Summary Book

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Summary: book "Introduction to International Economics,"

Dominick Salvatore
Economie (Universiteit Leiden)
Verspreiden niet toegestaan | Gedownload door Irish Beltran (icbeltran@yahoo.com)
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Introduction to International Economics

Dominick Salvatore
(2012, Third Edition)
ISBN 9781118092323
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Content
1. Introduction to the Global Economy.......................................................................... 2
2. Comparative Advantage............................................................................................. 4
3. The Standard Trade Model ........................................................................................ 6
4. The Hecksher-Ohlin and Other Trade Theories......................................................... 8
5. Trade Restrictions: Tariffs ....................................................................................... 10
6. Nontariff Trade Barriers and the Political Economy of Protectionism.................... 11
7. Economic Integration ............................................................................................... 14
8. Growth and Development with International Trade ................................................ 17
9. International Resource Movements and MNCs ....................................................... 20
10. Balance of Payments .............................................................................................. 23
11. The Foreign Exchange Market and Exchange Rates ............................................. 25
12. Exchange rate determination.................................................................................. 27
13. Automatic Adjustments with Exchange Rates ....................................................... 28
14. Adjustment policies ............................................................................................... 30
15. Exchange rates, European Monetary Systems and Macroeconomic Policy .......... 32
16. The International Monetary System: Past, Present, Future.................................... 35
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1. Introduction to the Global Economy

We live in a globalized world. Globalization, the increasing integration of economies
around the world (especially finance and trade), was facilitated by the revolution in
telecommunications and transportations. There were several periods of rapid
globalization.
1. 1870-1914: Industrial Revolution and newfound land full of resources
(America, Australia etc.) led to waves of immigrants and export of products.
2. 1945-1980: There was a rapid increase of international trade as heavy trade
protection (Started in the USA in 1929 during the Great Depression) was
broken down.
3. 1980-Now!: This period is the most important one due to great improvements
in telecommunications and transport. Never before did globalization happen at
such a high speed.
Globalization leads to more capital and opportunities around the world, but also
problems like financial crises. The anti-globalization movement blames
globalization for environmental problems and lesser human wellbeing. It is a
challenge to make globalization more human and let everyone benefit from it.
There are countries which can produce everything they need themselves and there are
dependent countries. Interdependence shows the (economic) relationships between
states. It can be measured with the ratio of their imports and exports to their gross
domestic product. Interdependence has grown strongly the last decades.
What else can affect interdependency? Interest rates (funds flow to or away to a state
with fortunate or bad interest rates), trade barriers and states stimulating their own
economies (inhabitants will buy products made elsewhere).
The subject matters of international economics
International trade theory: analyzes the basis and gains of trade
International trade policy: examines the reasons and effects of trade
restrictions.
Balance of payments: summary of all international transactions of all
residents of a nation in a certain period of time, usually a year.
Foreign market exchanges: the framework to exchange a national currency
for another.
Open-economy macroeconomics / international finance: the study of
foreign exchange markets, balance of payments and adjustments to balance-ofpayments disequilibria.
Microeconomics: study of an individual unit, like one nation or one commodity.
Macroeconomics: the study of the whole, like a nation's total payments.
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What are current problems?

1. Slow growth and high unemployment in advanced economies after the
recession of 2008
2. Trade protectionism in advanced countries in a rapidly globalizing world
3. Excessive fluctuations in exchange rates
4. Structural imbalances in advanced economies and insufficient
restructuring in transition economies
5. Deep poverty in many developing countries
6. Resource scarcity, environmental problems
There are four important institutions for the economies.
World Trade Organization (WTO)
- has authority over international trade in goods and services. It deals with the rules of
trade and implements new trade agreements. It rules over trade disputes among its
members.
World Bank
- the bank was created after World War II and provided loans to developing countries
for development programs to reduce poverty. Now, it aims more at development
purposes and reconstruction after humanitarian emergencies or disasters.
International Monetary Fund (IMF)
- It oversees that member nations follow the rules of conduct in international finance
and provides borrowing facilities for nations who have temporary balance of payment
issues. It focuses on macroeconomic policies, especially on exchange rates.
United Nations (UN)
Focuses on international law, security, economic development, social progress and
human rights.
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2. Comparative Advantage
Basis for trade: The forces that encourage trade between nations. Adam Smith
considers this absolute advantage, David Ricardo uses comparative advantage.
Gains from trade: Increase in consumption in a nation as a result of specialization in
production and trading.
Pattern of trade: commodities imported and exported by a nation.
Mercantilism
Mercantilism was a theory that was developed in the seventeenth and eighteenth
century when countries such as England, the Netherlands and Spain had become
modern national states. Mercantilists believed that to become rich and powerful, they
had to export more than was imported. The export surplus would lead to an inflow of
precious metals such as gold and silver. Trade barriers were created to restrict import.
Mercantilism believes a state can only gain something at the loss of others and
therefore promotes economic nationalism. Nowadays, we don't measure in gold and
silver but in flows of goods and satisfaction.
Absolute advantage
Most states voluntarily trade with each other. Adam Smith believed this to be because
of absolute advantage: a state is more efficient than another state in the production of
one commodity, but less efficient in a second commodity. The two states can then
specialize and the output of both commodities will rise, leading to gains. Absolute
disadvantage: a state is less efficient in producing a commodity than another state.
Comparative advantage
Law of comparative advantage: even if one nation is less efficient than the other
nation in the production of both commodities, there is still basis for mutually
beneficial trade. A state should specialize in the product with the least absolute
disadvantage (comparative advantage) and import the commodity with the most
comparative disadvantage (comparative disadvantage).
Wheat
Cloth
US
6
4
UK
1
2
The US would not trade 6W for less than 4C because they can produce that
themselves. The UK's wheat is the comparative disadvantage, cloth is the
comparative advantage. It has an absolute disadvantage on both commodities. Why
can a state still export? Using the above table as an example, the UK's cloth price is
lower than in the US and the price of wheat will be lower in the US.
Labor theory of value: the cost/price of a commodity is determined or can be
inferred from its labor content.
1. Labor is the only factor of production / labor is used in the same fixed proportion
with all commodities.
2. Labor is homogeneous.
Production costs other than labor costs did not affect the relationship between
productivity and export shares (see page 41, case study 2-3).
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Opportunity Cost
Opportunity cost theory: the cost of a commodity is the amount of a second
commodity that must be given up to release just enough resources to produce one
more unit of the first commodity.
Looking at the table on the previous page, this is the opportunity cost for the US:
1 Wheat = 2/3 Cloth. The opportunity cost of wheat is two-thirds of a unit of cloth.
Production possibility frontier
This curve shows all combinations of two commodities a nation can produce by
utilizing all of its resources with the best technology available. This is what it usually
looks like.
Frontiers are always negatively sloped or straight-line downward because a nation

must give up more of one resource to make another commodity. A straight-line
reflects constant opportunity costs: the constant amount of a commodity that must
be given up to produce one other commodity.
Constant opportunity costs happen when 1. Resources/factors in production are
perfect substitutes or are used in fixed proportion when producing both commodities.
2. All units are homogeneous and of the same quality.
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3. The Standard Trade Model

It's more realistic for a state to have increasing opportunity costs. This is the
negative sloped production frontier. The marginal rate of transformation of X for Y
refers to the amount of Y that must be given up to make more X. Costs increase when
1. resources/factors of production are not homogeneous and 2. not used in the same
fixed proportion during production.
Community indifference curve (see below): shows combinations of two

commodities that yield equal satisfaction to the community. Higher curves = greater
satisfaction, lower = less satisfaction. The curves are always negatively sloped
because for a nation to be satisfied, it must consume less of Y if it wants more of X.
Marginal rate of substitution of X for Y in consumption: the amount of Y that a

nation can give up for one extra unit of X and still remain on the same indifference
curve.
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The equilibrium point

In an isolated nation, the equilibrium point is at the highest indifference curve
possible given a nation's production frontier. Autarky: absence of trade, isolation.
Equilibrium-relative commodity price in isolation is the price at which a nation is
maximizing its welfare in isolation. You can see it where the production frontier and
indifference curve touch on page 60.
Equilibrium-relative commodity price with trade is the common relative price in
both nations at which trade is balanced. The amount of X Nation 1 exports should be
equal to the amount of X that Nation 2 wants to import.
What are the terms of trade? This is the ratio of the index price of a nation's export to
its import commodities. If nation 1 exports commodity X and imports Y, the terms are
given by Px / Py. An increase is usually seen as beneficial as the price for its exports
rise relatively to the price of its imports.
Specialization
Specialization leads to the job creation in sectors and industries with a comparative
advantage, but losses in sectors with an comparative disadvantage. More jobs are
created than lost, but more people call for trade protection to protect domestic jobs.
Many states are occupied with the problem of deindustrialization: the decline of the
relative importance of manufacturing and in the share of manufacturing employment.
Incomplete specialization: the continued production of both nations in both
commodities with increasing costs.
Complete specialization: the utilization of all of a nation's resources for the
production of only one commodity with trade. Often has constant costs.
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4. The Hecksher-Ohlin and Other Trade Theories

The Hecksher-Ohlin (H-O) theory focuses on the difference in the relative abundance
of factors of production in various nations as important determinant of the difference
in relative commodity prices and comparative advantage. There are two forms:
H-O theorem: deals with and predicts pattern of trade. "A nation will export
the commodity whose production requires the intensive use of the nation's
relatively abundant and cheap factors, and import the commodity which uses
relatively scarce and expensive factors".
The difference in relative factor abundance (factor endowments) are
considered the basis for international trade and comparative advantage. It is
also called the factor-proportions or factor-endowment theory.
Factor-price equalization theorem: deals with the effect of international

trade on factor prices. "International trade will bring about equalization in the
returns to homogeneous or identical factors across nations". This means that
international trade will cause wages of the same type of labor to be the same in
all trading nations (ignoring other costs and assumptions).
In reality, wages have converged a bit (like the theory predicted) but
differences remain large and it's unlikely wages will be the same everywhere.
Specific-factors model: the model to analyze the effect of change in
commodity price on the returns of factors in a nation when at least on factor is
not mobile between industries (i.e. a machine can only produce wheat, not
cloth)
Stolper-Samuelson theorem: free international trade reduces the real income of the
nation's relatively scare factor and increases the real income of the nation's relatively
abundant factor.
Testing the Hecksher-Ohlin theory
When the model was tested, the results were the opposite of what the H-O model
predicted. This was called the Leontief paradox. This happened because Leontief
only used physical capital and ignored human capital (health, job training, education).
Returns to scale
Even if two nations face identical conditions, there is still a basis for mutually
beneficial trade: increasing returns to scale, the production situation where output
grows proportionately more than the increase in inputs or factors for production. For
example, you double the input but the output grows more than double.
As a single worker specializes in making a commodity, their productivity goes up and
a larger scale of production allows a nation to make specialized machines to speed up
production. This also leads to outsourcing: moving parts abroad rather than
producing them at home to keep costs down in a global world economy. This has been
the source for an international economy of scale.
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Differentiated products are products with slight differences. Producers can specialize
on a few variants instead of many different products. Intra-industry trade ensures
other international companies will produce these variants, so consumers will have
more choice.
Intra-industry trade is based on product differentiation and economies of scale. Trade
based on comparative advantage is more likely to happen when differences between
nations are larger, but intra-industry trade is more likely to happen when these
differences are smaller! The first also only returns the nation's scarce factor while
intra-industry trade leads to gains on all factors.
Technological gap model
This model is a hypothesis that a portion of international trade is based on the
introduction of new products or processes. Industrialized countries innovate, and the
innovator will export their new product. They have a temporary monopoly based on
patents and copyrights.
Product cycle model: New, innovative products will become standardized and can be
produced in other nations with less skilled labour. Product cycle: 1. introduction 2.
expansion 3. standardization and imitation 4. imitators underselling the nation in third
markets 5. foreigners underselling innovating firms in their home market.
(Undersell = sell at a lower price)
Innovative products are most often made in rich nations because the opportunities are
greater, there is a large market which makes feedback possible and there is a need to
provide services.
Transportation
Transportation or logistics costs are the costs for transport and storage. A product will
only be traded if the price difference between nations is larger than the cost for
transport. Products that are not traded because the price difference is too small are
called nontraded goods and services.
Environmental standards: the level of pollution accepted in various countries. Trade
can be affected by this: nations can have lax rules on environmental pollution, which
results in lower costs and more companies willing to move. Strong anti-pollution
regulations are difficult to implant: rich countries have the money and technology to
be cleaner, but poor countries have other needs and less resources.
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5. Trade Restrictions: Tariffs

Trade or commercial policies: regulations concerning a nation's commerce or
international trade.
Import/export tariff: duty on imports and exports
Ad valorem tariff: a fixed percentage of the value of a traded commodity
Specific tariff: a fixed sum per unit of traded commodity
Compound tariff: a combination of ad valorem and specific (sum + percent)
Nominal tariff: tariff calculated on the price of a final commodity. The rate of
effective protection is the tariff calculated on the domestic value added in the
production of a commodity (example: import rate is lower for raw material
than for the finished product)
Trade effect of a tariff: reduction in the volume of trade in a commodity resulting
from a tariff. Revenue effect of a tariff: revenue collected by government from tariff.
Rent or producer surplus: a payment that need not be made in the long run in order
to induce producers to supply a specific amount of commodity/factor services. This is
also called the subsidy effect.
Protection cost/deadweight loss of a tariff: the real losses in a nation's welfare due
to inefficiencies in production/distortions in consumption as a result of tariffs.
Large nations are nations capable of affecting the world price of a commodity by its
trading. When this nation sets up an import tariff, demand lowers and the price of a
commodity goes down. This is also called terms of trade effect of a tariff: the
reduction in price of the import commodity that results when a large nation imposes
an import tariff.
Kinds of tariffs
Optimum tariff: maximizes the benefit, improves the nation's terms of trade against
the negative effect resulting from reduction in the volume of trade
Prohibitive tariff: a tariff sufficiently high to stop international trade > autarky
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6. Nontariff Trade Barriers and the Political Economy

of Protectionism
Import quotas: a restriction on the amount of commodities allowed to be imported or
exported into a nation. Differences from a tariff:
- an increase in demand will lead to a higher domestic price and production, while a
tariff leaves prices unchanged but will lead to higher consumption and imports.
- Quota involves the distribution of import licenses which can lead to firms gaining
monopoly positions
- The import is limited with certainty while the results of a tariff are uncertain
Nontariff trade barriers / new protectionism: voluntary export restraints, technical
or administrative regulations etc.
Voluntary export restraints: an importing country induces another nation to
reduce its exports of a commodity "voluntarily" (under threat of all-round
trade restrictions). The results are the same as import quotas, but less effective
since exporting nations are reluctant to reduce export.
Technical/administrative regulations: safety regulations, health regulations
etc. serve legitimate purposes, but hampers international trade.
Laws and acts: an example is the Buy American Act, which forces the US
government to buy from domestic suppliers.
International cartels: groups of suppliers around the world agreeing to
restrict output and exports of a commodity to maximize profits. A monopolist
cartel is called a centralized cartel. International cartels do not fall under the
jurisdiction of any one nation and are difficult to stop.
Countervailing duties: tariffs imposed on imports to offset subsidies by
foreign governments.
Dumping: export of a commodity below cost/lower price than sold domestically
Persistent dumping: continuous tendency of a domestic monopolist to
maximize profits by selling commodity at a lower price abroad than domestic
(international price discrimination)
Predatory dumping: temporary sale of commodity at a lower price to drive
out foreign producers out of business and gain monopoly power
Sporadic dumping: occasional sale of a commodity at a lower price to sell
unforeseen/temporary surplus abroad
Trigger-price mechanism: anti-dumping mechanism by imposing a duty on
underpriced imported steel to make its price equal to that of the lowest cost foreign
producer.
Export subsidies: granting of tax relief and subsidized loans to potential exporters or
low-interest loans to foreign buyers of the nation's export.
Protecting domestic labor against cheap foreign labor is a false argument: domestic
labor may have higher wages, but can also have a much higher productivity and so
costs can be lower. Scientific tariff (tariff rate that would make price of imports equal
to domestic prices to meet foreign competition) would eliminate trade in those
commodities.
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To protect a developing industry in which a state may have a potential comparative

advantage, a temporary trade protection is justified: infant-industry argument. This
is more justified for developing nations and once protection has been given it's
difficult to remove. Subsidy is considered a better alternative than protection.
External economy: a benefit to society at large, i.e. training workers who then work in
other industries. External diseconomies: pollution etc.
Strategic trade and industrial policies
Strategic trade policy: Argument that an activist trade policy in oligopolistic markets
subject to extensive external economies can improve a nation's welfare. I.e. subsidies
in industries such as technology that are deemed crucial to a nation's further growth.
Industrial policy: activist policy by the government to stimulate (high-tech) industry
in an industrial nation.
History of US commercial policy
1934: Trade Agreement Acts of 1934. Authorized the President to negotiate with
other nations mutual tariff reductions of up to 50% under the most-favoured-nation
principle (extension to all trade partners of reciprocal tariff reduction by the US).
1947: General Agreement on Tariffs and Trade (GATT). An organization devoted
to the promotion of freer trade through multilateral trade negotiations. GATT was
based on the principles of:
1. non-discrimination.
2. elimination of non-tariff trade barriers except for agricultural products and nations
with payment-of-balance difficulties.
3. consultation among nations in solving trade disputes.
This was limited by the peril-point provisions (protectionist device that prevented
the president from negotiating any tariff reduction that would damage a domestic
industry) and the escape clause (a protectionist device that allowed any industry to
claim injury from imports to petition the International Trade Commission which could
then recommend to the president to revoke negotiated tariff reductions.)
1962: Trade Expansion Act and the Kennedy Round: granted the President
authority to negotiate across-the-board tariff reductions of up to 50% of the 1962 level
and replace the no-injury principle with adjustment assistance.
Trade and Tariff act of 1984: 1. authorized the president to negotiate international
agreements for the protection of intellectual property and lower barriers for trade in
high-tech products. 2. extended the Generalized System of Preferences, preferential
access to the exports of developing countries to the US. 3. provided authority for
negotiation in the Uruguay Round.
Omnibus Trade and Competitiveness Act of 1988: called on the US Special Trade
Representative to set a schedule to negotiate reductions in trade barriers that heavily
restricted US exports.
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The Uruguay Round

This brought several proposals which were agreed on in 1994 and took effect in 1995.
Tarrifs were reduced from 4.7 to 3 percent and the amount of goods without tariffs
was increased to 40-45%. Nations were allowed to use safeguards: raise tariffs or
other restrictions in case an import surge could severely harm a domestic industry.
Quotas were replaced with less restrictive tariffs.
Antidumping measures such as quicker and tougher action were agreed on.
Subsidized agricultural exports were reduced with about 21% and the US and Europe
agreed to limit government subsidies to certain industries. Intellectual property was
agreed on to provide 20-year protection for patents etc. and a 10-year phase in for
developing countries.
Most importantly, the GATT was replaced by the World Trade Organization with
authority in not only agricultural, but also industrial products. Trade disputes can be
settled by a vote of two-thirds or three-quarters of the nations.
Four current trade problems:

1. Rising protectionism as a result of nations trying to protect domestic production
and jobs in a financial crisis.
2. Subsidies and tariffs on agricultural products are high and antidumping measures
are abused.
3. European Union, North America Free Trade Area and the Asian bloc may lead to
free trade cooperation, or to stumbling blocks and protectionism.
4. Labor standards and working environment standards can easily be turned into
protectionism: poorer countries can't always afford high-standard work environments.
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7. Economic Integration
Forms of economic integration
Preferential trade arrangements: loosest form of economic integration,
provides lower barriers to trade among participating nations than on trade with
non-participating nations.
Free trade area: removes all barriers on trade among members, but nations
maintain their own barriers with non-members.
Customs union: removes all trade among members and harmonizes trade
policies towards the rest of the world.
Common market: removes all trade barriers, harmonizes trade policies and
allows the free movement of labour and capital among member nations.
Economic union: removes all trade barriers, harmonizes trade policies, allows
free movement of labour and capital among member nations and
harmonizes/unifies the monetary, fiscal and tax policies of members.
New forms to stimulate trade: duty-free zones/free economic zones: areas set up to
attract foreign investments by allowing raw materials and semi-products duty free.
Trade creation: occurs when some domestic production in a member of the customs
union is replaced by lower cost imports from another member nation. Increases
welfare. Trade diversion: lower cost imports from outside the union are replaced by
higher cost imports from another union member. This reduces welfare.
Besides the above mentioned effects, there are several dynamic benefits.
Increased competition: Without a customs union, producers are likely to glow
sluggish and complacent behind trade barriers. When trade barriers are
eliminated, they are forced to become more efficient and grow.
Economies of scale: Possible effect, but also possible without being in a
customs union. Plants (factories) may grow when a country has a high export.
Stimulus to investment: Companies can take advantage of a large market and
meet increased competition. Tariff factories: companies moving inside a
customs union to avoid non-member tariffs.
Better utilization of economic resources, due to free movement of labour and
capital.
The European Union
- Treaty of Rome 1957, founded as the 'European Common Market' in 1958.
First countries: West Germany, France, Italy, Belgium, Netherlands, Luxemburg.
Common external tariff was the average of tariffs of all these countries in 1957.
1968: free trade in industrial goods in the EU, common price for agricultural products
1970: reduced restrictions on movement of labour and capital
1971: generalized tariff preferences on import of (semi-)manufactured products from
developing nations.
1975: Lom convention, eliminated most trade barriers on imports from 46
developing nations in Africa, Caribbean and Pacific (former colonies of EU countries)
1993: removal of all restrictions on free flow of goods, services and resources
2000: Cotonou Agreement. 2008: New partnership agreements (NPAs) based on
reciprocity. Same content as Lom convention.
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Common agricultural policy: consumers had to pay more as farm prices are relatively
high. It sets variable import levies (import duties on imports of agricultural
commodities, equal to difference between higher EU prices and low world prices.)
The formation of the EU increased trade due to the large, growing market and
reduction of tariffs. Other developments of the EU:
1. Common value-added tax system (VAT or btw)
2. Commission: proposes laws, monitors compliance of treaties+administers policies.
3. Council of Ministers makes final decisions but only on recommendation of the
Commission. European Parliament (elected every five years, not much power) and
Court of Justice (rules on constitutionality of decisions of Commissions and Council).
4. Plans have been drawn for a full monetary union.
The European Free Trade Association
1960: the EFTA was made by the outer seven nations: United Kingdom, Austria,
Denmark, Norway, Portugal, Sweden and Switzerland, with Finland joining in 1961.
It achieved free trade in industrial goods in 1967, but there were few reductions on
agricultural trade barriers. On top of that, each nation maintained their own tariffs.
Trade deflection: the entry of imports from the rest of the world into the low-tariff
member of a free trade area to avoid the higher tariffs of other members. It joined the
EU in 1994 to form the European Economic Area.
US Free Trade Agreements and the NAFTA
In 1985, the USA negotiated a free trade agreement with Israel, the first bilateral trade
agreement signed by the US. It reduced tariffs and non-tariff barriers. In 1989, a free
trade agreement went into effect between Canada and the US.
The NAFTA took effect in 1994, leading to free trade in goods and services over the
entire North American area. It was signed by the USA, Canada and Mexico. It is
designed to reduce barriers to cross-border investment in the three countries.
NAFTA led to an increase in jobs, doubled trade (Mexico benefited much more due to
its smaller economy) and minimal harm to workers in the USA. Mexico's agricultural
production reduced, while industry grew.
Attempts in developing countries
1. Central American Common Market in 1960, dissolved 1969, restarted 1990.
2. Latin American Free Trade Association (LAFTA) 1960 by Mexico and most
of South America.
3. Southern Common Market (Mercosur) formed by Argentina, Brazil, Paraguay
and Uruguay 1991. Became a customs Union in 1995.
4. Free trade Area of the Americas (FTAA) 1998, 34 democratic areas of North
and South America.
5. Caribbean Free Trade Association (CARIFTA) in 1968, became common
market (CARICOM) in 1973.
6. East African Economic Community 1967.
7. West African Economic and Monetary Union (UEMOA-WAEMU).
8. Southern Africa Development Community (SADC)
9. Association of Southeast Asian Nations (ASEAN). Common market 1977.
China joined in 2010 and created the Asia Free Trade Area (AFTA).
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Economic integration in Central / Eastern Europe and in former Soviet republic

In 1949, the Soviet Union created the Council of Mutual Economic Assistance
(CMEA or COMECON), with the communist bloc nations in Eastern Europe plus
Mongolia. It had to divert trade from Western nations and achieve self-sufficiency.
There were state trading companies which are organizations in centrally planned
economies handling trade in specific product lines. The state decided which goods to
export in order to pay for imported products. The centrally planned economies is an
economy where production is owned by the government and prices are determined by
government directives.
Bilateral agreements often involved barter trade and countertrade: one good is
exchanged for another, or an attempt was made to balance trade with each nation
individually. Example: If Poland exports more than it imports from the SU, Poland
can only use the surplus rubles (currency) to import more from the SU.
In 1989, communism collapsed. Central and Eastern European Countries (CEEC) are
now converting their economies to compete in the worldwide markets. In some
countries, planned economies have resulted in economic disasters, inflation,
unemployment and budget deficits. They are now experiencing growth.
Commonwealth of Independent States (CIS): Organization of most former Soviet
republics, created when the Soviet Union dissolved at the end of 1991.
Central European Free trade Association (CEFTA) 1992, called for establishment
of free trade for its members. Signed by Poland, Hungary, Czech Republic and
Slovakia.
Baltic States Free Trade Area (BFTA) Agreement between Estonia, Latvia and
Lithuania to set up a free trade area to prepare for admission to the EU. Some have
already become EU members.
Most unions fail due to uneven benefits for member states and the lack of states that
are willing to give up their sovereignty.
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8. Growth and Development with International Trade

Over time, nations gain an increasingly large labour force, more accumulation of
capital (also human capital) and improvements in technology. When a nation creates
products, there are products that are either labour intensive (L) or capital intensive
(K). If the labour force grows faster than capital, a nation will be able to produce less
of K (see frontier curves).
Traditional trade theory believes that if each nation specializes in the commodity of
its comparative advantage, world output will be greater and all nations will benefit.
Developing nations should therefore continue to supply raw materials etc. to
developed countries. In reality this is frowned upon as developing nations believe that
they are taken advantage of by developed nations.
Developed nations have industrial production, which means a more trained labour
force, more innovations, higher and stable prices and a higher income (dynamic
benefits). Traditional trade theory therefore only works in the short term. However,
developing nations can become developed (no shit) but growth has been slowed due
to a lower demand for raw materials.
Contributions of trade to development
1. Full utilization of otherwise unused resources.
2. By expanding the size of the market, trade can make division of labour and
economies of scale possible.
3. International trade provides innovation and new technologies.
4. Trade stimulates international flow of capital from developed to developing
nations.
5. Import of new manufactured products stimulated demand, until domestic
production was possible.
6. Anti-monopoly weapon because it stimulates greater efficiency by domestic
producers to keep up with foreign competitors.
Commodity/net barter/terms of trade: ratio of the price index of the nation's
exports to the price index of its imports x 100. N = (Px / Pm) x 100
N = ( 95 / 110 ) 100 = 86.36, which means the nation's export prices went down with
about 14% compared to the import prices. The commodity terms of trade went down
for developing nations.
If growth in a nation leads to more exports, but its commodity terms of trade
deteriorate more, the nation's welfare declines. This is called immiserizing growth:
terms of trade deteriorate so much as a result of too much growth that a nation is
worse off after growth. This is hardly ever encountered.
Export instability and economic development
Developing nations also face large short-run fluctuations which hampers their
development progress. This may be due to inelastic prices and unstable demand and
supply curves for exports. Products from developing nations can change in price, but
the products only cost a fraction of what a household in a developed nation spends
anyway so they will keep buying it. The price for minerals and other raw materials is
inelastic because there are no substitutes for it. Supply curves can change due to
weather conditions, pests etc. affecting crops.
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Export instability: short-run fluctuations in export prices and earnings.

Did not seem to have inferred with developing nations' progress though.
Marketing boards: National schemes set up by several developing nations after
WW2 to stabilize export prices for individual producers of agricultural commodities.
Example: domestic prices would be lower in good years to gain funds and sell more,
while they would be higher to reimburse their bad years.
International commodity agreements: organizations of producer and consumer
nations attempting to stabilize and increase the prices and earnings of the primary
exports of developing nations.
Buffer stocks: international commodity agreements that involves the purchase of a
commodity into stocks when the commodity price falls below an agreed minimum
price, and the sale of it out of stock when the price is above the maximum price.
Export controls: the type of international commodity agreement that seeks to
regulate the quantity of the commodity exported by each nation.
Purchase contracts: long-term multilateral agreements that determine a minimum
price at which importing nations agree to purchase a specified quantity of a product.
Import substitution versus export orientation
After WW2, most developing nations attempted to industrialize instead of continuing
to specialize in primary commodities. Industrialization generally provides
1. faster technological progress.
2. creation of high-paying jobs to relieve serious unemployment.
3. greater backward/forward linkages in production process.
4. rising terms of trade.
5. relief from balance-of-payments difficulties as the demand for manufactured
products rose faster than the export earnings.
Import substitution industrialization strategy:
Advantages
1. market for industrial product already exists as evidenced by imports so there is a
market to replace those imports.
2. It is easier for developing nations to protect their domestic market against foreign
competition than to force developed nations to lower trade barriers against exports.
3. Foreign firms are induced to establish so-called tariff factories to overcome the
tariff wall of developing nations.
Disadvantages
1. Difficult to set up export industries due to competition of efficient industries in
developed nations.
2. Import substitution can lead to inefficient industries because of the smallness of
domestic market.
3. After simpler manufactured imports are replaced, it starts to become more difficult.
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Export-oriented industrialization
Advantages
1. Overcomes smallness of domestic market and allows of economies of scale
2. Production of manufactured goods for export requires/stimulates efficiency in
economy.
3. Expansion of manufactured exports is not limited by growth of domestic markets.
Disadvantages
1. Difficult to compete with efficient industries from developed nations.
2. Developed nations protect their industries producing simple labour-intensive
commodities and have an advantage.
Most developing nations chose import substitution, which generally failed due to
inefficient industries and high prices, excessive capital intensity and little labour
absorption and the neglect of other sectors resulting in a decline in earnings. Most
nations now focus on export-oriented industrialization, such as the BRICs.
Current problems in developing nations
1. Poverty in developing countries.
2. Foreign debt problem in developing countries. The IMF has measures to reduce
imports and cut inflation, wage increases and domestic programs.
3. Trade problems of developing countries. Developed countries experiences slow
growth, large unemployment and too much trade protection, leading to less imports
from developed countries.
Newly-industrialized countries (NIC): Hong Kong, Korea, Singapore, Taiwan.
Export pessimism: feeling that developing countries' exports to developed countries
cannot grow rapidly due to the latter's protectionism.
Uruguay Round, 1994: reduction in trade restrictions and protectionism.
Doha Round 2001: prevented from completion due to disagreements, should've dealt
with the trade demands of developing countries.
New International Economic Order (NIEO):
1. Renegotiation of the foreign debt of developing countries and reduction in interest
payments
2. Establishment of international commodity agreements
3. Preferential access in developed nation's markets to all manufactured exports of
developing nations.
4. Removing trade barriers on agricultural products
5. Increasing the transfer of technology to developing nations and regulating MNCs
6. Increase the yearly flow of foreign aid
7. Allowing developing nations a greater role in international decision making.
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9. International Resource Movements and MNCs

There are two types of foreign investments.
Portfolio investments: Purchase of purely financial assets such as bonds or stocks
(only if less than 10% of total stocks of a company). Usually arranged through banks
or investment funds. Foreign long-term securities (stocks and bonds) have grown
rapidly from the 1950s until now.
Direct investments: real investments in factories, capital goods, land and inventories
where both capital and management are involved. Investor retains control over the use
of invested capital.
Motives for international portfolio investment
Basic motive: earn higher returns abroad.
People buy stocks with higher returns in other nations. Investors also invest in highrisk stocks which is why flows also go to stocks that do not always have as high
returns, but can also become very profitable.
Risk diversification: investments in securities with yields that are negatively
correlated, or investments in different lines of products in order to spread and reduce
risk.
Portfolio theory: by investing in securities with yields that are inversely related over
time, a given yield can be obtained at a smaller risk or a higher yield can be obtained
at the same level of risk for the portfolio as a whole.
Motives for direct foreign investments
Includes same sort of motives for international portfolio: greater availability of
infrastructure, avoiding higher tax rates, avoiding custom tariffs, higher growth rates
abroad etc.
Many companies have unique production knowledge/managerial skill that the
corporation wants to retain direct control over. This results in horizontal integration:
production abroad of a differentiated product that's also produced at home.
Another reason is that companies want to obtain control of a needed raw material to
ensure uninterrupted supply. This is vertical integration: the expansion of a firm
backward to supply its own materials.
Direct foreign investments have been accelerated because of telecommunication and
transportation advances. The distribution in investments is dependent on geographical
proximity as well with countries' investment flows moving to countries/continents
close to them.
Effects of international capital flows
If capital is allowed to move freely, it will move from a nation with low returns to one
with high returns until they become equal. International capital transfers affect the
balance of payments.
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Balance of payment
A foreign investment increases foreign expenditures and cause a deficit (more foreign
expenditures than receipts). However, the receiving country may increase their import
of parts and products from the investing country in 5-10 years, which is considered
the 'payback' period.
Taxes go down in the investing country. The taxes are often lower which leads to
more investments in another country. Many countries signed the double-taxation
agreement (avoiding double taxation on equal grounds), they can ask a much lower
tax percentage. Example: Host UK 25% tax, Investor US 35%, US can only ask 10%
tax.
Long-term effects are uncertain. There are developing countries that have greater
receipts than expenditures but still face balance-of-payments difficulties.
Reasons for the existence of multinational corporations
1. Competitive advantage of a global network of production and distribution by
vertical and horizontal integration, economies of scale etc.
2. Have greater access to international capital markets
3. Concentrate departments in nations best suited for these purposes, like R&D in
advanced nations
4. Large size allows them to shop around in poor countries to find cheap labour
MNCs are often oligopolies selling differentiated products, technological gap and
product cycle models and with economies of scale.
Problems of MNCs in investing country
1. Loss of jobs due to MNCs investing in labour in other nations. However,
employment increases in managerial and technical jobs.
2. Export of advanced technology combined with cheaper foreign factors may
undermine technological advantage due to copies (hard to do since R&D
departments are located in rich nations)
3. Avoid tax revenues due to moving to other low-tax areas.
4. MNCs can avoid local monetary policies and make government control
harder. However, most nations do place restrictions on MNCs.
Problems of MNCs in host country (receiving)
1. MNCs dominate the economy, Americanisation of tastes
2. MNC may not want to export to a nation considered an enemy of the home
nation
3. Host countries leech off of home nations' R&D developments, while MNCs
also use up local talents in host country which prevents them from setting up
new businesses that may help a developing nation
Many host nations regulate MNCs to avoid these effects. A nation like China only
allows joint ventures and has set rules for the transfer of technology etc. It can also
nationalize foreign production facilities but this might lead to a low flow of direct
foreign investments.
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Motives and welfare effects of international labour migration

Labour is generally less mobile, but large flows of immigrants have moved before:
from Europe to the New World (USA) and more. Most move after considering costs
and benefits: transportation costs, new languages vs benefits. Costs are reduced when
immigrants move in waves. Immigrants and emigrants lead to an efficient utilization
of labour. In some cases there is a brain drain: the migration of highly skilled people
from developing nations to developed nations.
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10. Balance of Payments

The balance of payments is a statement of all the transactions of the residents in a
nation during a particular period of time, usually a year. Other nations keep it on a
quarterly basis. It informs the government of a nation's international position and help
it formulate monetary, fiscal and trade policies.
It is a summary statement. All earnings are summarized into a few major categories
and only the net balance of each type is included. It also includes transactions that do
not include citizens but things like banks.
International transaction: exchange of a good/service between residents of two nations
Gifts and other transfers: no payment required, included on balance of payment
Note: international institutions are not residents of their host nation.
Credit transactions: receipt from foreigners
Debit transactions: payments to foreigners
Financial inflows: 1. increase in foreign assets in a nation or 2. reduction in the
nation's assets abroad (a nation's asset is sold for money = credit)
Financial outflows: increase in the nation's assets abroad or 2. reduction in foreign
assets in the nation
Double-entry bookkeeping
This is the accounting procedure where every transaction is entered twice: once as a
debit and as a credit. Example: the US exports products worth $500, but payment only
arrives in 3 months. This $500 is entered as promise of the payment (financial
outflow) because the US has 'lended' money to the buying nation.
Unilateral transfers: gifts or grants extended to/received from abroad.
Statistical discrepancy: the entry made in a balance of payments to make total
credits equal to total debits
Current account: an account that includes all sales/purchases of produced goods,
services, income on foreign investment and unilateral transfers. A minus dampens
domestic production and income, while a surplus stimulates production and income.
Measuring deficits/surpluses in the balance of payments
Current account balance + financial account balance + statistical discrepancy =
balance of payments.
Total debit is larger than credits = deficit in the balance of payments.
This deficit must be settled in the official reserves account: the change in U.S.
official + foreign official reserve assets Surplus in the balance of payments = total
credits > debit. The difference is written in the official settlements balance: net
credit/debit balance in the official reserve account.
Autonomous transactions take place for business/profit motivations, independently
of balance-of-payments considerations, all in financial/current accounts.
Accommodating transactions: take place in official reserve assets required to
balance international transactions.
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The postwar balance of payments of the United States

1. Positive trade balance on goods in the 1960s became negative in the 1970s.
2. Sharp rise in price of imported petroleum products.
3. Rapid growth of United states, more than Europe and Japan, during 1990s.
4. Sharp increase in petroleum prices since 2004.
A positive trade balance may be misleading: a positive means there are less items to
consume domestically (export > import). Interactions are also closely interrelated.
Also, measuring the deficit/surplus in a balance of payments is only correct in a fixed
exchange rate, not a flexible exchange rate.
The international investment position of the United States
The international investment position / balance of international indebtedness
measures the total amount of the distribution of a nation's assets abroad and foreign
assets in the nation at the year end. It can be used to project the future flow of
income/earnings from the nation's foreign investments and the flow of payments on
foreign investments in the nation.
Balance of payments = flow concept.
International investment position = stock concept.
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11. The Foreign Exchange Market and Exchange Rates

Foreign exchange market: the framework to exchange a national currency for another.
A nation earns foreign currencies when a tourist spends money in the nation, when
they export products, receive foreign investments etc. The banks regulate these
transactions and function as clearing houses. Banks sell currencies to banks who have
a shortage of currencies that are in demand.
Users of the foreign exchange market:
1. Traditional users: importers, tourists, investors etc.
2. Commercial banks
3. Brokers, even out foreign exchange position (interbank/wholesale market)
4. A nation's central bank
Some currencies are vehicle currencies: currencies used for international transactions
and to denominate international contracts, these are the euro and dollar. Example: the
USA can invest with dollars, the other nation would have to convert dollars to another
currency. This leads to seigniorage for the USA (benefit for a nation when its
currency is used as an international currency).
Foreign exchange markets also provide credits. Exporters give importers time to pay.
Most importers pay the exporter and the bank takes the money from the exporter.
Equilibrium exchange rates
Exchange rate: domestic currency price of the foreign currency. When the price is
low, demand rises. Supply will rise when the price is higher as well as people earn
more when selling.
Depreciation: increase in the domestic currency price of the foreign currency (foreign
currency worth more / domestic currency worth less)
Appreciation: decrease in the domestic currency price of the foreign currency
(foreign currency worth less / domestic currency worth more)
Cross exchange rates and arbitrage
Cross exchange rate: exchange rate between currency A and B, with respect to
currency C.
Effective exchange rate: weighted average of the exchange rates between a domestic
currency and the nation's most important trade partners (currencies are weighted
depending on importance)
How to calculate exchange rate
The exchange rate between the pound and euro:
Value of pound / value of euro = 2 / 1.25 = 1.60. It takes 1.60 euros to buy one pound.
Arbitrage: purchase of a currency in the monetary center where it is cheaper, then
resold in the center where it is more expensive for profit.
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Spot and forward exchange rates

Spot rate: the exchange rate in foreign exchange transactions that calls for the
payment and receipt of the foreign exchange within two business days.
Forward rate: exchange rate in foreign exchange transactions involving delivery of
the foreign exchange in one, three or six months. This can result in a forward
discount when the future forward rate is lower than the present spot rate or a forward
premium when it is higher than the spot rate.
The forwards are calculated like this: FD/FP = FR (forward rate) - SR (spot rate) / SR
x 4 x 100. It is a percentage. You multiply it by four because a FP or FD is calculated
on a yearly basis.
Foreign exchange futures and options
Foreign exchange futures: forward contract for standardized currency amounts and
select calendar dates. This was first done by the International Monetary Market of the
Chicago Mercantile Exchange. Only a few currencies are traded and often for smaller
amounts than forward contracts.
Foreign exchange option: a contract specifying the right to buy (a call option)/sell (a
put option) a standard amount of traded currency at/before a stated date.
Foreign exchange risks
Exchange rates may vary rapidly, reflecting constant change in the economic forces at
work. Large differences in rates can lead to companies having to pay more when
using forward rates or exporters receiving less money. People who buy currencies to
sell them three months later may also lose money due to depreciation and appreciation
of currencies.
Hedging: avoidance of foreign exchange risk (covering of an open position). Comes
at a high cost: you have to invest a large deal of your money, or borrow for several
months. You deposit the money in a bank and take it out three months later, with
interest.
Speculation: opposite of hedging. A speculator accepts risk and even seeks higher
risks to gain more profits. If he thinks a spot rate will rise, he can purchase a currency
and resell it later when the spot rate has gone up. However, if the speculator is wrong
he can lose his money.
Interest arbitrage
Interest arbitrage refers to the international flow of short-term liquid capital to earn
higher returns abroad. The money is conversed into another currency, then exchanged
back into the previous currency for profit. Uncovered interest arbitrage is the same
but funds are brought t the international monetary center and the foreign exchange
risk is not covered. When the risk is covered by spot purchase of foreign currency and
a simultaneous forward sale, it is called a covered interest arbitrage.
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12. Exchange rate determination

What forces affect exchange rates?
1. Economic growth, a nation's demand for imports increases
2. An increase in its price level (inflation). Export will drop.
3. A reduction of its interest rates
4. The expectation that a currency will depreciate. In economics, expectations usually
become self-fulfilling.
Trade or elasticity approach
The trade or elasticity approach stresses the role of trade/the flow of goods and
services in the determination of exchange rates. This is useful for explaining rates in
the long run, not short run.
Purchasing-power parity theory
Absolute purchasing-power parity theory: Postulates that the equilibrium exchange
rate is equal to the ratio of the price levels in two nations. This can be misleading.
Calculate this: R = P / P* (price level at home / price level at other nation)
Relative purchasing-power parity theory: postulates that the percentage change in
the exchange rate is equal to the difference in the percentage change in the price level
in two countries. R = P - P* but now with percentages.
Monetary model of exchange rates
This theory postulates that exchange rates are determined in the process of balancing
the stock/total demand and supply of money in each nation. The supply is set by the
monetary authorities in a nation, but demand depends on the income, price level and
interest rate.
Nominal exchange rate: exchange rate/domestic currency price for another currency.
Real exchange rate: nominal exchange rate weighed by the consumer price index in
two nations.
Asset/portfolio model of exchange rates
This theory postulates that exchange rates are determined in the process of balancing
the demand/supply of financial assets in a country. An increase in supply leads to a
decline in interest rate and people move to foreign bonds.
Exchange rate dynamics
Exchange rates are volatile and often overshoot. Exchange rate overshooting is the
tendency of exchange rates to immediately depreciate/appreciate by more than
required for long-run equilibrium, then partially reversing their movement. A
depreciation would be followed by a slight appreciation and the other way around.
The monetary and asset models have not been successful in forecasting exchange
rates because exchange rates are affected by new information, and the expectations of
the market participants often become reinforcing and self-fulfilling which leads to
speculative bubbles.
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13. Automatic Adjustments with Exchange Rates

When the exchange rate of two currencies is not as elastic, a currency will depreciate
or appreciate less fast. In healthy economies, market forces will push the exchange
rate back towards the equilibrium rate after a disturbance: stable foreign exchange
market. If a disturbance pushes the exchange rate away from the equilibrium, it's an
unstable foreign exchange market.
It is stable if the sum of the values of the price elasticity of the demand curve for
imports and the price elasticity of the foreign demand for exports exceeds 1. Unstable
if below 1. This is the Marshall-Lerner Condition.
J-curve effect: the deterioration before a net improvement in a country's trade
balance due to a deprecation/devaluation.
Pass-through: proportion of an exchange rate change that is reflected in export and
import price changes
Adjustment with fixed exchange rates: the gold standard
In a fixed exchange rate system, trade deficits are corrected by automatic changes in
domestic prices. It differs from flexible exchange rates where a trade deficit is
corrected through a depreciation of the deficit nation's currency.
How did the gold standard come to be?
The international monetary system operated from 1880 to 1914 had gold as the only
international reserve. Exchange rates fluctuated only within gold points and balanceof-payments adjustment was described by the price-specie-flow mechanism. Nations
stored gold and bought/sold the amount of gold to adjust their currency and
determined how much gold was in a single coin.
Mint parity: the fixed exchange rates resulting under the gold standard from each
nation defining the gold content of its currency and passively standing ready to
buy/sell any amount of gold at that price.
Gold export point: the mint parity + the cost of shipping an amount of gold equal to
one unit of the foreign currency between two nations.
Gold import point: mint parity - cost of shipping an amount of gold equal to one unit
of the foreign currency between two nations.
The price is usually determined at the point where the demand-supply lines intersect.
How was the price adjusted in a fixed exchange rate system? This was done through
the price-specie flow mechanism.
Nations had a supply of gold: gold itself or a paper currency. The money supply goes
down in a deficit nation and rises in a surplus nation, leading to a rising price in the
deficit nation and a lower price in the surplus nation (demand/supply). The deficit
nation is encouraged to export and reduce imports, leading to a financial inflow.
This is the price-specie flow mechanism.
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Income determination in a closed economy

How do automatic income adjustments operate when all prices remain constant? In a
closed economy without a government sector, the equilibrium level of income is
Y (income) = C (consumption) + I (investments)
A small part of Y also goes to people's savings (S), so: Y = C + I = C + S
Therefore S = I and S - I = 0.
Savings are leakages because the income isn't spent on anything. Investments are
injections because they require production to be carried out.
Multiplier: the ratio of the change in income to the change in investment.
K = Y / I. Investments increase Y due to the increase of production etc.
If you don't know the investments multiplier, you can also calculate it with savings.
Example: S = 0.25. For every dollar, 75 cent is for consumptions and 25 cent is saved.
The multiplier is calculated like k = 1 / s (savings). k = 1 / 0.25 = 4. An investment of
200 would lead to an increase of Y with 4(200) = 800.
So K = Y / I = 1 / s.
Income determination in an open economy
In an open economy, imports rise as income rises. The increase in imports per dollar
increase in income is the marginal propensity to import (m). Imports are leakages
because they don't lead to investments in the domestic system.
The equilibrium level is at S (savings) + M (imports) = I (investments) + X (exports).
If the economy changes, it is S + M = I + X.
Foreign trade multiplier: k = Y / I = 1 / (s + m)
Foreign repercussions
An increase in imports may reduce production in the nation itself, leading to lower
income which also reduces imports, a smaller foreign trade multiplier and a lower
increase in income
Absorption approach
A nation can get rid of its deficit by depreciating its currency if the market is stable.
The trade balance will increase depending on price elasticity of demand for its exports
and imports. However, if the deficit nation is already at full employment, production
cannot rise and a nation still can't export more. The absorption approach examines
and integrates the effect of induced income changes in the process of correcting a
balance-of-payments instability by a change in the exchange rate.
Y = C + I + (X - M)
A = domestic absorption C + I and B is the trade balance (X - M)
So Y - A = B. This is the domestic production/income minus domestic absorption
equals trade balance.
Synthesis of automatic adjustments: attempts to integrate the automatic price,
income and monetary adjustments to correct balance-of-payments disequilibria.
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14. Adjustment policies

The most important economic goals of nations are
1. internal balance: objective of full employment wit price stability
2. external balance: objective of equilibrium in nation's balance of payments
3. reasonable rate of growth
4. equitable distribution of income
5. adequate protection of the environment
Internal balance can be achieved through expenditure-changing policies: fiscal
policies changing government expenditures, taxes etc. Expanding government
expenditures leads to more domestic production and income. Monetary policy
changes the nation's money supply that affects domestic interest rates: the money
supply increases, interest rates fall and this increases investment and income.
Expenditure-switching policies: a change in the exchange rate. A devaluation
switches expenditures from foreign to domestic commodities and can correct deficits
in balance of payments. It can also increase production. A revaluation switches
expenditures from domestic to foreign products and can be used to correct a surplus in
the nation's balance of payment. This is for external balance.
Both expenditure-changing and expenditure-switching policies are needed when
reaching internal and external balances. There are four combinations/types of
imbalances:
- Inflation and surplus
- Recession and surplus
- Recession and deficit
- Inflation and deficit
Effect of monetary policy on internal/external balance under fixed exchange rate
Expansionary monetary policy: monetary supply is increased
1. Interest rate falls
2. Financial assets flow out
and investment and income rise > current account worsens
3. Overall balance of payments worsens
4. money supply falls in order to maintain fixed exchange rate
5. Monetary policy ineffective
The nation would then require intervention in which the nation's central bank sells the
foreign currency and buys domestic currency to pay for/cover the deficit. Otherwise a
fixed exchange rate would have to be abandoned. A government can also sell
government bonds but there is a limit to how much can be sold.
Effect of fiscal policy on internal/external balance under fixed exchange rates
Expansionary fiscal policy: government spending rises/taxes falls
1. Interest rate rises + production and income rise
2. Financial assets flow in + current account worsens
3. Overall balance of payments may improve.
4. Money supply rises to defend fixed exchange rate.
5. Fiscal policy more effective.
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This works with high international financial flows. The improvement in the balance of
payments would lead to official purchases of the foreign currency with the domestic
currency to prevent an appreciation of the nation's currency.
Policy mix for internal and external balance
Inflation and surplus: both monetary and fiscal policies should be used but in
appropriate 'dosages'.
Recession and surplus: Monetary policy for external balance.
Recession and deficit: expansionary fiscal policy and contractionary monetary policy.
Inflation and deficit: contractionary fiscal policy, may need monetary policy.
Effect of policies on internal balance under flexible exchange rates
Expansionary monetary policy, money supply is increased.
1. Interest rate falls
2. Financial assets flow out + investment and income rise > current account worsens
3. Currency depreciates
4. Current account improves
5. Income rises more
Expansionary fiscal policy: government spending rises or taxes fall
1. Interest rate rises + production/income rise
2. Financial assets flow in + current account worsens
3. Currency may appreciate
4. Income expansion is reduced.
With fixed exchange rates, fiscal policy is effective and monetary policy is ineffective
for an internal imbalance. Monetary policy is effective with flexible exchange rates.
Correcting unemployment with inflation
Cost-push inflation: price rises in the face of high unemployment, recession and
slow growth. To recover, a state has three goals: full employment, price stability and
balance of payments equilibrium.
Direct controls, divided in:
Trade controls: tariffs, quotas, advance deposits on imports and more restrictions on
international trade
exchange control: restrictions on international capital flows, intervention in forward
markets, multiple exchange rates and exchange rates (see chapter 5)
The most common exchange control is multiple exchange rates: different exchange
rates enforced by developing nations for each class of imports depending on the
usefulness of imports.
Contractionary monetary policy reduces the money supply's size.
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15. Exchange rates, European Monetary Systems and

Macroeconomic Policy
Fixed exchange rates (not necessarily based on gold, can be based on reserves)
For:
- a single currency in one nation and thus permanently fixed exchange rates
throughout a nation is helpful.
- Fixed rates are more stable without day-to-day wild fluctuations which leads to a
larger volume of international trade and investment.
- Price discipline, a nation with a higher rate of inflation than the rest of the world is
likely to face persistent deficits in its balance of payments and loss of reserves under a
fixed exchange rate system. The nation has to restrain the inflation.
- A fixed exchange rate provides more stability to an open economy with large
internal shocks.
Against:
- inefficient, requires changing of all domestic prices rather than the price of one
currency)
- requires the use of policies that will also effect non-economic things
- policy mistakes can be made.
- destabilizing speculation can also be done here when speculators expect a currency
to be changed: selling a devalued currency and buying a revalued one
Flexible exchange rates
For:
- flexible rates facilitate the achievement of internal balance and other economic
objectives.
- External balance is easier to achieve because a deprecation/appreciation can change
the balance of payments.
- There is stabilizing speculation which dampens fluctuations in exchange rates, and
small fluctuations can be hedged.
- governments can't set the exchange rates at a different level than equilibrium
- Protects the domestic economy better from external shocks more than fixed rates
Against:
- advocates for fixed exchange rates say destabilizing speculation can happen due to
the large fluctuations in exchange rates
- can worsen an internal shock which results from a domestic investment
Optimum currency areas
This optimum area is a group of nations whose national currencies are linked through
permanently fixed exchange rates and conditions that make it an area optimum. Price
stability is more likely with fixed exchange rates. There are no costs for interventions
in foreign exchange markets involving currencies of member nations, cost of hedging
and cost of exchanging a currency. Members can't pursue their own policies.
When can an optimum currency area be more beneficial? 1. great mobility of
resources among member nations, great structural similarities and willingness to
cooperate on fiscal, monetary and other policies.
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European monetary system and transition to monetary union

1979: The European Union announces the formation of the European Monetary
System with one European currency unit of account (weighted average of currencies
of the EU members), the Exchange Rate Mechanism (ERM) and formation of the
European Monetary Fund (EMF).
If a nation's currency fluctuated about 75% in its allowed range, they had to take
corrective measures. If it reached the limit, the burden had to be shared by weak- and
strong-currency members.
1990: convergence of economic performance and cooperation in monetary and fiscal
policy, as well as removal of all restrictions on financial movements.
1991: call for the creation of an European Monetary Institute, the forerunner of the
European Central Bank of 1994, centralizing macroeconomic policies of member sate.
1992: Maastricht Treaty that called for the creation of the EMI and monetary union
by the EU by 1999. It also set conditions before a nation could join the EMU:
1. inflation rate may not exceed 1.5% of the average of the three community
nations with the lowest rates
2. a budget deficit that does not exceed 3% of GDP
3. Overall government debt can not exceed 60% of GDP
4. Long-term interest rates not exceeding two points more than average
interest rate of the three countries with the lowest inflation rates
5. Average exchange rate not falling with more than 2.25% of the average of
the EMS for the two years before joining
1997: Stability and Growth Pact (SGP) pact that requires condition 2 (above).
1998: creation of the European Central Bank, which is the operation arm of the
European System of Central Banks. Its responsibility is the common EMU monetary
policy.
1999: the euro comes into existence and begins in Austria, Belgium, Germany,
Finland, France, Ireland, Luxembourg, Spain, Portugal and the Netherlands
Note: bank notes and coins were only introduced in the beginning of 2002, it was
solely used as a unit of account before
Currency board arrangements and dollarization
These arrangements are the most extreme form of a fixed exchange rate system and
the central bank loses its ability to conduct an independent monetary policy. The
money supply can't be changed to change the balance of payments. This usually
occurs in a crisis or a time of severe inflation.
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Dollarization: situation where another nation adopts another nation's currency as its
legal tender. This term is used even when it's not the dollar that is adopted. Good
candidates are small open economies who's dominant trade partner is either the USA
or Europe. Benefits:
1. avoiding cost of exchanging currency for dollars.
2. Facing an inflation and interest rate similar to US.
3. Avoiding foreign exchange crises and need for foreign exchange/trade controls.
4. Fostering budgetary discipline and encouraging more international financial
integration.
Downsides:
1. cost of replacing the domestic currency with the dollar
2. loss of independence of monetary/exchange rate policies
3. loss of its central bank as a lender of last resort to bail out domestic banks and other
financial institutions.
Adjustable pegs, crawling pegs and managed floating
Adjustable pegs: system under which exchange rates or par values are periodically
changed to correct balance-of-payment disequilibria.
Crawling peg system: system under which par values or exchange rates are changed
by very small preannounce amounts at frequent and clearly specified intervals until
the equilibrium exchange rate is reached. Destabilizing speculation is discouraged
because of the small, short-term changes in rate that neutralize any profit.
Managed floating exchange rate system/dirty float: policy of intervention in
foreign exchange markets by monetary authorities to smooth out short-run
fluctuations without attempting to affect the long-run trend in exchange rates.
Leaning against the wind: a nation's monetary authorities supply, out of
international reserves, a portion of any short-run excess demand for foreign
exchange in the market and absorb a portion of any short-run excess supply of
foreign exchange in the market. This avoids depreciation and appreciation of
currencies.
Most of the world has had a floating exchange rate system of sorts due to the collapse
of the Bretton Woods system.
International macroeconomic policy coordination
In this world, nations are becoming increasingly interdependent. They have to work
together: international macroeconomic policy coordination becomes more desirable. It
means that nations create modifications of national economic policies in recognition
of international interdependence.
There are still several obstacles: one is a lack of believe in the functioning of the
international monetary system, another is a lack of agreement on the precise policy
mix required. And how do we distribute gains from successful policy coordination
and spread the cost of negotiating and policing agreements?
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16. The International Monetary System: Past, Present,

Future
Meaning of the international monetary system
The system consists of all the rules, customs, instruments, facilities and organizations
for effecting international payments.
Adjustment: the process by which balance-of-payments imbalances are corrected.
Liquidity: amount of international reserve assets available to nations to settle
temporary balance-of-payments disequilibria.
Confidence: the knowledge that the balance-of-payments adjustment mechanism is
working adequately and reserves will maintain their relative + absolute value.
A good international monetary system maximizes the flow of international trade and
investments and leads to an equal distribution of the gains among nations.
The gold standard and the interwar experience
See chapter 13.
After World War I, exchange rates fluctuated wildly from 1919 to 1924. This led to
people wanting the stability of a fixed gold standard and in 1925 the UK reestablished the convertibility of the pound into gold at the pre-war price which left it
grossly overvalued.
1930: Smoot-Hawley Tariff Act, raised U.S. import duties.
1931-1936, great instability and competitive devaluations as nations try to 'export'
unemployment
1933-1934, the US devaluated the dollar from a position of balance-of-payments
surplus to stimulate exports. This was a mistake. Most nations also imposed high
tariffs and other restrictions.
The Bretton Woods system
Bretton Woods: the gold-exchange standard that operated from the end of World
War II until 1971. Other nations were to fix the price of their currencies in terms of
dollars (and implicitly in gold). States had to buy and sell dollars to
depreciate/appreciate their currency.
Intervention currency: a convertible national currency (usually dollar) used by
nations' monetary authorities to intervene in foreign exchange markets in order to
keep the exchange rate from moving outside the allowed/desired range of fluctuation.
Currency convertibility: the ability to exchange currencies without any restriction.
International Monetary Fund: the institution created under the Bretton Woods
system. It oversees that nations follow a set of agreed-upon rules of conduct in
international trade and finance. It also provides borrowing facilities for nations in
temporary balance-of-payment difficulties. Fundamental disequilibrium: large and
persistent balance-of-payments surpluses/deficits.
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International Bank for Reconstruction and Development (IBRD / World Bank)

This institution provides long-run development assistance to developing nations and
was established after WWII. Its affiliate International Development Association
(IDA) was set up in 1960 and makes loans at subsidized rates to poorer developing
nations. The International Finance Corporation is another affiliate and was set up
in 1956 to stimulate foreign, private investments in developing nations.
Operation and evolution of the Bretton Woods system
Many stations were reluctant to change their par values, unless it was necessary and
basically forced upon them because of the resulting destabilizing speculation. Deficit
nations see devaluations as a sign of national weakness, while surplus nations prefer
to continue accumulating international reserves instead of revaluing.
What did this unwillingness lead to?
- balance-of-payments adjustment is difficult/impossible
- destabilizes international financial flows
- collapse of the Bretton Woods system
Trade Expansion Act of 1962 and GATT reduced the average tariffs on manufactured
goods to less than 10%. Many non-tariff barriers remained, especially in agriculture
which is important for developing nations.
1962 General Arrangements to Borrow: arrangements under which the IMF
negotiated to borrow from the Group of Ten (most important industrial nations) and
Switzerland to receive its resources if needed to help nations with balance-of-payment
difficulties. Included: United States, United Kingdom, West-Germany, Japan, France,
Italy, Canada, The Netherlands, Belgium and Sweden.
Standby arrangements: arrangements under which member nations negotiate with
the IMF for advance approval for future borrowings so that funds will be available
immediately when needed. Central banks began negotiating swap arrangements,
arrangements under which central banks negotiated to exchange each other's currency
to be used to intervene in exchange markets to combat international hot money flows.
The IMF created Special Drawing Rights (SDR) which are international reserves to
supplement other international reserves. These are distributed to member nations
according to their quotas in the IMF.
U.S. balance-of-payments deficits and the collapse of Bretton Woods
From 1945-1949, the US had huge surpluses with Europe and extended Marshall
Plain aid to help in Europe's reconstruction. However, when Europe recovered, the
US balance of payments went into a deficit. There was a dollar shortage: inability of
war-torn nations during the late 1940s-1950s to accumulate dollar reserves, and the
US settled deficits mostly in dollars. The deficits raised due to investments n Europe
and the Vietnam War.
In 1970-1971, everyone expected that the US would have to devalue the dollar and on
1971, the convertibility of the dollar to gold was removed. The Smithsonian
Agreement in 1971 devaluated the dollar with 9% and other strong currencies were
revalued. We still use the dollar standard: the international currency without gold
backing.
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Operation of the present international monetary system

1973 - most of the world now has a managed floating exchange rate system.
1976 - Jamaica Accords (ratified 1978), recognized the managed float and abolished
the official price of gold.
1973 - 1977 and 1981 - 1985: Benign neglect: the policy of non-intervention in
foreign exchange markets followed by the United States.
First credit tranche: 25% of a nation's quota in the IMF that the nation is required to
pay in SDRs or in other currencies of other members selected by the Fund. They
could then borrow from the Fund almost automatically.
Even now, nations still need reserves to intervene in exchange markets. The IMF
expanded the GAB to New Arrangement to Borrow which provided the IMF with
$47-49 billion more to lend out. These were negotiated in 1997. Borrowing rules were
also relaxed. IMF conditionality: conditions imposed by the IMF on members'
borrowings from the IMF.
*Look at page 417 for a full table of all important dates.
Problems with the present international monetary system
- exchange rates are volatile and this discourages the flow of trade and investments.
Exchange rate misalignments can possibly be solved through target zones, where
leading industrial nations estimate the equilibrium exchange rate and agree upon the
range of allowed fluctuation (the zone).
Another possible solution was the IMF's objective indicators which signal the type of
coordinated macropolicies for nations to follow, i.e. inflation, GNP, unemployment. A
last solution could be a restriction on speculative capital flows by a transaction tax.
- dollar overhang, large amount of foreign-held dollars resulting from past US
balance-of-payment deficits. Moving dollars from monetary center to other centers
can lead to large exchange rate fluctuations. Eliminating this problem could possibly
go through a substitution account: an account proposed to exchange all foreign-held
dollars for SDRs to solve dollar overhang.
Financial crises in emerging market economies
The international monetary system seems to be incapable of preventing crises from
happening. The fundamental causes were different but the process was similar:
massive withdrawal of short-term liquid funds at the first sign of financial weakness
in the nation. Example: Investors poured money into emerging economies for
portfolio diversification and higher returns but immediately withdrew at the first sign
of trouble, causing a crisis.
How to prevent this?
- Increase transparency in international monetary relations for timely information
- Strengthening emerging markets' banking and financial systems
- Promoting greater private sector involvement
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The recent global financial crisis

This crisis was caused by the US housing sector in 2007. Banks gave out huge
amounts of (sub-prime) loans or mortgages to individuals and families who could not
afford them. These people defaulted, leaving the banks to fall into a deep crisis which
spread to the financial sector in 2008. This spread to Europe.
Imports and direct investments sank to a deep low which hurt other economies. Major
emerging market economies like China and India have continued to grow rapidly,
however. Other economies like Russia, Mexico and Turkey went into a deep
recession.
The Group of 20 (G20) replaced the G7 and was formed in 2009 as the steering
committee of the world economy.
Other current international economic problems
1. Slow growth and high unemployment in advanced economies after the great
recession. Most advanced nations rescued banks from bankruptcy and introduced
huge stimulus packages which only succeeded in making the recession less bad.
Further policies and investments could lead to deficits and too much liquidity in the
system.
2. Trade protectionism in advanced countries in the context of a rapidly
globalizing world. Since the 1970s, there has been a growth in non-tariff trade
barriers which now pose a threat to the post-war trading system. Dumping is a serious
problem, patent protection is strict and some products are still subject to tariffs.
Nations should work on education and preparing new people for information and
technological jobs instead of blocking emerging economies.
3. Structural imbalances in advanced economies and insufficient restructuring in
transition economies. The US faces deep structural imbalances from its excessive
spending and inadequate saving and is borrowing excessively. It has unsustainable
trade deficits. Europe is facing dampened growth and high unemployment due to
over-generous social security benefits and inflexible labour markets. Transition
economies need more access to established markets if they want to finish their
transition to a more liberal, full-fledged market economy.
4. Deep poverty in many developing countries. While many countries are growing
rapidly, most African countries face international unmanageable debts, stagnatikon
and inequalities. The United Nations Conference on Trade and Development has put
forward proposals to improve conditions, but developed countries were too focused
on domestic problems to work on it. A New International Economic Order has been
created.
5. Resource scarcity, environmental degradation and climate change. Growth in
rich countries and development in poor countries are in danger due to a lack of
resources. Especially China and India demand a great amount of raw products. Prices
of raw materials, petroleum and food has gone up significantly.
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Introduction to International Economics

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1. Introduction to the Global Economy

What are current problems?

Frontiers are always negatively sloped or straight-line downward because a nation

3. The Standard Trade Model

Community indifference curve (see below): shows combinations of two

Marginal rate of substitution of X for Y in consumption: the amount of Y that a

The equilibrium point

4. The Hecksher-Ohlin and Other Trade Theories

Factor-price equalization theorem: deals with the effect of international

5. Trade Restrictions: Tariffs

6. Nontariff Trade Barriers and the Political Economy

To protect a developing industry in which a state may have a potential comparative

The Uruguay Round

Four current trade problems:

Economic integration in Central / Eastern Europe and in former Soviet republic

8. Growth and Development with International Trade

Export instability: short-run fluctuations in export prices and earnings.

9. International Resource Movements and MNCs

Motives and welfare effects of international labour migration

10. Balance of Payments

The postwar balance of payments of the United States

11. The Foreign Exchange Market and Exchange Rates

Spot and forward exchange rates

12. Exchange rate determination

13. Automatic Adjustments with Exchange Rates

Income determination in a closed economy

14. Adjustment policies

Contractionary monetary policy reduces the money supply's size.

15. Exchange rates, European Monetary Systems and

European monetary system and transition to monetary union

16. The International Monetary System: Past, Present,

International Bank for Reconstruction and Development (IBRD / World Bank)

Operation of the present international monetary system

The recent global financial crisis

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