International Economics, 7th Edition James Gerber Solution Manual by Ace Test Banks

International Economics, 7th Edition By James Gerber

Email: Richard@qwconsultancy.com

Contents Chapter 1

The United States in a Global Economy .....................................................................

Chapter 2

International Economic Institutions since World War II ............................................

Chapter 3

Comparative Advantage and the Gains from Trade ....................................................

Chapter 4

Comparative Advantage and Factor Endowments ......................................................

Chapter 5

Beyond Comparative Advantage ................................................................................

Chapter 6

The Theory of Tariffs and Quotas ...............................................................................

Chapter 7

Commercial Policy ......................................................................................................

Chapter 8

International Trade and Labor and Environmental Standards .....................................

Chapter 9

Trade and the Balance of Payments ............................................................................

Chapter 10

Exchange Rates and Exchange Rate Systems .............................................................

Chapter 11

An Introduction to Open Economy Macroeconomics .................................................

Chapter 12

International Financial Crises......................................................................................

Chapter 13

The United States in the World Economy ...................................................................

Chapter 14

The European Union: Many Markets into One ...........................................................

Chapter 15

Trade and Policy Reform in Latin America ................................................................

Chapter 16

Export-Oriented Growth in East Asia .........................................................................

101

Chapter 17

China and India in the World Economy ......................................................................

106

Chapter 1 The United States in a Global Economy ◼

Outline

Introduction: International Economic Integration Elements of International Economic Integration The Growth of World Trade Capital and Labor Mobility Features of Contemporary International Economic Relations Multilateral Organizations Regional Trade Agreements Trade and Economic Growth Twelve Themes in International Economics The Gains from Trade and New Trade Theory (Chapters 3, 4, and 5) Wages, Jobs, and Protection (Chapters 3, 6, 7, and 8) Trade Deficits (Chapters 9, 11, and 12) Regional Trade Agreements (Chapters 2, 13, and 14) The Resolution of Trade Conflicts (Chapters 2, 7, and 8) The Role of International Institutions (Chapters 2, 8, and 12) Exchange Rates and the Macroeconomy (Chapters 10 and 11) Financial Crises and the Global Contagion (Chapter 12) Capital Flows and the Debt of Developing Countries (Chapters 2, 9, and 12) Latin America and the World Economy (Chapter 15) Export-Led Growth in East Asia (Chapter 16) China and India in the World Economy (Chapter 17)

Gerber • International Economics, Seventh Edition

◼ Learning Objectives After studying this chapter, students will be able to: 1.1 Discuss historical measures of international economic integration with data on trade, capital flows, and migration. 1.2 Compute the trade-to-GDP ratio and explain its significance. 1.3 Describe three factors in the world economy today that are different from the economy at the end of the first wave of globalization. 1.4 List the three types of evidence to support the idea that trade supports economic growth.

◼ What Students Should Know after Reading Chapter 1 The goal of Chapter 1 is to examine international economic integration in historical perspective. Most features of globalization aren’t new, and international economic integration is described as re-emerging after a period of disruption during World War I, the Great Depression, and World War II. The chapter adds a brief discussion of new features in the current wave of globalization, including regional trade agreements and multilateral organizations. It also briefly discusses three types of evidence to support the idea of gains from trade: historical experiences of similar countries such as North and South Korea; economic theory; and large statistical comparisons of countries. There are three aspects of international economic integration considered: 1.

The growth of world trade. World trade has grown over the last sixty or seventy years but is roughly comparable in percentage terms to trade in 1900. Trade has become a larger share of national economies as measured by the: Trade-to-GDP ratio = (Exports + Imports)/GDP This index does not tell us about a nation’s trade policies. Nations with higher figures for the index of openness do not necessarily have lower trade barriers. Large economies are less dependent on international trade and often have lower measures of openness than small countries do. Figure 1.1 shows the openness index for six nations at different points in time. It shows the drop in trade from 1913 to 1950 and its growth (even above 1913 levels) for most nations by 2000. A trend obscured in the overall trade data is that in 1890 most U.S. trade was in agricultural products and raw materials, while today it is mostly in manufactured goods. The relative importance of capital goods has increased dramatically.

Chapter 1

The United States in a Global Economy

Capital and labor mobility. Labor is much less mobile internationally now than it was in 1900. For capital, it is somewhat more mobile. There is a difference between financial capital and physical capital. Foreign Direct Investment (FDI) is the flow of capital representing physical assets such as real estate, factories, and businesses. While capital flows to developing countries have increased in recent decades, the level of investment in any country is still correlated with its domestic level of savings, making national savings rates an important element in national economies. Capital flows today differ from earlier periods in three ways. More types of financial instruments exist today, and flows of financial capital are likely much greater. In 1900, the world operated on a fixed exchange rate standard, and much of today’s financial market transactions are aimed at protecting against exchange rate risk caused by floating exchange rates. Transactions costs associated with foreign capital flows have also fallen significantly. Volatility in international capital flows, while often a subject of intense attention today, is not new.

Movement of prices in different markets. The text does not develop this, but points out that in the late 1800s wheat farmers, meat packers, and fruit growers all produced for a global market where international, rather than domestic, supply and demand determined prices. News reports today could easily demonstrate this for most commodities.

New issues in international trade and investment: 1.

Deeper integration. Barriers to manufactured goods have fallen significantly as a result of a process that began at the end of WWII. As formal restrictions on imports have been reduced, domestic policies on issues such as the environment, labor, and fair market conditions have become the barriers to further increases in trade flows. Reducing trade barriers has been the focus of negotiations between nations. Eliminating the traditional barriers to trade, tariffs, and quotas is referred to as shallow integration because it just changes policies “at the border.” Eliminating domestic policy differences that create trade barriers is much more complicated and is referred to as deep integration.

Regional trade agreements. Since the 1960s, and increasingly after 1990, nations have formed preferential trade agreements with one or more other nations. The European Union, NAFTA, ASEAN, ASEAN+3, and a host of other agreements have provided privileged market access for member countries.

Multilateral organizations. While the number of preferential trade agreements has grown dramatically, it has occurred within an international economic environment that contains several key international institutions: the WTO, IMF, and World Bank are each important and are the main institutions discussed in the text. Their roles are discussed more fully in Chapter 2.

Economists are in agreement that the benefits of trade outweigh the costs, although there is a great deal of disagreement over the form that trade agreements should take (and if preferential agreements are even desirable), the role that multilateral institutions should play, and the optimal trade policy for developing countries. Chapter 1 challenges the belief that the world has embarked on an entirely new and unprecedented era of globalization. In the long run, it seems clear that the period 1870 to 1914 was an earlier era with similar trends. Those years experienced rapid technological change, which came into widespread use in the form of railways, steamships, and telegraphs; they underwent business and financial sector innovation through rapid growth in the corporate form of business organization, the invention and spread of demand deposits, and the development of stock markets; trade policies were liberalized in many nations; and there were widespread protests against immigration and the global economy. In the United States, the protest ..

Gerber • International Economics, Seventh Edition

movement was centered in populist movements that are reminiscent of the rhetoric of some politicians and commentators today. This is not an argument about history repeating itself. Rather, it is an attempt to encourage students to think of the period from World War I to the end of World War II as an aberration in the last 150 years of world history. The long-run trend is toward integration, punctuated by protests and nationalistic movements that temporarily halt or reverse the trend. When students are asked what they think is new about today’s economy, they inevitably answer “technology.” E-mail, faxes, satellite systems, jet aircraft, and less visible forms such as container cargo transportation systems have each made significant contributions to increasing trade flows. It is useful to engage students in a discussion over the marginal impacts of these new technologies versus the marginal effects of steam-powered oceangoing vessels or transatlantic telegraphy. Telegraphy cut the time it took information to cross the ocean from around three weeks to relatively instantaneously, and reduced the time it took to buy a foreign bond from around three weeks to roughly one day. It is useful for students to realize two points. First, much of what has happened over the last fifty years has been aimed at fixing something that was broken, not creating a new phenomenon. Second, the international institutions that deal with the global economy are new and were created because of a shared recognition that integration was important and helpful and needed to be encouraged. An important subtheme of the text is the idea of deep versus shallow integration and the institutional process that nations go through to create deeper levels of integration. The chapter also cover issues unique to today's economic climate. Important points include flexible exchange rates, regional trade agreements, and the changing mix of the types of goods nations produce. Domestic policies will be a key focus when trade barriers and capital flows are considered. Another important issue will be the developing role of international organizations in negotiating and enforcing changes in domestic policies.

◼

Assignment Ideas

I like to use the trade-to-GDP ratio to contrast the importance of trade to various nations and to drive home the fact that relative value matters. The United States is a huge participant in trade in dollar terms, but it is not as dependent on trade as many other countries. Some countries’ entire economies are dependent on international trade. I find students need some practice calculating and interpreting the trade-to-GDP ratio. The data below are from the World Trade Organization (exports and imports, http://www.wto.org/english/res_e/statis_e/trade_data_e.htm) and the International Monetary Fund (GDP, http://www.imf.org/external/pubs/ft/weo/2012/02/weodata/index.aspx). They are for 2011 and are in billions of current U.S. dollars. Country

Exports

Imports

GDP

Goods

Services

Goods

Services

Bahrain

19.6

3.0

12.7

1.8

25.9

Brazil

256.0

36.7

236.9

73.1

2,492.9

Cambodia

6.9

2.2

9.3

1.4

12.9

Chad

4.6

0.2

2.4

1.9

9.3

New Zealand

37.7

9.9

37.1

10.8

158.9

Chapter 1

Nigeria

116.0

2.3

55.0

The United States in a Global Economy

22.5

244.0

For homework very early in the course, I sometimes assign each student a nation to study, with its trade-to-GDP ratio as one of the pieces of information to collect. I also ask them to find out its currency and its current exchange rate with the U.S. dollar, primary exports, imports, major trading partners, and the trade agreements in which it participates. The WTO’s Trade Profiles (http://stat.wto.org/Home/WSDBHome.aspx?Language=E) has much of this data and is a useful data source for students. For comparison with U.S. historical data, you might ask them to track the nation’s trade figures over time. While these are basic matters of record, I find it helps make what we are discussing more concrete.

The chapter also lends itself to students developing some factual knowledge about U.S. trade history. One possibility is to look at U.S. trade policy through various time periods. The U.S. had relatively high tariffs (greater than 40 percent on average) throughout the second half of the nineteenth century. In 1890, Congress passed the McKinley Tariff, followed in 1897 by the Dingley Tariff. Both tariffs raised rates further from their already high base. President Wilson tried to reduce tariffs but was thwarted by World War I. Rates in the 1920s fell, but the Tariff Act of 1930 (Smoot-Hawley Tariff) raised the rates back up to nearly 45 percent. In the midst of the Great Depression (1934), Roosevelt and his secretary of state, Dulles, persuaded Congress to pass the Reciprocal Trade Agreement Act. The act authorized Roosevelt to negotiate bilateral, reciprocal tariff reduction agreements. This piece of legislation marks an historic shift in U.S. tariff policy, away from protectionism and toward more openness.

◼

Answers to End-of-Chapter Questions

How can globalization and international economic integration be measured? Answer:

The chapter offers three ways to measure globalization and economic integration: (1) trade flows; (2) factor movements; and (3) convergence of prices (goods, factors, and assets). In what sense is the U.S. economy more integrated with the world today than it was a century ago? In what ways is it less integrated? Answer:

The WTO’s Trade Profile for the United States gives an average trade-to-GDP ratio of 28.3 for 2009-2011. That implies that the United States’ ratio is about 150 percent greater today than it was in 1913 ((28.3 − 11.2)/11.2 = 1.53). At the same time, the composition of goods traded has changed from agricultural output to manufactured goods. This is consistent with the observation that world trade has been growing faster than world output, at least since 1950. Much of the growth in trade since then, however, simply brought us back to where we were before World War II. In terms of labor flows, the United States is probably less integrated with the world economy than it was in 1890 or 1900. During that time we had an open door immigration policy (for all but Chinese citizens), and a larger share of our population was foreign born (14.5 in 1890 versus less than 8 percent in 1990 and 12 percent today). Capital flows are more difficult to generalize since they can be measured several ways. While the absolute volume of capital flows has increased dramatically, as a share of world GDP it is probably no more than it was at the turn of the twentieth century, and it may even be less. The level of investment in nearly all countries is still highly correlated with domestic savings rates. What is different, however, is the ease with which capital can ..

Gerber • International Economics, Seventh Edition

cross international boundaries (lower transaction costs) and the much greater variety of assets that are traded. The need to protect against exchange rate risk is a key component of today’s international financial markets and is a primary difference from the fixed exchange rate standard of the past. The incidence of financial crises has not increased and, as a metric of integration, it implies no increase in capital market integration. The growth of regional trade agreements is also an indicator of increased integration. A growing role for international institutions such as the IMF or World Bank may also indicate an increase in international integration. 3.

What does the trade-to-GDP ratio measure? Does a low value indicate that a country is closed to trade with the outside world? Answer:

The trade-to-GDP ratio is a measure of the relative importance of trade to a national economy. It is measured by the ratio of exports plus imports to GDP. A relatively small ratio does not necessarily mean that an economy is intentionally closed to the outside world. Large countries like the United States have large domestic markets that enable firms to specialize and produce in volume in order to attain an optimal scale. Specialization and high volume in manufacturing is often associated with increased productivity, so firms in large markets can achieve the highest possible level of productivity without having to sell to foreign markets. Firms located in smaller countries have to trade their output across international boundaries if they want to have the same technology and the same level of productivity. Consequently, large countries tend to have lower trade-to-GDP ratios regardless of their trade policies.

4. Describe the pattern over the last century shown by the trade-to-GDP ratio for leading industrial economies. Answer: The ratio fell between 1913 and 1950, but then began to rise relatively rapidly. The main causes of the pattern shown in Figure 1.1 are the two world wars and the Great Depression of the 1930s, and changes in trade policy accompanying that period. By 2000, the ratios were mostly higher than they were before World War I. Another pattern the chapter notes is that the ratio is smaller for the large population countries of Japan and the United States, and higher for The Netherlands, with its small population. ] 5. Trade and capital flows were described and measured in relative rather than absolute terms. Explain the difference. Which term seems more valid—relative or absolute? Why? Answer: Absolute values are the dollar amounts of trade and capital flows. Relative values are the ratio of dollar values to GDP. Relative values are a better indicator of the importance of trade and capital flows since they are proportional to the size of national economies. Large economies like the United States may have large export and import values, but the importance of trade to the national economy is not nearly as great as it is for other economies. The United States is a large exporter and importer, but the national economy is so large that trade is much less important for the United States than it is for many smaller countries such as Canada, Belgium, or The Netherlands.

Chapter 1

In relative terms, international capital flows may not be much greater today than they were a hundred years ago, although they are certainly greater than they were fifty years ago. Qualitatively, however, capital flows are different today. Explain. Answer:

The United States in a Global Economy

Major qualitative difference between late nineteenth and late twentieth century capital flows include the fact that there are many more types of financial instruments available now compared to a century ago. These instruments can be finely tailored to the income and risk preferences of investors. Secondly, a large share of the total flow of capital across borders is related to the need to protect against fluctuations in the value of currencies. This use of international capital markets was not as necessary when nations operated within fixed exchange rate systems. Third, the transaction costs of participating in international capital markets are much lower today than it was a century ago.

What are the new issues in international trade and investment? In what sense do they expose national economies to outside influences? Answer:

The new issues involve policy differences between nations that until recently were considered the exclusive responsibility of local or national governments. Examples include labor standards, environmental standards, competition or antitrust policies, and industrial support policies. Negotiations between nations potentially give foreign interests a voice in setting domestic policy. The scope and the depth of the negotiations determine how great a voice foreigners will have. It is often the case, however, that negotiations either occur or are proposed because some aspect of domestic policy is perceived by foreigners as a barrier to trade, and they seek to alter the domestic policy that created it.

Describe three kinds of evidence that economists use to support the assertion that economies open to the world economy grow faster than economies that are closed. Answer:

Economists base these conclusions on three types of evidence: causal empirical evidence of historical experience; evidence based on economic models and deductive reasoning; and evidence from statistical comparison of countries.

Gerber • International Economics, Seventh Edition

Describe the three kinds of evidence economists use to support the assertion that economies open to the world grow faster than economies that are closed. Answer:

These are: (1) casual empirical evidence of historical experience; (2) economic logic and deductive reasoning; and (3) evidence of statistical comparisons of countries. (1) The historical evidence examines the experiences of countries that tried to isolate themselves from the rest of the world. First, not only did trade protection exacerbate the Depression of the 1930s, but it also led to the misery and tragedy of World War II. Second, an examination of countries such as former East and West Germany, North and South Korea, and other countries with the same historical, economic, and ethnic background that were divided by war, indicate that those who closed their economies from the rest of the world suffered in terms of prosperity and environmental degradation. East Asia experienced an economic takeoff when it decided to integrate with the rest of the world, while Latin America, which had the same economic background as East Asia but chose to remain partially closed, experienced mediocre growth. (2) The logic of economic theory also suggests a strong causal relation between trade and faster economic growth. The following is a summary of this linkage: Following Adam Smith, David Ricardo proved that comparative advantage leads to trade and this in turn leads to the reallocation of resources and the improvement of the standard of living of any nation, large or small. Modern trade theory also makes the case for exports and open trade as the causes for economic expansion. Exports and open trade foster competition, innovation, and learning by doing and bring international best practices to the attention of domestic producers, spurring greater efficiency and export expansion. This helps domestic producers to realize economies of scale when they attempt to produce for the world market rather than for their own limited base of domestic consumers. Larger markets create incentives for firms to engage in research and development, and allow countries to import important production inputs and foreign capital by minimizing foreign exchange constraints. They facilitate the transfer of technology and managerial skills. It follows that open trade and exports increase the demand for the country’s output and therefore contribute strongly to positive economic growth. (3) Even though the statistical evidence is not quite conclusive (mainly due to measuring trade policy), the evidence of statistical comparison of countries (cross-sectional time series) indicates that countries benefit from open trade.

Chapter 2 International Economic Institutions Since World War II ◼

Outline

Introduction: International Institutions and Issues since World War II International Institutions A Taxonomy of International Economic Institutions The IMF, the World Bank, and the WTO The IMF and World Bank The GATT, the Uruguay Round, and the WTO Case Study: The GATT Rounds Regional Trade Agreements Five Types of Regional Trade Agreements Case Study: Prominent Regional Agreements Regional Trade Agreements and the WTO For and Against RTAs The Role of International Economic Institutions The Definition of Public Goods Maintaining Order and Reducing Uncertainty Case Study: Bretton Woods Criticism of International Institutions Sovereignty and Transparency Ideology Implementation and Adjustment Costs Case Study: China’s Alternative to the IMF and World Bank: The AIIB

Gerber • International Economics, Seventh Edition

◼ Learning Objectives After studying this chapter, students will be able to: 2.1 Classify with examples the main types of international economic organizations. 2.2 Identify economic circumstances in which the IMF, the World Bank, and the WTO are active. 2.3 Compare the different levels of integration found in regional trade agreements with examples. 2.4 Analyze the roles of international economic organizations. 2.5 Debate the pros and cons of international economic organizations.

◼

What Students Should Know after Reading Chapter 2

Chapter 2 introduces the major international governmental organizations of the global economy. This background material is designed to remove some of the mystery about the IMF, World Bank, WTO, and GATT early in the course. Chapter 2 also addresses both the need for these organizations and the criticisms against them. Institutions are supposed to reduce uncertainty and increase stability. Drawing on material from the new institutionalists, such as Doug North, the chapter introduces international institutions as organizations that set the rules that govern behavior and potentially constrain or limit a nation’s actions. Chapter 2 makes the case for international institutions and addresses some of the criticism they have received. It defines international public goods and addresses the free-rider problem. It gives some examples of international economic crises that may have been related to market failures. The main benefits of institutional relationships are the maintenance of order and the reduction of uncertainty. The latter part of the chapter address some of the criticism these organizations receive, including issues related to sovereignty and transparency, ideology, and implementation and adjustment costs. Another chapter goal is for students to understand the various types of regional trade agreements and the level of policy integration associated with each type of agreement. In the recent past, bilateral and regional trade agreements have expanded more rapidly than multilateral negotiations. Chapter 2 provides a taxonomy of these agreements and includes accompanying arguments for and against as drawn from the economics literature.

◼

Supplemental Lecture Possibilities

The Global Players: Given some of the sub-themes of this chapter, it usually takes a day to lecture on what I call the global players: national governments, international multilateral and regional organizations, multinational or transnational corporations, and nongovernmental organizations. Understanding issues related to global economic development, the politics of trade policies and agreements, the responsibilities and criticisms of international economic institutions, and other current developments requires a clear sense of who the players are and what they bring to the table. I define each of these players and address their strengths and weaknesses. I focus on economic development, national sovereignty, and how trade-related laws are negotiated and changed. For development, I focus on the increasing role of direct foreign investment, which covers multinational corporations and national governments. Criticisms of world trade often come from civil society/NGOs, who often have a special role to play in the least-developed countries.

Chapter 2

International Economic Institutions Since World War II

In presenting the major international organizations that deal with the global economy, it is useful to do a historical overview. What happened in terms of trade, foreign investment, and exchange rates from World War I through the Bretton Woods conference that made the United States and the United Kingdom think the IMF, World Bank, and something resembling GATT were necessary institutions? By covering prior crises, we can explain the framework in which the Bretton Woods institutions were created and how they operate. The prior lecture on the global players helps students understand why it was easy to create institutions that were banks and more difficult to create an institution that would affect trade laws.

Prior to starting Chapter 3, some instructors prefer to go directly from Chapter 2 to a case study on a specific regional trade agreement. Chapter 14 on the European Union is one such case study. One purpose moving to a specific case study is to familiarize students with the various levels of economic integration as well as the concepts of “widening” versus “deepening.” Students tend to be able to handle Chapter 14 without first having a more theoretical base, and it builds some interest in later topics such as foreign exchange. It also gives them a real-world foundation for understanding trade theory.

◼

Assignment Ideas

Most important international organizations have Web sites where they provide a large variety of information as well as detailed descriptions about themselves. Students could be assigned to choose an organization, go to its Web site, and use the information there to write a short paper (two to three pages) detailing both the organization's purpose and structure and the institutional environment it creates. In addition, they should be asked to think about which countries have the greatest control over their organization’s policies. The table below contains the URLs for a number of important international organizations. These organizations are particularly relevant throughout the book. Addresses for a large number of additional sites can be found on the United Nations Web server: http://www.unsystem.org. Name

URL

Asia-Pacific Economic Cooperation (APEC) European Union (EU) International Labor Office (ILO) International Monetary Fund (IMF) Organization for Economic Cooperation and Development (OECD) Organization of American States (OAS) United Nations Conference on Trade and Development (UNCTAD) World Bank Group World Bank and links to its subgroups International Finance Corporation (IFC) Multilateral Investment Guarantee Agency (MIGA) World Trade Organization (WTO)

www.apecsec.org europa.eu www.ilo.org www.imf.org www.oecd.org www.oas.org www.unctad.org www.worldbank.org www.ifc.org www.miga.org www.wto.org

Note that the World Bank is divided into five subgroups, two of which have their own Web sites. These five subgroups are: the International Development Association (IDA), the International Finance Corporation (IFC), the Multilateral Investment Guarantee Agency (MIGA), the International Bank for

Gerber • International Economics, Seventh Edition

Reconstruction and Development (IBRD), and the International Center for Settlement of Investment Disputes (ICSID). The following questions can be worked into the assignment: • What is the role of the organization you chose to write about? • What kind of public good does it try to provide? • Describe the main elements of the institutional environment it supports. • What is its structure? Do some countries have a greater voice in setting policies?

◼

Answers to End-of-Chapter Questions

What is an institution? Give examples of both formal and informal institutions. Explain how they differ from organizations. Answer:

An institution is a set of rules of behavior. It sets limits or constraints on social, political, and economic interaction. The rules can be formally recognized in a code of laws, club rules, or an organization’s standards of behavior. The rules of an institution may also be informal as in the case of table manners or social customs. Examples of formal institutions include civil codes, commercial codes, and university standards of behavior (e.g., regarding plagiarism or sexual harassment). Examples of informal institutions include gift exchanges on birthdays, eating salad with the small fork, and giving up your seat to an elderly person on a crowded bus. Institutions differ from organizations in the same way that the government of the United States differs from the Constitution. The latter is the set of rules that governs the former. Organizations are associations of individuals or groups, institutions are the rules that determine the limits and imperatives of their behavior.

What are the arguments in favor of international organizations? What are the arguments against them? Which do you think are stronger? Answer:

Arguments in favor: International organizations are essential for the containment of national or regional crises and the avoidance of their propagation internationally. By providing a set of rules (institutions) which are certain and known (transparent), they reduce uncertainty and increase stability. In many instances, they overcome problems of free riding in the international economy in order to insure the provision of (international) public goods such as lender of last resort financing for resolving a liquidity crisis, or open markets in a recession. Arguments against: The text describes the problems with institutions in terms of issues of sovereignty (may force adoption of domestic policies against nation’s will or interests), transparency (decision making at institutions may be dominated by others pursuing their own interests), ideology (advice may be bad or biased), and implementation and adjustment costs (asymmetries in negotiation power and in ability to absorb costs imposed). Overall, critics question whether institutions generate economic inequality and compound risks to vulnerable groups. The issue of which arguments are stronger is ambiguous. Either can be viewed as more cogent. The key is that students understand both arguments and that they develop a set of reasons to support their views.

Chapter 2

International Economic Institutions Since World War II

Give the arguments for and against free trade agreements. How might the signing of a free trade agreement between the United States, Central America, and the Dominican Republic have harmed Bangladesh? Answer:

Proponents of RTAs view them as building blocks for freer, more open, world trade. They are able to perform this function because it is easier for a few countries to reach agreement on difficult trade matters than it is for a large number of countries to reach the same agreements. Furthermore, the domestic effects of a reduction of trade barriers are less dramatic since fewer countries are involved. Import flows and job losses and displacements are smaller and more easily managed. In addition, RTA members can experiment with new agreements, such as labor and environmental standards that are too contentious in a larger set of negotiations. Opponents question these assumptions and argue that RTAs undermine progress toward multilateral agreements, such as the Doha Round of the WTO. They argue that RTAs polarize countries because they are discriminatory against nonmembers and because they disadvantage smaller countries that enter into agreements with large ones, since the small countries lack the ability to negotiate effectively and they are often unable to take advantage of the market opening of the larger country due to their limited infrastructure and other resources. Bangladesh may be hurt by a free trade agreement between the United States and Central America due to the trade diversion that might result. If Bangladesh is the lowest cost producer of apparel, for example, then a lowering of U.S. tariffs against Central America could result in production for the U.S. market shifting from Bangladesh to Central America.

What are public goods and how do they differ from private ones? Give examples of each. Answer:

Public goods are nondiminishable and nonexcludable. Private goods generally share neither of these characteristics. Private goods include most things that are bought and sold in private markets (restaurant meals, clothing, houses, cars, etc.) while public goods are often provided collectively. Public goods include national defense, public airways, civil and commercial codes, and so forth.

Describe the main functions of each of the following: • The IMF • The World Bank • The GATT • The WTO Answers: (1) The IMF’s role is to act as a lender of last resort in the case of a debt crisis or foreign exchange crisis. It provides technical expertise and advice and assists national governments with necessary but difficult reorganizations of their national economies. (2) The World Bank’s mission, in general terms, is to assist the economic development of nations through the provision of loans, technical expertise, and advice. (3) GATT is a series of multilateral trade negotiations and resulting treaties which binds the tariffs and trade policies of nations and limits their ability to arbitrarily change them. Its mission is to keep markets for goods open and to ensure that nations follow a set of rules governing fair trade.

Gerber • International Economics, Seventh Edition

(4) The WTO is an umbrella organization created by the Uruguay round of GATT. Its role is similar to GATT’s, but it has expanded its function to include agreements on services, agriculture, and textiles and apparel, all of which were omitted from the previous rounds of GATT. In addition, it provides rules for the resolution of trade disputes between nations and acts as a forum for the discussion and implementation of further reductions in trade barriers. 6.

When nations sign the GATT agreement, they bind their tariffs at their current level, or lower. Tariff binding means that they agree not to raise them except under unusual circumstances. Explain how tariff binding in the GATT prevents free riding during a global slowdown. Answer:

During a global slowdown, nations may be tempted to raise barriers to imports. The hope is that reduced imports will provide greater incentive for domestic production and add jobs in import-competing industries. This part of the strategy usually works but at the cost of the loss of jobs in export industries. Export industries are hurt if other nations retaliate and impose similar barriers to imports. The problem is that every country wants to let the others be the ones to keep their markets open. The free-rider problem occurs because nations that impose import barriers are free riding on the policies of nations that do not similarly impose barriers. Tariff binding eliminates this possibility.

Kindleberger’s study of the Great Depression of the 1930s led him to believe that market economies are sometimes unstable and that nations can get locked into prolonged downturns. Other economists are not convinced. Suppose that you disagree with Kindleberger and that you believe that market based economies are inherently stable. How would you view the need for international institutions to address the provision of each of the public goods in Table 2.5? Answer:

If the international economy is inherently stable, then the need for international institutions decreases. Most of the cases where there is a failure to provide the public goods in Table 2.3 are a consequence of the failure governments to implement sound economic policies. Governments may try to close markets during a recession but enlightened governments recognize this as self-defeating since other nations will retaliate. Government closure of markets is a governmental failure, not a market failure. Private capital markets will channel funds to developing countries if these countries have the right policies. Again, the problem of capital shortages in developing countries may be as much a failure of the developing country’s economic policies as it is a failure of markets. Private markets will seek out payment methods that are acceptable to all the parties involved. Financial crises caused by a shortage of liquidity are an indicator of deeper problems. At times, it is necessary to let bad firms fail. These types of crises will burn themselves out and leave little lasting impact on the international economy.

Chapter 2

International Economic Institutions Since World War II

What are the five main types of regional trade agreements and what are their primary characteristics? Answer:

The five main types of regional trade agreements are: (1) a partial trade agreement; (2) a free trade area; (3) a customs union; (4) a common market; and (5) an economic union. (1) A partial trade agreement frees up trade between two or more countries in a few goods. An example is the U.S.-Canada Auto Pact which created free trade in cars and car parts in the 1960s. It later formed the basis for the U.S.-Canada free trade agreement. (2) A free trade area allows goods and services to cross international borders without paying a tariff and without limitations imposed by quotas. Many items, such as labor and environmental issues, are usually left out of the agreement. Example: NAFTA. (3) A customs union is a free trade area plus a common set of tariffs toward non-members. In this situation, members have free trade with each other and agree to levy the same tariff on imports from non-members. Examples: MERCOSUR, and from the mid-1970s to early 1990s, the European Union. (4) A common market is a customs union plus an agreement to allow the free mobility of inputs such as labor and capital. Example: the European Union in the 1990s. (5) An economic union is a common market with substantial coordination of macroeconomic policies, including a common currency, and harmonization of standards and regulations. Example: the 12 European Union members that participate in the euro. Since most formal agreements combine incomplete elements, this classification is more clear-cut than the messier reality.

Critics of the global institutions have a variety of complaints about the WTO, the IMF, and the World Bank. Explain the main categories of complaints. Answer:

The text describes the problems with institutions in terms of issues of sovereignty (may force adoption of domestic policies against nation’s will or interests), transparency (decision making at institutions may be dominated by others pursuing their own interests), ideology (advice may be bad or biased), and implementation and adjustment costs (asymmetries in negotiation power and in ability to absorb costs imposed). They especially question the dominance of the United States and industrialized nations in determining the policies institutions set for client countries, since those policies may be wrong or biased or impose particular harm to some groups in the client nations’ populations. Overall, critics question whether institutions generate economic inequality and compound risks to vulnerable groups.

Chapter 3 Comparative Advantage and the Gains from Trade ◼

Outline

Introduction: The Gains from Trade Adam Smith and the Attack on Economic Nationalism A Simple Model of Production and Trade Absolute Productivity Advantage and the Gains from Trade Case Study: Gains from Trade in Nineteenth-Century Japan Comparative Productivity Advantage and the Gains from Trade The Production Possibilities Curve Relative Prices The Consumption Possibilities Curve The Gains from Trade Domestic Prices and the Trade Price Absolute and Comparative Productivity Advantage Contrasted Gains from Trade with No Absolute Advantage Case Study: Changing Comparative Advantage in the Republic of Korea, 1960–2010 Comparative Advantage and “Competitiveness” Economic Restructuring Case Study: Losing Comparative Advantage

Chapter 3

Comparative Advantage and the Gains from Trade

◼ Learning Objectives After studying this chapter, students will be able to: 3.1 Analyze numerical examples of absolute and comparative advantage. 3.2 Draw a diagram showing gains from trade. 3.3 Numerically compare and contrast absolute and comparative advantage. 3.4 Explain how a country with no absolute advantage can still gain from trade. 3.5 Contrast the concepts of comparative advantage and competitiveness. 3.6 Discuss the economic and ethical considerations of economic restructuring caused by international trade.

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What Students Should Know after Reading Chapter 3

The chapter begins with Adam Smith’s attack on economic nationalism. Mercantilists believed trade was a zero sum activity; Smith said both sides must gain in order for trade to take place between willing partners. Smith observed that specialization of labor not only improved well-being, but that specialization depends on the size of the market. Smith disliked trade barriers because they decreased specialization, technological progress, and wealth creation. The first case study looks at oil producers and examines the important role—and limitations—of their economies of oil production. The idea of the resource curse is introduced in an attempt to get students to question the idea that resources are either essential to development or that they are completely beneficial. The Ricardian trade model differentiates absolute productivity advantage, which is the basis of Smith’s support for trade, from comparative advantage, which is based on opportunity cost. The simple model is presented starting from output per hour worked for two products for two countries. Absolute productivity advantage is defined as being able to produce more output per hour worked. Opportunity costs are introduced for each country and comparative advantage is defined in terms of being able to produce a unit of output at a lower opportunity cost. The production possibilities curve is introduced to illustrate the trade-off each nation faces and the relative price of each product. The price line or terms of trade line is introduced to illustrate the gains from trade, or how trade enhances consumption by allowing nations to achieve points beyond their individual production possibilities curves. The text discusses the connection between domestic prices and trade prices, illustrating the discussion with cases where the trade price is not between the nations’ pre-trade domestic prices. In order to clarify the idea of comparative advantage, an example is shown in which one country has no absolute advantage yet both countries gain from trade. This is followed by a case study of Korea and its successful attempt to develop its economy with no resources and, by implication, no absolute advantages. The connection between comparative advantage and competitiveness is addressed. The interests of business enterprises are contrasted with the interests of nations in terms of efficient resource allocation. .

Gerber • International Economics, Seventh Edition

Government policies may lead to situations where a firm has a commercial or competitive advantage where the nation does not have a comparative advantage. The real-world case of Indonesia developing an aircraft industry is an example of government policy misallocating resources from the nation’s point of view to the benefit of firms. Nations don’t compete with each other in the normal sense of the word, and nations can all simultaneously increase their incomes. Finally, economic restructuring means that changes in the economy may require some industries to grow and others to shrink or perhaps disappear. Gains to the nation from trade are not gains to every individual agent. Some individuals gain and others may be harmed. The economic gains of the winners are greater than the economic losses of the losers, which creates the net gain to trade for the nation. Changes caused by free trade can mean a transition period that is quite costly for some. Protection through trade barriers is a suboptimal solution to the social problems of economic change caused by trade, and some argue that doing nothing is best. Other approaches call for the government to find ways to get the winners to compensate the losers. Trade adjustment assistance is a common approach, usually taking the form of extending unemployment benefits and assistance with worker retraining. The primary goal for Chapter 3 is to convey the idea of comparative advantage and to distinguish it from absolute advantage. Chapter 3 presents a standard Ricardian model with two countries, two outputs, and one input, labor. Labor is homogeneous and full employment is assumed. Emphasis is placed on understanding how opportunity costs/relative prices are determined and how differences in opportunity costs lead to the potential gains from trade. Gains from trade are a focus of this chapter and of Chapter 4, and these are presented as the ability to achieve consumption bundles that are beyond the domestic production possibilities curves. The chapter addresses the difference between the national interests and the interests of specific workers and firms in its discussion of competitive advantage and economic restructuring. Students sometimes have difficulty distinguishing between absolute and comparative advantage so more practice with specific cases may be helpful. End-of-chapter questions give students practice calculating and comparing opportunity costs to determine comparative advantage and terms of trade. Students also have trouble with real-world issues related to absolute advantage and economic nationalism. The case study on the Republic of Korea points out that in the real world, factors of production are combined to produce output and that it is productivity that matters, not differences in nominal wages. This is a good transition to Chapter 4, as is the discussion of the difference between national well-being and individual well-being. Chapter 4 will focus on understanding the income differences that result from trade, so some extension of the model now may facilitate the transition to this material.

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Assignment Ideas

The International Trade Administration in the Department of Commerce keeps an up-to-date Web site with the easiest to access U.S. trade data. See http://tse.export.gov for their Trade Stats Express site. Data are also provided for state exports. (Everything you might want to know about these data series, and then some, is available on the Census Bureau’s Web site in their Foreign Trade section. See http://www.census.gov/foreign-trade/guide/sec2.html for a complete description of data, collection methods, measurement issues, and other background information.) Using the Trade Stats Express page: • What are the leading U.S. exports and imports in terms of value? • Is there a pattern? That is, in what kinds of goods does it look like the United States might have a comparative advantage? .

Chapter 3

Comparative Advantage and the Gains from Trade

• Which trading partners are most important to the United States? This can be measured in terms of total exports, total imports, or total exports plus imports. • Which countries have the largest trade deficits and trade surpluses with the United States? 2.

A sample problem: Foodland Production Possibilities at Full Employment Food (Billions of Bushels)

Computerland Production Possibilities at Full Employment

Point

Food (Billions of Bushels)

Computers (Millions)

4.5

1.5

Point

Computers (Millions)

a. Draw the production possibility curve for each country using the data provided in the table. b. Which country has an absolute advantage in what product? Which country has a comparative advantage in what product? Show your work! c. Without trade, what is the price of food in terms of computers for both countries? Show your work! d. What is the range of prices (i.e., the CPC) at which trade can occur? Also, show (a) the possible CPC for each country and (b) the possible production and consumption possibility lines for both countries after trade. Show your work! e. What happened to employment? Answers: c. d. e.

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2 1 = 2; Computerland: PCF = . 1 1.5 2  PWF  0.67. See Figure 3.4 in the text.

Foodland: PCF =

Foodland specializes in food. This means that the firms and workers engaged in computer production would lose while those engaged in food production would gain. The opposite applies to Computerland. In other words, specialization may inevitably lead to economic restructuring. The losers would complain and may engage in rent-seeking behaviors. Both countries are better off if the benefits outweigh the costs (after specialization). The rent-seeking behaviors would be minimized or eliminated if a mechanism could be found so that the winners could compensate the losers.

Answers to End-of-Chapter Questions

Gerber • International Economics, Seventh Edition

Use the information in the table on labor productivities in France and Germany to answer questions a through f.

Cheese Cars a. b. c. d. e. f.

Output per Hour Worked France Germany 2 kilograms 1 kilogram 0.25 0.5

Which country has an absolute advantage in cheese? In cars? What is the relative price of cheese in France if it does not trade? In Germany? What is opportunity cost of cheese in France? In Germany? Which country has a comparative advantage in cheese? In cars? Explain your answer. What are the upper and lower bounds for the trade price of cheese? Draw a hypothetical PPC for France and label its slope. Suppose that France follows its comparative advantage in deciding where to produce on its PPC. Label its production point. If the trade price of cars is 5 kilograms of cheese per car, draw a trade line (CPC) showing how France can gain from trade.

Answers: a. France has the absolute advantage in cheese and Germany in cars. This follows because France’s productivity is higher in cheese and Germany’s is higher in cars. b. The autarkic relative price of cheese in France is one-eighth car per kilogram; in Germany it is one-half car. c. Opportunity costs are equal to relative prices. d. France has a comparative advantage in cheese because its opportunity cost is lower (one-eighth car versus one-half car in Germany). By the same reasoning, Germany has a comparative advantage in cars. e. The trade price of cheese will settle between one-eighth and one-half car per kilo. f.

Chapter 3

Comparative Advantage and the Gains from Trade

Suppose the table in Problem 1 looks as follows. Use the information to answer questions a through f. Output per Hour Worked France

Germany

Cheese

1 kilogram

2 kilograms

Cars

0.25 car

2 cars

Answers: a. Germany has an absolute advantage in both cheese and cars. b. 1 cheese = 0.25 car in France; 1 cheese =1 car in Germany c. same as Part (b). d. France has a comparative advantage in cheese because its opportunity cost in terms of cars is lower (0.25 car vs. 1 car); Germany has a comparative advantage in car production (1 cheese vs. 4 cheese). e. The trade price of cheese will settle between 0.25 car and 1 car. f.

Explain how a nation can gain from trade even though not everyone is made better off. Is this a contradiction? Answer:

This is not a contradiction. The gains from trade imply that the winners could compensate the losers completely and still have gains left over. Some people may lose jobs (in the example in the text, as the United States moved toward specialization in steel, American workers were shifted out of the bread industry and into the steel industry), but others benefit from the higher demand for their product (workers in the steel industry). As long as the winner’s gains are greater than the loser’s losses, we can conclude that the nation wins.

Economic nationalists in developed countries worry that international trade is destroying the national economy. A common complaint is that trade agreements open the economy to increased trade with countries where workers are paid a fraction of what they earn at home. Explain the faulty logic of this argument. Answer:

The error in logic is the failure to take into account the differences in productivity. The low-wage workers in less developed countries in general are paid less because they produce less output during each hour of labor. Furthermore, the developed nations and

Gerber • International Economics, Seventh Edition

the less-developed nations are not in competition for economic growth. Growth in one country benefits the other through an increase in the demand for its products. Economic nationalists tend to view trade as a zero-sum game in which one side loses and the other wins. 5.

Many people believe that the goal of international trade should be to create jobs. Consequently, when they see workers laid off due to a firm’s inability to compete against cheaper and better imports, they assume that trade must be bad for the economy. Is this assumption correct? Why, or why not? Answer:

The goal of trade is to improve a nation’s allocation of its resources so they are directed to their most valuable use. Trade is not about creating jobs, but is about raising the standard of living through a more efficient allocation of resources. Trade may cause workers to become laid off if they are in inefficient industries that do not produce according to the national comparative advantage. While this may be hard on the people who lose their jobs, it also frees up labor and capital so it can be directed to better uses.

Suppose that Germany decides to become self-sufficient in bananas and even to export them. In order to accomplish this, large tax incentives are granted to companies that will invest in banana production. Soon, the German industry is competitive and able to sell bananas at the lowest price anywhere. Does Germany have a comparative advantage? Why, or why not? What are the consequences for the overall economy? Answer:

Government subsidies can lower the cost of production but they will not change the productivity of banana production. The labor and capital that is pulled into banana production are pulled out of the production of some other good. There is nothing in the tax incentives that changes the relative price or opportunity cost of bananas. Hence Germany does not have a comparative advantage even though the tax incentives allow firms to sell their output at competitive prices. The consequence for the economy is that labor and capital are used up in a relatively inefficient endeavor and are less available for use in the production of goods where Germany does have a comparative advantage. Hence overall economic welfare falls, even though the banana producers are doing well. Resources that are used for the tax incentives are diverted from some other program, creating an additional opportunity cost.

Chapter 4 Comparative Advantage and Factor Endowments ◼

Outline

Introduction: The Determinants of Comparative Advantage Modern Trade Theory The HO Trade Model Gains from Trade in the HO Model Trade and Income Distribution The Stolper-Samuelson Theorem The Specific Factors Model Case Study: Comparative Advantage in a Single Natural Resource Empirical Tests of the Theory of Comparative Advantage Extension of the Heckscher-Ohlin Model The Product Cycle Case Study: United States-China Trade Foreign Trade versus Foreign Investment Off-Shoring and Outsourcing Case Study: Off-Shoring by U.S. Multinational Corporations Migration and Trade The Impact of Trade on Wages and Jobs Case Study: Do Trade Statistics Give a Distorted Picture of Trade Relations? The Case of the iPhone 3G

Gerber • International Economics, Seventh Edition

◼ Learning Objectives After studying this chapter, students will be able to: 4.1 Use the Heckscher-Ohlin Trade Model to analyze trade patterns between two countries with two inputs and two outputs. 4.2 Predict the impacts on different factors of production of trade-opening. 4.3 Discuss the limits of the HO model. 4.4 Explain the trade-offs for firms between trading and investing internationally. 4.5 Give examples of the determinants of international migration and its impact on comparative advantage. 4.6 Describe the controversies surrounding the impact of international trade on wages and jobs.

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What Students Should Know after Reading Chapter 4

Chapter 4 introduces the Heckscher-Ohlin and related models. The primary goal is to present the factor proportions theory of the determinants of comparative advantage. A secondary goal is to understand the effects of trade on the owners of factors of production. The Stolper-Samuelson and the specific factors models allow students to consider the income distribution effects of trade. Students are walked through a simple application that synthesizes the debates surrounding NAFTA and shows how these models can be used to think about the distributional impacts of the agreement. Product cycle theory is presented not as an alternative to comparative advantage but as an extension of how comparative advantage might change over the life cycle of a product. This extension applies to intra-firm trade as well, although the focus is on why a firm would choose foreign investment rather than foreign trade. The goal in presenting both models is to put them into the context of traditional trade theory. The discussion of intra-firm trade focuses on Dunning’s OLI (ownership-location-internalization) theory. Ownership gives firms an asset that leads to a competitive advantage. Location refers to the fact that firms will seek a production location that gives them advantages. Internalization is the firm’s attempt to capture all the advantages of owning the asset. Firms decide whether to invest abroad or whether to trade from their present location. Since comparative advantages may differ by location and firms are internationally mobile, intra-firm trade does not contradict trade theory. The case study of U.S.-China bilateral trade illustrates the discussion.

Chapter 4

Comparative Advantage and Factor Endowments

Outsourcing and off-shoring are both discussed in this chapter. Outsourcing and off-shoring are often confused in popular discussion. It is useful to emphasize the differences in class so students can correctly use the terms. Note that firms can practice any combination of off-shoring and outsourcing: outsource but not off-shore, or vice versa, or do both or neither. Off-shoring has grown as global production chains have expanded and with advances in communications technology. Both concepts are controversial in the public’s opinion, but less so for economists. The final case study that ends the chapter tries to make clear that off-shoring and the development of global production chains are calling into question many of our assumptions about bilateral trade balances. Migration is also discussed, including the simple model of the factors that influence the decision to migrate: social networks, demand-pull factors, and supply-push factors. HO theory assumes labor cannot migrate so immigration suggests the possibility that comparative advantage may shift due to migration. The text concludes that in most circumstances immigrant labor either flows into non-tradeable production or supplements what was already in place in the economy, so migration has not caused shifts in long-run comparative advantage. This discussion on migration introduces terms that will be used later in the text. Finally, the chapter tackles the issue of manufacturing job losses in the United States and Europe. Two key points about jobs and wages are stated here and throughout the remainder of the book. First, for a given population size, the number of jobs in our economy is dependent on macro policies and labor market policies; the impact of trade is miniscule by comparison and affects the composition rather than the number of jobs. A majority of the reduction in manufacturing jobs in all industrial countries appears to have resulted from increasing productivity, not trade, although in recent years the consensus among economists seems less firm. Second, wages depend on productivity. While trade may have caused some of the decline in wages for the less-skilled workers, the primary culprit is technological change, which has reduced the role of unskilled and semi-skilled workers in manufacturing.

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Assignment Ideas

With the ratification and implementation of CAFTA in 2005, the Dominican Republic and a number of small Central American countries now have a free trade agreement with the United States. Have students look at the patterns of trade between the United States and these countries and write a short paper using the Heckscher-Ohlin Theorem to predict the winners and losers in a more open trade relationship. They might also look at the potential impact on Mexican trade from this agreement.

A more general assignment would be to ask students to pick a country, to identify its key resources and its major exports and imports, and to decide whether the country’s trade pattern supports the Heckscher-Ohlin Theorem. You can vary the nations over the class or let students pick a country based on personal interests. They can report their findings in an oral presentation or a paper. For courses with an online component, this could be a Web page/Web posting exercise. This could be extended to include the product cycle (or intraindustry trade as described in Chapter 5). Or, you could ask them to look more deeply at a specific bilateral trade pattern, such as the U.S.-Mexico trade pattern addressed in the text.

Gerber • International Economics, Seventh Edition

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Answers to End-of-Chapter Questions

1. According to the following table, which country is relatively more labor-abundant? Explain your answer. Which is relatively more capital-abundant? United States

Canada

Capital

40 machines

10 machines

Labor

200 workers

60 workers

Answer:

The capital-labor ratios are 1/5 and 1/6 for the United States and Canada. Since 1/5 is greater than 1/6, the United States is capital abundant. By the same reasoning, the labor-capital ratio is higher in Canada, so it is labor abundant.

2. Suppose that the United States and Canada have the factor endowments given in the table in Question 1. Suppose further that the production requirements for a unit of steel is 2 machines and 8 workers, and the requirement for a unit of bread is 1 machine and 8 workers. a. Which good, bread or steel, is relatively capital-intensive? Labor-intensive? Explain your answer. b. Which country would export bread? Why? Answers: a. The capital-labor ratio to make steel is 1/4; to make bread it is 1/8. Hence steel is more capital intensive and bread is more labor intensive. b. Since the United States is capital abundant and steel is capital intensive, according to the Heckscher-Ohlin trade model, the United States will export steel and Canada will export bread. 3. Suppose that before trade takes place, the United States is at a point on its PPC where it produces 20 loaves of bread and 20 units of steel. Once trade becomes possible, the price of a unit of steel is 2 units of bread. In response, the United States moves along its PPC to a new point where it is producing 30 units of steel and 10 loaves of bread. Is the country better off? How do you know? Answer:

The United States is definitely better off because it can consume a greater quantity of both goods. If it traded five steel for 10 bread it would have 20 bread and 25 steel. This is the same amount of bread as before trade, and five more units of steel. It can keep the extra five steel, or trade some or all of them for additional bread. In either case, the consumption bundle is greater than it was before trade.

4. Given the information in Questions 1 and 2, explain what happens to the returns to capital and labor in each country after trade begins. Answer:

The changes in the returns to capital are different by country. In the United States, the demand for capital increases because more steel will be produced; conversely, the demand for labor falls because of the drop in bread production. Owners of capital benefit from the increase in demand for their inputs, while owners of labor suffer a decline in their returns (wages). In Canada, the effects are reversed.

Chapter 4

Comparative Advantage and Factor Endowments

5. Suppose that there are three factors: capital, labor, and land. Bread requires inputs of land and labor, and steel requires capital and labor. a. Which factors are variable, and which are specific? b. Suppose Canada’s endowments of land and capital are 10 capital and 100 land, and the United States’ are 50 capital and 100 land. Which good does each country export? c. How does trade affect the returns to land, labor, and capital in the United States and in Canada? Answers: a. Labor is the variable factor and capital and land are specific. b. Canada is land abundant relative to the United States (100/10 is greater than 100/50), so Canada’s comparative advantage is in the export of bread, the good with the specific input of land. The United States’ comparative advantage is steel. c. In the United States, owners of land are hurt by trade, owners of capital benefit, and the effects on labor are indeterminate. The latter effect depends on labor’s preference for bread and steel. In the United States, bread prices fall, but steel prices rise. In Canada, owners of land benefit from trade, owners of capital are hurt, and the effects on labor are indeterminate. The latter effect depends on labor’s preference for bread and steel. In Canada, bread prices rise, but steel prices fall. 6. Describe the changes in production requirements and the location of production that take place over the three phases of the product cycle. Answer:

In the first phase, all production is in high-income countries. The input requirements include relatively large amounts of scientific and engineering skills, marketing expertise, and access to risk capital. Experimentation with new products depends on access to highincome consumers, and competitive pressures require a quick feedback from consumers to producers. The new products tend to be highly variable in their design and performance characteristics, and experimentation is important in finding the right combination of prices, options, and quality. In the second phase, some standardization is taking place, along with some sales of the product in developing countries. The early period of intense experimentation is over and firms are beginning to settle on the lowest-cost production technologies. Production is migrating overseas, where labor costs are lower. In the final phase, experimentation with design and manufacturing technologies is over, the product is completely standardized, and the input requirements are more heavily biased towards unskilled or semi-skilled labor. Much of the production can be accomplished in assembly operations, which can be located in low-wage countries. By the third phase, most of the production has left the high-income countries except in the cases where product differentiation can continue.

7. Does intrafirm trade contradict the theory of comparative advantage? Why or why not? Answer:

No, in general it does not, but it may in some cases. Most intrafirm trade can be understood as a firm that cuts up its production process into several distinct stages, and then relocates some or all of the stages to different countries where the factor endowments are consistent with the production requirements of each stage. Laborintensive production stages will be relocated to labor-abundant countries, and so forth.

Gerber • International Economics, Seventh Edition

In this case, firms are taking advantage of the comparative advantage of different nations in order to produce their goods at the lowest overall cost. In some cases, however, there may be other motives for locating a production stage in another country. These motives include the desire to avoid trade barriers by producing all or part of a good inside the country where sales are anticipated, the desire to escape taxation, the attempt to deter market entry by a rival firm, and as insurance against unforeseen events (e.g., political instability). 8. General Motors is a U.S.-based multinational, but it is also one of the largest car manufacturers in Europe and South America. How might Dunning’s OLI theory explain the trade-offs GM faced as it decided whether to export to those two markets or to produce in them? Answer:

Transportation costs are significant in the auto sector, meaning that producing close to the final market can have cost advantages. The European market may have design preferences that are different from the U.S. market (i.e., driving on the right side of the road, fuel economy given higher gas prices, higher speed limits, and the need for power on highways… ). This would give advantages to a production location with more direct access to the final market. Other auto manufacturers that could handle production are GM’s direct competition, making GM unlikely to choose licensing and a sharing of its manufacturing, design, and technology.

9. Many domestically owned apparel manufacturers buy their garments overseas, sew their labels into them, and then sell them abroad or back into the home market. What are some of the considerations that a clothing manufacturer might go through to choose this strategy instead of producing at home and exporting? Answer:

These firms perceive their asset to be their brand. This may involve some elements of design (ordering specific output from foreign suppliers) but also could involve quality. It can be based strictly on marketing and advertising, creating an image from something that is in the end relatively cheap and easy to create. Allowing foreign firms the ability to brand the clothes through licensing makes them lose control of this asset. Sewing labels in allows some element of quality control while reducing production costs. Garment assembly is relatively labor intense and low skill, making it more likely to occur in lessdeveloped, labor-abundant countries. Design, marketing, and access to high-spending consumers are more likely to be assets of firms in developed countries. Owning an assembly operation directly is not necessary for them to preserve this asset as long as they have ultimate control over what they put their name on and how that product is distributed and marketed.

10. Suppose Spain were to open its doors to a large number of unskilled Africans seeking to immigrate. In general, what effects would you expect to see in Spain’s trade patterns and its comparative advantage? Answer:

In theory, labor becomes more abundant and Spain’s comparative advantage could shift to more unskilled, labor-intense production. In practice, this labor inflow may be used to produce services that are not traded. They may free up citizens to work in the already existing export sector and have little effect on comparative advantage.

Chapter 5 Beyond Comparative Advantage ◼

Outline

Introduction: More Reasons to Trade Intraindustry Trade Characteristics of Intraindustry Trade The Gains from Intraindustry Trade Case Study: United States and Canada Trade Trade and Geography Geography, Transportation Costs, and Internal Economies of Scale Case Study: The Shifting Geography of Mexico’s Manufacturing External Economies of Scale Trade and External Economies Industrial Policy Industrial Policies and Market Failure Industrial Policy Tools Case Study: Clean Energy and Industrial Policy Problems with Industrial Policies Case Study: Do WTO Rules Against Industrial Policies Hurt Developing Countries?

Gerber • International Economics, Seventh Edition

◼ Learning Objectives After studying Chapter 5, students will be able to: 5.1 Give examples of interindustry and intraindustry trade. 5.2 Compare and contrast internal and external economies of scale. 5.3 Analyze the effects of international trade in a monopolistically competitive market. 5.4 Describe the gains from intraindustry trade. 5.5 Explain how transportation costs and internal economies of scale help determine firm location decisions. 5.6 Present the pros and cons of industrial policies.

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What Students Should Know after Reading Chapter 5

One of the main objectives of Chapter 5 is to show that a large share of international trade is intraindustry trade and to describe why this trade occurs. Intraindustry trade is not based on comparative advantage since it consists of the export and import of similar products; rather, it is based on economies of scale and product differentiation. Because a large share of world trade is between industrialized countries with similar factor endowments, understanding intraindustry trade is important in explaining real-world trade patterns. Understanding the source of economies of scale (internal or external) and how that affects firm behavior is also emphasized. Internal economies of scale may lower costs for existing firms and domestic consumers, creating a win-win situation and making this type of trade less controversial. Internal economies of scale may result from (1) ability to spread fixed costs over a larger market; (2) capabilities for better engineering and marketing associated with larger firms; (3) capabilities by larger firms to conduct R&D for better machines and tools; and (4) increasing specialization of labor in larger firms, etc. External economies of scale may come from regional agglomerations of firms. The decrease in costs from an agglomeration may be caused by: (1) knowledge spillovers that help keep all firms abreast of the latest technology and newest developments; (2) the presence of a large number of producers in one area helping to create a deep labor market for specialized skills (thereby reducing search costs); and (3) a large concentration of producers leading to a dense network of suppliers with high levels of specialization. This explains why some industries are clustered (Silicon Valley for computers and software products, Hollywood for film production, etc.). The text directly incorporates the monopolistic competition model in this chapter, and discusses scale economies and their impact on the geography of production. The case study on Mexico’s manufacturing sector describes its shift from an inward set of industrial development policies, which implicitly favored production for the domestic market, and reinforced the growth of Mexico City and the concentration of firms around the major metropolitan areas (Mexico City, Monterey, Guadalajara), to a new outward.

Chapter 5

Beyond Comparative Advantage

orientation in the 1980s (pre-NAFTA). This shift from inward to outward policies was an important factor in the concentration of firms on the border with the United States where they are nearer the new, larger market. The chapter bridges from external economies to industrial policy by explaining how small differences in initial conditions can lead to large differences in outcomes because of scale economies. The example focuses on U.S. agglomerations for aircraft production. European nations used subsidies and other interventions to help Airbus become competitive against the U.S. cost advantages. Chapter 5 addresses both the justifications for industrial policy (market failures) and also the challenges facing governments when they try to intervene in any way that might possibly improve on market allocations. While Chapter 5 tries to convey a sense of the range of industrial policies, its real goal is to impress upon students the difficulties that stand in the way of implementing an efficient and cost-effective industrial policy. Spending $100 million to capture $50 million of external benefits is a real possibility when information is scarce. Chapter 5 does not argue against industrial policies per se; the real point is to acknowledge the difficulties that policy makers face when they try to create industrial policies and the rent-seeking activities of firms advocating for those policies. Governments probably better serve national interests by providing the basic components of a well-functioning economy, such as education, stable institutions, the rule of law, etc., and leaving questions of what to produce to the market. Chapter 5 concludes with a new case study that examines the relationship between industrial policies and trade rules set forth in the Uruguay Round of the GATT agreement. This material reflects the commonly heard complaint that the new agreements on intellectual property, investment, and subsidies, limit the abilities of developing countries to use some of the same policies that today’s high-income countries used while they were industrializing. There is not a clear consensus as to the harm or benefits of these new agreements, and students may find the discussion both informative and useful.

◼

Assignment Ideas

Ask students to analyze bilateral trade between two nations that have similar factor endowments. Which items seem to be intraindustry trade? Which items seem to be interindustry trade? In percentage terms, how much of the top-ten exports/imports are intraindustry trade? Has any political or media attention been paid to this bilateral trade pattern, and if so, in what areas? (Assuming different students focus on U.S. bilateral trade with different nations there may be some variation in answers that could support the general idea that interindustry trade is more controversial because it necessarily creates winners and losers.)

Have students choose an industrial policy and analyze it according to the criteria given in Chapter 5. Begin with a description of the policy and then focus on whether the policy is justified. In particular, for what market failure is the policy designed to compensate? Does the description of the policy address this issue? Are there justifications for this particular industry and not for others? Finally, what are the reciprocal obligations of the industry? Is it required to invest its own resources? Are limits placed on its scope of action so that it cannot simply accept any assistance without meeting some criteria for using the assistance?

Given the case study on commercial aircraft, students could seek information on the latest developments in the trade disputes.

Gerber • International Economics, Seventh Edition

◼

Answers to End-of-Chapter Questions

What is intraindustry trade how is it measured, and how does it differ from interindustry trade? Are the gains from trade similar? Answer:

Intraindustry is international trade of products made within the same or similar industries, for example, car-for-car, beer-for-beer, etc. Differentiated products, which are characteristics of monopolistic competition and often oligopoly, lead to trade between nations with commodities in the same industry. Homogeneous goods, therefore, would not make any sense for intraindustry trade. It is measured by examining the trade in similar products from each country; the more aggregated the industry categories, the more intraindustry trade there will appear to be, so the data must be at a very disaggregated level to accurately measure the amount. Thus the definition of an industry is important. Interindustry trade is international trade of two or more different products, for example, car-for-bread. Interindustry trade can be explained by comparative advantage. One of the distinguishing characteristics of intraindustry trade is the presence of internal economies of scale with falling average costs over a relatively large range of output. The presence of internal economies of scale is why firms want to enter export markets. Exports enable firms to realize lower average costs and be competitive both internally and externally. This is one of the gains from intraindustry trade, and this gain contrasts with comparative-advantage-based trade because domestic consumers of the exported product also gain. Consumers gain since competition forces firms to pass on their lower costs to them. Intraindustry trade would also expand the number of firms, thereby enhancing competition and the variety of goods available for consumers.

2. Comparing U.S. trade with Germany and Brazil, is trade with Germany more likely to be based on comparative advantage or economies of scale? Why? Answer: Trade with Germany is more likely to be based on economies of scale since it consists of the export and import of similar products and occurs mostly in countries that have similar productivity, technology, and factor endowments. Trade with Brazil is likely to be based on comparative advantage since Brazil’s productivity, technology, and factor endowments are not similar to the United States. 3. What are the differences between external and internal economies of scale with respect to (i) the size of firms, (ii) market structure, and (iii) gains from trade? Answers: i. An external economy of scale exists when the fall in the average costs of the industry lowers the average costs of the typical firm. With external economies, the size or scale effects are located in the industry, and NOT THE FIRM. Thus, even though the size of each firm in the industry does not increase, the industry expands due to declining costs. There are just more firms in the expanding industry. This could be due to the entry of more firms as existing firms realize economic profits, or it could be due to the splitting of existing firms into different firms with increasingly narrow specialization. Thus with external economies of scale, the firms are expected to be small in size. With internal economies of scale, the cause for the expansion of a firm’s size is its own declining average costs. That is, the size or scale effects are located in the firm, and NOT IN THE INDUSTRY. Average costs of the firm decline as output expands. .

Chapter 5

Beyond Comparative Advantage

This usually leads to larger firms because size confers a competitive advantage in the form of lower average costs.

Gerber • International Economics, Seventh Edition

ii. As mentioned above, with external economies of scale the scale effects are located within the industry, and not within the firm. The potential for external economies of scale gains leads firms to concentrate in specific regions. The market structure in this case is agglomerations. On the other hand, declining average costs within internal economies of scale invite outsiders to enter the industry. With internal economies of scale, there is also the potential for products to be similar but differentiated. This industry structure, called monopolistic competition, exists when a large number of firms compete with each other to produce a variety of goods. Monopolistically competitive structures may also be the result of modest gains from internal economies of scale. On the other hand, the scale economies could be substantial with internal economies of scale. If so, some firms have room to grow since they would be able to exploit this situation for further expansion, market control, and even domination. Therefore, internal economies of scale may lead to an oligopoly market structure. On the extreme, a single firm may serve the entire (world) market. This kind of market structure is called a monopoly. This suggests the possibility of more than one long-run industry equilibrium condition (multiple equilibria). iii. Intraindustry trade is a byproduct of internal economies of scale. As explained in the text, the benefits include: (a) lower prices passed on to consumers by monopolistically competitive firms enjoying economies of scale; (b) lower prices passed on to consumers when international trade leads to an increase in firms; (c) increases in consumer choice due to international trade, etc. Unfortunately, the gains from trade are less certain (even harmful) with external economies of scale, which hypothetically could lock in production in less efficient countries and prevent the development of production in a more efficient country. This is partly due to historical accidents rather than efficiency advantages in trade patterns. 4.

What are the three key incentives for firms in a particular industry to cluster together in geographical region? Answer:

How might trade hurt a country if it imports goods that are produced under conditions of external economies of scale? Answer:

These are: (1) large pool of skilled labor, which reduces the search costs and encourages high degrees of labor specialization, (2) specialized suppliers of inputs, which helps firms hold down their costs by reducing their transportation and informational costs, and (3) knowledge spillovers due to information exchange through formal and informal networks of people.

Trade may stifle the development of new industries that could be more efficient than the existing ones, reducing global efficiency. This could be due to a historical accident of an initial head start, or trade otherwise gives a scale advantage to already existing firms in one country. The initial head start creates efficiency advantages for the existing firms. This happens for a number of reasons, such as (a) better developed linkage between the already existing producers and their suppliers, and (b) lower prices offered by the firms enjoying external economies of scale.

When the United States signed a free trade agreement with Canada (1989), no one in the United States thought twice. When the agreement with Mexico was signed (1994), there was significant opposition. Use the concepts of interindustry and intraindustry trade to explain the differences in opposition to the two trade agreements.

Chapter 5

Answer:

Beyond Comparative Advantage

Canadian productivity, technology, and factor endowments are more or less comparable with those of the United States. Consequently, trade between the United States and Canada is intraindustry rather than interindustry trade. As shown in Question 3, there are quite a few benefits from intraindustry trade. On the other hand, trade with Mexico is likely to be based on comparative advantage (interindustry trade) since Mexico’s productivity, technology, and factor endowments are not similar to those of the United States. Consequently, there were possibilities for Canada and Mexico to lose in the production of goods and services for industries in which that they didn’t have comparative advantage. Since unskilled labor is relatively scarce in the United States, jobs that did not require high-skilled labor, abundant capital, and sophisticated technology would have gone to Mexico. This was one of the fundamental reasons why people in the United States were against NAFTA. On top of this, politicians incorrectly portrayed NAFTA, despite the fact that trade can create as well as destroy jobs. Further, the United States benefited from the production of goods and services that required skilled labor, abundant capital, and sophisticated technology. Some Mexicans saw this as unfair, and rebelled.

7. What are the theoretical justifications for targeting the development of specific industries? Answer:

The primary justification is to counteract a market failure. Although market failures come in all shapes and sizes, all imply that markets do not result in the optimal allocation of resources—either producing too much or too little. Industrial policies are mostly concerned with cases where too little (or none) of a good is produced. Market failures also imply that the social returns of an activity are not the same as the private returns. When markets produce too little, social returns are greater than private returns and the social optimum involves higher levels of output. Theoretically, the reasons for too little production may be due to the following: (1) when skills and/or technologies spill over into the economy beyond the firms that create them. This occurs when information leaks out of the first entrant firms about production, technological, and marketing feasibilities. When this occurs, the social returns are higher than private returns. (2) when capital market imperfections result in inadequate investment capital. According to this argument, new firms may face difficulties in attracting sufficient new startup capital. They also face inadequate financing opportunities for research and development. Targeting specific industries, therefore, is important. A second justification for industrial policies is strategic trade policy, where it is theoretically possible to capture above-normal profits earned by a foreign firm. In order for strategic trade to be relevant, the industry must have very strong economies of scale and firms must have market power.

Gerber • International Economics, Seventh Edition

8. What are some of the common problems in implementing industrial policies? Answer:

They are: (1) the difficulty of obtaining information necessary to measure the extent of market failure, and choosing which industry to target; (2) knowing the optimum amount of resources (costs) to provide the targeted industry; (3) encouraging rent-seeking behavior (which may require the hiring of lobbyists, economists, etc.) by firms in other industries. This activity uses up resources without adding to total output. (4) containing the external benefits of R&D spending within national boundaries. If the benefits of R&D spending are not kept within national boundaries, the benefits are partly captured by foreign firms.

Figure 5.3 in the text illustrates the case of an industry that generates external social benefits with its production. Draw a supply and demand graph for an industry that creates external costs with its production. Compare and contrast the market determined price and output level with the socially optimal price and output levels. Answer:

In a negative externality the social returns are less than private returns, so a free market produces more than the optimal amount (Q2 instead of Q1 in Figure 5.3). This is because producers fail to take into account the external costs when calculating their costs of production (and if they do, they will produce less than the optimal amount). As a result, the marginal private cost is less than the marginal social cost. Consequently, Spriv in Figure 5.3 should be labeled as Ssoc and the two-way arrow line connecting the two supply curves must be labeled as “External Costs.” Producers charge P2 instead of P1.

Chapter 6 The Theory of Tariffs and Quotas ◼

Outline

Introduction: Tariffs and Quotas Analysis of a Tariff Consumer and Producer Surplus Prices, Output, and Consumption Resource Allocation and Income Distribution Case Study: A Comparison of Tariff Rates Other Potential Costs Retaliation Innovation Rent-Seeking The Large Country Case Effective versus Nominal Rates of Protection Case Study: The Uruguay and Doha Rounds Analysis of Quotas Types of Quotas The Effect on the Profits of Foreign Producers Hidden Forms of Protection Case Study: Intellectual Property Rights and Trade

Gerber • International Economics, Seventh Edition

◼ Learning Objectives After studying this chapter, students will be able to: 6.1 Use supply and demand analysis to explain and illustrate consumer and producer surplus. 6.2 Graphically demonstrate the effects of tariffs and quotas on prices, output, and consumption for small and large countries. 6.3 Differentiate and explain the resource allocation and income distribution effects of tariffs and quotas. 6.4 Use tariff data on inputs and outputs to compare effective and nominal rates of protection. 6.5 Compare and contrast quotas and tariffs.

◼

What Students Should Know after Reading Chapter 6

Chapter 6 introduces students to tariffs, quotas, and non-tariff measures. Tariffs are addressed first, using the tools of consumer and producer surplus in a simple partial equilibrium setting to show the effects of tariffs on resource allocation and income distribution. Deadweight losses from tariffs are identified, and a distinction is drawn between consumption losses and efficiency losses. Other potential costs of tariffs, including retaliation, lack of incentives for innovation, and rent seeking are addressed. The chapter illustrates the possibility for large countries to potentially gain from tariffs and explains the difference between nominal and effective rates of protection. A case study compares tariffs for high-income and low-income countries within the framework of the Doha negotiations. Quotas are introduced and are explicitly contrasted with tariffs, both in terms of their transparency and in terms of their revenue effects and deadweight losses. Quotas, import licenses, and voluntary export restraints are all presented. The last part of the chapter addresses other non-tariff measures. Examples and the problem of interpreting whether a measure is protectionist or serves the public interest are identified. A case study on intellectual property rights describes both the benefits and the potential costs of enforcement through TRIPs. Subthemes to develop could include the lack of overall coordination of trade protection and problems of transparency. Transparency is addressed in terms of the mechanisms of protection, but it can be extended to non-tariff barriers to trade. When is a health law motivated by market failure and when is it protection? The fact that individual trade laws are based on special interests and assembled piecemeal over time means that they often don’t have the intended effects. Barriers in one sector sometimes undermine the goals of barriers in another sector, and it is often difficult to separate protectionist measures from measures that are implemented for entirely different reasons. Note that the WTO’s Web site has extensive tariff data and information on other forms of import protection. See http://www.wto.org, click on Resources, then Trade and Tariff Data. The trade profiles section for individual countries also provides information on bound and applied rates, as well as the share of trade subject to non-tariff measures.

Chapter 6

The Theory of Tariffs and Quotas

◼

Assignment Ideas

Have students research trade barriers that are important to a specific industry. These could be assigned by country or at a multilateral level. Students could be asked to create a briefing for use in lobbying U.S. governmental officials prior to multilateral trade talks. If this industry wants to increase its exports, which international trade barriers will it want to have reduced? Are the barriers largely tariffs, quotas, or non-tariff measures?

Have students research the trade policies and trade barriers of a particular country. A number of questions can be used to guide the assignment. (See the WTO site, mentioned above.) • How high are tariffs? Are there quotas or quota-like measures? In what sectors? • Are there other non-tariff measures that the United States finds objectionable? Are there currently discussions to resolve these issues? Resources for these assignments include: i. World Trade Organization (www.wto.org). ii. Country Commercial Guides, published by the International Trade Administration of the Department of Commerce (http://www.stat-usa.gov/mrd.nsf). The Office of the United States Trade Representative (USTR) also publishes short trade profiles. See www.ustr.gov/countriesregions/countries-z. iii. National Trade Estimate Report on Foreign Trade Barriers, also published by the Office of the United States Trade Representative (http://www.ustr.gov/about-us/press-office/reports-andpublications/2012).

Suppose a domestically produced motor bicycle sells at a world price of $5,000 under unrestricted trade. The domestic producer uses $3,000 worth of imported inputs, (VA*). The $2,000 difference between the world price of the final motor bicycle and the cost of the imported components represents domestic value added (VA). Domestic value-added includes the payments made to domestic labor and capital inputs. Under restricted trade, domestic value-added cannot exceed $2,000, or the price of the domestically produced motor bicycle will exceed that of imported ones and the domestic ones will not sell. Suppose a 10 percent ad valorem (on the value) tariff is imposed on the imported motor bicycle. i. What is the domestic price of the imported motor bicycle? ii. What is the possible price of the domestically produced motor bicycle? iii. What is the domestic value-added of the imported motor bicycle (VA*)? iv. What is the effective rate of protection (ERP)? v. Is this an effective rate of protection? Why or why not? vi. What price do domestic producers pay on the imported components that they use as inputs? vii. What is the amount of the new domestic value-added after the tariff? (Note: the new value-added is the difference between the tariffed price of imported motor bicycles and the tariffed price of imported inputs used in domestic production.) viii. What is the value of the new ERP? ix. Suppose that the government decided to tax the imported inputs by the same rate (10 percent) as the finished imported good. What is the ERP under this condition? Answers: i. $5000(1 + 0.10) = $5500.

Gerber • International Economics, Seventh Edition

ii. Between $5000 and $5500. It is likely to be $5500 for two reasons: (1) the tariff effectively reduces the supply curve, thereby raising the price level, and (2) because the tariff is intended to help domestic producers, who they will charge higher prices unless demand decreases substantially. iii. It is $5500 – $3000 = $2500. iv. Applying the formula in the text, we have: ERP = (VA* − VA)/VA = ($2500 − $2000)/$2000 = 25% Hence, a 10 percent nominal tariff rate resulted in a 25 percent ERP! v. Yes, it is! As long as there is no tariff on the imported inputs, the ERP and the nominal tariff rate would always be higher than the nominal tariff rate (25 percent  10 percent). Note that the relationship between the nominal tariff and the ERP depends on: (1) the share of imported inputs in the production process, and (2) the presence or absence of tariffs on imported inputs. Suppose now that the 10 percent tariff on finished motor bicycles is accompanied by a 5 percent tariff on imported components used in the domestic production of motor bicycles. Answer the following three questions based on this proposition. vi. $3000(1 + 0.05) = $3150. vii. VA* = $5000(1 + 0.10) – $3000(1 + 0.05) = $5500 – $3150 = $2350. viii. Applying the formula: ERP = (VA* − VA)/VA = ($2350 − $2000)/$2000 = 17.5% ix. New VA* = $5000(1 + 0.10) – $3000(1 + 0.10) = $5500 – $3300 = $2200. Thus: ERP = ($2200 − $2000)/$2000 = 10%

◼

Answers to End-of-Chapter Questions

Graph the supply and demand of a good that is both produced domestically and imported. Assume that the country is not large enough to affect the world price. Illustrate the effects of a tariff on imports. Discuss the following: a. Income distribution effects b. Resource allocation effects c. Domestic production and consumption effects d. Government revenue effects e. Price of the good effects Answers: See Figure 6.3 in the text. a. The income distribution effects are a loss in consumer surplus, some of which is destroyed, but other parts of which are transferred to producers and the government.

Chapter 6

The Theory of Tariffs and Quotas

b. The resource allocation effects include a production inefficiency from the expansion of relatively higher cost domestic production. The consumption side also experiences a reduction in efficiency due to squeezing consumers, who value the good more than it costs to buy it, out of the market. c. Domestic production rises, consumption falls. d. Government revenue rises by the amount of the tariff times the number of units imported. e. The price rises by the amount of the tariff. 2.

Suppose the world price for a good is 40 and the domestic demand-and-supply curves are given by the following equations: Demand: P = 80 – 2Q Supply: P = 5 + 3Q a. b. c. d.

How much is consumed? How much is produced at home? What are the values of consumer and producer surplus? If a tariff of 10 percent is imposed, by how much do consumption and domestic production change? e. What is the change in consumer and producer surplus? f. How much revenue does the government earn from the tariff? g. What is the net national cost of the tariff? Answers: a. Using the demand curve to determine consumption, 40 = 80 – 2Q, or Q = 20. b. Using the supply curve to determine production, 40 = 5 + 3Q, or Q = 11.67. c. Consumer surplus is given by 20  (80 – 40)  1/2 = 400; producer surplus is 11.67  (40 – 5)  1/2 = 204.17. d. A 10 percent tariff raises prices by 4, from 40 to 44. Consumption moves along the demand curve: 44 = 80 – 2Q, or Q = 18. Production moves up the supply curve: 44 = 5 + 3Q, or Q = 13. e. The new value for consumer surplus is 18  (80 – 44)  1/2, or 324; hence it has fallen by 76. Producer surplus is 13  (44 – 5)  1/2 = 253.5; hence it has grown by 49.33. f. Tariff revenue is 5  4 = 20. g. The net national cost of the tariff is the combination of the efficiency loss and the consumption deadweight loss. It is equal to the lost consumer surplus minus the transfer to producers and the government, or 76 − 49.33 − 20 = 6.67. 3.

Under what conditions may a tariff actually make a country better off? Answer:

It is possible for a large country to improve national welfare by levying a tariff. The conditions that must hold are that the country is large enough to affect the world price when it imposes a tariff, and other nations must not retaliate. It is possible under these circumstances to design a tariff that raises national welfare by causing the price of imports to fall. As long as the gains from the cheaper imports are greater than the production and consumption side losses, the national welfare improves.

In addition to the production and consumption side deadweight losses, what are some of the other potential costs of tariffs?

Gerber • International Economics, Seventh Edition

Answer: Other potential costs of tariffs include the threat of retaliation and the potential loss of exports markets, the stifling of the incentive to innovate, and the encouragement of rent seeking. 5.

The Uruguay Round of the GATT began a process of phasing out the use of voluntary export restraints. Why did they come into widespread use in the 1980s? For example, given that VERs are a form of quotas, and that they create quota rents and a larger reduction in national welfare than tariffs, why did nations use them instead of tariffs? Answer: Voluntary export restraints avoid the obligations nations share under the rules of the GATT to not raise tariffs. They do not require legislative action to implement. Furthermore, VERs permitted politicians to claim they supported free trade while at the same time offering protection to special interests.

The GATT strongly favors tariffs as a protective measure over quotas or other nontariff measures. It encourages new members to convert quotas to their tariff equivalents. One of the main reasons tariffs are preferred is because they are more transparent, particularly by comparison to nontariff measures. Explain the idea of transparency, and how nontariff measures may be nontransparent. Answer: Transparency refers to the ability of everyone to easily discover and understand the rules. Tariffs are transparent because they usually are not associated with special circumstances known only to a select few. Non-tariff barriers like an outright quota may or may not be transparent. Quotas may vary according to the country trying to export; they may also be implemented in the form of import licenses that involve large amounts of red tape and unknown availability. Nontariff measures such as health and safety codes, product standards, or testing requirements can be even less well defined and pose an even greater uncertainty for firms trying to enter the market.

Suppose that bicycles are made in the United States out of a combination of domestic and foreign parts. a. If a bike sells for $500 but requires $300 of imported parts, what is the domestic value added? b. If a 20 percent tariff is levied on bikes of the same quality and with the same features, how do the price and the domestic value added change? (Assume the United States cannot cause the world price to change.) c. What is the effective rate of protection? d. If in addition to the 20 percent tariff on the final good, a 20 percent tariff on imported parts is also levied, what is the effective rate of protection for U.S. bike manufacturers? Answers: a. Value added is $500 – $300 = $200. b. The domestic price rises by 20 percent to $600; the value added is $600 – $300 = $300, hence it has risen $100. c. The effective rate of protection is (300 – 200)/200 = 0.5 = 50 percent. d. The cost of inputs rises from $300 to $360, so value added is $600 – $360 = $240. The effective rate of protection is now (240 – 200)/200 = 0.2 = 20 percent.

Chapter 7 Commercial Policy ◼

Outline

Introduction: Commercial Policy Tariffs, and Arguments for Protection Tariff Rates in the World’s Major Traders The Costs of Protectionism The Logic of Collective Action Case Study: Agricultural Subsidies Why Nations Protect Their Industries Revenue The Labor Argument The Infant Industry Argument The National Security Argument The Cultural Protection Argument The Retaliation Argument Case Study: Traditional Knowledge and Intellectual Property The Politics of Protection in the United States Antidumping Duties Countervailing Duties Escape Clause Relief Section 301 and Special 301 Case Study: Economic Sanctions

Gerber • International Economics, Seventh Edition

◼ Learning Objectives After studying this chapter, students will be able to: 7.1 Describe the differences in tariffs across economic sectors and over time. 7.2 Cite at least three reasons why economists favor trade openings. 7.3 Explain why costs to consumers of a tariff or quota are greater than the net welfare costs to a nation. 7.4 Analyze the economic validity of common justifications for protectionism. 7.5 Define each form of legal protection granted by the U.S. government.

◼

What Students Should Know after Reading Chapter 7

Chapter 7 is focused on protection in three sectors—agriculture, clothing, and textiles—by China, the European Union, the United States, and Japan. These sectors are chosen because they are among the most highly protected industries in nearly all industrial regions and because this protection potentially harms developing countries. Chapter 7 begins with a look at tariff rates in general and then proceeds to estimates of the costs based on mid-1990s data, when tariff rates were somewhat higher. From Chapter 6, students should have a theoretical basis for understanding the costs of protection. This introduction puts real numbers on the costs of protection. Perhaps for students these costs are just areas on a graph—the real magnitude should be eye-opening for many. Trade barriers are an inefficient policy for addressing employment issues, as illustrated by the high cost per job saved. The point is not to downplay the issue of economic restructuring and job losses, but rather show that trade policies are too indirect a mechanism to address labor market issues and unemployment, and that alternative policies (macro and labor market policies) must be used in their place. Students are likely hearing more in the media about the loss of U.S. manufacturing jobs than about how U.S. cotton subsidies hurt U.S. consumers and African farmers. Chapter 7 goes on to summarize the major reasons nations protect industries. The ability to raise government revenue from tariffs is addressed and most other arguments for protection can be put into one of the categories listed. The section discussing the arguments for protection ends with a short case study of traditional knowledge and intellectual property rights. A growing concern in some developing countries is that market openness is leading to the loss of control over native plants and traditional folk remedies, such as the use of the Indian spice turmeric as a healing agent. The purpose of this case study is to make students aware of a growing concern about openness. Chapter 7 ends with a brief explanation of the paths to protection that are open to American firms and industries. By far the most important, in terms of usage, are antidumping duties. A case study addresses the issue of agricultural subsidies. Finally, the issue of economic sanctions is taken up in the last case study.

Chapter 7

Commercial Policy

◼

Assignment Ideas

This material lends itself to case studies of whatever issue is currently getting the most attention politically and in the media. In the past that has included: patent protection for pharmaceuticals in developing countries, U.S. steel tariffs, agricultural subsidies when Doha negotiations and development conferences are taking place, and the loss of U.S. manufacturing jobs or “exporting America.” (Note that Chapter 13 has a time series graph of the real value added in U.S. manufacturing which clearly shows an ever-onward and upward trend, except during periods of recession. For convenience, the number of workers in manufacturing is also plotted for the same time period. It may be useful to refer to that case study. The Chapter 5 case study on off-shoring by U.S. multinationals may be useful as well.) Current commercial policy issues can be the basis of a writing assignment, a classroom discussion, a policy debate—you can ask students to take a position, to counter an argument, or to provide analysis. For all that trade benefits us, it will never cease to be controversial, so there is surely something in the news today that you can use to keep this section current.

I have students research trade disputes and look up information on the WTO Web site related to those cases. The huge number of dumping cases relative to other disputes is quite clear with a quick tour through the Web site. In particular, students with an interest in law school seem to respond well to the case studies on the WTO site: http://www.wto.org/english/tratop_e/dispu_e/dispu_e.htm.

The current status of the Doha Round might be interesting to monitor. While the Doha round seems moribund (2012), it is still officially under discussion. The Millennium Development Goals and other global agreements put trade issues front and center in global discussions about development.

◼

Answers to End-of-Chapter Questions

1. Which industries are more heavily protected in the United States and Japan? Are high-income or low-income nations more affected by American and Japanese trade barriers? Explain. Answer:

In the United States, the most heavily protected industries are textile and apparel producers and, to a lesser degree, agriculture. In Japan, protection is concentrated on agriculture and the food and beverage industry. Protection in both countries is in older, labor-intensive industries where the countries no longer have comparative advantages. The effects are greatest on low-income countries since these are the industries where they do have a comparative advantage. The failure of the United States, Japan, and other industrial nations to open their markets to the agricultural products and apparel from developing countries has deprived those nations of potential export markets.

2. What new areas of trade and investment received coverage under the agreement signed in the Uruguay Round of the General Agreement on Tariffs and Trade? Answer:

The Uruguay Round extended the GATT and created several new agreements. GATT now covers agriculture, textiles, and apparel, and new agreements were signed for the first time in the areas of trade in services, treatment of foreign investment, and the protection of intellectual property rights. In addition, the agreement created the umbrella organization called the World Trade Organization that will oversee the GATT and related agreements. The WTO also conducts periodic reviews of each nation’s trade policies, and has created a streamlined dispute resolution procedure.

Gerber • International Economics, Seventh Edition

3. Given that tariffs and quotas cost consumers and that they are grossly inefficient means for creating or preserving jobs, why do citizens allow these policies to exist? Answer:

The costs of tariffs and quotas are diffused throughout an entire nation, while the benefits are concentrated. This creates an asymmetric set of incentives to organize around the issue of trade policy. Beneficiaries of protection stand to gain a great deal and consequently find it economically worthwhile to organize in order to receive protection. Individual consumers lose just a little, so there is only a small economic incentive to organize against protectionist policies.

4. What four main groups of arguments do nations use to justify protection for particular industries? Which are economic, and which are noneconomic? Answer:

The arguments are (1) revenue, (2) the labor argument, (3) the infant industry argument, (4) the national security argument, (5) cultural protection, and (6) the retaliation argument. The first three arguments are about government revenue, jobs, and manufacturing, so they are economic arguments. Arguments 4 and 5 have economic components, but are primarily based on noneconomic considerations. The retaliation argument is perhaps more explicitly economic as well.

5.Evaluate the labor and infant industry arguments for protection. Answer:

The labor argument is based on the false assumption that lower wages automatically confer a competitive advantage to a nation. Lower wages are the most visible indicator of lower productivities. The proponents of the pauper labor argument fail to completely consider the causes of lower wages and their consequences for trade. The advantages of lower wages are offset by the lower productivity that inevitably accompanies them. The infant industry argument requires three conditions in order for it to be valid. First, there must be a technological externality that cannot be captured by the firms that produce it. Second, the protection must be limited in time. Third, it must enable the firms receiving it to experience falling costs so that the initially higher costs disappear and the low or negative rates of return are converted into normal returns. The latter condition is equivalent to requiring the policy to pay for itself in the long run.

6. Are tariffs justified as a retaliatory measure against other nations? Justify your answer. Answer:

There is no agreement among economists on this issue. One school says that tariffs make us less efficient, so they are unwarranted. If others choose to hurt their own economies, why should we follow suit? Another school says tariffs are justified if they cause the offending nation to open its markets. Trade is beneficial for all, so if they can lead to increased trade, they are warranted. The third group sees them as warranted because they worry about the unfair advantage they may grant the nation levying the tariff, particularly in high-tech industries where scale economies are important. Tariffs shut out foreign competition and grant the firms in the country access to a larger market—their own domestic market plus foreign markets. This may be an economic advantage in some industries.

Chapter 7

Commercial Policy

7. What are the four legal procedures that American firms have at their disposal for seeking protection? What are the conditions that would generate a request for each kind of protection? Answer:

The four procedures are (1) countervailing duties, (2) antidumping duties, (3) escape clause relief, and (4) Section 301 retaliation. Countervailing duties are granted in response to foreign subsidies; antidumping duties are granted when a foreign firm sells in the domestic market at a price that is considered too low (less than fair value); escape clause relief is granted as a temporary protection against sudden surges in imports; and Section 301 retaliation is used to punish a nation for some other type of practice that is perceived as conferring an unfair advantage on its firms, or in response to a lack of openness to American goods.

Chapter 8 International Trade and Labor and Environmental Standards ◼

Outline

Introduction: Income and Standards Setting Standards: Harmonization, Mutual Recognition, or Separate? Case Study: Income, Environment, and Society Labor Standards Defining Labor Standards Case Study: Child Labor Labor Standards and Trade Effectiveness Hazy Borderline between Protectionism and Concern The Specific Content of Labor Standards The Potential to Set off a Trade War Evidence of Low Standards as a Predatory Practice Case Study: The International Labor Organization Trade and the Environment Transboundary and NonTransboundary Effects Trade and Environmental Impacts That Do Not Cross Borders Trade and Transboundary Environmental Problems Case Study: Trade Barriers and Endangered Species Alternative to Trade Measures Labels for Exports Requiring Home Country Standards Increasing International Negotiations Case Study: Global Climate Change

Gerber • International Economics, Seventh Edition

◼ Learning Objectives After studying this chapter, students will be able to: 8.1 Compare and contrast the three options for setting standards in trade rules. 8.2 Give examples of the relationship between income levels and environmental and labor problems. 8.3 Define labor standards. 8.4 State four potential problems with using trade sanctions to enforce labor standards. 8.5 Compare and contrast transboundary and nontransboundary environmental problems. 8.6 Explain three alternatives to trade measures for enforcing labor and environmental standards.

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What Students Should Know after Reading Chapter 8

As formal barriers to international trade have been removed, new obstacles have appeared. National laws and regulations, which are adopted strictly for domestic reasons, unintentionally limit commerce and economic integration between nations. Conflicts emerge over different national standards. These can be technical product standards, health and safety standards, or labor and environmental standards. Firms that already produce to a given standard have a competitive advantage when that standard is more widely adopted. This fact makes countries desire a wider application of their own standards. Standards differ by income level, so wide variation in world income means wide variation in standards and the potential for conflict. People in high-income markets question the standards of low-income countries producing the products they import. Firms in high-income countries have an incentive to argue for the adoption of the standards already in place in their home markets. Harmonization of standards is one option. Mutual recognition of standards is another. Separate standards are likely to lead to trade barriers as countries refuse to recognize the practices of trading partners. Technical standards may be easier to harmonize than labor, environment, health, or safety standards. Students have certainly heard the argument that nations are engaged in a race to the bottom. Increasing attention to labor and environmental standards will continue to be part of the political discourse about trade. The charge of unfair trade is frequently raised around differing labor and environmental standards. The first problem is to define standards and the second to see if there is any evidence to support a race to the bottom. Anecdotal evidence is widespread, but it is useful to ask students to reflect about labor and environmental standards today. Do they think they are higher or lower than in 1950, for example? While

Chapter 8

International Trade and Labor and Environmental Standards

anecdotes of companies relocating to escape standards are common, and not necessarily inaccurate, the general trend appears to move in the other direction. It is also important to recognize that even where standards are otherwise “high,” agriculture is often not covered by similar labor policies or labor standards. Family farms in developing countries often employ their own children, and even in the United States the labor code exempts agriculture from many of its standards. Trade barriers are unlikely to be an effective tool for changing standards. This is partly due to the problems described in Chapters 6 and 7, but also due to fact that very few countries have enough market power to change foreign firm behavior. If firms move outside the formal economy to avoid standards, practices could actually worsen as a result of trade barriers. The borderline between concern for foreign workers and the environment and protection of domestic firms is also quite hazy. Fears of retaliation and trade wars emerge as countries begin to treat each other differently and unilaterally over standards, which is not allowed generally under WTO rules. Sanctions in general are less effective when there is not universal support for the sanction and its enforcement. Environmental problems located entirely within a specific country (non-transboundary) have the usual external cost analysis. It is in the firm’s best interests to shift environmental costs onto the nation, but it is in national interests to force firms to address their pollution externalities. While there may be some situations where firms have powerful control over national policy, in general, environmental standards in most countries have gotten tougher over time. There is strong evidence that the idea of nations becoming pollution havens is invalid. Optimal environmental standards seem to vary across nations, with countries prioritizing different types of environmental protection. Global welfare may be reduced by trying to impose a single standard that doesn’t take into account local preferences, resources, and cost structures. When environmental problems are transboundary, nations have to work together to address the problems. Unilateral action is unlikely to have any impact on the environmental problem or the practices of trade partners and may violate WTO principles. Multilateral negotiations and procedures will be necessary to address these problems. In the endangered species case, the WTO forced a multilateral solution by arranging for the United States to assist developing countries in acquiring the technology they need to meet the U.S. standard. Because labor and environmental problems are byproducts of production and consumption decisions, the optimal policies to address these problems are not trade policies, but policies aimed at the producer and consumer level. More efficient policies may include (1) labeling exports to tell consumers that the good is produced under conditions that are humane or environmentally sustainable, (2) requiring home firms to follow home country standards whenever they open foreign operations; and (3) increasing international negotiations by using existing international organizations (such as the ILO for labor), or creating new agreements and organizations for the environment.

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Assignment Ideas

Gerber • International Economics, Seventh Edition

There is a misconception by the general public, students included, that economists and organizations such as the WTO do not care about the environment. This misconception arises in part because economists disagree with people who use environmental issues, covertly or otherwise, as trade barriers. To dispel this incorrect notion, the instructor might ask students to visit the WTO “Environment Gateway” where they can find a short summary of the trade and environment debate, along with links to various cases, including the U.S.-shrimp dispute. In addition, there are sections covering the key provisions and history of environmental concerns in the GATT and WTO decisions: http://www.wto.org/english/tratop_e/envir_e/envir_e.htm. Similarly, the International Labor Organization’s home page (www.ilo.org) has a link to the issue of labor standards: http://www.ilo.org/washington/areas/promoting-international-laborstandards/lang--en/index.htm. There are a variety of documents, reports, background briefings, and other material on labor standards, cases the ILO has taken on, and their efforts to promote standards. The information available on either site may be used for a short paper as long as a clear rubric is developed, or students may be asked to summarize a part of the Web site dealing with a specific topic.

There are many international agreements on the environment. These are not part of the WTO, and some have been highly effective in addressing specific environmental problems. The Montreal Protocol, for example, has been effective at reducing CFC emissions, and the long-run trends are currently looking more hopeful for the ozone layer. Students could be assigned a specific agreement or a specific proposed agreement and report on the content and scope of that agreement. Ronald Mitchell at the University of Oregon has developed a database of International Environmental Agreements: http://iea.uoregon.edu/page.php?file=home.htm&query=static. The database attempts to cover all agreements, both historical and current. Students may be surprised to learn that the first known bilateral environmental agreement in Western history was an agreement between England and Castile, signed in 1351.

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Answers to End-of-Chapter Questions

What are the three ways for countries to handle different standards abroad? Do standards have to be the same for countries to be integrated? Answer:

The three ways for countries to handle different standards are harmonization, mutual recognition, and separate standards. Countries do not have to have the same standards to be economically integrated. In fact, requiring the same standards may pose potential problems. Harmonization standards, for example, might lead to the adoption of inferior standards and may fail to take into account income differences. By imposing undue standard requirements, a country may also fail to achieve all that is possible of its trading partners. It is generally better for trading countries to recognize each other’s standards or maintain separate standards when the level of economic development differs.

What are the advantages and disadvantages for countries that adopt the same standards? Answer:

Advantages: One possible advantage is the gain in economic efficiency from sharing the same standard. Shared standards permit manufacturers to produce a single standard rather than multiple standards, and this may allow firms to capture economies of scale. Also,

Chapter 8

International Trade and Labor and Environmental Standards

common standards have the potential to increase and expand the commercial ties between two or more countries. Disadvantages: a. Requiring the same standards may cause a loss of efficiency if the adoption of a common standard results in a locking of an inferior standard. b. For at least two reasons it may be extremely difficult, costly, or even impossible to adopt the same standards. First, there may be thousands (hundreds of thousands in the case of a fully integrated common market like the EU, for example) of goods that would require harmonization and/or the adoption of the same standards. This in turn would require the hiring of a large number of boards and committees of experts to both determine the best compromise between the existing individual national standards and develop one national standard. Second, cultural issues may be involved in the harmonization of standards. This makes the issue political and economic as well as technical. 3.

When high-definition television (HDTV) was first considered a possibility in the United States, the U.S. government held a competition to select the technical standards that would be used nationwide. Why would the government see an advantage to setting one standard for HDTV, and what are the pros and cons for the private businesses that were interested in producing HDTV for the U.S. market? Answer:

There are efficiency gains when two or more countries adopt the same standards. For example, since shared standards permit manufacturers to capture economies of scale, we would expect all 50 U.S. states to adopt the same standards. Further, the adoption of common standards allows states or countries to work together and increase their commercial ties. To prevent locking into or adopting inferior standards, the U.S. government might also hold a competition to select the technical standards. On the downside, sharing and adopting one standard does have its costs. Choosing one standard has the unintended effect of lessening the differences between nations, therefore destroying some sources of comparative advantage. The cost to society would be even greater if the country is dealing with a newly introduced product (such as HDTV). In the situation of unknown “best standards,” it may be wise for regulators to leave their options open or adopt a “competition of future standards.” Concerning the specific HDTV example, private businesses that produced the first HDTVs have an advantage over others simply because their product could be adopted as the standard. While this could be very profitable for these firms, if an inferior standard is locked in, this could harm to society as a whole. (Note: The case of HDTV was not explicitly considered in this chapter!)

Why do standards vary across countries? Illustrate your answer with examples in the area of labor standards. Answer:

Standards in general, and labor standards in particular, vary greatly. They range from basic standard rights such as the right to be free from forced labor and the right to representation in a union, to more contentious rights such as universal standards for minimum wages, limits on the number of hours someone can work in a day, health and safety standards, etc. Of course, labor standards are difficult to define given the wide

Gerber • International Economics, Seventh Edition

variation in incomes and living standards around the world. For example, if low-income countries (with relatively abundant unskilled labor) were forced to pay a minimum wage high enough to satisfy critics in high-income countries, low-income countries would suffer when the high wage rates force employers to close down their production. Consequently, unemployment would rise. 5.

What are labor standards, and why are arguments about labor standards confined primarily to arguments between high-income countries on the one hand, and low- and middle-income countries on the other? Answer:

As mentioned in the text, defining labor standards is difficult given the wide variation in incomes and living standards around the world. Even though there is a fair amount of ambiguity attached to labor standards, most people would probably agree with the standards proposed by the ILO and OECD, which are: (1) prohibition of forced labor; (2) freedom of association; (3) the right to organize and bargain collectively; (4) an end to exploitation of child labor; and (5) nondiscrimination in employment. Arguments about labor standards are confined primarily to arguments between highincome and low-income countries because the conditions and living standards in developing countries are starkly different from those in high-income countries. Labor and environmental standards and the enforcement of existing laws tend to be lower in developing countries than in high-income countries. Most countries tend to place higher values on better pay and greener environmental policies as their economies develop. When low- and high-income nations begin to trade, and the prices of the goods imported from developing countries are lower than their high-income counterparts , people in highincome countries have many questions. They tend to associate the lower prices with such things as exploitation of child labor, unsafe working conditions, lesser or no pollution controls, etc.

Discuss the reasons why using trade barriers to enforce labor or environmental standards may be less efficient than other measures. Answer:

First, as was shown in Chapter 7, imposing trade barriers is very costly. They create deadweight losses at home in consumption and production. Second, only large countries, if any at all, could use trade barriers successfully to stop the offending country. Even a large country may be unable to use trade barriers effectively unless a large number of countries join together to impose the trade sanctions. Convincing other nations to take part in the sanctions has proved difficult in the past. Moreover, imposing trade barriers may make conditions worse rather than better, since some producers may move their facilities into the informal sector of the economy. If sanctions against a country create incentives for businesses to avoid the scrutiny of labor inspectors, then a larger share of the working population could find themselves dealing with worse conditions. Third, there is also the borderline between protectionism and concern. In countries that use trade barriers as an enforcement mechanism it is not hard to find special interest groups using trade barriers as a means to justify their real goal—obtaining protection against foreign competition. Given that industrialized countries protect agricultural and textile/apparel products (two industries in which developing countries have a comparative advantage), developing countries are highly reluctant to give in to the sanctions. Fourth, since child labor laws are vague and vary according to the income level of each country, there is no international agreement for universal child labor laws. Last but not least, the use of trade

Chapter 8

International Trade and Labor and Environmental Standards

barriers may lead to retaliation and larger trade wars, which could be very costly to all countries involved. 7.

What are the arguments in favor of using trade barriers to enforce labor and environmental standards? Assess each argument. Answer:

Labor and environmental activists advocate for the use of trade barriers (tariffs, quotas, or outright limitation of imports) to enforce labor standards. They argue that pressuring a country could alter its labor standards. Trade economists are skeptical about the efficacy of trade barriers as tools for overturning foreign labor practices on several theoretical and empirical grounds (see also Question 6). There are no clear standards that could be universally adopted and enforced in both labor and environment standards.

One common critique of the WTO is that it overturns national environmental protections and forces countries to lower their standards. For example, when the United States tried to protect endangered sea turtles, the WTO prevented it. Assess this claim. Answer:

The United States sought to protect endangered sea turtles that were harmed by shrimp trawlers that do not use turtle excluder devices (TEDs) on their nets. In 1987, the United States issued guidelines requiring shrimp trawlers to use TEDs on their nets. It then announced in 1989 that it would ban shrimp imports beginning May 1991 from countries that were not certified. The guidelines applied only to the Caribbean and Western Atlantic. By 1996, more conditions were placed and the guidelines were extended worldwide. India, Malaysia, Pakistan, and Thailand protested to the WTO, arguing that they were given only four months to comply, while Caribbean countries were given three years and technical assistance. In addition, they complained that the GATT rules forbid discrimination against imports based on the process of production. In May1998, the WTO ruled against the United States citing that it ignored its obligation to consult and negotiate before taking action. The United States appealed the case and the decision was partially reversed by the WTO Appeals Body stating that the U.S. import barriers are potentially allowable but that the failure to negotiate or confer with the affected countries placed it in violation of WTO rules. That is, the WTO reversed one of the two rulings that were passed against the United States. In effect, this WTO decision ended up being multilateral in nature because it allowed the United States to extend its protection while allowing the South Asian fishing fleets to remain commercially viable. This episode raises the question about the connection between the environmental laws of an individual country and trade laws. Even though the WTO rules ended up being multilateral and at least partially kept the interests of both parties, there is a combination of trade and non-trade issues here. Because of differences in incomes and standards of living, labor and environmental standards have become (and will continue to become) a point of conflict between trading nations.

What are the alternatives to trade measures for raising labor and environmental standards? What are the strengths and weaknesses of each one? Answers: These are: (1) Labels for exports: this is a certification process producing a label that is attached to the good when it is produced and has been partially successful in telling

Gerber • International Economics, Seventh Edition

consumers that the good is produced in humane and environmentally friendly ways. Even though this mechanism plays an important role in alleviating conflicts between trading countries, it has its own problems. First, it has been a cause of conflict between labor and management when foreign inspectors are allowed to intrude. Second, many countries consider foreign intrusion as an infringement of their sovereignty. It may be hard to convince consumers to trust the labeling information as labeling becomes more widespread. (2) Requiring home country standards: This measure requires firms that open operations in foreign countries to hold these operations to the same standards as their domestic, or home, operations. In other words, a firm cannot try to cut corners or save money by allowing its foreign holdings to operate according to lower foreign standards. There are a few advantages of this measure: (a) it eliminates the fear of a race-to-thebottom by making it impossible for home-based companies to exploit low standards; (b) it shifts the costs of improved standards to firms and consumers in high-income countries; (c) it removes the threat that domestic firms will relocate abroad and ensures that any relocation that takes place is due to foreign comparative advantage; and (d) it avoids the problems of high-income countries dictating which standards are used. The requirement of home-country standards forces firms with cross-national boundaries to conform to whichever standards are higher. One weakness of this approach, of course, is that it only addresses the problem of firms in high-standards countries that go abroad to potentially low-standard countries, and not vice versa. (3) Increasing international negotiations, possibly using the ILO for labor and creating new agreements for the environment.

Chapter 9 Trade and the Balance of Payments

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Outline

Introduction: The Current Account The Trade Balance The Current and Capital Account Balances Introduction to the Financial Account Types of Financial Flows Limits on Financial Flows Case Study: The Crisis of 2007–2009 and the Balance of Payments The Current Account and the Macroeconomy The National Income and Product Accounts Are Current Account Deficits Harmful? Case Study: Current Account Deficits in the United States International Debt Case Study: Odious Debt The International Investment Position Appendix A: Measuring the International Investment Position Appendix B: Balance of Payments Data Appendix C: A Note on Numbers

Gerber • International Economics, Seventh Edition

◼ Learning Objectives After studying this chapter, students will be able to: 9.1 Define the current, capital, and financial accounts of a country’s balance of payments. 9.2 Explain the importance of the three main components of the current account. 9.3 Describe three types of international capital flows. 9.4 Use a simple algebraic model to relate the current account to savings, investment, and the general government budget balance. 9.5 Discuss the pros and cons of current account deficits. 9.6 Show the relationship between a country’s balance of payments and its International investment position.

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What Students Should Know after Reading Chapter 9

The accounting detail of Chapter 9 remains relatively aggregated, but students should become familiar with the key subaccounts within the balance of payments and be able to classify transactions as credits or debits. The study questions provide practice problems and frequent examples of similar questions. It should be noted that U.S. balance of payments accounting was revised significantly in 2014, and the text reflects these changes. Most notable, perhaps, is the change to “primary income” (largely income on investments) and “secondary income” (remittances and aid). Students doing research may find older versions of this system and thus should be familiar with the term “unilateral transfers”, the previous term for secondary income. Once they understand the basic accounting, students can consider the deeper implications of the balance of payments framework. The implications of a current account deficit or surplus on the financial account side should become clear. Students should realize that trade flows are related to savings and investment balances and cannot be treated as a separate independent variable. The 7th edition maintains the focus of the previous edition. The case study on the impact of the recent financial crisis on the U.S. balance of payments has been updated, and the emphasis continues to focus on the very visible shift in financial flows, with the intent to give an idea of some of the impacts of the crisis. The second case study examines the potential causes and consequences of the large and growing U.S. current account deficits which are addressed in both historical and policy terms.

Chapter 9

Trade and the Balance of Payments

The chapter includes an analysis of international debt. The notions of unsustainable debt and debt service are important for students who are used to hearing nominal dollar figures and flows, if they have heard anything about debt at all. The extension to debt forgiveness and the situation of Highly Indebted Poor Countries rounds out the discussion of non-trade issues.

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Assignment Ideas

Students should be introduced to the data on the U.S. balance of payments available from the Bureau of Economic Analysis at www.bea.gov. You may find it useful to provide data if the source is too complicated for the students to navigate in a reasonable amount of time, and to ask them to write a one- or two-page narrative describing the table. The goal is to encourage them to write like an economic journalist and to show they understand the concepts by making them clear and accessible to someone who has not studied this chapter.

Similarly, the IMF’s Balance of Payments Statistics is available in most research libraries and is a very clear presentation of data for the most of the world’s nations. They provide both a detailed view and a condensed view. Students should be able to navigate the condensed view without too many problems. A short paper on a country before and during a crisis, or comparing a high-savings and low-savings country, or trends in a country over time, are all possibilities.

The Bureau of Economic Analysis also provides data on the international investment position of the United States, along with information on foreign direct investment, broken down by sector and by country, both for inward and outward investment. It is useful for students to see where the United States invests outside its border and what types of direct investments are most common. Similarly, a look at inward direct investment is useful for building their background knowledge of the economy and for learning to navigate tables of data.

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Answers to End-of-Chapter Questions

Use the following information to answer the questions below. Assume that the capital account is equal to 0. Exports of goods and services

500

Primary income received

200

Secondary income received

300

Imports of goods and services

700

Primary income paid abroad

300

Secondary income paid

100

Net acquisition of financial assets

300

Net incurrence of liabilities

400

Net change in financial derivatives

600

a. What is the trade balance? b. What is the current account balance?

Gerber • International Economics, Seventh Edition

c. Does the financial account equal the current account plus the capital account balance? d. What is the statistical discrepancy? Answers: a. The “trade balance” is 700-600 = 100. Note that this is really the balance on goods and services, not the merchandise trade balance. b. The current account is 500 + 200 + 300 − 700 − 300 -100 = −100 c. The financial account is 300 −  + (−) = -200 d. The statistical discrepancy is (–200 − (-100)) = –100 2.

Look at each of the cases below from the point of view of the balance of payments for the United States. Determine the subcategory of the current account or financial account that each transaction would be classified in, and state whether it would enter as a credit or debit. a. The U.S. government sells gold for dollars. b. A migrant worker in California sends $500 home to his village in Mexico. c. An American mutual fund manager uses the deposits of his fund investors to buy Brazilian telecommunication stocks. d. A Japanese firm in Tennessee buys car parts from a subsidiary in Malaysia. e. An American church donates five tons of rice to the Sudan to help with famine relief. f. An American retired couple flies from Seattle to Tokyo on Japan Airlines. g. The Mexican government sells pesos to the United States Treasury and buys dollars. Answers: a. The United States “exports” official reserve assets; it is a credit in the financial account. b. A resident of the United States transfers money to a foreign locale; it is a debit in the current account and goes in the secondary income category. c. There is an “import” of foreign assets; it is a debit in the financial account under the category of a net change in U.S. private assets abroad. d. An American-based producer imports goods; it is a debit in the current account (imports of goods). e. There is secondary income from the United States to abroad foreign country; it is a debit in the current account. f. American residents purchase a service from a foreign firm; it is a debit in the current account (imports of services). g. There is a net increase in nonreserve foreign assets held by the U.S. government; it is a debit in the financial account.

Weigh the pros and cons of a large trade deficit. Answer:

Trade deficits are generally considered a negative for a country, but the reality is more subtle. On the negative side, large deficits signal that a country is accumulating foreign debt that can be difficult to service if the excess imports are not used to enhance national productivity. Furthermore, trade deficits require capital inflows. If foreign investors lose confidence, it may be difficult to search the necessary foreign reserves. This is partly what happened to Mexico in 1994 and Thailand and Indonesia in 1997.

Chapter 9

Trade and the Balance of Payments

On the positive side, a large trade deficit can also signal that foreigners have confidence in the current set of economic policies and the future prospects of the economy. Furthermore, and most importantly, a large trade deficit and the attendant capital inflows allow a higher level of investment than would be possible solely on the basis of domestic savings. 4.

Is the government budget deficit of a country linked to its current account balance? How so? Explain how it is possible for the United States’ current account deficit to grow while the budget deficit has disappeared, as happened in the 1990s. Answer:

Compare and contrast portfolio capital flows with direct investment capital flows. Answer:

The budget deficit and the current account are linked but there are the other variables of domestic private savings and domestic investment that are also joined in the savingsinvestment balance. For this reason, there is no such thing as a one-to-one correspondence between budget and trade balances. The basic relationship is captured in the equation (4b in the text): Sp + government budget = I + current account. From this it can be seen that as the government budget went to zero and the current account became more negative, either savings fell, investment rose, or some combination of the two occurred.

These two types of capital flows are similar in that they both provide a nation with the use of foreign savings. That is, they both represent financial flows that are a net increase in the amount of resources available for investment. On the other hand, they are very different in the time dimensions that they represent and in their liquidity. FDI is illiquid and generally represents funds with a longer time horizon than portfolio capital. Portfolio investment can move in or out of a nation extremely quickly and is the main focus of concerns about the destabilizing effects of foreign investment.

Why is a current account surplus equivalent to foreign investment? Answer:

A current account surplus leads to the net accumulation of foreign assets, whether real or financial. In either case, there is the prospect of a future stream of revenue that will be generated from the assets. Another way to look at it is to consider that in order to export a greater value than imports, a nation must not consume some of its income (production). Instead, the goods and services are sent abroad. The effect is the same as domestic investment: Consumption out of current period production is postponed until a future date, and the excess output is used to increase the capacity of the economy to generate a future stream of income (production).

Chapter 10 Exchange Rates and Exchange Rate Systems

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Outline

Introduction: Fixed, Flexible, or In-Between? Exchange Rates and Currency Trading Reasons for Holding Foreign Currencies Institutions Exchange Rate Risk The Supply and Demand for Foreign Exchange Supply and Demand with Flexible Exchange Rates Exchange Rates in the Long Run Exchange Rates in the Medium Run and Short Run Case Study: The Largest Market in the World The Real Exchange Rate Alternatives to Flexible Exchange Rates Fixed Exchange Rate Systems Case Study: The End of the Bretton Woods System Choosing the Right Exchange Rate System Case Study: Monetary Unions Single Currency Areas Conditions for Adopting a Single Currency Case Study: Is the NAFTA Region an Optimal Currency Area? Appendix: The Interest Rate Parity Condition

Chapter 10

Exchange Rates and Exchange Rate Systems

◼ Learning Objectives After studying this chapter, students will be able to: 10.1 List the reasons for holding foreign exchange and the main institutions in the foreign exchange market. 10.2 Diagram the effects on the home currency of a change in supply or demand for foreign currency. 10.3 Differentiate short-run, medium-run, and long-run forces that help determine the value of a currency. 10.4 Calculate a currency’s forward premium or discount based on interest rate differentials. 10.5 Explain in words and with an equation the relationship between price changes and the real exchange rates. 10.6 State the necessary conditions for two or more countries to form a successful single currency area.

Gerber • International Economics, Seventh Edition

◼ What Students Should Know after Reading Chapter 10 Chapter 10 starts with a principles-level introduction to exchange rates and the determination of the value of national currencies in the context of simple supply-and-demand analysis. It is worth emphasizing that the exchange rate is the price of one currency in terms of another, and that it can be measured as either “units of domestic currency per unit of foreign currency” or its inverse, “units of foreign currency per unit of domestic currency.” It is both dollars per pound, and pesos per dollar. However, in order to be consistent in our graphical and algebraic treatments, we need to define it as either one or the other. In this text, domestic per foreign is used. That simplifies some analysis, but it also makes the meaning of appreciation and depreciation counterintuitive. Students will need to memorize that an increase in the exchange rate is a depreciation of the home currency, since it costs more to buy a unit of foreign currency. I usually introduce the theories of purchasing power parity and interest rate parity (in words rather than equations) as concepts in this phase to help students understand the long-run versus short-run effects on flexible exchange rates. We identify a number of factors that might change the demand and/or supply of currencies given that, depending on the timeframe, ultimately both inflation and real interest rates are important factors in determining exchange rates. The text introduces some algebraic treatment for interest rate parity with the full derivation in the appendix. The real exchange rate is then introduced algebraically. It is important for students to understand the difference between this concept and nominal rates as we begin to consider other exchange rate systems. The terminology and concepts relevant to different types of exchange rate systems are then introduced. The costs and benefits of fixed and flexible rates are considered along with evidence from current research. The chapter considers single currency areas and monetary unions along with the factors that might lead a group of countries to consider forming one or the other. The question of whether the NAFTA region is an optimal currency area is addressed in a case study. The euro crisis is taken up later in the text, in the chapter on Europe (Chapter 14).

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Suggested Assignments

Students may be assigned individual nations to make presentations on that country’s exchange rate with the dollar. They may also collect inflation data and compare that with U.S. data to see if it may account for some of the exchange rate fluctuations over time. This could also be done as a written report.

It is fairly straightforward to use business periodicals to find current evidence of winners and losers from exchange rate fluctuations. Students could be asked to find articles on the topic and to provide some analysis of the impact on a specific firm, industry, or group. For students, this could begin to connect exchange rate fluctuations to balance of payments.

Dollarization, both formal and informal, is not uncommon. The euro crisis had undoubtedly increased awareness of the costs of giving up a national currency, and the information presented in the case study about dollarization and single currency areas has touched some of the issues involved. Further exploration of the economic benefits and costs of dollarization may be needed, however. Students could be asked to provide a written summary of the pros and cons of dollarization.

◼ Answers to End-of-Chapter Questions .

Chapter 10

Exchange Rates and Exchange Rate Systems

1. Draw a graph of the supply of and demand for the Canadian dollar by the U.S. market. Diagram the effect of each of the following on exchange rates, state in words whether the effect is long, medium, or short run, and explain your reasoning. a. More rapid growth in Canada than in the United States. b. A rise in U.S. interest rates. c. Goods are more expensive in Canada than in the United States. d. A recession in the United States. e. Expectations of a future depreciation in the Canadian dollar. Answers: a. The Canadian supply of currency to the U.S. market increases in response to the rise in Canada’s demand for American exports. The supply curve shifts right; the U.S. dollar appreciates; the Canadian dollar depreciates. This effect is medium run because effects of economic expansions and contractions—the business cycle—on exchange rates run for a few years (usually less than a decade). As Canada experiences more rapid economic growth than the United States, disposable income in Canada rises, causing consumption to rise. Consumer confidence gradually rises as jobs become secured and plentiful. Canadian expenditures on imports rise. b. The supply of Canadian dollars to the U.S. market increases in response to the higher interest rates; the supply curve shifts right; the U.S. dollar appreciates; the Canadian dollar depreciates. This is a short-run effect because the factors that cause interest rates to change are themselves short-run processes. Good examples are changes in government (fiscal and/or monetary) policies, expectations, and financial capital flows in and out of a country. c. The U.S. demand for Canadian dollars decreases in response to higher prices for Canadian goods. The demand curve shifts left causing the exchange rate to fall. The U.S. dollar appreciates and the Canadian dollar depreciates. This is a long-run effect in part because the prices of goods move gradually. The higher prices of goods in Canada could also be caused by government policies such as tariffs and quotas. In general, changing government policies takes time. Goods arbitrage will eventually equalize the prices of goods between the two countries, but achieving purchasing power parity is a long-run process because of the following factors: (1) shipping, insurance, and other transportation may be prohibitively expensive; (2) trade barriers such as tariffs, quotas, import license, and inspection fees may be too high; and (3) a substantial number of goods may not be traded. All of these play a significant factor for purchasing power parity to exert influence only in the long run. d. The U.S. demand for Canadian dollars decreases in response to the drop in demand for imports; the demand curve shifts left; the U.S. dollar appreciates; the Canadian dollar depreciates. As explained in (a) above, the effect of recessions and expansions on exchange rates can be considered medium term. e. The demand for Canadian dollars decreases in response to its expected loss in value; the demand curve shifts left; the U.S. dollar appreciates; the Canadian dollar depreciates. Like the effects of interest rates, the effects of expectations on exchange rates are short run. As everyone knows, expectations could change swiftly and could reverse course almost instantaneously. Some expectations could be unexpected and flimsy but they could have catastrophic effects on the exchange rates and financial sectors of the country. See Table 10.3 for a summary of the short-, medium- and long-run factors that determine exchange rates.

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2. Suppose the U.S. dollar-euro exchange rate is 1.20 dollars per euro, and the U.S. dollar-Mexican peso rate is 0.10 dollar per peso. What is the euro-peso rate? Answer:

The euro-peso rate is (0.1 dollar per peso)  (1.2 dollars per euro) = 0.083 euro per Mexican peso.

3. Suppose the dollar-yen exchange rate is 0.01 dollar per yen. Since the base year, inflation has been 2 percent in Japan and 10 percent in the United States. What is the real exchange rate? In real terms, has the dollar appreciated or depreciated against the yen? Answer:

The real exchange rate is Rr = 0.01(102/110) = 0.0093 dollar per yen. The dollar has appreciated.

4. Which of the three motives for holding foreign exchange are applicable to each of the following? a. A tourist. b. A bond trader. c. A portfolio manager. d. A manufacturer. Answers: a. A tourist holds foreign currency to engage in transactions. b. A bond trader holds foreign currency to take advantage of interest arbitrage opportunities. c. A portfolio manager holds foreign currency to take advantage of investment opportunities (transactions), interest arbitrage opportunities, and speculative opportunities. d. A manufacturer holds foreign currency to engage in transactions. 5. If U.S. visitors to Mexico can buy more goods in Mexico than they can in the United States when they convert their dollars to pesos, is the dollar undervalued or overvalued? Explain. Answer:

The dollar is overvalued and the peso is undervalued. The dollar buys “too many” pesos when it is converted. Hence it buys more in Mexico after its conversion to pesos. Conversely, a traveler to the United States would find that the pesos he exchanged for dollars buys him fewer goods than the same pesos spent in Mexico.

6. In a fixed exchange rate system, how do countries address the problem of currency market pressures that threaten to lower or raise the value of their currency? Answer:

Nations must stand ready to counteract shifts in the demand and supply curves for foreign currency. If demand rises, they must fill the excess demand for foreign currency by selling their reserves. If demand for foreign currency falls, then they must increase it by buying up the excess supply with domestic currency.

Chapter 10

Exchange Rates and Exchange Rate Systems

7. In the debate on fixed versus floating exchange rates, the strongest argument for a floating rate is that it frees macroeconomic policy from taking care of the exchange rate. This is also the weakest argument. Explain. Answer:

Fixed exchange rate systems require the monetary authority to closely monitor the exchange rate. In effect, the domestic money supply is a captive of the need to maintain sufficient reserves to be able to supply any excess demand for foreign exchange. The potential conflict in this arrangement is that the needs of the exchange rate system can be in conflict with the needs of the domestic economy. This is the scenario that the United States and the United Kingdom faced during the Great Depression of the 1930s. Interest rates were raised in order to reduce the demand for foreign exchange; the rise in interest rates deepened the recession and caused unemployment to rise further. Nevertheless, the freeing of monetary policy from the task of maintaining an exchange rate has its own problems. Some economists believe that the lack of external discipline on monetary policy leads to an overreliance on inflationary policies to satisfy domestic economic needs. Argentina, for example, was unable to cure its constant tendency toward hyperinflation until it abandoned the ability to freely change the money supply.

8. Brazil, Argentina, Paraguay, and Uruguay are members of MERCOSUR, a regional trade area that is trying to become a common market. What issues should they consider before they accept or reject a common currency? Answer:

The first issue they need to consider is whether or not their business cycles are well synchronized and whether or not a “one-size-fits-all” monetary policy would satisfy each member. Conflicts between them will arise if their economies do not contract or expand at the same time. The second issue involves their willingness to allow factors to freely move across borders and whether factors of production (capital and labor) could actually move to keep the business cycle smooth. Third, if regions or countries remain depressed and factors are immobile, they may have to design policies to assist the depressed regions or countries. Fourth, they need to consider deeper integration than the simple removal of trade barriers. Deeper integration may require harmonization of national economies and strong political ties. While the four issues above are generally true for any group of countries seeking to establish a common currency, there are some issues that are particular to this region: Some members of the MERCUSOR, such as Argentina and Uruguay, have a significant amount of U.S. dollar deposits. As explained in the text, the use of such a currency reduces exchange rate fluctuations, adds credibility to their exchange rate and financial systems, and brings needed foreign capital into the country. However, it is not an option for some of these countries, particularly Brazil, to give up their currencies. First, these countries need to decide if they are willing to give up their own currencies and in return adopt another as their common currency. Second, after they have agreed to go along with another country’s currency, they need to agree on which currency to adopt as their common currency—the U.S. dollar or the Brazilian real? Given the above described benefits of using the U.S. dollar, and the historical troubles of these countries, some of them may insist on using the U.S. dollar as the common currency. Third, if they agree to use the U.S. dollar as the common currency, all member countries would lose the ability to influence their own economies using monetary policy. They would also have to follow

Gerber • International Economics, Seventh Edition

the decisions of the Federal Reserve, which conducts monetary policy for the United States. 9. Suppose that U.S. interest rates are 4 percent more than rates in the EU. a. Would you expect the dollar to appreciate or depreciate against the euro, and by how much? b. If, contrary to your expectations, the forward and spot rates are the same, which direction would you expect financial capital to flow? Why? Answers: a. Capital would flow into the United States increasing the supply of foreign exchange. Due to higher interest rates, investment at home is more attractive than in Europe. This also reduces the demand for foreign exchange. As a result, we expect the dollar to appreciate by 4 percent. This interest rate arbitrage activity continues until equilibrium is restored (that is, interest rate parity is reestablished). b. This suggests that the right-hand side of the interest parity equation is equal to zero, while the left-hand side of the same equation is greater than zero. If F = R as the statement suggests, then currency markets are signaling that no changes are expected in the exchange rate. Capital would flow to the United States, decreasing the demand for foreign currency and increasing the supply of foreign currency. Both of these decrease R. 10. Why do some economists claim that the most important feature of any exchange rate system is its credibility? Answer:

Both flexible and fixed exchange rate systems have advantages and disadvantages. As a result, no system seems to rank above any other in its ability to provide superior economic performance. Also, history has proven that a financial crisis can take place whether a country follows a fixed or flexible exchange rate system. Further, the source of the shocks to a financial system or economy vary from episode to episode, as do each country’s trade partnerships and economic and political characteristics. Due to this, there appear to be discrepancies between what might work in theory and what it has worked in practice. In other words, it has become increasingly difficult, and even impractical, to design a “onetype-fits-all” exchange rate policy, even if the countries considering such a policy share similar stages of economic development. Thus, no matter which exchange rate system is adopted, to be successful a system must generate investor confidence and a belief that the system is sustainable. In a fixed exchange rate system, for example, credibility is assured only if there is strong control of the money supply. Floating exchange rate systems are also vulnerable due to the lack of monetary discipline and the temptation to finance the deficit with additional creation of money. Thus, credibility is very important and seems to be the only useful common guide that can serve all countries. This is especially true in this era of increased capital mobility, international trade, and investment with numerous players. How a country establishes credibility is an entirely different issue, which again depends on the characteristics of the individual country and the exchange rate system it adopts.

Chapter 11 An Introduction to Open Economy Macroeconomics ◼

Outline

Introduction: The Macroeconomy in a Global Setting Aggregate Demand and Aggregate Supply Fiscal and Monetary Policies Fiscal Policy Monetary Policy Case Study: Fiscal and Monetary Policy during the Great Depression Current Account Balances Revisited Fiscal and Monetary Policies, Interest Rates, and Exchange Rates Fiscal and Monetary Policy and the Current Account The Long Run Case Study: Argentina and the Limits to Macroeconomic Policy Macro Policies for Current Account Imbalances The Adjustment Process Case Study: The Adjustment Process in the United States Macroeconomic Policy Coordination in Developed Countries

Gerber • International Economics, Seventh Edition

◼ Learning Objectives After studying this chapter, students will be able to: 11.1 Diagram a shift in aggregate demand or supply and explain the impact on the price level and GDP. 11.2 Diagram the effects on GDP and the price level of expansionary and contractionary fiscal and monetary policies. 11.3 Analyze the effects of fiscal and monetary policies on the current account and the exchange rate. 11.4 Explain how expenditure switching and expenditure reducing policies can be used to reduce a current account deficit. 11.5 Draw a J-curve and use it to show how exchange rate depreciation does not lead to an immediate reduction in the current account deficit.

◼

What Students Should Know after Reading Chapter 11

The chapter begins with a review of open economy macroeconomics at the principles level, relying mainly on the aggregate demand/aggregate supply model. The primary purpose of this review is for students to understand the role of fiscal and monetary policies and the impact those policies have on interest rates, exchange rates, current accounts, and business and consumer decision making. The first case study examines fiscal and monetary policies in the Great Depression in the United States, while the second case study poses the question whether it is possible for small countries to use macroeconomic policies to counteract a recession when financial markets are internationally integrated. The short-run and long-run effects of fiscal and monetary policies on the current account are addressed. This part of the chapter examines the role of expenditure-switching and expenditure-reducing policies and the adjustment process. A case study addresses the adjustment process in the United States. The chapter ends with a discussion of developed nations’ macroeconomic coordination policies and the effects of these policies on economic growth. The economic and political limits of policy coordination, as well as the possible benefits, are addressed.

◼ Suggested Writing Assignment The most important and interesting topic that students need to understand in Chapter 11 is the relationship between current account imbalances, particularly deficits, and fiscal and monetary policies. The instructor may want to ask students for a written explanation of the main policy effects summarized in Table 11.2. For example, the student might suppose that a country is facing a current account deficit. What kind of monetary and/or fiscal policy is called for: • under a fixed exchange rate system?

Chapter 11

An Introduction to Open Economy Macroeconomics

• under a floating exchange rate system? Alternatively, students might be asked to summarize the pros and cons of fixed and floating exchange rate systems. Students can be encouraged to think about the effects of volatile exchange rates on investment and the exchange rate risks associated with a floating exchange rate system. They can also be reminded about the efficiency gains with a floating exchange rate system and the possibilities of addressing current account deficit problems using monetary and fiscal policies within a flexible exchange rate system.

◼ Answers to End-of-Chapter Questions 1.

Using aggregate demand and aggregate supply, graph the effects on the price level and GDP of each of the following. a. A cut in income taxes b. An increase in military spending c. A drop in export demand by foreign purchasers d. An increase in imports e. A decline in business investment spending Answer:

A and B both shift aggregate demand to the right, putting upward pressure on the price level and potentially expanding GDP. C, D, and E all shift aggregate demand to the left, putting downward pressure on the price level and potentially contracting GDP.

Explain the concepts of fiscal and monetary policy. Who conducts them and how do they work their way through the economy? Answer:

Fiscal policy is the deliberate manipulation of government spending and taxes in order to affect aggregate economic activity. Congress and the president conduct it. Monetary policy is conducted by the central bank of a country—the Federal Reserve in the case of the United States—and involves changes in the money supply to achieve desired macroeconomic goals. Expansionary fiscal policy involves either increases in government spending or decreases in taxes, or a little of both. Both of these actions result in increases in disposable income, then in consumption, repeating in turn until the last dollar or last penny is spent. The effects of this expansionary fiscal policy dissipate over time due to leakage caused by saving, taxes, and spending on imports. Contractionary fiscal policy is symmetric to expansionary fiscal policy. It involves either decreases in spending or increases in taxes, or a little of both. It results in a decrease in income, then in consumption, repeating in turn, etc. Expansionary (or easy) monetary policy involves increases in the money supply that cause interest rates to decline. The decrease in interest rates in turn causes increases in investment and consumption. Increases in investment and consumption cause output and income to rise, thereby causing consumption to rise. Contractionary monetary policy is exactly the reverse, and involves a decrease in the money supply, leading to a rise in the interest rate, followed by decreases in investment and consumption, then decreases in income and consumption, and so on. Therefore, both fiscal and monetary policies affect the economy through a multiplier process by affecting the behaviors of consumers and businesses, directly or indirectly. The multiplier is positive with expansionary policies and is negative with contractionary policies.

Gerber • International Economics, Seventh Edition

What are the some of the problems in trying to use fiscal and monetary policies? Why can’t economists and politicians make precise predictions about the effects of a policy change on income and output? Answer:

It is hard to predict the effects of fiscal policy because of its inherent problems. First, expansionary fiscal policy tends to cause the inflation rate to rise, thereby offsetting some of the increased consumer spending. Second, there is a substantial margin of error in the estimation of the size of the multiplier. Third, the effects of fiscal policy vary depending on how it is financed. For example, the multiplier is larger if expansionary fiscal policy is accommodated by expansionary monetary policy. Fourth, there are time lags: recognition lag, implementation lag, and effectiveness lag. As a result, fiscal policy is politically cumbersome. Some even argue that fiscal policy is destabilizing rather than stabilizing. Even though monetary policy is not as cumbersome as fiscal policy (assuming the central bank is independent of fiscal authorities), it also has its own problems. First, it is difficult to predict interest rates because a number of other factors, such as expectations, also affect them. Second, monetary policy may be ineffective if investment and consumption fail to respond to changes in interest rates. Third, there is considerable uncertainty on the value of the money multiplier (this may be one reason why the Fed changes the interest rate several times in just one direction). Moreover, some economists, such as Milton Friedman, believe that the Federal Reserve blundered during the Great Depression (by tightening the money supply in 1928 and 1929; by allowing U.S. banks to fail and therefore creating banking panics; and by attaching the value of the dollar to gold, effectively establishing a fixed exchange rate system). As shown in other chapters, in a fixed exchange rate system monetary policy cannot be used to stabilize the economy. Moreover, expansionary monetary policy may only affect monetary variables such as the inflation rate.

Describe the mechanism that leads from a change in fiscal policy to changes in interest rates, exchange rates, and the current account balance. Do the same for monetary policy. Answer:

Expansionary fiscal policy raises incomes and consumption. These raises in turn lead to an increase in the demand for money. The increase in the demand for money puts an upward pressure on the interest rate. Higher domestic interest rates cause an inflow of foreign funds (excess supply of foreign currency), thereby increasing the value of the domestic currency. The exchange rate rises and the domestic currency appreciates. The rise in exchange rates causes domestic goods to be more expensive relative to foreign goods and results in current account deficits. The increased value of the dollar enables domestic consumers and firms to buy more foreign goods. This may result in the deterioration of the current account deficit. Contractionary fiscal policy works in the opposite direction. An expansionary monetary policy reduces domestic interest rates. The decline in interest rates reduces the inflow of foreign financial capital, decreasing the supply of foreign currency. The decrease in the supply of foreign capital reduces the value of the domestic currency. The decrease in interest rates stimulates the economy by causing consumption and incomes to rise. This is the income effect of expansionary monetary policy. On the other hand, exchange rate depreciation switches some consumer spending from foreign goods to domestic goods (assuming that the exchange rate is flexible). This is the exchange rate effect on expansionary monetary policy. The impact of expansionary monetary policy on the current account is ambiguous since the income effect of monetary policy on the current account is the opposite of the exchange rate effect. Contractionary monetary policy involves the increase of interest rates which has the opposite effect of expansionary monetary policy. Decreases in the money supply lead to the rise in interest

Chapter 11

An Introduction to Open Economy Macroeconomics

rates. The rise in interest rates causes an inflow of foreign capital, thereby increasing the supply of foreign currency. The inflow of foreign currency in turn causes the domestic currency to appreciate. As a result, foreign goods become relatively cheaper than the domestic goods. The impact of contractionary monetary policy on the current account is ambiguous since the income effect of monetary policy on the current account is the opposite of the exchange rate effect. The increase in the supply of foreign capital raises the value of the domestic currency. The increase in interest rates depresses the economy by causing consumption and incomes to fall. This is the income effect of expansionary monetary policy. These results are summarized in Table 11.2. 5.

Some countries have fixed exchange rate systems instead of flexible exchange rate systems. How does the exchange rate system limit their ability to use monetary policy? Answer:

There is a market-determined equilibrium exchange rate that equates the demand for and supply of a currency in a flexible exchange rate system. Consequently, changes in the exchange rate affect exports and imports and thereby correct any imbalances. As shown in the text, these changes in the exchange rate are generally due to fiscal and/or monetary policy changes. Unlike a floating rate system, a fixed exchange rate is either determined (by decree) by the monetary authorities or pegged to a major currency or group of major currencies. A fixed exchange rate system is either weak or unresponsive to market forces. One reason for this is that economic conditions may force the government to change the value of a fixed exchange rate system, regardless of market fundamentals. If the domestic currency is pegged to another major currency or a group of major currencies, it will fluctuate with the currency to which it is pegged. Neither of these fixed exchange rate systems can be used effectively to correct any current account imbalances. To illustrate a little further, consider changes in monetary policy under a fixed exchange rate system. Suppose that the central bank reduces interest rates in order to stimulate the economy or take it out of recession. The fall in interest rates increases output but it also causes the exchange rate to depreciate, thereby causing an outflow of capital. To maintain a fixed exchange rate, the monetary authority would have to intervene in the foreign exchange market and buy the domestic currency. This in turn decreases the money supply, offsets the initial increase in the money supply, and blunts the output and employment expansion initially intended.

The United States is currently running a large current account deficit. If Congress and the White House decided to enact policies to reduce or to eliminate the deficit, what actions should they take? Describe the set of policy options that would be available to them. Answer:

Generally, expenditure-reducing policies such as contractionary fiscal or monetary policies would be used to cut the overall level of demand in the economy. This would need to be combined with expenditure-switching policies so that reduced demand for output does not cause a recession. Expenditure-switching policies increase demand for domestic output (as opposed to foreign output) and without expenditure-reducing policies could cause inflation. A combination of policies switches spending from foreign producers to domestic producers in such a way as to avoid recession (too much expenditure reduction) or inflation (too much expenditure switching). An exchange rate depreciation is one way to do this. The United States could adopt a contractionary fiscal policy, causing domestic interest rates to fall. A decrease in interest rates would in turn result in the depreciation of

Gerber • International Economics, Seventh Edition

the exchange rate, and a rise in the domestic price of foreign goods. This turns domestic expenditures away from foreign-produced goods and toward domestically produced goods. Expansionary monetary policy is likely to lower interest rates and the exchange rate, but may be inflationary. 7.

Describe the larger economic effects of the policies in the previous question. That is, what would be the effects on income, consumption, employment, interest rates, and real exchange rates of policies designed to reduce or eliminate the current account deficit? Answer:

During the second half of the 1980s, the United States depreciated the dollar in hopes that it would reduce the current account deficit. After a year, the deficit was actually larger and newspaper editorialists were writing columns claiming that there is no link between the exchange rate and the current account. Explain why they got this wrong. Answer:

Contractionary fiscal policy is likely to lead to less spending, consumption, income, and employment in the short run. Lower interest rates and a depreciation of the currency may help domestic firms recover over time as people switch to domestic firms from foreign firms. If expansionary monetary policy is used to depreciate the currency, greater domestic spending, consumption, and income are likely, but inflation is a more likely result as well, eroding the real exchange rate. Contractionary monetary policy may reduce spending but may cause an increase in interest rates and the exchange rate.

They got it wrong because the current account improved, but with a longer than expected lag of almost two years. The lag could have been due to several factors. Foreign firms previously may have had above-normal profit margins and may have chosen to accept lower profit margins rather than raise prices, losing sales in the short run. Other effects of the previously strong U.S. dollar also still may have been working their way through the economic system—consumers need time to find substitute products, and firms to need time as well to find new suppliers and negotiate contracts. Finally, exports had to grow from a much smaller base than imports and had to increase more rapidly in percentage terms in order to offset the larger import base and close the trade deficit. As shown in Figure 11.8, there was a cause-and-effect linkage between the exchange rate and the trade balance, once the time lag was taken into account.

Suppose the United States, Japan, and many other places around the world go into recession, but growth remains strong in Europe. Why would macroeconomic policy coordination help, who should coordinate, and what are some of the obstacles to coordination? Answer:

The usual goal for policy coordination is to achieve a desirable level of world economic growth, but there are other objectives as well. Policy coordination may help avoid imposing a disproportionate burden to one or a single group of major world economies (Europe in this case). Suppose, for example, world economic growth is unacceptably low, even though the growth rates of one or a variety of developed nations (Europe in this case) are just fine. A coordinated policy may raise the incomes of developed nations. This in turn could stimulate production in other countries, lifting the worldwide economic slump. The political problem is that there is no international organization capable of arranging a multilateral agreement among nations, nor is a multilateral agreement possible without a significant sacrifice of national sovereignty. The economic problem is that there is rarely

Chapter 11

An Introduction to Open Economy Macroeconomics

a period in which nations find it in their own interest to pursue the same policies as their leading partners.

Chapter 12 International Financial Crises ◼ Outline Introduction: The Challenge to Financial Integration Definition of Financial Crisis Sources of International Financial Crises Crises Caused by Macroeconomic Imbalances Crises Caused by Volatile Capital Flows Case Study: The Mexican Peso Crisis of 1994 and 1995 Domestic Issues in Crisis Avoidance Moral Hazard and Financial Sector Regulation Exchange Rate Policy Capital Controls Case Study: The Asian Crisis of 1997 and 1998 Domestic Policies for Crisis Management Reform of the International Financial Architecture A Lender of Last Resort Conditionality Reform Urgency Case Study: The Global Crisis of 2007

Chapter 12

International Financial Crises

◼ Learning Objectives After studying this chapter, students will be able to: 12.1 Define three types of crises. 12.2 Distinguish a crisis caused by economic imbalances from one caused by volatile capital flows. 12.3 List and explain three measures countries can take to reduce their exposure to financial crises. 12.4 Explain the need for reforms in the architecture of international finance and international financial institutions. 12.5 Describe the main forces behind the global financial crisis that began in 2007.

◼ What Students Should Know after Reading Chapter 12 The primary goal is for students to understand the characteristics and economic results of an exchange rate crisis and a banking crisis. Although financial crises have many characteristics, the chapter shows that they usually refer to either a banking crisis (2007) or a currency crisis (Mexico’s case study). The Asian crisis case study shows that it began as a currency crisis but quickly developed into a banking crisis as well. The crisis might be caused by macroeconomic imbalances or it could be caused by volatile flows of financial capital. Because each crisis is unique, there is not a “one-size-fits-all” solution to the problem of financial crisis. Optimal solutions depend on the causes of the individual crises themselves. Students should understand the roles played by domestic and international policymakers in crisis avoidance and the significant macroeconomic problems they face once a crisis has begun. The chapter addresses the acute moral hazard problem, the policy dilemma facing lending agencies, and ways of minimizing these problems. The chapter includes several case studies which build on each other, beginning with the “Tequila Crisis” of the Mexican peso in 1994–1995, the Asian crisis of 1997–1998, and culminating in the global financial crisis of 2007–2009. The later crisis is presented as having resulted from three microeconomic factors and one macroeconomic factor. The micro-factors are global integration of financial markets, financial innovation, and regulatory failure. The overarching macro-factor is the set of global imbalances that developed in the wake of the Asian Crisis, as several high-savings countries began to systematically accumulate reserves, while several low-savings countries such as the United States and the United Kingdom borrowed those reserves to finance housing and investment. Students should not come away from this chapter thinking that the answer is to eliminate financial innovation or to terminate financial integration. Rather, the key is to find ways to capture the benefits of those activities while reducing the risks they pose. The cases address the possible or probable causes of the crises, the effects of these crises on other countries, the economic tools available to address the crises, and the policies that can help prevent future crises. The chapter’s case studies show how painful financial crises can be on individuals, governments, economies, and the world as a whole. Given both the frequency and the high costs of financial crises in recent years, the chapter discusses the possibilities for reforming the world financial structure, paying

Gerber • International Economics, Seventh Edition

particular attention to the IMF. Its past and present practices, lending policies, and conditions are included, as are areas under discussion for future reform. A final section to the chapter addresses reasons for the lack of progress on reform in the last decade.

◼ Suggested Writing Assignment 1.

One of the most important concepts discussed in the text is the moral hazard problem. Even though this problem cannot be eliminated completely, it can be reduced through various actions such as the Basel Agreements. Students find moral hazard very interesting and intellectually stimulating. Students may be asked to submit a summary of these agreements (Basel I and II) using the Web site of the Bank of International Settlements. Specifically, students may be asked to briefly explain the moral hazard concept and summarize the three pillars of the Basel Agreements, which are: a. Minimum capital requirement b. Supervisory review process c. Market discipline

An alternative writing assignment could involve the contagion effects of a financial crisis. Multiple opinions on this topic exist. Some argue that there may not be any contagion effects of a financial crisis. On the other hand, as is shown in the text, the moral hazard problem is very real and has a strong theoretical and practical foundation. Moreover, countries with no strong structural problems, such as Hong Kong, Taiwan, and Singapore, were affected by the crisis that erupted in Thailand. This suggests that there may indeed be contagion effects of a financial crisis. Furthermore, self-fulfilling prophecies may ensue once investors begin to suspect other countries might face the same problems. Students could be asked to write a short paper discussing contagion effects of a financial crisis. Publications and information on this topic are available from Web sites of various think tanks as well as the IMF and the World Bank.

After researching current proposals for reform, students could write up or present to the class one proposed reform and explain its potential advantages and disadvantages. A broader question could be focused on whether the IMF is necessary today, and if so, what should its functions include?

◼ Answers to End-of-Chapter Questions 1. What is an international financial crisis, and what are the two main causes? Answer:

An international financial crisis is a financial disintermediation characterized by a collapse in the value of a currency or a group of currencies and usually followed by a steep recession. There are two separate causes of a financial crisis. The first is a result of definite macroeconomic imbalances, such as large budget deficits, hyperinflation, an overvalued exchange rate, or large current account deficits. The second is brought about by volatile flows of financial capital, which results in speculative attacks on a country’s currency and a run on its international reserves.

Chapter 12

International Financial Crises

2. In the text, the point is made that the expectation of a crisis from volatile capital flows is sometimes a self-fulfilling crisis. How can a crisis develop as the self-fulfillment of the expectation of a crisis?

Answer: At times, investors and portfolio managers look to each other for information about the

direction of markets. This creates a kind of herd behavior that can take over at critical moments and intensify a small problem, turning it into a major crisis. This happens especially when international investors expect a crisis, and as a result are unwilling to give domestic banks the time they need to convert illiquid assets into liquid ones. Because of the refusal of lenders to rollover bank debts, which generally are illiquid, banks become insolvent and the belief becomes a self-fulfilling prophecy. The increasingly large volume of savings entering the international capital markets, while beneficial, exacerbates this problem.

3. What are three things countries can do to minimize the probability of being hit by a severe international financial crisis? Answer:

Governments can minimize the likelihood of, and the damage caused by, financial crises by increasing the transparency of their policies and banking systems. Specifically, they can minimize their likelihood by (1) adopting and maintaining credible and sustainable fiscal and monetary policies; (2) engaging in active supervision and regulation of their financial intermediaries; and (3) providing timely information about key economic variables, such as the central bank’s holding of international reserves. These measures are good for both foreign investors and the countries themselves because (1) the measures could signal investors before they massively pour their assets into the country, and (2) the country would be able to avoid a looming financial crisis when foreign investors attempt to withdraw their assets.

4. Why are crises associated with severe recessions? Specifically, what happens during an international financial crisis to create a recession in the affected country or countries? Answer:

There are at least two reasons why crises are associated with recessions. First, in addition to the possible trigger(s) of the crisis, several economic problems and weaknesses often are present at the time of a crisis. Unfortunately, most of the weaknesses don’t appear until a crisis has already begun. Second, it is generally impossible to avoid a recession once a crisis has begun. Remember that there are two types of crises: those caused by macroeconomic imbalances, and those caused by non-macroeconomic imbalances (such as speculative attacks on the financial system). As shown in the text, governments face the dilemma that there are costs attached to using alternative policy tools. Therefore governments must carefully decide which kinds of policies should be adopted in order to minimize the damage caused by the crisis, and determine the least painful ways of getting out of the recession as quickly as possible.

5. What type of exchange rate is associated with a higher probability of experiencing a crisis? Why? Answer:

The type of exchange rate associated with a higher probability of experiencing a crisis is a pegged exchange rate system called the crawling peg. With a crawling peg, the pegged exchange rate involves regular (daily, or several times monthly) adjustments or “devaluations” according to a set of indicators (for example, level of foreign exchange reserves, export performance, balance of payments positions, the difference between the country’s inflation rate and the inflation rate of the country whose currency it pegs to, etc.) or according to the judgments of the monetary authority. One good mechanism

Gerber • International Economics, Seventh Edition

presented in the text is the relationship between the real and nominal exchange rates,  P* given by the equation: Rr = Rn  .  P  Even though this system has had mixed success in controlling inflation, it is likely to cause a financial crisis. For example, the monetary authority’s attempt to maintain a crawling peg against the currency or currencies of its trading partner(s) may be difficult in the face of high domestic inflation and market pressures resulting from wider variations in the actual exchange rate. Another problem with the crawling peg is that it is politically difficult to find a way to exit from the system if the exchange rate is (or thought to be) overvalued. 6. In a crisis not caused by macroeconomic imbalances, economists are uncertain whether a country should try to guard against recession or try to defend its currency. Why are these mutually exclusive, and what are the pros and cons of each alternative? Answer:

Economists are uncertain whether a country should try to guard against recession or try to defend its currency in a crisis caused by non-macroeconomic imbalances such as sudden capital flows. If policymakers decide to defend the economy by reducing interest rates, this may cause further depreciations in the domestic currency. If domestic firms have debt that is denominated in dollars, a depreciation would lead to an increase in their debts and spread additional bankruptcies throughout the economy. On the other hand, if policymakers decide to defend the currency by raising interest rates, they would be sending the economy into a recession. To repeat, the dilemma faced by policymakers is: (1) defend the currency with high interest rates and spread the recessionary effects of a crisis; or (2) defend the domestic economy against the recessionary effects of a crisis and intensify the problems of a collapsing currency. Unfortunately, neither of these alternatives is attractive.

7. Explain the moral hazard problems inherent in responding to a crisis. Answer:

A moral hazard problem exists when one party involved in a transaction has both the incentive and the ability to shift costs onto the other party. For example, responding to a crisis with a lender of a last resort such as the IMF creates incentives that both invite reckless behavior on the part of the country in crisis and bad policies for the investors and host borrowing countries. If investors and the country in crisis know that they will be bailed out, they tend to take greater risks than is prudent. On the other hand, the outcome of the crisis could be worse if there is no response. Investors may lose a substantial portion, or all, of their assets and the country in crisis may plunge into a deeper recession than it otherwise would. This is the policy dilemma facing international institutions such as the IMF. The three-point Basel Capital Accord is designed to ease the moral hazard problem described above. But since there is no way to eliminate it completely, the moral hazard problem associated with the mere existence of a lender of last resort still remains.

8. Some people argue that the U.S. loans to Mexico in 1995 led to the East Asian crisis. Explain the logic of this argument. Answer:

The main argument is that the United States created a moral hazard problem by bailing out Mexico. Critics charge that the IMF loans to Mexico set a precedent, teaching lenders that their mistakes would be covered by loans from the IMF. The same moral hazard argument is made concerning the countries in crisis themselves. Some allege that even though the

Chapter 12

International Financial Crises

IMF might have warned these countries of their looming financial crisis, the countries’ authorities failed to aggressively reform their financial institutions, knowing that they would get financial help from the IMF and industrial nations. 9. Some countries impose capital controls as a means of preventing a crisis. Evaluate the pros and cons of this policy. Answer:

The issue of capital controls (usually accomplished by limiting the quantity of capital transactions, taxing transactions, requiring advance notices and waiting periods, etc.) is a slippery slope and an unsettled issue because there are potential benefits and costs associated with this action. On the one hand, the use of capital controls helps minimize the volatility of the capital market and the risks associated with it. Moreover, selective capital controls such as maintaining the proper balance between portfolio capital and FDI entering the country may help avoid and/or minimize a financial crisis like the one that hit Mexico in 1994–1995. Interestingly, some countries such as Malaysia and Chile were able to manage their economies by adopting capital control policies. By not heeding the IMF advice against the use of capital controls, Malaysia was able to recover as quickly, if not quicker, than other countries, even in the face of a financial crisis. Chile was able to insulate its economy from contagion effects of the financial crises by keeping a proper balance between portfolio investment and FDI. On the other hand, a country using capital controls risks at least the following drawbacks: (a) an increase in the uncertainties of its financial markets and a drying-up of needed foreign investments; (b) if (1) investors think that the value of the country’s currency is overvalued, or (2) if the country’s savings are insufficient to support the desired investment (i.e., domestic investment exceeds domestic saving) and therefore it wants to attract more foreign capital, then it may want to devalue its currency. However, devaluation hurts investors already in the market. In order not to lose their assets further, they may want to take it out of the country. These may create financial havoc in the country; (c) if a financial crisis has already taken place and the country is unable to control the markets, then all foreign capital may leave the country almost instantly, thereby intensifying the financial havoc. These are some of the things that took place during the 1994–1995 Mexican crisis.

10. How has the role of the IMF come under scrutiny in the recent discussion of reforms in the international financial architecture? Answer:

As shown in Chapter 2 of the textbook, one of the roles of the IMF is to act as a lender of last resort. There are two questions that are being raised on the role of the IMF as a lender of last resort: First, what are the roles of a lender of last resort, and should there be any rules governing its lending practices? Second, are there conditions that a lender might impose on borrowers, and if so, what are they? By acting as the lender of last resort, the IMF creates the moral hazard problem. The other issues include how high an interest rate it should charge when making the loans, the length of the payback period, and the size of its loans. Unfortunately, there is no consensus on any of these issues. Countries such as Malaysia, who refused to work with the IMF, were able to recover from the crisis as quickly as countries such as South Korea which accepted the IMF advices and conditions. Given this fact and the potential moral hazard problem the IMF creates, some question the importance of such an institution. The IMF was also criticized for taking the responsibilities that were better left to the World Bank and other regional

Gerber • International Economics, Seventh Edition

development banks (“mission creep”). As a result, several proposals are suggested to reform and reduce the role of the IMF. The other issues involve the conditions that the IMF could impose on countries facing financial crises. These may include changes in fiscal, monetary, and trade policies and a restructuring of the financial system and public enterprises. All of these infringe upon the rights of any sovereign nation and generate significant opposition. Policy makers and experts do not agree on the conditionality issue either. Some take the conditional ties as being too punitive and too contractionary. Others think they are too lax and too generous.

Chapter 13 The United States in the World Economy ◼

Outline

Introduction: A Changing World Economy Background and Context The Shifting Focus of U.S. Trade Relations Case Study: Manufacturing in the United States The NAFTA Model Demographic and Economic Characteristics of North America Canada-U.S. Trade Relations Mexican Economic Reforms The North American Free Trade Agreement Two NAFTA-Specific Issues Case Study: Ejidos, Agriculture, and NAFTA in Mexico New and Old Agreements Labor and Environmental Standards Investor-State Relations Jobs and Trade Agreements Case Study: The African Growth and Opportunity Act

◼

Gerber • International Economics, Seventh Edition

Learning Objectives

After studying this chapter, students will be able to: 13.1 Identify major changes in U.S. economic relations that have led to bilateral and plurilateral agreements. 13.2 Evaluate the relative importance of the North American Free Trade Agreement, both for what it accomplished and as a model for subsequent agreements. 13.3 Explain when purchasing power parity estimates of income per person are superior to the alternatives, and when they are inferior. 13.4 State the reasons why Mexico and Canada sought free trade with the United States. 13.5 Differentiate free trade agreements from preferential trade agreements and give examples of each. 13.6 State why it is difficult to have precise estimates of job gains and losses due to trade, and give specific examples of how imports may create jobs and exports may occur after a loss of jobs. ◼

What Students Should Know after Reading Chapter 13

Chapter 13 presents a broad view of U.S. trade agreements while maintaining the primacy of NAFTA as the model for subsequent agreements. Students should be encouraged to see NAFTA in these terms: a key agreement with two of our three most important trade partners (China is the third, as measured by value of exports and imports), and the foundation for bilateral and plurilateral agreements with other countries and regions. Chapter 13 discusses the continued controversy surrounding NAFTA in the United States. At the time NAFTA was signed, U.S. barriers to Mexican imports were already low and there was a pre-existing free trade agreement with Canada. The U.S. market accounts for the vast majority of the nearly $18 trillion NAFTA market, so any impact on the U.S. would be small. The popular controversy in the United States over NAFTA’s economic impacts continues to be largely about labor and environmental issues, but several other issues have become important, particularly as the NAFTA model has been replicated in other agreements. These include investor-state relations and intellectual property issues. In addition, there is a brief discussion of immigration issues and drug violence in Mexico. Counterintuitively, it is hard to find a significant negative impact of drug violence outside of the effects on tourism. Mexican manufacturing has continued to develop and multinational companies do not appear to find the added security costs to be a deterrent to investment. Immigration has decreased over the 2005-2010 period, and 2011 is perhaps the first year in which Mexican’s leaving the United States outnumbered Mexicans arriving (both legal and undocumented). The reasons are probably the weakening of pull factors in the U.S. with the weak

Chapter 13

The United States in the World Economy

economy and more hostile political environment, improvements in Mexico’s economy, and demographic shifts that are reducing the number of 18-40 year olds. Chapter 13 discusses Mexico’s reasons for wanting NAFTA, including the desire to attract more foreign investment and implement an external treaty that would help to institutionalize economic policy reforms. Canada wanted a free trade agreement with the United States to keep the U.S. committed to free trade and to put competitive pressure on Canadian firms to be efficient. The chapter gives some background for the economic history and the changes in economic policy that occurred, especially within Mexico, where tremendous policy changes have taken place as the country shifted from an inward-looking, import substitution industrialization strategy to an outward-looking strategy. Students are always tempted to understand correlation as causation and it is tempting to look at the passage of NAFTA as somehow having caused whatever came next—the peso crash of 1994-95, economic growth, and so forth. It is important to emphasize that trade agreements are about trade and they should be judged as successes or failures in those terms and not in terms of the unemployment rate or GDP growth. NAFTA should lead to more efficient resource allocation, but that does not lead to easily countable effects on employment. Students should understand that jobs will be distributed differently as resources can be allocated to the more productive uses, which doesn’t necessarily mean a huge effect on overall job creation, especially for a market as large as the United States. This rather commonplace observation by trade economists is largely lost on both students and the general public, where the widespread belief is that countries sign trade agreements for mercantilist reasons: jobs and exports. This means the chapter can play an important trade education function. As NAFTA is presented in the media, it appears to give permission for direct foreign investment and for outsourcing jobs abroad that was lacking prior to its signing. Students should understand that economic integration between the three NAFTA countries is as much market driven as it is institutionally driven— perhaps even more. Canadian-Mexican ties may be an exception, but indicators of economic interaction between the United States and Mexico and between the United States and Canada show that trade and investment were growing significantly before NAFTA. Furthermore, much of the recent growth in bilateral relations between the United States and Mexico was dependent on Mexican economic reforms— not on NAFTA per se, although NAFTA certainly helped to cement those reforms in Mexican policy. Even without a NAFTA agreement, many of the same trade and investment flows would probably have occurred. The chapter illustrates how the U.S. has turned towards bilateral and regional agreements as the Doha Round of multilateral negotiations has faltered. This strategy allows the U.S. to negotiate trade agreements that include matters relating to labor and environmental standards, investor-state relations, and intellectual property rights that it would never be able to negotiate in a multilateral setting with more than 150 nations. It is an alternative strategy to multilateralism, and in the long run may prove to be very significant. The first case study is designed to challenge the view that the United States does not have a vibrant manufacturing sector. Ask your students: In what year did the inflation adjusted value of U.S. manufacturing reach its peak? The answers they give usually range from the 1960s to the 1980s. Few of them understand that productivity increases have reduced the manufacturing labor force but not the value of output, which continues to grow each year except during recessions. This issue is further complicated by the shift within the United States of manufacturing, broadly speaking, from north to south.

Gerber • International Economics, Seventh Edition

◼ Assignment Ideas 1.

NAFTA has been controversial, but with almost twenty years experience, there has been the opportunity for follow-up research on its impacts. Have students research the impact of NAFTA on a particular industry or analyze NAFTA’s overall impact on the U.S. and Mexican economies, as described in the chapter. A particularly interesting exercise would be to look at the shift in manufacturing from northern industrial states such as Ohio to southern Sunbelt states such as Texas. Is this due to NAFTA? An excellent data source for student papers is the Department of Commerce and International Trade Administration’s Trade Stats Express: http://tse.export.gov/TSE/TSEHome.aspx

What are the prospects of NAFTA becoming a customs union? Have students identify the policy changes that would be necessary and the likely political and economic obstacles to those changes taking place. What would be the major benefits and the major costs to deeper economic integration in North America?

The Migration Policy Institute has a wealth of data, much of it in map form, on migrant settlement patterns. Which are the largest receiving states in the United States (www.migrationpolicy.org)?

Chapter 16 has a case study on the World Bank’s Doing Business homepage. You may find it useful to introduce this Website at this point (http://www.doingbusiness.org/) and have students compare the indicators for the NAFTA countries, or some of the other trade partners of the U.S.

◼ Answers to End-of-Chapter Questions 1.

What factors caused the U.S. to shift its focus from a more multilateral approach to a more bilateral and plurilateral one? Answer:

As membership in the WTO has grown to include more than 150 members (157 in August, 2012), and as tariffs and quotas have been reduced, trade negotiations have become more difficult. In part this is because negotiations among so many countries with such disparate interests and priorities is cumbersome and difficult, and in part it is because the content of negotiations frequently focuses on sensitive elements of domestic policy such as intellectual property regimes, foreign investment, standards for labor and environmental conditions, and industrial development policies. Consequently, it has become easier to develop trade agreements with economically or politically important trading partners. It also allows the U.S. to experiment with new rules and new processes for implementation and enforcement.

Chapter 13

The United States in the World Economy

How has the trade-to-GDP ratio changed for the United States over the last several decades? Answer: Between 1960 and 2007, when the subprime crisis began, the trade-to-GDP ratio tripled, rising from 10 to 30. After the onset of the crisis, it fell back as world trade declined, but has begun to recover.

Why is the trade-to-GDP ratio for Canada greater than that for the United States? Answer:

Explain how an increase in U.S. and Canadian intraindustry trade altered the level of productivity in the affected Canadian sector. Answer:

The 1965 Auto Pact created nearly free trade in the automotive sector. Prior to the Auto Pact, strict Canadian content requirements forced manufacturers to make most of the cars in Canada that they wanted to sell domestically. This reduced consumer choice because Canadian-based plants could not afford to make as many different styles and models given the small size of the Canadian market. In addition, it meant that plants often operated well below their minimum efficient size. Productivity in the auto sector was consequently about 30 percent less than in the United States, even though the auto plants were owned by the same big firms that owned American plants. Once the market was opened, Canadian firms could concentrate on a few styles that they produced for the combined U.S. and Canadian markets. This increased plant scale and productivity. Consumer choice was increased because there were many more models to choose from.

What were Canada’s motives for proposing and signing the Canadian-U.S. Free Trade Agreement? Answer:

The primary reason for the difference is the sizes of the two countries. Canada’s much smaller population does not allow it to specialize in as many different goods as the United States or enjoy the same economies of scale. Consequently, it is more dependent on trade.

Canada worried about the increasingly protectionist tendencies it saw developing during the 1970s and 1980s in the United States. It depended heavily on trade and, in particular, trade with the United States. Hence one of its major goals was to lock the United States into a free trade agreement in which it would be much more difficult for the United States to raise protectionist barriers. In addition, many observers inside Canada felt that Canadian firms needed to restructure to become more competitive in a more globally competitive market, especially given Asian manufacturing. The goal was to open the Canadian market to stiffer competition from the United States and use the competitive pressures that were generated as a force for positive change in the Canadian economy.

What were the forces at work in the Mexican economy that led to the market reforms and market opening of the mid-1980s? Answer:

The main force was the debt crisis that began in 1982. The crisis resulted from heavy Mexican borrowing during the late 1970s when the price of oil was high. The Mexican government borrowed in order to spend and stimulate the national economy. When the debt crisis began, Mexican policy was inward oriented (antitrade) and highly activist. Government owned a large number of economic enterprises and attempted to direct growth through controls rather than through market mechanisms. Foreign capital stopped flowing, credit became scarce, and investment declined. In the crisis atmosphere of the early 1980s, it was no longer possible for the government to be an activist in the economy because it lacked the resources. In addition, there was a widespread recognition that market forces needed to play a much larger role in the economy. To get foreign investment and to lessen the role of government, reforms were adopted.

Gerber • International Economics, Seventh Edition

What were Mexico’s motives for proposing and signing the North American Free Trade Agreement? Answer:

In what areas are there NAFTA side agreements? Discuss the pros and cons of these agreements. Answer:

President Salinas wanted to attract direct foreign investment to Mexico in order to supplement the low level of national savings and also to make sure future Mexican governments didn’t return to government’s traditional role as one of the primary sources of investment. Salinas wanted to tie up reforms in an international treaty, making it harder to reverse those reforms. A treaty granting full access to the U.S. market for anyone producing products in Mexico would help foreign investment. For Salinas, NAFTA would change international perceptions about the Mexican economy and help to prevent future Mexican presidents from reversing the market-opening changes in Mexican policy that he and his predecessor had implemented.

The side agreements cover labor and environmental standards. Essentially, they entail international scrutiny of each country’s rules and inspection to determine whether the rules are being enforced. They do not harmonize rules. The pro arguments are that the agreements create institutional mechanisms that approved a process by which economic actors in each country can initiate formal complaints about the lack of enforcement of standards. Prior to the agreements, there was no process for lodging a complaint or starting an investigation. The hope is that the creation of a process will reduce suspicion and distrust and lead to greater acceptance of NAFTA. The con arguments can be divided into two distinct points of view. One group, unionists for example, argue that the agreements are ineffective by design. In their view, they do not go far enough. They should harmonize standards and impose heavier penalties on violators. The opposite point of view is that the agreements should not exist in the first place. Trade issues should not be mixed with nontrade matters. It leads to protectionism through the back door and has the harmful effect of eliminating some of the comparative advantage of nations.

Why has Mexican migration to the United States slowed? Answer:

The text gives three reasons: (1) It is harder, more dangerous, and more expensive to cross the border; (2) The economic and political environment in the U.S. is less receptive to immigrants, particularly those without documentation; and (3) demographic changes in Mexico. Increased border enforcement has pushed undocumented migrants into the desert and mountain regions of the border where conditions can be extremely harsh. At the same time, migrants have become targets of organized criminals, and prices for a guide in to the United States have continued to climb. At the same time, the slowdown in the U.S. economy means that it is harder to find a job, and anti-immigrant sentiment has increased, sometimes taking the form of legislation that seeks to punish employers and others who help immigrants. The Obama administration has increased the number of deportations. In the long run, the most important factor may be demographic changes in Mexico that are reducing the number of people in the high migration age groups, 18–40.

10. What are preferential agreements and why are they used by the United States? Answer:

Preferential agreements are usually unilateral agreements involving an advanced economy such as the United States with several other developing countries. The U.S. unilaterally opens its market to some or all of the products from a group of developing economies. The goal is to support economic and political goals, such as economic growth and development, and in the case of the Andean Trade Preference Act, alternatives to cocaine production. .

Chapter 13

The United States in the World Economy

11. Explain why claims about job creation and job destruction due to NAFTA are likely to be misleading and inaccurate. Answer:

It is extremely difficult to measure the job creation and destruction effects of a trade agreement like NAFTA. Looking at job creation first, there is the problem that if an American firm that buys supplies from other American firms moves to Mexico or Canada, the inputs it buys suddenly become exports, yet no new jobs are created. Measurements of job destruction are marred by the fact that imports from Mexico may displace imports from some other country. Hence there is no new job destruction associated with the increase in imports from Mexico. Furthermore, there is the problem of trying to know what would have happened without the agreement. Some firms may move abroad and destroy jobs at home, but without the agreement and the move, they may have become uncompetitive and gone under. With the agreement, however, they continue to order goods from other American suppliers and keep jobs open elsewhere in the economy.

12. Explain how NAFTA served as a model for subsequent trade agreements. Answer: NAFTA provided a framework and starting point for including labor and environmental standards in trade agreements. This was its most important contribution. Since its signing, nearly all U.S. agreements have included similar provisions. In addition, NAFTA also has provided a framework for including rules on the treatment of foreign investors. This has proved particularly important in the many bilateral investment treaties (BIT) that the U.S. has signed. The investor clauses attempt to ensure that foreign investors receive national treatment and that they are not subjected to discrimination by the host government.

Chapter 14 The European Union: Many Markets into One ◼ Outline Introduction: The European Union The Size of the European Market The European Union and Its Predecessors The Treaty of Rome Institutional Structure EU Institutions and Finance Deepening and Widening the Community in the 1970s and 1980s Before the Euro The Second Wave of Deepening: The Single European Act Case Study: The Schengen Agreement The Delors Report Forecasts of the Gains from the Single European Act Problems in the Implementation of the SEA The Effects of Restructuring Harmonization of Technical Standards Value-Added Taxes Public Procurement Case Study: The Erasmus Program and Higher Education The Third Wave of Deepening: The Maastricht Treaty Monetary Union and the Euro Costs and Benefits of Monetary Union The Political Economy of the Euro Case Study: The Financial Crisis of 2007–2009 and the Euro Widening the Union New Members Case Study: Spain’s Switch from Emigration to Immigration The Demographic Challenge of the Future .

Chapter 14

The European Union: Many Markets into One

◼ Learning Objectives After studying this chapter, students will be able to: 14.1 Describe the major institutions and treaty agreements of the EU. 14.2 Distinguish EU widening from EU deepening. 14.3 Give the economic rationale for each of the three waves of deepening of the EU. 14.4 Explain the obstacles to regional integration agreements. 14.5 State two theories as to why the single currency moved forward so quickly. 14.6 Analyze the EU’s single currency program within the theoretical framework of an optimal currency area.

◼ What Students Should Know After Reading Chapter 14 The goal of the European Union is peaceful political, social, and economic integration. The chapter introduction highlights the progress that has been made, and points out that this is the oldest, largest, and most ambitious integration agreement in the world. While the text recognizes that the name used for the participating countries has changed through various stages of the agreement, in the chapter the name European Community (EC) is used for events prior to 1993 and European Union (EU) for events since 1993. The focus of the chapter is on the EU’s institutional structure and the history of its widening and deepening. The stages of deepening of the EU are broken into four steps: the Treaty of Rome, which established a free trade area in the six original members, the European Monetary System (1979), the Single European Act (1993), which created a common market, and the Treaty on European Union (or Maastricht Treaty), which created an economic union. The customs union stage was reached during the 1970s. The recent expansion of the EU to 27 members has generated a number of additional issues. One of the most difficult has been the issue of governance. The Lisbon Treaty, which looks like it will be implemented, provides for a reorganization of voting and representation within the main governance structures. An onagain, off-again issue is Turkey’s accession. Turkey is negotiating membership, but to date it appears as if several key EU members oppose its membership. There is also a brief description of the Erasmus Program, which students may be familiar with if they have studied abroad. Finally, I think it is hard to convey to students the level of violence that raged through Europe for most of the first half of the twentieth century. In spite of that, Europe has achieved the most advanced level of integration of any regional grouping. That achievement is remarkable.

Gerber • International Economics, Seventh Edition

◼ Assignment Ideas 1.

Depending on when you cover this chapter in your course, you might want to start with some basic trivia. Some faculty cover this chapter right after Chapter 2 (as a sort of case study on regional trade arrangements). Pop quizzes on the names of countries, euro-area members, or other basic facts about Europe help reinforce students’ geographical knowledge.

A writing assignment could have students look at the economic situation of any of the recent EU members or countries seeking to join the EU. What are the costs and benefits to each nation of joining the EU? What are the costs and benefits to the EU of adding this nation? I would especially ask students to look at issues related to bringing national policies into line with EU policies. Or, you could ask students to analyze other current economic issues in the European Union. If you are covering this chapter later in the semester, this could allow students to apply knowledge they have developed in other units. In the recent past, the strong euro/weak dollar has gotten a lot of media attention. Noncomplying budget deficits in euro countries have also been getting attention in the media, and agricultural subsidies are almost guaranteed to be an ongoing issue. Addressing these topics could require students to use analysis and synthesis skills as an end-of-term assignment.

The European Union’s official Website, http://europa.eu/, has a wealth of information that can be shaped into a variety of assignments. The European Central Bank also has an interactive games that test knowledge of the EU or allow the student to try different monetary policy regimes.

◼ Answers to End-of-Chapter Questions 1.

What were the three main stages of deepening that occurred in the European Community after the passage of the Treaty of Rome? Answer:

The three main stages of deepening in the EC were (1) the creation of the European Monetary System in 1979, (2) passage and implementation of the Single European Act in 1987 and 1993, and (3) the passage of the Treaty on European Union (Maastricht Treaty) in 1991. The EMS linked EC currencies and reduced their fluctuation against each other. The SEA established the Four Freedoms (freedom of movement for goods, services, labor, and capital) and turned the EC into the EU with a common market. The Treaty on European Union moved the EU into economic and monetary union. The single currency is its most notable feature.

What are the three main institutions of the European Union, and what are their responsibilities? Answer:

The three main institutions are (1) the European Commission, (2) the Council of the European Union, and (3) the European Parliament. The Commission is the executive branch and is charged with enforcing the treaties and introducing new laws. The Council of the EU is the legislative branch and is responsible for enacting laws based on the proposals submitted by the Commission. It has more control over the budget than the Commission or the Parliament. The Parliament is primarily an advisory body that serves as a conduit through which citizens of the EU can express opinions, but has gained some legislative power over time.

Chapter 14

It was hard to reach an agreement because a number of deep integration issues were involved. Issues touching on national policy and reflecting deep differences in history, philosophy, and policy were involved. Some of the most difficult areas involved harmonization or mutual recognition of differing national standards for products, safety codes, industrial processes, and skill certification. Another difficult area involved variation in value-added taxes. Value-added taxes reflect fundamental differences in the philosophy of business-government relations, and harmonization proved impossible even though the high-tax countries are likely to lose businesses, jobs, and revenues to the lowtax countries. Another difficult problem concerns the effects of the inevitable restructuring on communities and workers who are left jobless. As anticipated, some industries (autos, for example) were more able than others to prevent the full effects of a common market. A final area of difficult problems is public procurement. Some nations are unwilling and at times incapable of opening government purchases to non-national firms.

How did the European Union expect to create gains from trade with the implementation of the Single European Act? Answer:

The Single European Act is a case in which it was difficult to create an agreement, despite of the fact that there was near unanimity in support for an agreement. If everyone wanted the agreement, why was it hard to negotiate? Answer:

The European Union: Many Markets into One

The EU expected the gains from trade to show up in several ways. First, it expected the reduction in border barriers would speed the movement of goods and services and reduce the costs of doing business outside one’s nation. Another gain was expected from the increase in competition that firms would experience. It was anticipated that this would lead to new investments, a more mobile and skilled labor force, and greater information flow. The third source of gains from trade was expected to result from economies of scale. Firms have an incentive to reduce duplication in their operations across nations.

A sudden sharp increase in the demand for the German mark almost destroyed the Exchange Rate Mechanism in 1992. Explain how a rise in the demand for a currency can jeopardize a target zone or exchange rate band. Answer:

The demand for the mark in 1992 increased its value. An increase in the value of the mark is equivalent to a decrease in the value of the other currencies. With a target zone exchange rate, currencies are required to remain within a given range of each other’s value. The fall in value suffered by the French franc and other currencies pushed them out of the range of values they were obliged to maintain against the mark, at which point their monetary authority had to intervene. Intervention usually occurs through the offering of marks to the market (buying up their own currency) or through an increase in interest rates. Both policies create extra demand for the currency that is falling in value. The problem worsens if either the reserves of foreign currency that are being used to buy up the domestic currency runs out, or if the increase in interest rates is harmful to the domestic economy. At this point, countries may decide that the cost of staying in the target zone is too great and decide to leave. This is what the UK did.

Gerber • International Economics, Seventh Edition

Discuss the pros and cons of the single currency. Answer:

The pros are that it reduces transaction costs of doing business in the single currency countries. No costs are paid to change money, to hedge in forward markets, or to have multiple accounts. There is some hope that it may also increase trade and investment flows, but there is little empirical evidence pointing to this as a benefit. Another pro, not discussed in the text, is purely political. A single currency may provide political momentum for deeper reforms which generate even greater cooperation between nations. On the other hand, a failed single currency is likely to lead to acrimony and blame. The cons are the loss of an independent monetary policy. If the nations are not part of an optimal currency area, then this could be a significant cost. Given the size of the German economy, some may argue that most nations in the EC could not exercise a truly independent monetary policy anyway. This is likely the case, particularly for the smaller countries such as The Netherlands; however, it is probably not the case for larger countries like the UK.

What problems arose from the admission of twelve new members between 2004 and 2007? Answer:

Problems include the following. (1) Agriculture and agricultural policies. Several of the new EU countries have large agricultural sectors that are problematic given the EU’s Common Agricultural Policy. (2) Migration is a potentially a problem, especially as more time passes. (3) Changing the governance structure of the EU institutions was necessary and difficult. (4) The widening differences in income between new and old members also could be a problem. The low incomes of such a large number of new members may make it difficult to meet their economic needs. Nations also have differences in infrastructure due to the income differential. (5) Relationships between new EU members and the nations farther to the east could create challenges, especially in EU-Russian relations. Instructors may have to revise this answer as time passes and we experience the actual transition for Bulgaria and Romania.

How does the European Union compare and contrast to the NAFTA region in size, institutional structure, and depth of integration? Answer:

In terms of population, the EU is larger than the NAFTA market. The NAFTA market is larger in terms of total GDP. NAFTA is only a free trade area and does not have the overlying political institutional structure that the EU has. Each nation in NAFTA continues to set its own external trade policy and economic policy. Labor is not allowed to flow across borders in NAFTA. The twelve countries that use the euro have participated in the deepest level of economic integration, economic union, while the other members of the EU share a common market, including some non-EU participants. The twelve newest members (and all future members) are expected to someday participate in economic union.

Chapter 15 Trade and Policy Reform in Latin America ◼ Outline Introduction: Defining a “Latin American” Economy Population, Income, and Economic Growth Import Substitution Industrialization Origins and Goals of Import Substitution Industrialization Criticisms of Import Substitution Industrialization Case Study: ISI in Mexico Macroeconomic Instability and Economic Populism Populism in Latin America Case Study: Populism in Peru, 1985–1990 The Debt Crisis of the 1980s Proximate Causes of the Debt Crisis Responses to the Debt Crisis Neoliberal Policy Reform and the Washington Consensus Stabilization Policies to Control Inflation Structural Reform and Open Trade Case Study: Regional Trade Blocs in Latin America The Next Generation of Reforms Case Study: The Chilean Model

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◼ Learning Objectives After studying this chapter, students will be able to: 15.1 Describe the strengths, weaknesses, and reasons for import substitution industrialization. 15.2 Explain the strategy and performance of economic populism. 15.3 Give the main reasons for the debt crisis of the 1980s and analyze its relationship to ISI. 15.4 Discuss the goals of economic policy reforms that began in the later 1980s. 15.5 Explain why some Latin American leaders have become impatient with Economic policy reforms.

◼ What Students Should Know after Reading Chapter 15 Recent Latin American economic experiences cover most of the material in the text, making it an excellent arena for bringing together the interplay of trade, finance, and integration issues of Chapters 1 through 14. The goal of both this chapter and the next two is to provide case studies that demonstrate the utility of the earlier material. It begins with an orientation to the countries, population, and GDP of Latin America. Chapter 15 proceeds historically from the mid-twentieth century, describing in turn the retreat from the world economy through the adoption of ISI policies, the appearance of economic populism and the resulting macroeconomic instability, the debt crisis, and the policy reforms of the 1980s and 1990s. This chapter does not argue that ISI caused the economic failures of the 1980s, but that it did produce manufacturing sectors that were less able to respond to the failures brought on by unsustainable macroeconomic policies. The long-term disadvantages of inward-looking policies are most clearly seen in economic history of Latin America in the 1980s. The Washington Consensus is used as shorthand for the broad series of reforms undertaken by most countries beginning in the mid-1980s but gaining momentum and greater weight in the 1990s. Students should be familiar with the label “neoliberalism” after reading this section. The second generation of reforms and reaction to the policy changes of the 1980s and 1990s is covered briefly, but given the high degree of uncertainty regarding the direction that these responses will ultimately take, I have not tried to provide a complete categorization. Venezuela’s Chavez presents one type of response, while Brazil’s Lula is another, and Chile’s socialist presidents (Lagos and Bachelet, who left office in 2009) are a third response. This is not an exhaustive list, and other experiments continue. The primary point and one that is shared by most analysts, regardless of their political perspective, is that Latin America has made a lot of changes and did not get much in return. Growth came back, but it has been mediocre at best in most countries, and little progress has been made in reducing poverty or income inequality. The one exception to this characterization of the reforms is Chile. The chapter concludes with a case study of the Chilean Model, which looks a great deal like the social democracy in Western European countries.

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◼ Assignment Ideas 1.

The very recent past in Latin America suggested at least the possibility of a swing back toward populism. Students can research this question and decide whether current populism in Latin America is similar to past populist movements, especially by comparing economic policies. Candidates for populist leaders include Chavez (Venezuela), Correa (Ecuador), Ortega (Nicaragua), Morales (Bolivia), Kirchener and Fernandez (Argentina), and Zelaya (Honduras). Perhaps most notably is the way Lula (Brazil) confounds this category.

Latin America has a wealth of regional trade agreements. A complete list and access to the texts (some only in Spanish) is the Foreign Trade Information System (SICE is the Spanish acronym) created by the OAS and available at http://sice.oas.org/. Most information is available in English as well as Portuguese and Spanish. Students could be asked to review an agreement (some are quite long), or to review a country’s set of agreements, or to analyze their likely effects on exports and imports. For example, Chile just signed an agreement with China. What products are most likely to be involved in expanded Chilean–Chinese trade?

◼ Answers to End-of-Chapter Questions 1. What were the main characteristics of economic growth in Latin America from the end of World War II until the debt crisis of the 1980s? Answer:

The text characterizes growth in Latin America as (1) inward oriented, (2) unequal in the distribution of its benefits, and (3) unstable. Growth overall was adequate to good in most countries, at least until the 1970s (Table 15.3). The inward orientation of growth was a result of import substitution industrialization policies that targeted the development of industries producing import competing manufactured goods. Inequality was most prominent in the dichotomy between cities and rural areas, but even within cities extreme inequality was the norm. Latin American indicators of income and wealth equality (Gini coefficients, etc.) show it to be the most unequal region in the world. Instability was mostly the result of poor macroeconomic decision making. Huge fiscal deficits and hyperinflation became increasingly common in the period leading up to the debt crisis.

2. What is import substitution industrialization? Explain its goals and methods. Answer:

ISI is an economic development strategy that uses industrial policies to target industries producing import-competing goods. The goal is to develop the industrial capacity of the economy. Industrial policies are targeted on import substitutes because it was believed that declining terms of trade would create shortages of foreign exchange and constrain the importation of needed goods. Hence by producing substitutes for imports, countries could avoid the consequences of inadequate foreign exchange. The methods of ISI included all the methods of industrial policies. Among them were the nationalization of firms and industries, the subsidization of production through provision of inexpensive credit, foreign exchange or other inputs, and protectionist trade policies. In some countries foreign direct investment was encouraged but in others it was not. Often, when it was encouraged, performance requirements were placed on the foreign firms (Mexico, for example).

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3. What are the main criticisms of import substitution industrialization? Did ISI fail? Answer:

The text describes five main criticisms. These are (1) misallocation of resources when governments make production decisions, (2) the constant tendency toward overvalued exchange rates, (3) urban bias, (4) a worsening of income inequality, and (5) widespread rent seeking. Government involvement in production decisions meant that business criteria were not used to make allocative decisions. Even if they did not nationalize firms, they still were involved in decisions of credit and exchange rate provision, import licensing, granting of monopolies, and other acts that had a profound effect on the development of specific firms and industries. The tendency toward overvalued exchange rates was in part by design and in part resulted from higher rates of inflation coupled with pegged or fixed nominal exchange rates. Overvalued currencies enabled favored importers to obtain goods cheaply and kept prices lower for urban consumers who had a significant amount of imports in their consumption basket. The urban bias resulted from the favoritism shown to industry and the implicit discrimination against agriculture. It also had a political component since many modernizers depended on an industrial urban working class for political support. Since most poor people live in the countryside, an urban bias in development implies a worsening (or constant level) of inequality. Governments distributed valuable goods and services: import licenses, tariff protection, subsidized credit and foreign exchange, and monopoly rights. As a result, there was a strong incentive for firms to spend resources seeking the rights granted by governments.

4. Describe a typical cycle of economic populism. Why does it often leave its supporters worse off than before the cycle begins? Answer:

The typical cycle goes through phases. In the first phase, there is widespread disillusionment with current policy, often as a result of a recession or a period of very slow growth. In the second phase, populist governments begin a program of “reactivation, redistribution, and restructuring.” In this program, the usual macroeconomic constraints of budgets and foreign exchange are ignored. Budget deficits are run up—often through the printing of money—in order to stimulate the economy. It often works. In the third phase, however, growth leads to imports and trade deficits and the beginning of bottlenecks in the economy as shortages develop. In this phase, policymakers often raise wages and freeze prices as part of the redistribution package. Production is focused on import substitutes as part of the restructuring package and as a means to lessen the foreign exchange constraint. As growth resumes, prices begin to rise in spite of attempts to freeze them. This is due to the severe shortages and bottlenecks in production. In the fourth phase, inflation can become severe while the use of the government budget to stimulate production leads to large deficits. Ultimately, capital begins to flee the country as everyone anticipates that the policies are not sustainable and that the currency will be devalued. Capital flight and the perception that policies are unsustainable depress investment, which reduces growth and real wages. In the final analysis, the increase in wages falls behind the increase in prices and wage earners lose ground. Not uncommonly, extremely high rates

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of inflation cause wage earners to give up all their gains. In the end, they may be worse off than at the beginning of the cycle. 5. Explain how economic populist policies usually lead to overvalued exchange rates and large trade deficits. Answer:

Populist policies involve large increases in government expenditures. These are usually paid for by printing money because there is no market for bonds, and tax systems are inadequate. Ultimately, this leads to rapid inflation, even hyperinflation in a number of cases. Whenever domestic prices increase faster than the depreciation of the nominal exchange rate, the real rate must appreciate. Appreciating exchange rates lead to overvaluation and large import flows together with a decline in exports.

6. What were the proximate causes of the debt crisis? How did the United States and other industrial countries respond? Answer:

One may argue that decades of ISI policies caused the debt crisis, but the immediate causes were more direct. These included (1) a decline in oil prices, (2) a rise in world interest rates, and (3) recessions in most of the world’s industrial countries. The first factor reduced the creditworthiness of oil exporters such as Mexico and Venezuela and hurt their ability to service their debts with foreign revenue earnings. The second factor increased the cost of debt service since many loans were at variable interest rates. The third factor reduced the ability of all countries to earn revenue by exporting. The United States responded by trying to put together a new round of lending. It was hoped that new loans would restore growth and that countries could grow their way out of their problems. This was the Baker Plan. It was moderately successful in creating new loans, but growth did not rebound. The burden of debt service and the relatively small amount of new loans made it impossible for investment and consumption to begin growing. This stunted overall growth in the economy. By the late 1980s it was apparent that debt relief was needed. This led to the Brady Plan, which provided new money and some modest amounts of debt relief.

7. Why did the Latin American debt crisis of the 1980s cause recessions in each country? Answer:

The requirements to service the debt by making interest payments and principal amortization entailed large capital outflows and current account surpluses. This reduced the amount of savings that was available for investment. Furthermore, expenditure-reducing policies cut total consumption and increased savings. The lack of domestic demand led to recessions.

8. What is the difference between stabilization policies and structural adjustment policies? Give specific examples of each. Answer:

Stabilization policies are designed to stop inflation and eliminate large budget deficits. The main way to implement these policies is through a cut in government expenditures. This reduces demand and eliminates the need to print new money to finance government expenditures. Structural adjustment policies are designed to open the economy to more market-based decision making. These include trade reforms, privatizations, and deregulation.

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9. What is neoliberalism? Why do some people consider it a negative term? Answer:

Neoliberalism refers to the stabilization and structural reform policies that would be recommended in the Washington Consensus. It represents a return to the classical liberalism of the nineteenth century, which stressed minimal government involvement in the economy. In Latin America in the 1980s and 1990s it included the removal of government from much of the economic decision making and a turn toward market-based allocative mechanisms. Deregulation, privatization, an end to government subsidies, and less concern for market failures than for government-created inefficiencies are all part of the package. Additional specific policies usually include a cut in government spending, open markets, and heightened competition. Many people in Latin America believe the reforms have not solved the region’s most pressing and fundamental problems, such as inadequate growth (especially compared to rising population), high levels of inequality, and vulnerability to macroeconomic crises. They have been distrustful of markets and market-based allocation mechanisms. They worry that market failures will be ignored, that inequality will worsen, and that the pursuit of economic gain will undermine civic values. More recent reforms, often called secondgeneration reforms, are more focused on the problems of ending poverty and addressing income inequality.

10. What was the content of Latin American trade reforms of the late 1980s and 1990s? How do the actions taken relate to the desired goals? Answer:

Trade reform included (1) an opening of markets, (2) the creation of new trade blocs such as NAFTA and the revitalization of old ones such as the Central American Common Market, and (3) the signing of a number of bilateral free trade agreements. Market openings were pursued through a reduction in tariffs and quotas. Through these actions it was hoped to intensify competition, create economies of scale, and increase the efficiency of firms. These goals are expected to result from the market opening movements of (1) through (3). There has been some success, especially in Chile and in Mexico.

Chapter 16 Export-Oriented Growth in East Asia ◼

Outline

Introduction: The High-Growth Asian Economies Population, Income, and Economic Growth A Note on Hong Kong General Characteristics of Growth Shared Growth Rapid Accumulation of Physical and Human Capital Rapid Growth of Manufactured Exports Stable Macroeconomic Environments The Institutional Environment Case Study: Worldwide Governance Indicators Fiscal Discipline and Business-Government Relations Case Study: Doing Business in the Export Oriented Asian Economies Avoiding Rent Seeking Case Study: Were East Asian Economies Open? The Role of Industrial Policies Targeting Specific Industries Did Industrial Policies Work? Case Study: HCI in Korea The Role of Manufactured Exports The Connections between Growth and Exports Is Export Promotion a Good Model for Other Regions? Case Study: Asian Trade Blocs Is There an Asian Model of Economic Growth?

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◼ Learning Objectives After reading this chapter, students will be able to: 16.1 List four general characteristics of success in the export-oriented East Asian economies. 16.2 Describe how the institutional environment supported economic growth. 16.3 Analyze the degree of openness in the export-oriented East Asian economies. 16.4 Explain the pros and cons of the idea that industrial policies mattered to East Asian success. 16.5 Evaluate the impact of export promotion policies and the debate over their applicability to other world regions. 16.6 Define total factor productivity and explain why economists use it to understand whether growth in East Asia is similar to growth elsewhere.

◼ What Students Should Know after Reading Chapter 16 The high-growth economies of Asia covered in Chapter 16 stand in sharp contrast to the Latin American economies studied in Chapter 15. Generally speaking, these economies have avoided populist policies, have shared the benefits of growth, and had relatively open economies. The primary goal of this chapter is to flesh out this contrast in greater detail, and in the process, provide background information about the institutional and policy environments of the high-growth Asian economies. The institutional environment of East Asia is an important contributor to its success. Nevertheless, the 1997 crisis eroded some of the confidence about this view. This chapter maintains that the crisis has not undermined the validity of this view and that the rapid recovery underscores the fundamentally robust character of most countries’ institutions. Many of the problems of East Asia were attributable to speculative flows and to the tremendous success of these nations in attracting foreign capital. Other problems are attributable to “crony capitalism,” which is essentially a lack of transparency in business dealings, but this is controversial. Some have argued that in the West, we tend to call “crony capitalism” by the name “social networks,” but it amounts to the same thing. In the final analysis, the crisis of 1997–1998 did not alter the basic point that shared growth, rapid human and physical capital accumulation, fiscal discipline, cooperative business-government relations, and a relatively well-paid and respected bureaucracy have each played a key role in the growth performance of these nations. Chapter 16 explains some of the controversy over the role of industrial policies. This is an unsettled issue in the context of East Asia, although skepticism about the efficacy of those policies has probably grown since the crisis. One interpretation of the crisis is that it was made much worse by bad bank debts, which in turn were the result of industrial policies that directed credit to specific industries and enterprises. The view offered here is that industrial policies were not essential to the successes of the high growth Asian economies, nor were they a net drain.

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Chapter 16 ends on a note of skepticism about the idea that East Asian growth represents a new model of economic growth. The rapid accumulation of physical capital is suggested by empirical work to be the main contributor to economic growth in the these economies, so it appears that the keys to growth continue to be savings and investment.

◼ Assignment Ideas 1. The high growth Asian economies are also part of regional trade agreements, particularly the Association of Southeast Asian Nations (ASEAN). ASEAN’s website (asean.org) is in English and contains a wealth of information about the ASEAN agreement and the nations included in it. In particular, the Asian Economic Community, a subgroup of ASEAN, created a common market similar in many ways to the European Union. Research projects might compare and contrast the two economic communities and the challenges involved in integration. 2. As China and the high growth Asian economies continue to grow, wage pressure has increased. These countries, to greater and lesser extents, have specialized in labor intensive goods with standardized production methods. As wages rise, some or all of these countries have lost some or all of their comparative advantage in these goods. Students might research the wage differentials between these countries (with appropriate productivity adjustments) and trace the changes in major exports over time. In particular, they might study the differences between South Korea, on the high end of the growth spectrum, and Indonesia or one of the other Asian economies that has not industrialized as rapidly. What explains these differences? How do higher wages in these economies change the distribution of production of labor intensive goods, both between the countries themselves and the rest of the world? Textiles and apparel may be a particularly interesting case to focus on.

◼ Answers to End-of-Chapter Questions 1.

Contrast the characteristics of economic growth in the high growth Asian economies with the characteristics in Latin America. Answer:

Latin American economic growth was characterized as (1) inward oriented, (2) unequal, and (3) macroeconomically unstable. East Asian growth appears to have been nearly the opposite in every category, although the crisis of the late 1990s indicates that the region is vulnerable to macroeconomic instability. The high growth Asian economies pursued ISI strategies early on, but mostly abandoned them in favor of export promotion. Not only were they focused outward on exports, their economies tended to be more open to imports than most other developing countries. Income inequality has fallen in the high growth Asian economies throughout most of the period of high growth. This is attributable to investment in primary and secondary education, land reform, and the creation of rural infrastructure such as roads, water and sanitation systems, and health care. Again, this contrasts with Latin America. Macroeconomic stability was a general feature of the high growth Asian economies until the crisis of the late 1990s. Most of these countries were on positive growth paths again within a couple of years after the crisis. Growth for the 1990s as a whole lagged growth rates in the 1980s for most of the high growth Asian economies but, even taking into account the crisis, still approached 5 percent in several countries.

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How can passage through a demographic transition lead to higher savings and investment rates? Answer:

Passage through the demographic transition increases the ratio of those economically active to the total population. In other words, as birth rates fall, the share of the population that is in school or preschool age declines. With more people working, total income per person is higher. This creates a larger pool of income out of which savings can take place. Higher savings usually means higher investment.

What are the characteristics of East Asian institutional environments that contributed to rapid economic growth? Answer:

Several characteristics were instrumental. Among the more important ones are (1) well defined and secure property rights, (2) competent bureaucracies, (3) fiscal discipline, (4) business government coordination through mechanisms such as deliberation councils, (5) fewer incentives for rent seeking, and (6) a credible commitment to shared growth. Secure property rights reduce rent seeking and encourage investor confidence by reducing the probability of arbitrary redistributions. Competent bureaucracies reduce corruption and waste associated with political favoritism. Fiscal discipline keeps budget deficits and inflation low, which also encourages investment. Coordination councils are used in several countries and are a way to keep various elements of the business sector informed about each other’s plans as well as government plans. This helps with the coordination of interdependent investment projects and probably reduces rent seeking. The role of deliberation councils is not fully understood, however, and it is controversial. The credible commitment to shared growth reduces social tensions and creates a wider consensus. This plus several of the other factors probably reduces rent seeking, but the relationships are not well understood.

Economists are divided over the effectiveness of East Asian industrial policies. Provide a balanced assessment of the issues that are relevant to understanding the role of industrial policies in fostering growth. Do you think one particular point of view is better than another? Why? Answer:

Industrial policies did not work. The targeted sectors did not grow any faster than the rest of the economy, and the characteristics of overall growth simply reflected the changing endowments of the high growth Asian economies. For example, as literacy and savings rates rose, production developed in industries requiring higher skills and capital goods. Furthermore, one could argue that the chaos of the late 1990s was a result of directed credit programs—one of the most often used tools of industrial policies. Industrial policies worked. Comparisons of growth rates between targeted and untargeted sectors are irrelevant because what we need to know is what would have happened without such policies. Furthermore, you have to look at very specific industries, not broad industrial groupings, in order to see the effects. Given the enormous growth of manufacturing in general, and manufactured exports in particular, it is hard to believe that policies that promoted these industries were simply coincidental to their success. Which answer is better? There does not seem to be enough unambiguous information at this point. Either side can seem persuasive. Until there is more information, the prudent position seems to be one of uncertainty.

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How might manufactured exports contribute to economic growth? Answer:

Export-Oriented Growth in East Asia

There are several likely connections between manufactured exports and growth. Economists do not know for certain which is the most important. The connections include the following: (1) economies of scale when production is for the world market; (2) greater incentives for R&D when production must be competitive in world markets; (3) quicker adoption of international best practices; (4) higher export earnings, which enable a greater volume of imports, including those that embody useful technology; and (5) possible encouragement of FDI under some circumstances.

Is there a uniquely Asian model of economic growth? What are the issues, and how might we go about answering that question? Answer:

Probably not. The best procedure to date for looking at this issue involves an examination of total factor productivity. In the Asian case, the lion’s share of economic growth can be attributed to capital accumulation (savings and investment) and not TFP. Looking at the historical figures for a number of countries, we also see tremendous increases in savings rates (and labor force participation rates). This indicates that the traditional economic view that savings and investment play key roles in economic growth is probably true in the Asian case as well. Proponents of the view that there is a uniquely Asian model want to make an argument that industrial policies and government activism in the direction of economic inputs have played a key role. In part this reflects a genuine belief in the ability of government planners to correct market failures, but it also reflects also a desire to maintain authoritarian political systems.

Chapter 17 China and India in the World Economy ◼ Outline Introduction: New Challenges Demographic and Economic Characteristics Economic Reform in China and India The Reform Process in China Indian Economic Reforms Shifting Comparative Advantages Case Study: Why Did the USSR Collapse and China Succeed? China and India in the World Economy Chinese and Indian Trade Patterns Tariffs and Protection Current Account Balances Looking Forward Four Issues Services Manufacturing Resources Multilateral Institutions Unresolved Issues Environmental Pressures State Capitalism The Choices Ahead

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◼ Learning Objectives After reading this chapter, students will be able to: 17.1 State why China and India are considered disruptive to the status quo. 17.2 Describe the demographic trends in China and India. 17.3 Relate the economic reforms that occurred in China and India. 17.4 Compare and contrast the transition from socialism to capitalism in China and Russia. 17.5 Compare and contrast Indian and Chinese economic growth. 17.6 Use a gravity model to explain Chinese and Indian trade patterns. 17.7 Define total factor productivity and explain why economists use it to understand whether growth in East Asia is similar to growth elsewhere.

◼ What Students Should Know after Reading Chapter 17 This chapter is revised from the sixth edition to focus on the two most populous nations of the world, China and India. In addition to the basic facts about the economic and demographic characteristics of each country, their trade patterns are described in detail. The focus, however, is on the changes in policy that led each of them to turn from isolation and inward-oriented policies to outward-looking integration with world economy and a greater reliance on market-based allocation schemes. Chapter 17 emphasizes the importance of new players in the world economy and raises the question whether this is a return to a longrun historical pattern or is something entirely new. In raising the question, that chapter illustrates how each country had to implement difficult reforms with uncertain outcomes and how the world economy played a varying role in each country’s successful return or entrance on the world stage. Some of the most important remaining challenges facing these economies are presented at the chapter’s end. These include their unbalanced trade patterns, the environmental destruction that has accompanied their growth, political reforms in China, and the role of state capitalism. The latter concept is introduced as the idea that China in particular uses markets and enterprises to serve the national goals of the political class. Whether this will lead to greater vulnerabilities or conflict with more market-oriented economies is an open question, but the use of national champions, state-owned enterprises, and financial repression to direct capital and control economic activity, is an old phenomenon with new energy. Students will be able to apply much of what they learned in the rest of the book to this chapter, as the issues of trade balances, exchange rates, and stabilization policies are all included.

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◼ Assignment Ideas 1.

One issue in studying China is the accuracy of data. While the international community has long considered Chinese government data to be unreliable, in recent years, this has also been an internal issue, resulting in the removal of at least one government official. Thus many individuals and agencies have devoted time and statistical methods to creating better methods of estimating China’s GDP and other economic indicators. Students can discuss and research why China might have an incentive to misstate its economic data, both over time and in recent years, where growth has been less hearty. Likewise, in part due to the existence of a large shadow economy, India’s growth may be misstated. How might these figures be estimated if government data is inaccurate?

As China grows and as more of the population has moved from rural areas to cities, there has been upward pressure on wages. Since much of China’s traditional comparative advantage has relied on abundant supply of low wage labor, this is likely to affect China’s future production. Likewise, rising incomes will change consumer demand and thus the composition of China’s imports. Research projects might include study of changing import and export patterns over the last decade, as well as likely effects on the nations with which China trades.

◼ Answers to End-of-Chapter Questions 1.

Compare the role of agriculture in China and India. Answer:

Describe the process of Chinese reforms from their beginning in 1978 up until China’s accession to the WTO. Answer:

Much of China’s growth has stemmed from moving labor out of low valued added agriculture and into urban production, where the return is far higher. In contrast, India has not made a real push to encourage workers to move out of agriculture, and over half of the population still lives in rural areas. This reduces the efficiency and growth rate of India’s economy.

First reforms were in agriculture. Special economic zones were introduced to try out trade and investment in a controlled setting. These were expanded. In 1986, China applied to join the WTO but did not actually join until 2001, allowing a long period of negotiations and gradual change.

What were the factors that led to economic reform in India, and what were the main elements of the reforms? Answer:

India had an economic crisis which sparked a shift to reform. It also lost the USSR both as its major trading partner and as a model. It observed the changes that had taken place in other East Asian countries, such as Korea. It changed its permitting process, denationalized industries, and opened up to foreign trade and investment, abandoning import substitution industrialization policies.

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Use the gravity model of trade to explain why China trades with Korea, Japan, the United States, the European Union, Hong Kong, and Taiwan. * Answer: The gravity model of international trade uses two variables to predict which countries trade with each other: distance and GDP. The model hypothesizes that, all else equal, countries will trade more if they are closer to each other and therefore have lower transportation costs, and if their GDP is larger so that they are a larger market. Thus China trades with Korea, Japan, Hong Kong, and Taiwan because they are geographically close (as well as because of relatively high average incomes), and trades with the EU and the U.S. because they are large markets.

5. China is a middle-income country with abundant supplies of low-skilled labor. How does it manage to export high-technology products? Does it have a comparative advantage in high-technology goods? Answer: While China has abundant supplies of labor, it also has excellent coastal access and ports. China’s proximity to specialized design and high-technology manufacturing in Japan and Korea enables it to take part in the production chain of high-technology products, even if its own production capacity is not yet as sophisticated as Japan’s or Korea’s. Thus while it would not have a comparative advantage in high technology goods in standalone production, as part of a production chain, it becomes an integral part of assembly. 6.

What are the sources of China’s comparative advantage and how does that show up in the goods it trades? Answer:

Low-wage, low-skill labor, economies of scale, and coastal areas with convenient logistics for trading have all led China to be a leader in manufacturing. Imports of inputs and technology have risen along with its exports.

What are the factors that make India competitive in business services and computer and information services? Do those factors give it a comparative advantage or do they reflect some other source of competitiveness? Answer:

India has English as the language of business and a sector of its economy that is highly trained in information technology available at lower wages than in industrialized countries. It scores poorly on ports and transport, but these are not as necessary as a strong communication system for business and information services exists.

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Why has India not been able to develop a large low-wage, low-skilled manufacturing sector? Can it skip this stage of development and go directly to services economy that exports high value-added services? Answer: Trade imbalances and the outsourcing of services both may lead to more protectionist sentiment in industrialized countries. There are also new flows of funds related to natural resource demands that are providing resources to nations and leaders that at least some policymakers would prefer to isolate.

Chinese policies have created a great deal of controversy and discussion. What are some of the major concerns of the countries that trade with China? Answer: China has a large trade surplus with the United States but not with all of its trading partners. China’s imports have risen along with its exports. China’s trade surplus with the United States is not as large as the overall U.S. current account deficit. The United States could follow policies to reduce its current account deficit even if China made no changes in its policies. China’s currency may be undervalued and gives it a cost advantage on trading partners. China holds a large number of U.S. government bonds, but according to the Federal Reserve, we would only see about 1/4 percent increases in rates if China stopped buying altogether.