing exchange rate (the Marshall-Lerner conditions are met), the current account balance improves and stimulates greater income and interest rates (i.e., the IS curve shifts to the right along the fixed LM curve). The BP curve continues to shift downward and the IS curve rightward until a new three-way intersection of IS, LM, and BP occurs. Income and the interest rate will both be higher than original and most likely so will the interest rate. (See the discussion following Figure 8 regarding the interest rate change.) 9. Under a flexible-rate system, the foreign price increases in petroleum and food would stimulate U.S. exports and reduce U.S. imports, leading to upward pressure on income and interest rates and an appreciation of the currency. The stronger dollar offsets, at least in part, the foreign price increases and the economy settles back close to the original equilibrium level. (See the last part of the chapter for a discussion of foreign price shocks using the IS/LM/BP model.) In contrast, under fixed exchange rates the improved trade balance leads to upward pressure on income and interest rates, which results in an inflow of short-term capital and, consequently, an increase in the money supply. This money supply increase stimulates an even greater increase in income and, quite likely, an increase in domestic prices. Under fixed rates, then, foreign price increases are passed on to the domestic economy whereas, under flexible rates, the foreign price increases are filtered out by increases in the exchange rate. 10. With the increase in interest rates in the EU, there will be an increase in demand for foreign exchange (e.g., the euro or the British pound) to invest abroad in order to take advantage of the higher earning potential (i.e., the BP curve will shift up, indicating that it will now take a higher domestic interest rate at every level of income to balance the balance of payments). The increased demand for foreign exchange will cause the dollar to depreciate in the spot market. The depreciation of the dollar will stimulate U.S. exports and reduce U.S. imports, which will put upward pressure on income and interest rates (i.e., the IS curve will shift to the right). Thus, the statement is correct. (See Figure 8 for a graphical explanation.) In addition, if the higher foreign interest rate reduces the home demand for money (via a portfolio balance effect), the LM curve will shift to the right, exerting even more upward pressure on income.

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Chapter 26 - Economic Policy in the Open Economy under Flexible Exchange Rates

VI.

Sample Exam Questions

Essay Questions

1. Under a flexible exchange rate system, changes in the foreign rate of interest will affect both the financial markets and the real sector. Explain why this comes about using the IS/LM/BP model. What influence, if any, does the degree of international capital mobility have on the results? 2. If capital is imperfectly mobile (with BP flatter than LM), explain why governments find fiscal policy less effective under flexible rates compared to fixed rates. Is fiscal policy ever completely ineffective? If so, under what conditions? If not, why not? 3. Under flexible exchange rates, expansionary fiscal policy is less likely to lead to crowding out of investment and more likely to penalize the foreign sector than under fixed rates. Agree? Disagree? Explain. 4. It appears that the world is becoming more financially interdependent. How might you incorporate this change, if necessary, in the IS/LM/BP model? What are the implications of this change for macro policy in general and fiscal policy in particular? 5. The movement to more flexible exchange rates has made it necessary to more fully coordinate the use of monetary and fiscal policy. Explain why this is so, using the IS/LM/BP model, an income target, and an interest rate target. 6. Explain, using the IS/LM/BP model, how an increase in foreign interest rates can lead to an increase in domestic interest rates. 7. Explain, in the IS/LM/BP framework with flexible exchange rates, the impact of an autonomous increase in foreign demand for a country’s exports upon the country’s national income, money supply, and exchange rate. If there is no impact on a variable, explain why. B.

Multiple-Choice Questions

8. In a situation of flexible exchange rates and where the BP curve is steeper than the LM curve, a. monetary policy is less effective in raising national income than would be the case under fixed exchange rates. * b. expansionary fiscal policy will be more effective in raising the level of national income than would be the case under fixed exchange rates. c. expansionary fiscal policy will lead to an appreciation of the country’s currency. d. the BP curve stays fixed in the same position irrespective of any shifts that occur in the IS and LM curves. 26-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 26 - Economic Policy in the Open Economy under Flexible Exchange Rates

Given the following diagram, with flexible exchange rates:

Assume that the economy is in domestic equilibrium. In this situation, there will be __________ in the country’s balance of payments (official reserve transactions balance), with the consequence that the country’s currency will __________ in the foreign exchange markets. a. an incipient deficit; depreciate b. an incipient deficit; appreciate c. an incipient surplus; depreciate * d. an incipient surplus; appreciate 10.

In the situation in Question #9 above, during exchange-rate adjustment process that takes place due to the incipient imbalance in the external sector, * a. the BP curve will shift to the left (or vertically upward). b. the IS curve will shift to the right (or vertically upward). c. the LM curve will shift to the right (or vertically downward). d. the LM curve will shift to the left (or vertically upward).

11. In a situation of flexible exchange rates, other things equal, a shift of the IS curve to the left will lead to __________ of the country’s currency if the BP curve is steeper than the LM curve and __________ of the country’s currency if the LM curve is steeper than the BP curve. a. an appreciation; also will lead to an appreciation * b. an appreciation; will lead to a depreciation c. a depreciation; will lead to an appreciation d. a depreciation; also will lead to a depreciation 12.

Under flexible exchange rates, * a. fiscal policy is most effective in influencing national income when capital is perfectly immobile internationally and least effective when capital is perfectly mobile internationally. 26-2

Chapter 26 - Economic Policy in the Open Economy under Flexible Exchange Rates

b. monetary policy is more effective in influencing national income when capital is perfectly immobile internationally than when capital is perfectly mobile internationally. c. both fiscal policy and monetary policy are completely ineffective in influencing national income when capital is perfectly immobile internationally. d. fiscal policy has no effect on national income, regardless of what assumptions are made about the degree of international mobility of capital. 13.

Suppose that country A with a flexible exchange rate undertakes expansionary monetary policy. Especially if short-term funds are extremely mobile between countries, A’s currency will tend to __________ because of this policy, and this result suggests that A’s monetary policy will be __________ effective in influencing national income than if A had a fixed exchange rate rather than a flexible exchange rate. a. appreciate; less b. appreciate; more c. depreciate; less * d. depreciate; more

14. The IS/LM/BP analysis suggests that, if the BP curve is flatter than the LM curve and the exchange rate is flexible, expansionary fiscal policy will lead to __________ of the country’s currency, which will make the fiscal policy __________ effective in influencing national income than if the country had a fixed exchange rate. a. a depreciation; more b. a depreciation; less c. an appreciation * d. an appreciation; less 15.

In a situation of flexible exchange rates, an exogenous increase in foreign interest rates will cause __________ of the domestic currency and, most likely, a __________ in the domestic interest rate. * a. a depreciation; a rise b. an appreciation; a rise c. a depreciation; a fall d. an appreciation; a fall

16.

Under a flexible-rate system, when the BP curve is flatter than the LM curve, an autonomous increase in foreign interest rates will have what impacts on the domestic interest rate and domestic national income? a. domestic interest rate will increase, domestic national income will decrease b. domestic interest rate will increase, domestic national income will not change 26-3

Chapter 26 - Economic Policy in the Open Economy under Flexible Exchange Rates

* c. domestic interest rate will increase, domestic national income will increase d. domestic interest rate will not change, domestic national income will decrease 17.

The IS/LM/BP analysis suggests that, under flexible exchange rates, a. monetary policy is less powerful for affecting national income than under fixed exchange rates. b. a country may have difficulty in staying on the LM curve. * c. expansionary fiscal policy, in theory, may cause either depreciation or appreciation of the home currency. d. expansionary fiscal policy will always lead to a decline in national income.

18.

In the IS/LM/BP analysis, as a country’s currency depreciates (and assuming that the Marshall-Lerner conditions holds), the country’s a. LM curve shifts to the right. *

19.

b. BP curve shifts to the right. c. IS curve shifts to the left. d. LM curve shifts to the left. If, other things equal, a country with a flexible exchange rate decreases its money supply, this will lead to __________ in the value of the country’s currency, which will tend to __________ the country’s national income. a. a depreciation; increase b. a depreciation; decrease

c. an appreciation; increase * d. an appreciation; decrease 20. If we consider a situation of expansionary monetary policy under flexible exchange rates, the monetary expansion will lead to __________ of the home currency and thus will be __________ effective in increasing national income than under fixed exchange rates. a. an appreciation; more b. an appreciation; less * c. a depreciation; more d. a depreciation; less 21.

If a country’s BP curve is upward-sloping (i.e., it is neither vertical nor horizontal), then an intersection of the country’s IS and LM curves at a point below the BP curve will be associated with __________ in the country’s balance of payments. With flexible exchange rates, the country’s BP curve will consequently shift __________. a. an incipient deficit; upward and to the left * b. an incipient deficit; downward and to the right 26-2

Chapter 26 - Economic Policy in the Open Economy under Flexible Exchange Rates

c. an incipient surplus; upward and to the left d. an incipient surplus; downward and to the right 22. The effectiveness of monetary policy in influencing national income will, under a system of fixed exchange rates, be __________ under a system of flexible exchange rates. a. greater than *

b. less than c. perhaps greater than; perhaps less than d. the same as

23.

24.

In the diagram below, under flexible exchange rates, this country has an incipient balance-of-payments (official reserve transactions) __________; as a consequence, the BP curve will shift __________.

a. surplus; upward and to the left b. surplus; downward and to the right c. deficit; upward and to the left * d. deficit; downward and to the right In the view of economists, which one of the following statements is true? a. Fiscal policy is unambiguously more effective in influencing national income under flexible exchange rates than under fixed exchange rates. b. Fiscal policy is unambiguously more effective in influencing national income under fixed exchange rates than under flexible exchange rates. * c. Monetary policy is unambiguously more effective in influencing national income under flexible exchange rates than under fixed exchange rates. d. Monetary policy is unambiguously more effective in influencing national income under fixed exchange rates than under flexible exchange rates.

25.

With perfect capital mobility and other things equal, an exogenous increase in demand for a country’s exports will lead to __________ increase in the country’s national income under fixed exchange rates than under flexible exchange rates. * a. a greater b. a smaller c. the same 26-2

Chapter 26 - Economic Policy in the Open Economy under Flexible Exchange Rates

d. a greater, a smaller, or the same – cannot be determined without more information 26.

The IS/LM/BP analysis suggests that, if the BP curve is steeper than the LM curve and the exchange rate is flexible, contractionary fiscal policy by country A will lead to __________ in country A’s balance of payments and hence to __________ of A’s currency relative to other currencies. a. an incipient deficit; an appreciation b. an incipient deficit; a depreciation * c. an incipient surplus; an appreciation d. an incipient surplus; a depreciation

27.

If, in the IS/LM/BP diagram in a situation where short-term capital is imperfectly mobile internationally and a flexible exchange rate system exists, an incipient balance-ofpayments (official reserve transactions) surplus will cause the BP curve to shift __________ and the IS curve to shift __________. * a. upward and to the left; downward and to the left b. upward and to the left; upward and to the right c. downward and to the right; downward and to the left d. downward and to the right; upward and to the right

26-3 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 27 - Prices and Output in the Open Economy: Aggregate Supply and Demand

CHAPTER 27 PRICES AND OUTPUT IN THE OPEN ECONOMY: AGGREGATE SUPPLY AND DEMAND Learning Objectives: ■ ■ ■ ■ I.

Explain the fundamental links between international transactions and aggregate demand and aggregate supply. Demonstrate how economic shocks and policies affect prices and output. Differentiate between macroeconomic adjustment under fixed exchange rates and under flexible exchange rates. Distinguish between short-run and long-run effects of macro policies on output and prices. Outline Introduction - Crisis in Argentina Aggregate Demand and Supply in the Closed Economy - Aggregate Demand in the Closed Economy - Aggregate Supply in the Closed Economy - Equilibrium in the Closed Economy Aggregate Demand and Supply in the Open Economy - Aggregate Demand in the Open Economy under Fixed Rates - Aggregate Demand in the Open Economy under Flexible Rates The Nature of Economic Adjustment and Macroeconomic Policy in the Open-Economy Aggregate Supply and Demand Framework - The Effect of Exogenous Shocks on the Aggregate Demand Curve under Fixed and Flexible Rates - The Effect of Monetary and Fiscal Policy on the Aggregate Demand Curve under Fixed and Flexible Rates - Summary Monetary and Fiscal Policy in the Open Economy with Flexible Prices - Monetary Policy - Currency Adjustments under Fixed Rates - Fiscal Policy - Economic Policy and Supply Considerations External Shocks and the Open Economy Summary

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Chapter 27 - Prices and Output in the Open Economy: Aggregate Supply and Demand

II.

Special Chapter Features In the Real World: U.S. Actual and Natural Income and Unemployment In the Real World: Economic Progress in Sub-Saharan Africa In the Real World: Inflation and Unemployment in the United States, 1970-2011

III.

Purpose of Chapter

The purpose of the chapter is to examine the manner in which trade and international payments influence the macroeconomy when prices are flexible. Special attention is given to the implications of price flexibility for policy actions and for macroeconomic response to external shocks. IV.

Teaching Tips

A. Changes in international capital flows and trade flows exert pressure not only on income and employment but also upon prices. The less adaptable the economy is to changing economic conditions, the greater the price responses and adjustment costs for the economy. The severity of these problems is clearly evident in the adjustment difficulties experienced by Argentina (and some least-developed countries) described in the opening vignette. Discussing this experience with the class can help students appreciate these problems and see the need to incorporate price movements into policy analysis. B. We have attempted to provide a more rigorous background in aggregate demand and supply than is found in many international economics texts at this level. For those who have had a course in intermediate macro, the early part of the chapter provides a brief review of the basic ideas. For those who have never had such a course, this material will be more demanding. Because the class is likely to be diverse in background, you might find it useful to provide extra help sessions for those for whom the material is new. C. It is useful to emphasize that the principal difference in deriving the aggregate demand curve in the open economy rather than in the closed economy stems from the fact that the changing price level now also affects both the IS curve and the BP curve in addition to the LM curve. That is, there are now real effects of changes in prices, and these effects on exports, imports, and international capital flows involve shifts in IS and BP. D. The key to students grasping the AD framework is for them to realize that any factor that leads to an increase (decrease) in equilibrium income in the IS/LM/BP framework will lead to a rightward (leftward) shift in the AD curve. E. The AD/AS model provides a useful framework for contrasting the difference between policies that affect primarily demand and those which in addition influence the position of the long-run AS curve. For example, if restricting imports (expanding aggregate demand) is not to be solely inflationary in the long run, it must be accompanied by improved productivity, i.e., a rightward shift of the long-run AS curve.

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Chapter 27 - Prices and Output in the Open Economy: Aggregate Supply and Demand

F. We have found that students are very interested in problems such as foreign price shocks that affect both the AD and the AS curves as, for example, in the case of petroleum price changes. G. Although we have not focused on the issue directly in this chapter, this is a useful place to emphasize the intertemporal aspects of policy. The student should not lose sight of the factors that contribute to long-run growth and shift the long-run supply curve to the right, and how these factors are affected by exogenous shocks as well as by domestic policies. V.

Answers to End-of-Chapter Questions and Problems

1. The natural level of employment is the level of employment at which the demand for labor equals the supply of labor and actual prices and real wages equal expected prices and real wages. This need not, of course, correspond to some society-defined level of full employment. The long-run supply curve is vertical at this point since by definition, the long-run period is sufficiently long for labor to adjust its wage demands to price changes such that the same amount of labor, and hence output, is supplied at the constant equilibrium real wage. 2. The short-run aggregate supply curve indicates the change in output produced because of a change in the price level, but with no change in the expected real wage. As indicated in the answer to Question #1 above, the long run is a period that is sufficiently long to allow workers to adjust their nominal wage demands in response to changes in prices so as to maintain a constant real wage. The long-run and short-run supply curves are both vertical in the case where rational expectations holds and are in fact the same curve. In this case, workers make full use of all information available, anticipate the price changes resulting from policy actions, and raise their wages at the same time as prices rise. If an unanticipated price change occurs, then the AS curve in the short run is temporarily not vertical. 3. The aggregate supply curves are shifted by underlying factors such as changes in technology, scale economies, changes in the level of capital stock, improved management techniques, and improved marketing arrangements. An increase in international transactions and increased contact with other countries could certainly lead to shifts in the supply curves due to technology transfers, adoption of foreign management approaches, more efficient use of resources due to scale effects associated with larger world markets, increases in capital stock associated with foreign real investment, etc. If increased international transactions also mean greater vulnerability to exchange rate changes, these changes would affect aggregate supply curves through their impacts on imported inputs. 4. Other things equal, the restrictive monetary policy in Germany would push German interest rates higher and stimulate an inflow into Germany of foreign short-term financial capital. In terms of the IS/LM/BP apparatus, such a policy would shift the U.S. BP curve upward (to the left). Without a monetary policy response on the part of the Federal Reserve leading to an offsetting change in domestic interest rates and income in the United States, Germany’s restrictive monetary policy would result in an incipient U.S. balance-of-payments deficit (under flexible exchange rates) and a depreciation of the U.S. dollar. With currency depreciation, U.S. 27-3 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 27 - Prices and Output in the Open Economy: Aggregate Supply and Demand

exports to Germany increase and U.S. imports from Germany decrease. These foreign sector effects stimulate U.S. aggregate demand (shift the AD curve to the right) and put upward pressure on U.S. prices and income. However, given enough time for wages to adjust, the shortrun supply curve will shift up (to the left) and will return the U.S. economy to the “natural” level of income and employment, but now at a higher price level. 5. If imported inputs are important, the appreciation of the currency would have the effect of reducing the price of those imported inputs and hence reducing costs of production. This could lead to a rightward shift of both the long-run and the short-run aggregate supply curves, just as a sudden increase in the price of an important imported input led to a leftward shift in the aggregate supply curves in Figure 13 of the chapter. 6. If discretionary policy is to have more than a short-run impact on income and employment, it must result in changes in one or more of the structural factors that underlie the long-run aggregate supply curve. It must lead to changes in factors such as the capital stock, entrepreneurship, management techniques, scale effects, changes in technology, quality of the labor force, etc. 7. Expansionary monetary policy will increase aggregate demand, giving an even greater boost to prices. The stagflation has resulted from a leftward shift in the aggregate supply curves, and increasing demand alone will not solve the problem. Policies must be pursued to improve the supply situation through better technology, increased capital stock, improved education, etc. Income and employment will only increase in any permanent sense if there is an improvement in aggregate supply conditions. 8. If the home country’s currency is expected to depreciate, other things equal, it would lead to an increased demand for foreign currency. Under a flexible-rate system, this causes a depreciation of the home currency. As the currency depreciates, exports will increase and imports will decrease, leading to an increase in aggregate demand. If the country uses imported inputs, costs of production will also rise and both the short-run and long-run aggregate supply curves will shift to the left. The end result is an increase in the domestic price level and a reduction in the equilibrium level of income (output) in both the short run and long run. In addition, the natural level of employment falls. 9. Under the flexible exchange rate scenario of Figure 10, expansionary monetary policy would have the impact of shifting the aggregate demand curve to the right, leading to an expansion of income and accompanying increases in prices. With the appropriate level of money expansion, the economy could return to the natural level of income and employment. While this is desirable from the standpoint of employment, inflation would also occur. Were the government to do nothing and wages were flexible in a downward direction, with sufficient time, wages should fall and the short run aggregate supply curve would shift to the right until the natural level of income is attained at a lower price level. Which strategy is preferable depends on the country’s preferences with regard to reduced unemployment/inflation versus a longer period of unemployment with eventual lower price levels. If there are longer-run supply effects on the level of capital stock because of the continually-low interest rate, then the price level 27-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 27 - Prices and Output in the Open Economy: Aggregate Supply and Demand

would have downward pressure put upon it. VI.

Sample Exam Questions

Essay Questions

1. What effect does opening the economy have on the aggregate demand curve? The aggregate supply curve? Is it possible that the long-run supply curve will shift to the right more rapidly in the open economy than in the closed economy? Why or why not? 2. Suppose that the government attempts to stimulate income and employment by using monetary policy. Explain how this will affect the economy in the short run and the long run. What must occur for this policy action to have a permanent impact on income and employment? How might this occur? 3. Many positive investment opportunities with higher expected rates of return have recently been opening up in Central, Eastern, and Western Europe. Explain the effects that such opportunities might have on U.S. financial markets and economic activity, using the AD/AS framework. Will this have inflationary or deflationary effects on the United States? Why? What problems might occur if the U.S. government attempts to offset the short-run price effects of this external phenomenon? 4. Suppose that there is an exogenous increase in foreign prices. Using the AD/AS framework, explain how this would affect the domestic economy under fixed exchange rates and under flexible exchange rates. Would your answer be different if there were no imported inputs into the production process? Why or why not? 5. It has been argued that one advantage of fixed exchange rates is that they promote price discipline or price stability between trading partners. Is this argument supported by the AD/AS framework? Why or why not? 6. Suppose that, in a world of flexible wages and prices, there is a sudden autonomous increase in the flow of short-term financial capital into country A. Will the impact on country A’s aggregate demand (AD) curve and hence on output in the short run be different in if A has a flexible exchange rate rather than a fixed exchange rate? Explain.

Chapter 27 - Prices and Output in the Open Economy: Aggregate Supply and Demand

Multiple-Choice Questions

7. Other things equal, with imported intermediate goods, an increase in foreign prices will lead to a __________ shift in a home country’s short-run aggregate supply curve and __________ shift in the home country’s aggregate demand curve. a. leftward; also to a leftward * b. leftward; to a rightward c. rightward; to a leftward d. rightward; also to a rightward 8.

Expansionary aggregate demand-oriented fiscal policy leads, ceteris paribus, to a. a short-run fall in both income and the price level. b. a short-run rise in income and a fall in the price level. * c. no change in the long-run equilibrium level of income and to an increase in the price level. d. both an increase in the long-run equilibrium level of income and an increase in the price level.

Other things equal, a rise in foreign interest rates leads to __________ in the home country’s equilibrium level of income and to __________ in the home country’s price level in the short run. a. a rise; a fall b. a rise; no change c. no change; a fall * d. a rise; a rise

10.

If a country’s currency depreciates in the foreign exchange markets, the result will be a shift of the aggregate demand curve __________; in addition, if intermediate goods are an important component of the country’s imports, the short-run aggregate supply curve __________. a. to the left; also will shift to the left b. to the left; will shift to the right * c. to the right; will shift to the left d. to the right; also will shift to the right

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Chapter 27 - Prices and Output in the Open Economy: Aggregate Supply and Demand

11.

In considering the slope of the open-economy aggregate demand curve (AD), a valid general statement is that, other things equal, the open-economy AD __________.

a. will tend to be flatter with flexible rates than with fixed rates b. will tend to be steeper with flexible rates than with fixed rates c. will necessarily have the same slope with flexible rates as with fixed rates * d. will tend to be flatter or steeper, or will necessarily have the same slope, with flexible rates as with fixed rates – cannot be determined without more information. 12. According to the New Classical economists, with rational expectations, an increase in the money supply will * a. lead only to an increase in prices in both the short run and the long run. b. lead to an increase in the equilibrium level of income in the short run but to no change in the equilibrium level of income in the long run. c. lead to a fall in prices but to no change in money wages. d. lead to a rightward shift in the long-run aggregate supply curve. 13.

An increase in the long-run equilibrium level of income can result from a. improved technology. b. adoption of improved management techniques. c. a larger capital stock. * d. all of the above.

14.

Stagflation can result * a. from an increase in the price of foreign-produced inputs. b. from a fall in aggregate demand. c. whenever an economy has completely flexible money wages and prices. d. from a rightward shift of the short-run aggregate supply curve.

15.

In the AD/AS framework, when the economy is in long-run equilibrium, a. inflation is occurring. b. the entire labor force is employed. * c. actual prices are equal to expected prices. d. actual levels of income and employment are less than the natural levels of income and employment.

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Chapter 27 - Prices and Output in the Open Economy: Aggregate Supply and Demand

16.

In a situation of stagflation, the use of aggregate demand-oriented macro policy to address the problem of the rising price level would, at least in the short run, __________ the price level and __________ the level of output in the economy. a. increase; increase b. increase; decrease c. decrease; increase * d. decrease; decrease

17.

In the aggregate demand/aggregate supply framework * a. neither expansionary fiscal nor expansionary monetary policy has a permanent impact on the natural level of income and employment. b. only monetary policy has a long-run impact on income and unemployment under flexible exchange rates. c. only fiscal policy has a long-run impact on income and employment under flexible exchange rates. d. only monetary policy has a short-run impact on income and employment under fixed exchange rates.

18.

If the AD curve intersects the short-run aggregate supply curve to the left of the long-run aggregate supply curve, under flexible exchange rates, then the long-run equilibrium position * a. can be attained if labor adjusts its wages downward due to prices being lower than expected. b. can be attained by a decrease in government spending. c. can be attained by contracting the money supply. d. cannot be attained without a change in technology.

19.

Suppose that a partner country autonomously increases its demand for the home country’s exports. With a fixed exchange system, this increase in export demand __________; with a flexible exchange rate system, this increase in export demand __________. a. will shift the home country’s AD curve to the right; also will shift the home country’s AD curve to the right. * b. will shift the home country’s AD curve to the right; will not shift the home country’s AD curve. c. will not shift the home country’s AD curve; will shift the home country’s AD curve to the right d. will not shift the home country’s AD curve; also will not shift the home country’s AD curve

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Chapter 27 - Prices and Output in the Open Economy: Aggregate Supply and Demand

20.

When a country is in equilibrium on its long-run aggregate supply curve, the actual price level facing economic agents a. is greater than the price level expected by economic agents. * b. is equal to the price level expected by economic agents. c. is less than the price level expected by economic agents. d. is greater than, equal to, or less than the price level expected by economic agents – cannot be determined without more information.

21.

Appreciation of the domestic currency will a. increase domestic aggregate demand. b. decrease domestic aggregate supply. * c. decrease domestic aggregate demand, and possibly increase domestic aggregate supply. d. cause a deterioration in the trade balance, but have no effect on aggregate supply or demand.

22.

An expansion of the domestic money supply a. will increase aggregate demand under a fixed rate system. b. will have no effect on aggregate demand under a flexible rate system. c. will lead to an inflow of short-term capital under fixed exchange rates. * d. will lead to an expansion of aggregate demand and to upward pressure on domestic prices under a flexible rate system.

23.

The derivation of the aggregate demand curve (AD) in the closed economy builds upon the fact that, as the domestic price level rises, other things equal, the equilibrium level of income in the IS/LM diagram __________. a. rises b. is unchanged * c. falls d. rises, is unchanged, or falls – cannot be determined without more information

24.

In a situation of stagflation, the use of aggregate demand-oriented macro policy to address the problem of unemployment would, at least in the short run, __________ the price level and __________ the level of output in the economy. * a. increase; increase b. increase; decrease c. decrease; increase d. decrease; decrease

Chapter 27 - Prices and Output in the Open Economy: Aggregate Supply and Demand

25.

If actual prices in a country are less than the expected prices in the country, then the country’s a. aggregate demand curve will shift to the left. b. aggregate demand curve will shift to the right. c. short-run aggregate supply curve will shift to the left. * d. short-run aggregate supply curve will shift to the right.

26.

The derivation of the aggregate demand curve (AD) in the open economy builds upon the fact that, as the price level rises, other things equal, a. b. c. * d.

27.

the LM curve shifts to the left but the IS and BP curves do not shift. the LM and BP curves shift to the left but the IS curve does not shift. the IS and LM curves shift to the left but the BP curve does not shift. the IS, LM, and BP curves all shift to the left.

If exchange rates are fixed, an increase in the money supply will lead to __________ in the equilibrium level of income and to __________ in the price level. a. an increase; no change * b. no change; no change c. an increase; a decrease d. an increase; an increase

28.

The derivation of the aggregate demand curve (AD) in the closed economy builds upon the fact that, as the domestic price level rises, other things equal, the * a. LM curve shifts to the left. b. LM curve shifts to the right. c. IS curve shifts to the left. d. IS curve shifts to the right.

Chapter 28 - Fixed or Flexible Exchange Rates?

CHAPTER 28 FIXED OR FLEXIBLE EXCHANGE RATES? Learning Objectives: ■ ■ ■ ■ I.

Describe the differing impacts of fixed and flexible exchange rates on international trade, international investment, and resource allocation. Discuss how the macroeconomic responses to foreign and domestic shocks are influenced by the exchange rate system in place. Explain the advantages and disadvantages of a currency board and a monetary union. Compare and contrast the strengths and weaknesses of exchange rate systems that combine elements of both fixed and flexible exchange rates. Outline Introduction - Slovenia’s Changeover to the Euro – A Clear Success Central Issues in the Fixed-Flexible Exchange Rate Debate - Do Fixed or Flexible Exchange Rates Provide for Greater “Discipline” on the Part of Policymakers? - Would Fixed or Flexible Exchange Rates Provide for Greater Growth in International Trade and Investment? - Would Fixed or Flexible Exchange Rates Provide for Greater Efficiency in Resource Allocation? - Is Macroeconomic Policy More Effective in Influencing National Income under Fixed or Flexible Exchange Rates? - Will Destabilizing Speculation in Exchange Markets Be Greater under Fixed or Flexible Exchange Rates? - Will Countries Be Better Protected from External Shocks under a Fixed or a Flexible Exchange Rate System? Currency Boards - Advantages of a Currency Board - Disadvantages of a Currency Board Optimum Currency Areas Hybrid Systems Combining Fixed and Flexible Exchange Rates - Wider Bands - Crawling Pegs - Managed Floating Summary

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Chapter 28 - Fixed or Flexible Exchange Rates?

II.

Special Chapter Features In the Real World: Exchange Risk and International Trade In the Real World: Reserve Holdings under Fixed and Flexible Exchange Rates Titans of International Economics: Milton Friedman (1912-2006) In the Real World: “Insulation” with Flexible Rates – The Case of Japan In the Real World: Currency Boards in Estonia and Lithuania In the Real World: The Eastern Caribbean Currency Union and Other Monetary Unions In the Real World: Colombia’s Experience with a Crawling Peg

III.

Purpose of Chapter

The purpose of this chapter is to bring together in one place various issues surrounding the fixed-flexible exchange rate debate, and to survey some hybrid systems of fixed and flexible rates. The material builds upon points made in earlier chapters and prepares the students for the discussion of actual international monetary systems in the next chapter. IV.

Teaching Tips

A. The choice of an appropriate exchange rate regime is critical for many developing countries. Often faced with non-responsive economic systems and institutional rigidities, they experience domestic inflation problems that cannot be effectively overcome. In such an environment, tying the home currency to a major currency such as the dollar or euro or yen is very tempting. The case of Slovenia’s “Big Bang” approach to changing over to the euro is a good contemporary case to discuss with your students, and it gives them an appreciation of the impact of such an exchange rate decision. B. The “In the Real World” box on pages 725-26 deals with the influence of risk on trade volume. We have leaned toward the conclusion that exchange risk reduces trade to some extent. However, it is useful to emphasize that this is a controversial area and that there is no really clear answer – if you disagree with us, please do not hesitate to explain why to the students. C. Note the framework of the Hutchison and Walsh discussion on page 735’s “In the Real World” box. They are not concluding that there were fewer shocks in the flexible-rate period; rather, they are concluding that, for any given shock, Japan was more insulated in the flexiblerate period than in the fixed-rate period. D. The vicious circle hypothesis early in the chapter can easily be related to hyperinflation and PPP discussed in previous Chapters 20 and 22. E. Regarding the “In the Real World” box on page 745, note that Colombia stopped having a strict crawling peg in 1991. However, we still find the Colombian case interesting, and the general strategy has certain appeal for avoiding some of the disadvantages of both a freely flexible and a fixed exchange rate system.

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Chapter 28 - Fixed or Flexible Exchange Rates?

F. When you get to the optimum currency area material, you will likely want to bring in the economic and monetary union (EMU) in Europe as a case study. We discuss the EMU in detail in the next chapter, but that material could easily be utilized here. G. We have generally tried to maintain a neutral position in this chapter on the fixed-flexible debate. Obviously, however, you may want to dismiss some arguments, buttress others, and take a position. V.

Answers to End-of-Chapter Questions and Problems

1. Other things equal, a country that is willing to pursue continually expansionary policy in order to keep unemployment low (moving beyond its natural level of output and employment) will experience greater inflation than a country more willing to “accept” more unemployment (e.g., be at the natural level of output or below it). The more inflationary country will lose international reserves to the less inflationary country. To avoid running out of reserves, the more inflationary country will eventually have to devalue its currency (or impose continuallyincreasing exchange controls). The less inflationary country may also decide to revalue its currency upward to avoid the inflationary stimulus provided by its buildup of reserves. 2. A case that flexible rates can reduce the flow of foreign direct investment (FDI) is built around the fact that, if prices do not move exchange rates in purchasing-power-parity fashion, the real value of the return flow of profits and dividends when converted into domestic currency is uncertain and investing abroad can therefore result in a loss. On the other hand, firms may invest in a foreign country rather than export to the country if exchange rate variations cause exporting to be uncertain and if the firm plans to reinvest profits in the foreign country. In addition, flexible rates may mean fewer home country restrictions on the outflow of investment for a country that would have a chronic BOP deficit under fixed rates, or fewer restrictions on inward foreign investment by a country worried about the inflationary impact of capital inflows. Hence, other things equal, FDI could be greater than under fixed rates. 3. Generally speaking, a country more susceptible to external rather than internal shocks would tend to prefer a flexible rate. External real shocks conceptually would have no impact on national income in the flexible-rate case but would be transmitted onto national income with a fixed rate. However, external monetary shocks will have an impact on income under either exchange rate system, and which system produces the greater income response is not certain. (It depends on the relative slopes of the BP and LM curves, and the direction of income response even differs between fixed and flexible rates if the BP curve is flatter than the LM curve). A country subject to internal monetary shocks would prefer fixed rates, since such shocks have a greater impact on national income under flexible rates. Internal real shocks have a greater impact on income under a flexible rate if the BP curve is steeper than the LM curve, and a smaller impact if the BP curve is flatter than the LM curve.

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Chapter 28 - Fixed or Flexible Exchange Rates?

4. If you believe that markets maximize welfare, the conclusion in the quote follows if the exchange rate is a true scarcity price and reflects the true relative purchasing power of currencies. Then consumers and producers would indeed be able to direct their purchases and production according to true opportunity costs. (This assumes that market failure situations such as externalities and monopoly do not exist.) However, distortions in the exchange rate due to rumors and speculation can mean that the exchange rate doesn’t truly reflect opportunity costs and purchasing power, in which case maximum welfare is not assured. A fixed rate could conceptually be the true scarcity rate, but this seems highly unlikely to be the case over any time period other than the extremely short run. 5. Not necessarily. If underlying inflation rates and monetary conditions are compatible, for example, there may be little reason for speculators to expect prolonged currency movements in one direction, and any speculation may therefore be stabilizing. With stable monetary conditions, there will also be few abrupt changes in interest arbitrage capital flows. In addition, if real factors underlying the demand and supply of foreign exchange are stable, there may not be much movement in exchange rates because of shifts in the current account and direct investment flows. However, the above situations may be highly unlikely to be realized in practice, and unstable policies and conditions and autonomous real shocks can cause the exchange rate to change. 6. Risk can be detrimental to trade and international specialization if forward markets (and derivatives markets in general) are not well-developed; risk can also be detrimental to world welfare if direct investment flows are inhibited because of the risk. However, absorbing risk constitutes a very important feature in entrepreneurship, innovation, and a dynamic economy. If the degree of risk can be quantified and predicted, entrepreneurial activity in the pursuit of profit opportunities can proceed and can obviously enhance welfare. 7. A currency board has potential as a useful, practical arrangement for a country if that country has been facing severe inflationary problems due to rapid money creation by the central bank (on its own or in its passive financing of government budget deficits). The currency board arrangement can rein in such inflation because it forces the money supply to be firmly linked to the supply of foreign assets available to the country. However, the country must be committed to the idea of fiscal and monetary discipline and must be ready to make its internal economy’s behavior subject to the size and flow of external assets. It also must have the political will to stick with the currency board even when balance-of-payments deficits lead to contraction of the money supply and to possible deflation, recession, and unemployment. If political will and economic discipline are not present, the currency board arrangement in the country will likely be short-lived.

Chapter 28 - Fixed or Flexible Exchange Rates?

8. The world as a whole might be an optimum currency area if factors of production could move freely among all countries. Then any shifts in demand, for example, would produce supply responses as factors moved, and there would not necessarily be a problem of “pockets” of inflation in some countries and of unemployment in others. In addition, if national governments are maintained (rather than the formation of a world government), there would need to be similarity in policy goals across countries. The case for industrialized countries (ICs) being an optimum currency area could be defended by noting that a high degree of capital mobility exists among the ICs and that the ICs have relatively large trade among themselves (i.e., are relatively open) and have relatively little trade with developing countries (although such trade has been increasing in relative importance in recent years). However, there are clearly barriers to labor mobility, and policy targets are not identical. The case for integrating all developing countries into an optimum currency area is weak – they trade relatively little with each other, have considerably different inflation rates, and have only modest factor mobility among themselves. 9. This is obviously an opinion question, and the student’s answer may depend on whether he or she is a “glass half-full” or a “glass half-empty” person. The statement’s position could be defended, for example, by saying that the risks regarding trade and investment in a flexible rate system are still present to some extent with the hybrids, as are some of the resource misallocation effects with respect to fixing the exchange rate. On the other hand, international reserves may be less necessary in the hybrid systems than with a fixed rate, and some “discipline” is called for in a system such as the “wider bands.” Additional points pertaining to this question are given in the chapter. 10. Chile’s increased intervention in the foreign exchange market was designed to keep the Chilean peso from rising so much due to the foreign investment inflows. A more rapid rise in the peso would have caused a decline in exports, a rise in imports, and therefore a worsening of the current account and potential downward pressure on GDP. The reserve buildup and the foreign investment inflows are related because, with more fixity in the exchange rate, Chile’s international reserves had to rise because the incipient BOP surplus was not allowed to eliminate itself through an exchange rate change and hence became an actual BOP surplus. 11. A “true” (optimum) currency area preserves its fixed exchange rates by containing an effective BOP adjustment mechanism. Because of this effective mechanism, which can certainly be partly composed of coordinated macro policies, there is confidence in the fixed exchange rates and financial capital flows can play a stabilizing, non-speculative role in the economies. On the other hand, a “pseudo” currency area lacks an effective adjustment mechanism and can experience difficulties if business cycles are out-of-phase in the member countries and if macro policies do not concern themselves with preserving the fixed exchange rates. The lack of an effective adjustment mechanism can also trigger destabilizing capital flows. The distinction is useful because it focuses on the need for effective adjustment in order to attain a successful union, and it enables the analyst to make judgments about the likely success of any move toward monetary union by examining the structures and policy objectives of the proposed members.

Chapter 28 - Fixed or Flexible Exchange Rates?

VI.

Sample Exam Questions

Essay Questions

1. Explain why it is alleged that a system of flexible exchange rates could have “wasteful resource movements.” Why are these movements thought to be wasteful? Don’t resources need to move between sectors as demand, cost, and profitability conditions change in a dynamic economy? 2. Suppose that a currency plummets downward because of speculation against it. Can it necessarily be stated that this speculation is “destabilizing” in nature? Why or why not? 3. Present the argument that the adoption of flexible rates would lead to a removal of restrictions on trade. Do you agree that these controls would be eliminated? Does the adoption of flexible rates undermine all the reasons for seeking protection that were covered in the trade policy section of this course? Explain. 4. What case could be made for a wider “band” of permitted exchange rate changes of the home currency against some foreign currencies (say 15 percent) than against some other foreign currencies (say 10 percent)? What case could be made against this difference in width of permitted variations? Explain. 5. Using the IS/LM/BP framework, explain how two of the following shocks impact on the domestic economy under flexible exchange rates and under fixed exchange rates. (a) an increase in the foreign rate of interest (b) a decrease in foreign income (c) a decrease in foreign prices 6. How could exchange rate protection of, for example, 10 percent, be duplicated in its effects across export and import-substitute industries by using tariffs and subsidies instead? Explain. Suppose that you are a firm in an import-substitute industry that is currently receiving less protection than most other import-substitute industries. Would you be in favor of scrapping the existing protection framework and adoption of exchange rate protection as an alternative policy? Explain. 7. Describe the features of a currency board arrangement. Then indicate general conditions under which the adoption of a currency board by a country would be desirable for the country. 8. If an important oil exporter such as Saudi Arabia were successful in raising the price of petroleum in the next few weeks, would a flexible exchange rate or a fixed exchange rate for the United States be better for mitigating the negative economic impact upon the United States? Why? B.

Multiple-Choice Questions

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Chapter 28 - Fixed or Flexible Exchange Rates?

9. The view that inflation in a country can lead to depreciation of the country’s currency which in turn can cause further inflation is known as * a. the vicious circle hypothesis. b. the autonomous spending multiplier concept. c. the purchasing power parity problem. d. the exchange risk hypothesis. 10. Which one of the following is NOT an alleged disadvantage of a flexible exchange rate system? a. possibility of destabilizing speculation b. wasteful resource movements between industries * c. increased need for international reserves d. danger of a “vicious circle” between inflation in a country and depreciation of that country’s currency 11.

In view of the theory of optimum currency areas, a country would be a good candidate for membership in such an area if it had a __________ degree of factor mobility with other potential member countries of the currency area and if the country were a relatively __________ economy. a. low; closed b. low; open c. high; closed * d. high; open

12.

The optimal size of international reserves occurs for a country at the point where the a. total benefit of holding the reserves equals the total cost of holding the reserves. b. marginal benefit of holding the reserves exceeds the marginal cost of holding the reserves by the greatest amount. * c. marginal benefit of holding the reserves equals the marginal cost of holding the reserves. d. marginal cost of holding the reserves is zero.

13. A major advantage of the system of flexible exchange rates (as opposed to fixed exchange rates) is commonly thought to be a. the likelihood that external monetary shocks will not influence domestic national income under flexible exchange rates. b. the strong possibility that the greater exchange rate risk under flexible rates will increase the volume of international trade. * c. the enhanced effectiveness of monetary policy in influencing national income under

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Chapter 28 - Fixed or Flexible Exchange Rates?

flexible exchange rates. d. the “virtuous circle” that flexible rates can bring between depreciation and inflation. 14. If virtually all speculators buy a currency just before what would be the cyclical low points in the currency’s value without speculative activity, this speculation is likely to be __________ with respect to its impact on the amplitude of the cycle; if the speculators sell the currency just before what would otherwise be the high values of the currency during its fluctuations, this speculation __________ in its impact on the amplitude of the cycle.. a. destabilizing; also is likely to be destabilizing b. destabilizing; is likely to be stabilizing c. stabilizing; is likely to be destabilizing * d. stabilizing; also is likely to be stabilizing 15. The IS/LM/BP analysis suggests that an external real sector shock, such as a rise in national income abroad will cause, under fixed exchange rates, a __________ shift in a home country’s BP curve (assuming that short-term financial capital is not perfectly mobile), a __________ in the home country’s balance of payments, and __________ in the home country’s national income. * a. rightward; surplus; an increase b. rightward; deficit; a decrease c. rightward; surplus; a decrease d. leftward; deficit; a decrease 16.

A situation where a country announces a parity value for its currency and permits small variations around that value, but also adjusts the parity regularly by small amounts according to various indicators, is known as a. a dirty float. * b. a crawling peg. c. a managed float strategy of “leaning against the wind.” d. a “wider band.”

17.

If a country adopts a currency board arrangement, a result is that the country’s money supply __________ be increased by the purchase of domestic assets from the country’s citizens by the country’s central bank; in this arrangement, the country’s money supply __________ be increased by the purchase of foreign assets from the country’s citizens by the country’s central bank. a. can; also can b. can; cannot * c. cannot; can d. cannot; also cannot

Chapter 28 - Fixed or Flexible Exchange Rates?

18.

In theory, business cycles are __________ likely to be transmitted from one country to another under a system of fixed exchange rates than under a system of flexible exchange rates. It is also a generally-accepted theoretical result by economists that monetary policy is __________ useful for dampening business cycle activity under a system of fixed exchange rates than under a system of flexible exchange rates. a. more; more * b. more; less c. less; more d. less; less

19. If a country’s BP curve is flatter than its LM curve, then an external financial shock of a rise in interest rates abroad would, under flexible exchange rates, lead to __________ in the home country’s national income. If exchange rates were fixed, this external financial shock would __________ in the home country’s national income. a. a decrease; lead to an increase b. a decrease; also lead to a decrease c. an increase; also lead to an increase * d. an increase; lead to a decrease 20.

Other things equal, a domestic monetary or financial shock (a shift in the LM curve) tends to produce what relative degree of GDP change for the home country under a situation of flexible exchange rates compared to a situation of fixed exchange rates? a. smaller change with flexible rates b. same change with flexible rates as with fixed rates * c. larger change with flexible rates d. smaller, same, or larger change with flexible rates – cannot be determined without more information

21.

In a situation of imperfect short-term capital mobility between countries, if the BP curve is flatter than the LM curve for country A, then an internal real sector shock in country A (such as an autonomous increase in real investment spending) will have a __________ impact on A’s national income under fixed exchange rates than under flexible exchange rates; if the BP curve is steeper than the LM curve for country A, then that internal real sector shock __________ impact on A’s income under fixed exchange rates than under flexible exchange rates. * a. larger; will have a smaller b. larger; will also have a larger c. smaller; will also have a smaller d. smaller; will have a larger

22.

In comparing the size of central bank reserves relative to world imports in the 1948-1972

Chapter 28 - Fixed or Flexible Exchange Rates?

period (a relatively fixed exchange rate period) with the same ratio from 1973 onward (a relatively flexible exchange rate period), the ratio has been __________ in the more recent period. This result __________ consistent with the theoretical expectation of economists. a. smaller; is not * b. smaller; is c. larger; is not d. larger; is 23.

If a country has a currency board arrangement (with a 100 percent reserve system) in place, then the country’s money supply can be increased by a __________ by the country’s central bank. a. purchase of domestic assets from domestic citizens. * b. purchase of foreign (external) assets from domestic citizens. c. sale of domestic assets to domestic citizens. d. sale of foreign (external) assets to domestic citizens.

24.

A “crawling peg” arrangement

a. has currently been adopted by a majority of the member of the International Monetary Fund. * b. relies on a set of indicators, such as size of a country’s international reserves, to trigger changes in the parity value of the country’s currency. c. has been adopted by fewer than five members of the International Monetary Fund. d. usually permits very wide variations of the country’s currency around the parity value (such as variations of plus or minus 20 percent or more). 25. Proponents of fixed exchange rates would find the most support for their position in which one of the following empirical results regarding the relationship between exchange rate variations and the volume of international trade? (Assume that the empirical tests adequately account for other factors that influence the volume of trade.) a. no discernible relationship between exchange rate variations and the volume of trade * b. a negative relationship between exchange rate variations and the volume of trade c. a mildly positive relationship between exchange rate variations and the volume of trade d. a strongly positive relationship between exchange rate variations and the volume of trade

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Chapter 29 - The International Monetary System: Past, Present, and Future

CHAPTER 29 THE INTERNATIONAL MONETARY SYSTEM: PAST, PRESENT, AND FUTURE Learning Objectives: ■ ■ ■ ■ ■ I.

Identify the key characteristics of an effective international monetary system. Describe the historical evolution of the international monetary system from Bretton Woods to the present time. Explain the purpose of the IMF and understand its strengths and weaknesses. Differentiate among existing alternative monetary arrangements. Compare and contrast several proposals for reform of the current international monetary system. Outline Introduction - Global Crisis Requires a Global Solution The Bretton Woods System - The Goals of the IMF - The Bretton Woods System in Retrospect Gradual Evolution of a New International Monetary System - Early Disruptions - Special Drawing Rights (SDRs) - The Breaking of the Gold-Dollar Link and the Smithsonian Agreement - The Jamaica Accords - The European Monetary System - Exchange Rate Fluctuations in Other Currencies in the 1990s and 2000s Current Exchange Rate Arrangements Experience under the Current International Monetary System - The Global Financial Crisis and the Recent Recession Suggestions for Reform of the International Monetary System - A Return to the Gold Standard - A World Central Bank - The Target Zone Proposal - Controls on Capital Flows - Greater Stability and Coordination of Macroeconomic Policies across Countries The International Monetary System and the Developing Countries Summary

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Chapter 29 - The International Monetary System: Past, Present, and Future

II.

Special Chapter Features In the Real World: Flexible Exchange Rates in Post-World War I Europe: The United Kingdom, France, and Norway Concept Box 1: A World Central Bank within a Three-Currency Monetary Union In the Real World: Policy Coordination and the G-20

III.

Purpose of Chapter

The purpose of this chapter is to acquaint students with the desirable features of an effective international monetary system, to review the characteristics and problems of the Bretton Woods system, and to discuss contemporary international monetary arrangements and difficulties (including the Asian Crisis and the current global recession). Some suggested reforms of the current international monetary system are also considered, and brief consideration is also given to views held by developing countries regarding the international monetary system. IV.

Teaching Tips

A. Students often fail to appreciate the importance of a smoothly-functioning international monetary system. The devastating trade experience of the 1930s, when chaos reigned in international finance, serves as a reminder of this importance. You should stress to the students that the gains from trade discussed in the first part of the textbook are importantly dependent upon a stable monetary system such as is sought by the IMF, other institutions, and government leaders. B. In covering the IMF’s balance-of-payments loans, it would be useful to emphasize (as is also briefly mentioned in the chapter), that the IMF provides other types of loans than just these balance-of-payments loans. Additional lending has emerged, for example, for compensatory financing to alleviate the consequences of export instability and, importantly, for help for less developed countries (LDCs) with regard to their external debt problems (see Chapter 18). All of the IMF’s lending facilities are described in more detail in the early pages of the IMF’s monthly publication, International Financial Statistics. C. Some updating is periodically necessary with respect to Table 3 on exchange rate arrangements. These arrangements used to be indicated at the beginning of each month’s issue of International Financial Statistics but this is no longer the case. It is a little difficult to locate the information, and there is a time lag in the information, but we advise that you go to the IMF website (www.imf.org) and type “Exchange Rate Arrangements” or “De Facto Classification of Exchange Rate Regimes” into the Search box or locate the latest Annual Report of the Executive Board for the Financial Year. Another option is the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions. D. The Tobin proposal for a tax on short-term capital flows continues to be discussed in view of the huge volume of such flows (over $4 trillion of foreign exchange market transactions now occur in the world every business day). Hence, it is worthwhile to encourage discussion on the pros and cons of short-term capital controls. 29-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 29 - The International Monetary System: Past, Present, and Future

E. You may want to use some of the LDC external debt material of Chapter 18 in conjunction with this chapter’s material on the international monetary system. V.

Answers to End-of-Chapter Questions and Problems

1. An effective international monetary system needs to provide for relatively quick and smooth adjustment to imbalances in countries’ balance-of-payments positions. In addition, if exchange rates are not completely flexible, there must exist an adequate supply of internationally acceptable reserve assets so that effective intervention can be carried out without resort to trade and exchange controls. Because countries seem to differ in their internal macroeconomic target preferences, adjustment to and financing of imbalances should also be able to be undertaken without disruption of internal economic performance. Whether the current system meets these requirements is a matter of opinion. Some would say that the increasing exchange rate flexibility present in currencies provides for continuing adjustment without major interference in the attainment of domestic goals; others would say that domestic policy autonomy still needs to be sacrificed because of the need for coordination across countries, and that exchange rate changes are too slow in correcting current account imbalances. Also, many LDCs (who often have pegged rates) maintain extensive trade and exchange controls for balance-of-payments reasons, despite recent liberalization. 2. The problems with the Bretton Woods system are discussed in the chapter. The current system may provide greater adjustment of imbalances without undue interference with domestic performance, and the freedom of choice in exchange arrangements in the current system means that there is less danger of a “collapse” of the system as occurred with Bretton Woods. Further, the “confidence” problem seems to have been reduced. However, the increased international capital mobility since Bretton Woods has generated unstable exchange rates. Current account imbalances are also still prolonged, and the transmission of business cycles across countries is greater than was expected. Further, the level of international reserves may be inadequate in many LDCs. 3. An SDR is, like gold, an internationally acceptable reserve asset that is not simultaneously in use as a national currency. In addition, the growth rate of the asset can be kept relatively low, and the value of the asset is more stable than the value of any single (component) national currency. However, the SDR does not have a fixed official price (as gold did when it served as the principal reserve asset), and the SDR is not a physical asset with intrinsic value (it is only a bookkeeping entry at the IMF). SDRs can be used (within limits) in settlement of payments imbalances between countries and can provide international liquidity to SDR holders. Critical to the success of SDRs is that they have relative stability in value and, most importantly, that surplus countries are willing to accept SDRs in payment of imbalances. However, SDRs continue to be a very small fraction of international reserve assets held by central banks.

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Chapter 29 - The International Monetary System: Past, Present, and Future

4. The growth of the world money supply is dependent on only one source in either system (the world gold supply in one system, decisions at the world central bank in the other). Both rely on basically fixed exchange rates, and both have a mechanism for adjustment to imbalances in countries’ BOP positions. Also, both systems tend to sacrifice national autonomy in the pursuit of domestic goals to the requirement of external balance. An important difference between the systems is that the supply of gold is basically independent of international monetary needs, whereas the world central bank can control the growth of reserve assets. There are also competing demands for gold from the private sector that could potentially cause instability for the gold standard, while potentially destabilizing private sector activities with respect to a world currency in the world central bank plan could presumably be offset (at least in theory) by actions of the bank. 5. The original central purposes of the IMF were to provide relative stability in exchange rates through a pegged-rate system, to combine BOP adjustment with national autonomy in domestic macroeconomic policies, to encourage freedom in trade and payments (although capital controls were permitted in some circumstances), and to provide short-term financing for countries with BOP difficulties. Since the Bretton Woods system collapsed, pegged rates are no longer required but disruptive exchange rate movements are to be avoided, and the IMF has often expressed its desire to have SDRs substitute for gold and dollars as the principal assets in the international monetary system. Surveillance is justified by the IMF to meet its goal of avoiding disruptive and destabilizing movements in exchange rates. 6. With respect to a flexible-rate system, the target zone proposal permits the exchange rate to perform its adjustment function to some extent, allows for some protection against the transmission of real shocks across countries, and prevents speculation from driving currencies to wide swings. It also allows fiscal policy to perform a role in meeting internal goals. However, the freedom of exchange rates to move beyond narrow limits could potentially lead to wasteful resource movements as rates changed. There could also be enhanced risks associated with trade and foreign investment as compared to a fixed-rate system, and internal shocks could also generate greater instability in national income than would be the case with a fixed-rate system. As with a fixed-rate system, the target zone system provides for some discipline and coordination in domestic macroeconomic policies, and, because exchange rates are limited in variability to some extent, trade and foreign investment may not be deterred because of exchange risk. However, countries may not be able to attain their preferred inflation/unemployment tradeoffs because of having to take corrective policy steps regarding the exchange rate as the ceiling and floor of the zones are reached (although the ceiling and floor may not be reached in the Krugman version). The intervention needed could transmit business cycles across countries. If the intervention were predicted to be unsuccessful, one-way bets for speculators could also exist. Hence, the avoidance of destabilizing speculation crucially depends on confidence in the monetary authorities to keep rates within the limits. 7. The logic of the statement is that coordinated policies would keep real exchange rates stable because countries will not be having incompatible inflationary stances, for example. (This assumes that the inflation differences are not entirely offset by relative purchasing-power-parity exchange rate movements, in which case no coordinated policies would be necessary.) However,

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Chapter 29 - The International Monetary System: Past, Present, and Future

if the countries have compatible inflationary stances (or if relative PPP holds), there will be no need to specify ceilings and floors since the rates would not vary to any significant extent anyway: a fixed-rate system might as well be used. However, proponents of the target zones could say that the target zone system is superior to fixed rates because it provides more leeway in domestic policy, and they could also say that PPP tends to hold. 8. Advantages include the decreased exchange rate risk associated with foreign trade and investment, which would enhance specialization and the gains from trade and would allocate capital more effectively toward its most productive uses. In addition, if member countries are adhering to the convergence criteria, more stable growth and less disruption from exchange rate crises would occur. Further, of course, there are political and economic advantages to a country from being a member of a group that is a very important player in world political activity and in world markets. Potential disadvantages would be that each country is less insulated from real shocks in other EU countries, and that national monetary autonomy is basically lost. Also, a tight money policy in a dominant country such as Germany could leave a smaller country with more unemployment than it desired in accordance with its own unemployment/inflation tradeoff. This tension is also evident in recent years in smaller countries such as Greece and Portugal, which have been pressured to adopt austerity policies by the larger EMU countries and by the European Central Bank. VI.

Sample Exam Questions

Essay Questions

1. Because different inflation/unemployment trade-offs can make it very difficult for a fixed-rate system to be maintained, how could the creators of the Bretton Woods system have thought that that system would provide for some autonomy in domestic macroeconomic policy? Explain. 2. SDRs were first introduced as a means of strengthening the Bretton Woods system. If the Bretton Woods system had not collapsed soon after the introduction of SDRs, how (if at all) could SDRs have potentially contributed to alleviating the liquidity problem? The confidence problem? The adjustment problem? Why do you suppose that, since their introduction, SDRs have remained such a small fraction of international reserves? Explain. 3. Why did the Bretton Woods system break down? Do you think that that breakdown and the subsequent adoption of much greater flexibility in the value of the dollar have been “good” from the standpoint of the United States? Why or why not? 4. Some economists doubt whether the Bretton Woods system could have survived the OPEC and primary product price “shocks” of the mid-1970s and the subsequent stagflation period. What reasons could be used to support this position? Would a gold standard have performed ‘better” or “worse” than the Bretton Woods system during this time? Explain.

Chapter 29 - The International Monetary System: Past, Present, and Future

5. Proposals to alter the international monetary system have included (1) a return to the international gold standard, and (2) establishing a single world currency under the control of an international central bank. How would the adoption of each of these plans affect the ability of any given country to carry out independent monetary and fiscal policy? Explain. 6.

In order for monetary union to occur, why are “convergence criteria” desirable?

7. Compare and contrast the “target zone system” and the “world central bank” system for organizing exchange rates and the international monetary system. Which of the two systems would you prefer and why? 8. Do you think that “conditionality” on IMF loans to developing country is desirable or undesirable? Why? From what standpoint should “conditionality” be assessed – the IMF’s or the developing countries’? B.

Multiple-Choice Questions

Two of the “convergence criteria” pertaining to initial membership in the EMU were that a country’s ratio of government debt to GDP must be __________ and that a country’s ratio of government budget deficit to GDP must __________. * a. 60 percent or less; 3 percent or less b. 60 percent or less; 60 percent or less c. 3 percent or less; also be 3 percent or less d. 3 percent or less; 60 percent or less

10.

In the economic and monetary union in Europe (EMU), the member countries *

a. tie their currencies to the U.S. dollar. b. use a common currency (the euro).. c. tie their currencies to the SDR. d. have completely flexible exchange rates with each other.

11. Under the international monetary system as it actually operated between 1947 and 1971, the emergence of seemingly chronic deficits and surpluses in various countries’ balance- ofpayments positions (i.e., deficits and surpluses which did not seem to get eliminated) was called a. the liquidity problem. b. the confidence problem. * c. the adjustment problem. d. the IMF problem.

Chapter 29 - The International Monetary System: Past, Present, and Future

12.

The event that essentially led to the end of the Bretton Woods system was a. the devaluation of the British pound in 1967. b. the introduction of the euro in 1999. c. the introduction of Special Drawing Rights (SDRs) in 1970. * d. the U.S. government’s declaration in 1971 that it would no longer buy and sell gold from or to foreign central banks in exchange for dollars.

13.

In its lending to member countries, the International Monetary Fund (IMF) a. concentrates on long-term development loans and does not engage in short-term balance-of-payments loans. b. can lend to a country, at a maximum, only 25 percent of the value of that country's “quota” in the IMF. c. lends whatever amounts member countries may wish to borrow, and at a zero interest rate and no service charge on all loans. * d. may increase the difficulty of obtaining loans and may insist on internal policy changes by borrowing countries as the borrowers ask for additional loans.

14.

In a target zone system in which the money supply is to be varied in response to exchange rate variations as the exchange rate hits the ceiling or floor, if a country’s exchange rate (units of home currency per unit of foreign currency) hits the ceiling, the monetary authorities would be required to __________ the money supply; this change in the money supply would be carried out in order to __________ the value of the home currency. a. increase; appreciate b. increase; depreciate * c. decrease; appreciate d. decrease; depreciate

15.

In the current exchange rate arrangements of IMF members, * a. a substantial number of countries do not have a freely floating exchange rate. b. the European Union countries fix their exchange rates against the U.S. dollar. c. no countries are tied or “pegged” to the U.S. dollar. d. no developing country allows its currency to “float.”

16.

Under the Bretton Woods system set up at the end of World War II, exchange rates were a. absolutely fixed, i.e., no deviations from parity were permitted. * b. permitted to vary 1 percent above or below parity. c. permitted to vary 2¼ percent above or below parity. d. permitted to vary 10 percent above or below parity.

Chapter 29 - The International Monetary System: Past, Present, and Future

17.

At the present time in the international monetary system, a. gold is the largest component of international reserves held by central banks. b. no country is permitted to have a flexible (or floating) exchange rate. c. no country uses, as part or all of its money, another country’s currency unit. * d. one form of international monetary arrangement that has similarities with the old gold standard is a currency board.

18. Suppose that, using a system of multiple exchange rates, India wishes to discourage investors from sending their funds abroad relative to employing the funds in production for export. If the exchange rate for exports were set at 33⅓ Indian rupees = $1.00, then which one of the following exchange rates for capital transactions would potentially be appropriate for implementing the strategy? a. 20 Indian rupees = $1.00 b. 1 Indian rupee = $0.03 * c. 1 Indian rupee = $0.02 d. 1 Indian rupee = $0.06 19.

The “Asian crisis” of 1997-1998 importantly involved movement of short-term financial capital __________ countries such as Thailand and Malaysia, with a consequent __________ of their currencies, which in turn caused __________ in the trade balances of other countries of the world. a. out of; depreciation; an improvement b. out of; appreciation; a deterioration * c. out of; depreciation; a deterioration d. into; appreciation; an improvement

20. The post-Bretton Woods international monetary system is generally thought to have been characterized by all except one of the following features. Which one does NOT seem to have been a characteristic of the system? a. There has been substantial variability in the nominal exchange rates of developed countries, and this variability has included the phenomenon of “overshooting.” * b. Real exchange rates have been relatively constant during the period, and so the existence of the system per se has not had real economic effects. c. Countries with basically floating rates have not been completely insulated from outside economic disturbances. d. The size of international reserves held by central banks has increased substantially during the period.

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Chapter 29 - The International Monetary System: Past, Present, and Future

21. In the Williamson “target zone” plan, the major industrialized countries would negotiate mutually consistent __________ target exchange rates, and there would be __________ deviation permitted from these target rates. a. nominal effective; some b. nominal effective; no * c. real effective; some d. real effective; no 22.

In the Bretton Woods international monetary system, a country’s currency, unless its par value or parity value were officially changed, could not deviate more than __________ from its par value or parity value. If the country’s currency depreciated to its low point in this range, central banks needed to __________ the currency in the exchange markets in order to keep the currency’s value within the specified range. * a. plus or minus 1 percent; buy b. plus or minus 1 percent; sell c. plus or minus 10 percent; buy d. plus or minus 10 percent; sell

23.

In the current international monetary system, countries a. must keep their currency values absolutely fixed. b. must keep their currency values fixed within a certain small deviation from par values. c. must adopt floating exchange rates. * d. have considerable latitude in choosing an exchange rate arrangement.

24.

The original monetary unit in the European monetary system (EMS) in which currencies’ parity values were defined was the * a. European currency unit (ecu). b. Special Drawing Right (SDR). c. euro. d. German mark.

25.

If a country ties its currency to a specific foreign currency and allows its holdings of that currency to govern the country’s money supply, this arrangement is known as a * a. currency board. b. floating exchange rate. c. monetary union. d. Special Drawing Right.

Chapter 29 - The International Monetary System: Past, Present, and Future

26.

Under the original Bretton Woods agreement, a. countries were to permit absolutely no variation in exchange rates. b. gold was demonetized as an international reserve asset. c. the IMF was primarily to engage itself in long-term development loans. * d. a country joining the IMF was assigned a quota to be paid in gold and the country’s own currency.

27.

When a country joins the International Monetary Fund, the country is assigned a quota, or subscription fee. At the present time, this quota is paid a. entirely in the country’s own currency. b. 25 percent in gold and 75 percent in the country’s own currency. * c. 25 percent in internationally acceptable currencies (“hard currencies”) and 75 percent in the country’s own currency. d. 75 percent in internationally acceptable currencies (“hard currencies”) and 25 percent in Special Drawing Rights (SDRs).

28.

If a country’s currency’s external value is tied or pegged to the currency values of the country’s leading trading partners, this arrangement is known as a a. peg against the SDR. b. managed float. * c. peg against a “basket” of currencies or a “composite.” d. currency board.