EC3016 Vle

International economics
R. Versteeg
EC3016
2019
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 300 course offered as part of the University of London
undergraduate study in Economics, Management, Finance and the Social Sciences. This is
equivalent to Level 6 within the Framework for Higher Education Qualifications in England,
Wales and Northern Ireland (FHEQ). For more information, see: london.ac.uk
This guide was prepared for the University of London by:
Dr R. Versteeg, Department of Economics, Mathematics and Statistics, Birkbeck College,
University of London.
The previous edition of International economics was written by:
Dr D. Petropoulou, Stipendiary Lecturer in Economics, Hertford College, University of Oxford;
www.economics.ac.uk/index.php/staff/petropoulou and
A. Vanags, Director of the Baltic International Centre for Economic Policy Studies (BICEPS),
Latvia, and Lecturer in International economics at the Stockholm School of Economics, Riga,
Latvia.
Some material in this subject guide has been adapted from the subject guide for course
EC3115 Monetary economics (2011) written by:
Ryan Love, formerly of the London School of Economics and Political Science.
This is one of a series of subject guides published by the University. We regret that due
to pressure of work the authors are unable to enter into any correspondence relating to,
or arising from, the guide. If you have any comments on this subject guide, favourable or
unfavourable, please use the form at the back of this guide.
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Contents
Contents
1 Introduction to the subject guide 1

1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 Route map to the course . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.3 Introduction to the subject area . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.4 Syllabus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.4.1 Prerequisites . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.5 Aims of this course . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.6 Learning outcomes for the course . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.7 Overview of learning resources . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.7.1 The subject guide . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.7.2 Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.7.3 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.7.4 Online study resources . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.7.5 VLE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.7.6 Making use of the Online Library . . . . . . . . . . . . . . . . . . . . 7
1.8 Study time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.9 Examination advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.9.1 The examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.9.2 Examination technique . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Part 1 International trade 11
Introduction to international trade 13
2 The Ricardian model of international trade 15

2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.1.1 Aims of the chapter . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.1.2 Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
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2.1.5 References cited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

2.1.6 Synopsis of chapter content . . . . . . . . . . . . . . . . . . . . . . . 16
2.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.2.1 The Ricardian model . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.2.2 Techniques and some formal results . . . . . . . . . . . . . . . . . . . 17
2.2.3 Empirical evidence and application . . . . . . . . . . . . . . . . . . . 24
2.3 Overview of chapter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2.4 Reminder of learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2.5 Test your knowledge and understanding . . . . . . . . . . . . . . . . . . . . . 26
2.5.1 Sample examination questions . . . . . . . . . . . . . . . . . . . . . . 26
2.5.2 Guidance on answering Sample examination questions . . . . . . . . . 27
2.5.3 Feedback to selected activities . . . . . . . . . . . . . . . . . . . . . . 27
3 The Heckscher–Ohlin model 33

3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
3.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
3.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
3.2.1 Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
3.2.2 Tools and results for a closed economy . . . . . . . . . . . . . . . . . 36
3.2.3 Trade, income distribution and factor price equalisation . . . . . . . . . 44
3.2.4 Empirical evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
4 The specific factors model 49

4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
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4.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
4.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
4.2.1 Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
4.2.2 Tools and results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
4.2.3 Effects of trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
4.2.4 The pattern of trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
5 The standard trade model 57

5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
5.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
5.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
5.2.1 Techniques of the standard trade model . . . . . . . . . . . . . . . . . 58
5.2.2 The gains from trade . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
5.2.3 International borrowing and lending as intertemporal trade . . . . . . . 62
6 Factor movements 65
6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
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6.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
6.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
6.2.1 International mobility of labour . . . . . . . . . . . . . . . . . . . . . 66
6.2.2 International mobility of capital . . . . . . . . . . . . . . . . . . . . . 67
6.2.3 International borrowing and lending as intertemporal trade . . . . . . . 68
7 Imperfect competition and other alternative trade models 71

7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
7.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
7.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
7.2.1 Alternative models . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
7.2.2 The Krugman monopolistic competition model of trade . . . . . . . . . 73
7.2.3 Other models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
7.2.4 Reciprocal dumping . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
8 Instruments of trade policy 83

8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
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8.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
8.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
8.2.1 A taxonomy of trade policy instruments . . . . . . . . . . . . . . . . . 84
8.2.2 Trade policy issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
8.2.3 Partial equilibrium analysis . . . . . . . . . . . . . . . . . . . . . . . . 86
8.2.4 General equilibrium analysis . . . . . . . . . . . . . . . . . . . . . . . 91
8.2.5 Equivalence of a tariff and an export tax . . . . . . . . . . . . . . . . . 93
8.2.6 Analysis of a tariff and quota with a domestic monopolist . . . . . . . . 94
8.2.7 Effective protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
9 Economic arguments for protection and the political economy of trade policy 99
9.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
9.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
9.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
9.2.1 Economic arguments for protection . . . . . . . . . . . . . . . . . . . 101
9.2.2 The political economy of protection . . . . . . . . . . . . . . . . . . . 105
9.2.3 The anti-globalisation movement – the ‘globalisation backlash’ . . . . 107
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10 Preferential trading arrangements, customs unions and economic integration 111

10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
10.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
10.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
10.2.1 Basic theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
10.2.2 Trade creation and trade diversion . . . . . . . . . . . . . . . . . . . . 113
10.2.3 Terms of trade effects . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
10.2.4 Other effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
10.2.5 Other levels of integration . . . . . . . . . . . . . . . . . . . . . . . . 116
11 Trade policy in developing economies 121

11.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
11.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
11.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
11.2.1 The dual economy, trade policy and the Harris-Todaro model . . . . . . 122
11.2.2 Import-substitution as a development policy . . . . . . . . . . . . . . . 124
11.2.3 Export-oriented development . . . . . . . . . . . . . . . . . . . . . . . 124
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Part 2 International finance 127
Introduction to international finance 129
12 National income accounting and the balance of payments 131

12.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
12.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
12.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
12.2.1 National income account . . . . . . . . . . . . . . . . . . . . . . . . . 132
12.2.2 The balance of payments . . . . . . . . . . . . . . . . . . . . . . . . . 135
13 An introduction to foreign exchange markets 139

13.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
13.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
13.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
13.2.1 Foreign exchange markets . . . . . . . . . . . . . . . . . . . . . . . . 140
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13.2.2 Parity conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

13.2.3 The asset approach to exchange rates . . . . . . . . . . . . . . . . . . 145
13.2.4 The demand for money . . . . . . . . . . . . . . . . . . . . . . . . . . 146
13.2.5 Exchange rate overshooting (Dornbusch model) . . . . . . . . . . . . . 147
14 Prices and the exchange rate 151

14.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
14.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
14.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
14.2.1 The law of one price . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
14.2.2 Purchasing power parity . . . . . . . . . . . . . . . . . . . . . . . . . 153
14.2.3 Balassa-Samuelson effect . . . . . . . . . . . . . . . . . . . . . . . . . 156
14.2.4 The flexible price monetary model . . . . . . . . . . . . . . . . . . . . 157
14.2.5 The real exchange rate . . . . . . . . . . . . . . . . . . . . . . . . . . 160
15 Output and the exchange rate 165

15.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
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15.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
15.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
15.2.1 The AA–DD paradigm . . . . . . . . . . . . . . . . . . . . . . . . . . 166
15.2.2 Short and long-run equilibria for an open economy . . . . . . . . . . . 170
15.2.3 Further issues in the AA–DD framework . . . . . . . . . . . . . . . . 172
15.2.4 Competitive devaluations . . . . . . . . . . . . . . . . . . . . . . . . . 174
15.2.5 The Mundell-Fleming model . . . . . . . . . . . . . . . . . . . . . . . 176
16 Fixed exchange rates 181

16.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181
16.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
16.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
16.2.1 Different exchange rate regimes . . . . . . . . . . . . . . . . . . . . . 182
16.2.2 Intervention, the money supply and sterilisation . . . . . . . . . . . . . 184
16.2.3 Stabilisation policies under a fixed exchange rate . . . . . . . . . . . . 186
17 Currency crises 193
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17.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193

17.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
17.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
17.2.1 First generation: inconsistent policies . . . . . . . . . . . . . . . . . . 194
17.2.2 Second generation: contingent policies . . . . . . . . . . . . . . . . . 196
17.2.3 Third generation: financial fragilities . . . . . . . . . . . . . . . . . . . 197
18 Monetary systems 201

18.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
18.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
18.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
18.2.1 The impossible trinity . . . . . . . . . . . . . . . . . . . . . . . . . . 202
18.2.2 The Gold Standard, circa 1870 to 1914 . . . . . . . . . . . . . . . . . 203
18.2.3 Bretton Woods, 1944 to 1971 . . . . . . . . . . . . . . . . . . . . . . 205
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19 Optimum currency areas 211

19.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
19.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
19.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
19.2.1 European Monetary Union . . . . . . . . . . . . . . . . . . . . . . . . 212
19.2.2 The costs of a common currency . . . . . . . . . . . . . . . . . . . . . 213
19.2.3 Benefits of a common currency . . . . . . . . . . . . . . . . . . . . . 215
20 International capital markets 219

20.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
20.1.4 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
20.2 Chapter content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
20.2.1 Growth of the international capital market . . . . . . . . . . . . . . . . 220
20.2.2 Capital market performance . . . . . . . . . . . . . . . . . . . . . . . 222
A Sample examination paper 227
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B Sample Examiners’ Commentary 231
C Bibliography 243
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Chapter 1
Introduction to the subject guide
1.1 Introduction
Welcome to this course EC3016 International economics, which is divided into two parts:
international trade and international finance.
In this introductory chapter, we will look at the overall structure of the subject guide, we will
introduce you to the subject area, to the aims and learning outcomes for the course and to the
learning resources available. Finally, we will offer you some Examination advice.
We hope you enjoy this course and we wish you every success in your studies.
1.2 Route map to the course

The subject of international economics falls rather neatly into two distinct parts. One part
deals with international trade and the other part deals with international finance. An
undergraduate economics programme typically takes one term (or semester) to cover each
part. Accordingly, the guide has been structured to provide you with two separate work
programmes, one for international trade and one for international finance.
The subject guide consists of one introductory chapter, 10 chapters on international trade, nine
chapters on international finance and one Sample examination paper with the associated
Examiners’ commentary. You are advised to work through the introductory chapter and the 10
chapters of international trade in the Autumn term; in the Spring term, you are advised to
work through the chapters on international finance; and at the end to attempt the Sample
examination paper under examination conditions (that is, with closed books, limiting yourself
to three hours). You are advised to progress at a rate of one chapter per week (about 20 weeks
in total).
1.3 Introduction to the subject area

All countries are involved in economic relationships with other countries: they trade goods and
services with each other; they buy and sell each other’s assets; often, they engage in the direct
transfer of factors of production between one another in the form of foreign direct investment
or migration. The nature of these relationships experiences constant change. Over time, a
variety of formal and informal regional trading blocs and monetary unions has evolved.
Increasing liberalisation and integration of the world economy has led to an explosion of
international trade and movement of capital. In April 1998, average daily global foreign
exchange trading was already a staggering $1.5 billion but by April 2013 daily turnover
1
1. Introduction to the subject guide
exceeded $5.3 trillion (Source: Bank of International Settlements), making foreign exchange
markets the largest financial markets in the world.
With the liberalisation of trade and capital movements, the importance of international
economic relationships has increased, as have the links through which economic shocks are
transmitted across countries. The extent of these links can be witnessed in the global effects of
the 2007 US sub-prime crisis.
The above all highlights issues in the sphere of international economics. International
economics addresses questions such as:
Why do countries trade and what determines the pattern of international trade?
What are the sources of gains from trade and who might the losers be?
International economics is at the core of many important policy issues, for example:
Problems surrounding bilateral trade have, for years, dominated China/US economic
relationships.
The Asian financial crisis of 1997 was a consequence of the development of complicated
international financial linkages.
As the financial crisis emanating from the US sub-prime crisis continues to unfold,
important issues regarding the causes, consequences and policy responses to financial
crises are reevaluated.
The Euro, which may yet challenge the US dollar as a world currency, is a direct product
of the drive to European integration.
Considering the importance of international economics, it is not surprising that our
understanding of international economics is subject to constant change and development.
Within the context of your degree, international economics represents an important
application of the basic principles and methods that you have learned in your microeconomics
and macroeconomics modules.
1.4 Syllabus
The module international economics is divided into two parts: international trade and
international finance (sometimes referred to as international macroeconomics or international
monetary economics). This split essentially coincides with the distinction between the
microeconomics and the macroeconomics of the open economy.
International trade covers the reasons for trade and explanation of trade patterns and the
gains accruing from trade or from restricting trade. These are core areas and call for extensive
coverage. Linked to this core are a number of specific issues which must also be studied:
increasing returns and trade;
international factor movements;
growth and trade;
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1.5. Aims of this course
income distribution and trade;
economic integration;
multinational enterprises;
‘North-south’ issues.
Empirical evidence supplements the theoretical treatment. The European Union (EU), World
Trade Organization (WTO) and the United Nations Conference on Trade and Development
(UNCTAD) are institutionally involved in trade policy issues and their major concerns are
included in the subjects to be studied.
International finance covers the balance of payments, exchange rates and open-economy
macroeconomics. Linked to this core are a number of specific issues which must also be
studied: national income accounting; spot and forward markets; parity conditions; exchange
rate determination; exchange rate regimes; exchange rate stability and currency crises; and
currency unions. Empirical evidence, though often inadequate and conflicting, is relevant in
many areas. Issues associated with the European Monetary System (EMS), the International
Monetary Fund (IMF) and, in general, with international monetary relations are also included
in the syllabus.
1.4.1 Prerequisites
If you are studying for this course as part of a University of London BSc degree, you must
have already passed EC2065 Macroeconomics and either MN3028 Managerial economics
or EC2066 Microeconomics. Students should refer to the degree structures in the Regulations
when choosing which prerequisite to select.
1.5 Aims of this course

The course aims to:
enable you to acquire the analytical methods needed and understanding of how and when
to apply different models and approaches to events in the world economy
provide an understanding of the intellectual and practical problems that arise from the
economic interaction between countries
offer explanations of the international pattern of trade and specialisation and of the
reasons why similar economies often trade more with each other than with dissimilar
ones
provide an account of the sources of the gains from trade
offer explanations, in the monetary sphere, of the determinants of exchange rates, of the
timing and causes of financial crises and an analysis of the channels of international
economic interdependence.
3
1.6 Learning outcomes for the course

At the end of the course and having completed the Essential reading and activities, you should
be able to:
discuss and explain specific policy issues such as ‘environmentalism as protectionism’;

international dumping; the choice of exchange rate regime; the desirability of free capital
flows
apply a specific framework to illustrate the connection between a variety of models and
approaches. Explain the connections between Ricardian, Heckscher–Ohlin and the
specific factors models in trade theory, or between the ‘monetary approach’ and the ‘asset
approach’ in exchange rate theory
explain how international economic theory has been shaped by real world events.
1.7 Overview of learning resources
1.7.1 The subject guide

The subject guide is intended for you to use in conjunction with the suggested textbooks.
Therefore, it is important that you understand that the subject guide is not itself a textbook or a
substitute for a textbook. Each chapter of the guide roughly corresponds to one week’s work if
you were studying as a student on campus and covers a distinct topic or set of topics.
Each chapter begins with a list of Essential reading and Further reading. As the name
suggests, Essential reading is required reading in order for you to fully understand the
concepts introduced in the particular chapter. The items listed under Further reading will give
you greater insight into the topics covered in the chapter. They are meant to both provide
alternate textbook sources, if you still feel uncomfortable with the material, and advanced
references if you want to read more on a particular topic.
Each chapter also provides you with a set of activities together with some sample examination
questions that will enable you to test your understanding of the basic ideas and concepts. It is
vital that you attempt all the suggested activities since actively ‘doing’ is a better way of
learning than passively absorbing material by reading.
1.7.2 Essential reading

This course is built predominantly around the following textbook:
Krugman, P., M. Obstfeld and M. Melitz International Economics: Theory and Policy.
(Harlow: Pearson Education, 2018) 11th global edition [ISBN 9781292214870] (referred
to as ‘KOM’ in the subject guide).
International economics has a vast literature, including a large number of very good textbooks;
the book by Krugman, Obstfeld and Melitz is one of the very best. It is written by three
economists who have been at the forefront of recent advances in international economics and
4
1.7. Overview of learning resources
contains some of the latest developments. At the same time, the textbook remains very
user-friendly, is grounded in real-world experience and is widely used throughout the world.
The main body of the text is non-technical and more advanced material is contained in
appendices and mathematical appendices. References in this subject guide are (unless
otherwise stated) to the 11th edition, which has the advantage of including more recent case
studies, as well as an up-to-date discussion on international economic issues. Earlier editions
of the textbook are sufficient for much of the material, but do not address recent debates such
as those surrounding the global financial crisis and issues surrounding the use of
unconventional monetary policy in the wake of the crisis.
Detailed reading references in this subject guide refer to the editions of the set textbooks listed
above and below. New editions of one or more of these textbooks may have been published by
the time you study this course. You can use a more recent edition of any of the books; use the
detailed chapter and section headings and the index to identify relevant readings. Also check
the virtual learning environment (VLE) regularly for updated guidance on readings.
It is essential that you access the textbook and we advise you to purchase it if at all possible.
Note that references to book chapters, diagrams, etc. are for the editions of the books indicated
above. Earlier editions of the textbook may be available second hand at more favourable
prices, but you should weigh this against the fact that the references in this guide will not
match exactly.
In the second part of the syllabus, on international finance, there are a couple of instances
where KOM is supplemented with required readings from one other textbook:
Copeland, L. Exchange Rates and International Finance. (Harlow: Prentice Hall, 2014)
sixth edition [ISBN 9780273786047] (referred to as ‘C’ in the guide).
1.7.3 Further reading
Please note that as long as you read the Essential reading you are then free to read around the
subject area in any text, paper or online resource. You will need to support your learning by
reading as widely as possible and by thinking about how these principles apply in the real
world. To help you read extensively, you have free access to the VLE and University of
London Online Library (see below).
There are many textbooks that cover the topics discussed in this subject guide; one textbook
that can be used as a complement to KOM is:
Feenstra, R. and M. Taylor International Economics. (New York: Worth Publishers,

2014) third revised edition [ISBN 9781429278423] (referred to as ‘FT’ in the guide).
You may also find Copeland (2014), mentioned under Essential reading, useful as Further
reading for many chapters of Part 2 of the subject guide.
There are two free online textbooks available on international trade and international finance
written by Suranovic. These are excellent online resources that are very easy to access:
Suranovic, S.M. International Trade: Theory and Policy. (referred to as ‘S(IT)’ in the
subject guide);
http://internationalecon.com/Trade/tradehome.php
5
Suranovic, S.M. International Finance: Theory and Policy. (referred to as ‘S(IF)’ in the
subject guide);
http://internationalecon.com/Finance/financehome.php
However good a book might be, it is nevertheless essential that you read more widely. Many
of the chapters of the subject guide provide several additional references under Further
reading, which contain seminal contributions to the academic literature, survey papers, or in
some instances relevant policy reports.
Unless otherwise stated, all websites in this subject guide were accessed in February 2015. We
cannot guarantee, however, that they will stay current and you may need to perform an internet
search to find the relevant pages.
1.7.4 Online study resources
In addition to the subject guide and the Essential reading, it is crucial that you take advantage
of the study resources that are available online for this course, including the VLE and the
Online Library.
You can access the VLE, the Online Library and your University of London email account via
the Student Portal at: https://my.london.ac.uk
You should have received your login details for the Student Portal with your official offer,
which was emailed to the address that you gave on your application form. You have probably
already logged in to the Student Portal in order to register. As soon as you registered, you will
automatically have been granted access to the VLE, Online Library and your fully functional
University of London email account.
If you have forgotten your login details, please click on the ‘Forgotten your password’ link on
the login page.
1.7.5 VLE
The VLE, which complements this subject guide, has been designed to enhance your learning
experience, providing additional support and a sense of community. It forms an important part
of your study experience with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
Self-testing activities: Doing these allows you to test your own understanding of subject
material.
Electronic study materials: The printed materials that you receive from the University of
London are available to download, including updated reading lists and references.
Past examination papers and Examiners’ commentaries: These provide advice on how
each examination question might best be answered.
A student discussion forum: This is an open space for you to discuss interests and
experiences, seek support from your peers, work collaboratively to solve problems and
discuss subject material.
6
1.8. Study time
Videos: There are recorded academic introductions to the subject, interviews and debates
and, for some courses, audio-visual tutorials and conclusions.
Recorded lectures: For some courses, where appropriate, the sessions from previous
years’ Study Weekends have been recorded and made available.
Study skills: Expert advice on preparing for examinations and developing your digital
literacy skills.
Feedback forms.
Some of these resources are available for certain courses only, but we are expanding our
provision all the time and you should check the VLE regularly for updates.
1.7.6 Making use of the Online Library

The Online Library (https://onlinelibrary.london.ac.uk) contains a huge array of
journal articles and other resources to help you read widely and extensively.
To access the majority of resources via the Online Library you will either need to use your
University of London Student Portal login details, or you will be required to register and use
an Athens login.
The easiest way to locate relevant content and journal articles in the Online Library is to use
the Summon search engine.
If you are having trouble finding an article listed in a reading list, try removing any
punctuation from the title, such as single quotation marks, question marks and colons.
For further advice, please see the online help pages
(https://onlinelibrary.london.ac.uk/resources/summon) or contact the Online
Library team: onlinelibrary@shl.london.ac.uk
1.8 Study time

Study time is very much an individual matter. However, a student following an internal degree
programme would normally have three to four hours of contact time per week on an
international economics subject at this level. Normally an internal student would be expected
to back this up with at least the same amount of time devoted to individual study. This implies
a minimum of say, eight hours per week. If you are studying this subject over one year you
would be advised to devote at least as much time to the subject but you can break this up into
three or four sessions over the week.
1.9 Examination advice
1.9.1 The examination

Important: The information and advice given here are based on the examination structure
used at the time this guide was written. Please note that subject guides may be used for several
7
years. Because of this we strongly advise you to always check both the current Regulations for
relevant information about the examination, and the VLE where you should be advised of any
forthcoming changes. You should also carefully check the rubric/instructions on the paper you
actually sit and follow those instructions.
Assessment is by a three-hour unseen examination. From 2014, the examination will have two
sections:
Section A requires candidates to answer one compulsory question worth 40 marks

(Question 1). Answers must be supported with a brief justification or explanation, which
may include diagram(s) or equations, where appropriate. Unsupported answers will
receive no marks.
Section B contains 10 predominantly essay-style questions. Candidates are required to

choose any three questions from this section, each carrying 20 marks. These questions
are designed to test candidates’ analytical understanding of the course and require
application of knowledge to details provided in the question.
Candidates should refer to the VLE and read the Examiners’ commentaries on the Zone A and
Zone B examinations of recent years. These contain guidelines regarding what constitutes a
poor/good/excellent answer to past examination questions and general advice on how to
approach the examination, areas where candidates have exhibited weakness, etc.
1.9.2 Examination technique

Good examination technique can significantly improve your examination performance and
poor technique may result in serious underachievement relative to your ability and
understanding. Some aspects of good technique are elementary and require only awareness
and self-discipline while others are more subtle.
You should regard the examination as an opportunity for you to demonstrate to the Examiners
that you have covered the material of the subject, that you understand the material and that
you can use and apply it in different situations. You should bear in mind that your examination
script is the only evidence available to the Examiners on which to base their judgement about
what you have achieved. They cannot read your mind, or ask you what you mean.
Accordingly, it is important that what you write, clearly and unambiguously, demonstrates
your mastery of the subject. This suggests a number of rules that you should follow:
You should read carefully the instructions at the beginning of the question paper and follow
them. In particular, if you are asked to answer, say, three questions you should answer three. If
you answer only two questions you will receive zero marks for the ‘missing’ third question.
Thus you should pace yourself to allow time to answer all the required questions as even a
moderately-answered question will score more than zero!
If a question is compulsory, then you must answer it. Also, there is no advantage in answering
more than the required number of questions – you will receive credit only for what you are
asked to do.
It is important that what you write is legible. The Examiners can only give credit for what they
can read. If you have ‘problem’ handwriting you would be advised to write more slowly to
ensure legibility. You might ask a friend or teacher to advise you on the legibility of your
handwriting.
8
1.9. Examination advice
If you use diagrams or equations it is important that you label them and explain them clearly
and that you refer to them in the text (narrative) of your answer. An isolated and unexplained
diagram is useless.
You should read each question carefully and attempt to identify the nuances that the
Examiners may have included. Questions are rarely of the form: ‘Write all you know about
comparative advantage.’ Usually a question requires you to show how a concept or theory
might be used or interpreted. You need to identify the particular angle the Examiner has
decided to emphasise and address that particular angle. Often it is helpful to use the opening
paragraph of your answer to discuss your interpretation of the question. This serves the
purpose of informing the Examiners of how you are thinking and may also help you to
structure your answer.
Remember, it is important to check the VLE for:
up-to-date information on examination and assessment arrangements for this course
where available, past examination papers and Examiners’ commentaries for the course
which give advice on how each question might best be answered.
9
10
Part 1
International trade
11
Introduction to international trade
The subject matter of international economics divides rather neatly into what are referred to as
international trade and international finance. These areas form the two Parts of this subject
guide. The body of thought that comes under the title of ‘international trade’ is concerned with
‘real’ aspects of international economics where the term ‘real’ is to be understood as
contrasting with ‘monetary’ or ‘financial’. Alternatively, you might wish to think of
international trade as the application of microeconomics to the international economy and
international monetary economics as the application of macroeconomics.
The starting point for studying international trade concerns questions such as:
Why do countries trade with each other?
How do countries gain from international trade?
What determines the international pattern of specialisation and the commodity and
composition of trade?
These are issues addressed in Chapters 2 to 7, which together form a conceptual unit. Each
chapter deals with different international trade ‘models’ and offers a model that provides
alternative theoretical explanations of international trade. Chapters 2 to 4 relate to models of
international trade based on comparative advantage. Chapter 5 provides a synthesis of the
common features of the comparative advantage models dicussed in Chapters 2 to 4. Chapter 6
considers the movement of factors. Chapter 7 examines models of trade based on economies
of scale and imperfect competition. The different models/explanations for international trade
are in part complementary and in part competing, and the intention of these chapters is to
highlight these features.
Chapters 8 to 11 form another block that deals with trade policy or commercial policy. Trade
or commercial policy is to be understood as intervention by governments of international
agencies in the trading process. Chapter 8 deals with the fundamentals of trade policy: what
are the instruments of trade policy intervention? How do they work? How can they be
compared? Economists are typically in favour of the absence of trade policy intervention (that
is, in favour of what is sometimes known as ‘free trade’). In practice, very few countries
operate free trade regimes and Chapter 9 is devoted to exploring the reasons for this. Regional
trading arrangements have proliferated in recent years and Chapter 10 is devoted to exploring
the reasons for this. Chapter 11 finishes up with some of the special trade issues faced by
developing countries.
13
14
Chapter 2
The Ricardian model of international
trade
2.1 Introduction
International trade theory seeks to explain or answer some of the following questions: Why do
countries trade with each other? What are the gains from trade? What explains the pattern of
international specialisation? What explains the commodity composition of trade? How is it
possible for low productivity countries to trade with high productivity ones? How are
international prices determined? How are the gains from trade distributed? Answers to most of
these questions are offered by the principle of comparative advantage.
2.1.1 Aims of the chapter

This chapter aims to summarise the theory of comparative advantage, in particular with
reference to the Ricardian model, and apply this theory in the real world.
2.1.2 Learning outcomes

By the end of this chapter, and having completed the Essential readings and activities, you
should be able to:
explain the concept of comparative advantage and distinguish it from the idea of absolute
advantage
explain how comparative advantage based on technological differences is the determinant

of the pattern of trade and specialisation in the Ricardian model
explain how the gains from trade arise in this model
explain the relationship between relative international productivity and relative wages
manipulate the RD/RS diagram to illustrate different possible equilibria in the Ricardian
model
explain how comparative advantage might be interpreted in a real world situation.

KOM, Chapter 3 ‘Labor Productivity and Comparative Advantage: The Ricardian
Model’.
15
2. The Ricardian model of international trade

FT, Chapter 2 ‘Trade and Technology: The Ricardian Model’.
S(IT), Chapter 40:

http://internationalecon.com/Trade/Tch40/Tch40.php
Balassa, B. ‘An empirical demonstration of classical comparative cost theory’, The

Review of economics and statistics 45 1963, (The MIT Press), pp.231–38. Stable URL:
http://www.jstor.org/stable/1923892
Krugman, p.‘Growing world trade: causes and consequences’, Brookings papers on

economic activity 1 1995, pp.327–77.
Leamer, E. and J. Levinsohn ‘International trade theory: the evidence’, Chapter 26,
Handbook of international economics 3 1995, pp.1339–94.
MacDougall, G. ‘British and American exports: a study suggested by the theory of

comparative costs’, The economic journal 61 1951, pp.697–724.
Ricardo, D. The principles of political economy and taxation. (Mineola, NY: Dover
publications Inc., 2004) [ISBN 9780486434612].
2.1.5 References cited

No further references cited in the text.
2.1.6 Synopsis of chapter content

This chapter, like the other main chapters of this subject guide, follows a fairly standard
structure. It begins with an Introduction—in this case on the Ricardian model—considers this
model in more detail, before moving on to an Overview of the key content.
The chapter contains several activities for you to perform, and we recommend that you do
these in order to facilitate your learning, and we recommend that you consider these an
integral part of each and every chapter.
The chapter ends with a Reminder of your Learning outcomes for the chapter along with a
‘Test your knowledge and understanding’ section with sample examination questions that
directly relate to the content of the chapter. There will also be some guidance on answering
sample questions and there may be some guidance on approaching selected activities.
2.2 Chapter content
2.2.1 The Ricardian model

Adam Smith had previously shown the gains of trade in the presence of absolute advantage;
that is, the situation in which a country is more efficient in producing a good than another
country. Ricardo’s model shows that mutual gains from trade (and specialisation) arise even
16
2.2. Chapter content
when one of the countries (say, the ‘poor’ country) is less efficient in the production of both
goods. Although the poor country may be less efficient overall, and thus not have an absolute
advantage, it may still have a relative efficiency, giving it a comparative advantage.
Developed by David Ricardo in the early nineteenth century to provide intellectual support for
the abolition of Corn Laws in Great Britain – that is, to promote the benefits of free trade (in
grain) – the principle of comparative advantage remains one of the enduring insights of
economic theory. Many textbooks continue to use Ricardo’s original numerical example. The
example uses two countries, Portugal and England, and the production and trade of two
products, namely wine and cloth.
The further development of Ricardo’s numerical example as a two-good/two-country model
has come to be known as the Ricardian model, also known as the classical model. The
Ricardian model remains the starting point of the theory of international trade theory even
now, nearly 200 years after Ricardo originally developed it.
The basis for comparative advantage in the Ricardian model, which drives the pattern of
specialisation and trade lies in cross-country technological differences, as summarised by
differences in the opportunity cost of the production of goods.
The advantages of the Ricardian model
Here are some of the advantages of the model:
it is a particularly clear account of the principle of comparative advantage and how trade
and specialisation according to comparative advantage will generate mutual gains from
trade
it demonstrates that a regime of free trade will actually generate a trade and specialisation
pattern in accordance with comparative advantage
it provides an understanding of the roles of wages and productivity in international

competitiveness
it gives an introduction to a methodology which is used in the development of many other

propositions in trade theory
it is a working example of a simple general equilibrium model.
2.2.2 Techniques and some formal results

The usual assumptions of the Ricardian model may be summarised as follows:
1. There are two countries, which we shall refer to as Home (H) and Foreign (F).
2. There are two goods, which we shall refer to as wine (w) and cloth (c).
3. Each good is produced with the aid of one factor of production, usually thought of as
labour. (You might imagine that labour actually works with land and/or capital but these
other factors are suppressed in this model and formally you can assume that one unit of
labour works with a fixed bundle of other inputs.)
17
4. Production of both goods is subject to constant returns to scale and hence the technology
for each good may be summed up by its unit labour requirement. The unit labour
requirement in wine is given by the number of units (hours) of labour needed to produce
one unit of output (in this case, a litre of wine). In cloth production, it is the amount of
labour needed to produce a bale of cloth. The inverse of the unit labour requirement is the
average (and marginal) product of labour.
5. All markets are assumed to be competitive. This means that all markets clear (that is,
supply = demand) and that, in both sectors, price = average cost = marginal cost.
Note: It is not necessary for you to reproduce these assumptions in an essay or in an
examination answer unless they are specifically asked for, but you should understand why the
assumptions are needed.
You may find it helpful to approach the main properties and results of the model in two
alternative but complementary ways: (i) comparing the equilibrium under autarky with the
free trade equilibrium and (ii) the relative supply (RS)–relative demand (RD) analysis.
Equilibrium under autarky and the free trade equilibrium
One route to show the advantages of trade is to assume that initially there is no trade between
Home and Foreign (perhaps because transport costs are prohibitively high). This is known as
autarky (that is, both countries are self-sufficient in both goods and consume what they
produce). Thus, under autarky, each country can be regarded as a closed economy and hence
equilibrium in each is simply the closed economy equilibrium.
With two goods, constant returns to scale and one factor of production, the production
possibility frontier (PPF) can be depicted as a straight line. For each country, the area on and
below the PPF represents feasible production of that country (if there is full employment, the
actual production should lie on the PPF). The slope of the PPF reflects the opportunity cost of
cloth in terms of wine and in equilibrium also the autarky relative price of cloth in terms of
wine. (Here we assume that in the autarky equilibrium cloth and wine are both produced and
consumed.)
The coincidence of the price ratio and the opportunity cost ratio follows from the fact that in
competitive equilibrium, prices must equal costs.
Autarky equilibrium in Foreign can also be represented in this way with the difference being
that the slope of the production possibility frontier/relative price line will be different if
relative costs are different from what they are in Home.
Activity 2.1 Check for yourself that in equilibrium the price ratio = the cost ratio. (Hint:
for the price of each good note that price = marginal cost = unit labour requirement ×
wage rate.)
Let us assume for the sake of argument that Home has a higher opportunity cost of cloth in
terms of wine, relative to Foreign. That is, more wine needs to be sacrificed in Home to
produce one more unit of cloth, than in Foreign. This is reflected in Figures 2.1 and 2.2, where
Home’s PPF is drawn steeper than the PPF of Foreign. Hence cloth is more expensive in the
Home autarky equilibrium than it is in Foreign.
The autarky equilibrium in Home and Foreign is denoted by A and A0 in Figures 2.1 and 2.2,
18
Wine
B•
•C International Relative Prices

• A
IFT
Opportunity Cost and
Autarky Relative Prices IA
(PC/PW)FT
(PC/PW)H
PPF CPF
Cloth
0
Figure 2.1: Autarky and free trade equilibrium in Home
respectively, where consumers choose consumption to maximise utility (indifference curves

IA ), given the range of feasible production possibilities. Hence the PPF is also the consumers’
budget set in the autarky equilibrium. Note that the consumption side of these two economies
is assumed to be identical; that is, consumers in Home and Foreign have the same preferences
over wine and cloth.
Suppose that trade between Home and Foreign becomes possible (because of, say, a transport
revolution that slashes international transport costs). Economic agents observe that cloth is
relatively cheap in Foreign but wine is relatively cheap in Home, so Home buyers will switch
to Foreign as their source for cloth and Foreign consumers (realistically specialised importers
who are not modelled here) will switch to Home for wine. This will have two effects:
1. The demand switch will tend to lower the relative price of cloth at Home and the relative
price of wine in Foreign. Clearly relative prices in the two countries will tend to converge
and given free trade and negligible transport costs, there will be just one unified
international relative price. (Transport costs can be rather important for some
internationally traded goods and, of course, shipping and other forms of international
transport are important sectors in their own right. However, incorporation of transport
costs into trade models creates much complexity without changing the basic results.
Because of this, transport costs are conventionally assumed to be zero in trade models.)
2. These price developments will cause Home to specialise in wine production and Foreign
in cloth production and exchange goods in order to consume a mix of the two. It is the
ability to separate production and consumption through trade that generates gains in the
Ricardian model.
Specialisation in Home and Foreign is depicted by production points B and B0 in Figures 2.1
and 2.2, respectively. Home can export wine in exchange for cloth at world prices, reflected by
the shallower dotted relative price line in Figure 2.1. This Consumption Possibilities Frontier
(CPF) reflects consumers’ budget line under free trade, which is now higher than the PPF.
Similarly, the higher relative price for cloth in Foreign resulting from free trade expands
19
Wine
CPF
PPF
• C' International Relative Prices
A'
• IFT
Opportunity Cost and IA
Autarky Relative Prices (PC/PW)FT
(PC/PW)F
• Cloth
0 B'
Figure 2.2: Autarky and free trade equilibrium in Foreign
consumers’ consumption possibilities, as reflected by the CPF. Consumers in each economy

maximise their utility given their consumption possibilities so consumption under free trade is
at C and C 0 , respectively (for the moment we assume that trade is balanced; that is the value of
exports will be equal to the value of imports).
The gains from trade
In Ricardo’s numerical example the gains from trade are established by showing that if
specialisation is according to comparative advantage, the total world production of both goods
can be greater than under autarky. Thus both countries can be made better off. More generally,
it can be shown that free trade, and hence specialisation according to comparative advantage,
will expand consumption possibilities in both countries. This is shown in Figure 2.3, which is
constructed by combining Figures 2.1 and 2.2. The dimensions of the box in Figure 2.3 show
total world production of wine and cloth when both countries are specialised according to
comparative advantage. Under autarky, consumption must be identical with production in both
countries. Hence Home consumption (and production) would occur at a point like A and
Foreign production and consumption would be at a point like A0 . When free trade is possible,
both will specialise and be able to trade at international prices (the arrowed line in Figure 2.3).
Thus a consumption point such as C is attainable. The consumption point C is clearly superior
to both A and A0 . This is because at C Home consumers can consume more of both goods than
at point A and Foreign consumers can consume more of both goods than at A0 .
The gains from trade are also reflected in Figures 2.1 and 2.2 directly, as consumers are able to
reach a higher indifference curve (and thus welfare level) than under free trade.
Relative Supply (RS)–Relative Demand (RD) analysis
The relative world price of cloth to wine in the free trade equilibrium was argued to lie in
between the autarky relative prices of the two countries. The next issue we need to address is
20
Cloth
0
A'
• Foreign
•C
(PC/PW)F
Wine •A
Home (PC/PW)FT
(PC/PW)H
International Relative Prices
Figure 2.3: The gains from trade
exactly how relative world prices are determined. To do so, we need to use a piece of technical
apparatus emphasised in KOM, the world Relative Supply (RS)–world Relative Demand (RD)
analysis.
The RS curve is derived from the production possibility curves of the two countries and the
condition that producers maximise profits. The RS curve is step-shaped (see KOM Figure 3-3
‘World Relative Supply and Demand’, p.59) because the technology assumes fixed labour
requirements. The intersection of world RS and RD curves illustrates world trading
equilibrium. Two types of equilibria are possible:
1. An equilibrium in which both countries specialise (Equilibrium 1 in KOM Figure 3-3).
2. An equilibrium in which one of the countries is incompletely specialised (such as

Equilibrium 2 in KOM Figure 3-3).
Consider Figure 2.4, which illustrates RS and RD for the Ricardian model. RD is quite
straightforward to grasp: as the relative price of cloth falls, there is more demand for cloth
relative to wine in the world.
The RS is a piece-wise function and needs careful construction. Consider the incentives for
production for different relative prices of cloth to wine. If Pc /Pw < (Pc /Pw )F , then firms
cannot cover the costs of cloth production, so there will be no production of cloth in either
country. Hence the RS is vertical at 0 for all relative prices up to (Pc /Pw )F . If
Pc /Pw = (Pc /Pw )F , only country F can produce cloth, and can choose anywhere along its PPF,
giving a range of possible relative supplies of cloth to wine. For relative prices in the range
(Pc /Pw )F < Pc /Pw < (Pc /Pw )H , Foreign will produce only cloth, while Home will produce
only wine. This gives the vertical segment of the RS step-function. Finally, for prices
Pc /Pw > (Pc /Pw )H , there is no incentive for either country to produce any wine, so the relative
supply of cloth to wine tends to infinity at (Pc /Pw )H .
Combining the steps in this reasoning yields the RS schedule in Figure 2.4. The free trade
equilibrium relative prices are determined where RS and RD meet, such as point E in Figure
2.4.
Advantages of RS–RD approach:
21
PC/
P W
RS
(PC/PW)H
(PC/PW)FT •E
(PC/PW)F
RD
RS, RD
0
Cloth/Wine
Figure 2.4: Determination of world relative prices using RD – RS
It shows the simultaneous determination of prices, specialisation and trade.
One can use the diagram to do simple comparative statics (for example, analyse the
effects of changes in input requirements – productivity); of changes in size of country; of
demand changes.
The analysis can be extended to more than one country.

Consider how world relative prices might be different if the Foreign economy were very large
in size (large labour force) relative to Home. This could also reflect the case of an efficiency
gain in labour productivity; whereby the same labour force becomes uniformly more
productive. The PPF of the Foreign economy is further out than that depicted in Figure 2.2, so
there is more scope for the production of cloth (and wine) than before. It follows that the
step-function changes, with a deeper ‘step’ reflecting larger Foreign production if
Pc /Pw = (Pc /Pw )F . This is illustrated in Figure 2.5. Country size and world relative prices,
where an overall gain in labour productivity in Foreign results in a change from free trade
equilibrium E to equilibrium E 0 .
The interesting result is that the free trade relative price coincides with the autarky relative
price of Foreign. Without a change in relative prices, there is no CPF expansion in Foreign,
which implies Foreign does not gain from trade; by its sheer scale Foreign’s autarky prices
prevail for the world once trade is liberalised between Home and Foreign, with all the gains
accruing to Home.
Activity 2.2 Home has 1,200 units of labour available. It can produce wine (w) and
cloth (c), the unit labour requirement of wine production is 4, while the labour requirement
of cloth is 3.
(a) Graph Home’s production possibility frontier.
(b) What is the opportunity cost of wine in terms of cloth?
22
PC/
PW
(PC/PW)H
RS RS'
(PC/PW)FT •E
(PC/PW)F E'
•
= (PC/PW)FT'
RD
RS, RD
0
Cloth/Wine
Figure 2.5: Country size and world relative prices
(c) Explain what the price of wine, in terms of cloth, would be in autarky (that is, in the
absence of trade).
Now consider Foreign, with a labour force of 900. Foreign’s unit labour requirements are 5
for a unit of wine, and 1 for a unit of cloth.
(d) Graph Foreign’s production possibility frontier.
(e) Construct the world relative supply curve.

Now suppose that the world relative demand takes the following form:
(Dc /Dw )W = (Pw /Pc )W
where Dc and Dw are the demand for cloth and wine respectively.
(f) Graph the relative demand curve along with the relative supply curve.
(g) What is the equilibrium relative price of wine?
(h) Describe the pattern of trade.
(i) Show that both Home and Foreign gain from trade.
Add a third country, Moon, with labour force 2,000 and unit labour requirements of 4 for
both wine and cloth.
(j) Graph the relative demand curve along with the relative supply curve for the three
country case.
(k) What is the new equilibrium relative price of wine?
23
Relative wages
The Ricardian model offers a clear insight into the way in which international relative wages
are influenced by relative productivity. This can be seen most clearly in the case of complete
specialisation. Assume that Home specialises in wine and Foreign in cloth so that the price =
cost conditions imply:
Pw = awH × wH (2.1)
Pc = aCF × wF (2.2)
where aH w and aF C are the labour input coefficients in Home for wine production and in
Foreign for cloth production, respectively. wH and wF are wages at Home and in Foreign.
Taking the ratio of equation 2.1 to 2.2 and rearranging to solve for relative wages yields:
wH awF Pw
= H× (2.3)
wF aw Pc
Thus equation 2.3 shows that in equilibrium, relative wages are linked to relative
productivities, through the ratio of input requirements, and to product demand through the
price ratio. Other things being equal, higher productivity at Home (a lower unit labour
requirement) implies higher relative Home wages and a lower productivity implies lower
wages. Thus wages adjust to compensate for productivity in the Ricardian model. This
adjustment in wages ensures that the country will have a labour cost advantage in at least one
sector.
Activity 2.3
1. Reading KOM Chapter 3 section ‘Misconceptions about Comparative Advantage’,

pp.65–68, list three common arguments against free trade and provide reasons against
these arguments.
2. Reading KOM Chapter 3 section ‘Comparative Advantage with Many Goods’,

pp.68–72, show how the two goods, two country model described in this chapter can
be extended to a multi-goods model. Verify the results given in KOM Table 3-2
‘Home and Foreign Unit Labor Requirements’, p.69, and KOM Figure 3-5
‘Determination of Relative Wages’, p.71.
2.2.3 Empirical evidence and application

As with all economic models, it is important to ask yourself the question: does this model
desribe reality well? For the Ricardian model, the answer is a heavily qualified yes.
For instance, MacDougall (1951) shows that post-Second World War Britain had lower
productivity than the USA in almost every sector. Still, Britain was exporting about as much
as the United States. As the trade could not have been the result of an absolute advantage on
the side of Britain, this is indicative of a comparative advantage of some sort. Balassa (1963)
provides further support to the concept of comparative advantage by looking at the trade of
individual industries within the USA and Britain. KOM Figure 3-6 ‘Productivity and Exports’,
p.74, shows that sectoral exports from the USA were positively related to the comparative
advantage of that sector.
24
2.3. Overview of chapter
It is difficult to directly test the Ricardian model because its predictions depend on properties
of unobservable autarky equilibria or equivalently upon the relative supply curve that is also
unobservable. Attempts to test the model have accordingly examined the way in which
productivity differences have influenced trade shares in third country markets. On the whole
such indirect evidence is supportive of the model.
Of course, we need to be careful when applying the Ricardian model, or any other trade
model. Leamer and Levinsohn (1995) provide the following two pieces of sobering advice:
1. Don’t take trade theory too seriously.
2. Don’t take trade theory too casually.

The Ricardian model, like all economic theory, is not meant to be taken literally. It is a
simplified version of reality, meant to elucidate certain key points, not to describe it
exhaustively. As such you should not take it too seriously. This also means that finding a piece
of evidence against the Ricardian model is not necessarily useful; it is much more useful to
establish how important comparative advantage is, rather than showing that it is not always
exactly true.
However, this does not mean that one should ignore the Ricardian model, and trade theory in
general. To make sense of the data, it is important to try and connect it to a good theoretical
model. The theory provides predictions on what patterns to look for in the data, and how to
interpret these patterns.
In particular Leamer and Levinsohn (1995) conclude, based on the economic literature up to
that point, that the empirical evidence validates the predictions of the Ricardian model that:
1. Except when labour inputs are equal across countries, there exist gains from trade.
2. A country exports the commodity in which it has a comparative labour cost advantage
and imports the commodity in which it has a comparative disadvantage.
2.3 Overview of chapter

In this chapter, we have discussed the theory of comparative advantage and in particular how
the Ricardian model relates to this. We have considered the advantages of this model and how
it can be applied in terms of estimating comparative advantage from a country’s trade data.
This model is important within international trade and is therefore significant for the chapters
that follow.
2.4 Reminder of learning outcomes

Having completed this chapter, and the Essential readings and activities, you should be able to:
explain the concept of comparative advantage and distinguish it from the idea of absolute
advantage
25
explain how comparative advantage based on technological differences is the determinant

of the pattern of trade and specialisation in the Ricardian model
explain how the gains from trade arise in this model
explain the relationship between relative international productivity and relative wages
manipulate the RD/RS diagram to illustrate different possible equilibria in the Ricardian
model
explain how comparative advantage might be interpreted in a real world situation.
2.5 Test your knowledge and understanding
2.5.1 Sample examination questions
1. Hardware, H, and Software, S , are perfect substitutes. Consumers combine a unit of

hardware with a unit of software to obtain a laptop, so that consumers have a Leontief
utility function of the form
U(H, S ) = min{H, S }.
Hardware and Software are produced both in England and in Portugal using labour as the
only production factor. England is endowed with 800 units of labour, while Portugal is
endowed with 400 units of labour. Labour productivity is described in the following
matrix:
Hardware Software
England 1/10 1/30
Portugal 1/40 1/20
(Namely, one unit of labour in England produces one tenth of Hardware, etc.)
(a) Does either of the two countries have an absolute competitive advantage? Does
England have a comparative advantage? In which sector? What about Portugal?
(b) How many laptops are produced in England under autarky? How many laptops are
produced in Portugal under autarky? How many units of labour are employed in the
production of Hardware in the two countries? What are the relative autarky prices?
(c) Suppose free trade is now allowed between England and Portugal. Is either of the
two countries fully specialising? What is the number of Hardware and Software
units produced in Portugal and in England? What is the free trade equilibrium
relative price?
2. Show how the relative supply/relative demand (RS–RD) curve diagram may be used to
illustrate international equilibrium in the Ricardian model. How would equilibrium
change if the size of one of the countries doubled but labour productivity halved?
26
2.5. Test your knowledge and understanding
2.5.2 Guidance on answering Sample examination questions

1. (a) Neither country has an absolute competitive advantage, but England has a
comparative advantage in making Hardware and Portugal has a comparative
advantage in making Software.
(b) As consumers have a Leontief utility function, the quantity of Hardware produced in
each country will be equal to the quantity of Software. For example, in England it
will take 40 hours of labour to produce one laptop: 10 hours to produce a piece of
hardware and 30 hours to produce a piece of Software.
So, Portugal will produce six laptops (400 / (40 + 20) = 6.67, round down to
the nearest integer).
England will use 200 hours of labour in the production of Hardware
(10/40 × 800), Portugal 266.67 hours = (40/60 × 400).
The relative price of Hardware is 10/30 = 0.33 in England and 40/20 = 2 in
Portugal.
(c) A good answer would conduct an analysis similar to that provided in KOM Figure
3-3 ‘World Relative Supply and Demand’, p.59. From (a), we know that England
will produce mainly Hardware, and Portugal mainly Software. In equilibrium the
number of Hardware produced equals the number of Software produced: a total of
35 units of each.
Portugal will specialise completely in Software.
Portugal will produce 20 units of Software (and no Hardware), England will
produce 35 pieces of Hardware and 15 pieces of Software.
As Portugal specialises completely, the relative price of Hardware is determined by
the productivity in England: the relative price of Hardware will be 0.33 (see (b)).
2. See KOM and the subject guide (Figure 2.4 and surrounding text) for details on the
RS–RD diagram.
2.5.3 Feedback to selected activities

Activity 2.2
(a) The Home production possibility frontier is given in Figure 2.6; it is a straight line that
intercepts the Y-axis at 1, 200/4 = 300 and at the X-axis at 1, 200/3 = 400.
(b) The opportunity cost of wine in terms of cloth is 4/3 = 1.33. For each wine produced,
1.33 units of cloth could have been produced instead.
(c) Labour mobility between the two sectors ensures that wages are equal in both sectors,
and in efficient markets the price of each good reflects the marginal price, so the relative
price of wine will be equal to the opportunity cost of wine, at 1.33 units of cloth per unit
of wine.
(d) The Foreign production possibility frontier is given in Figure 2.7; it is a straight line that
intercepts the Y-axis at 900/5 = 180 and at the X-axis at 900/1 = 900.
27
Wine
300
400 Cloth
Figure 2.6: Home production possibility frontier

Wine
180
900 Cloth
Figure 2.7: Foreign production possibility frontier
28
Relative price of
wine (Pw/Pc)
RS1
5
3
4
/3
RD
1
/3
Relative quantity of
wine (QHW + QFW) / (QFC + QFC )
.
Figure 2.8: World relative supply and demand curve
(e) The World relative supply curve is constructed by determining the supply of wine
relative to the supply of cloth at each relative price. The lowest relative price at which
wine is produced is 1.33 units of cloth per unit of wine. The relative supply curve is flat
at this price. The maximum number of wine supplied at the price of 1.33 is 300, supplied
by Home. At this price, Foreign produces 900 units of cloth and no wine. This implies
that the relative supply of wine is 300/900 = 1/3. This relative supply holds for any price
between 1.33 and 3 (the autarky price in Foreign). At the price of 3, both countries would
produce only wine and no cloth and the relative supply of wine goes to infinity. Thus, the
relative supply curve is step shaped, as seen in Figure 2.8.
(f) See Figure 2.8.
(g) The equilibrium price and supply can be found where the supply and demand intersect.
In this case, the equilibrium price would be three units of cloth per unit of wine.
(h) At the equilibrium, Home produces only wine and exports some of it to Foreign, while
importing some of the cloth from Foreign. (In particular, Home will export 150 units of
wine and import 450 units of cloth).
(i) Home now consumes 150 units of wine and 450 units of cloth, a consumption bundle
that lies well outside its autarky production possibility frontier. Likewise the
consumption bundle of Foreign (150 wine, 450 cloth) also lies outside its autarky
possibility frontier. Figure 2.9 compares the PPF before and after trade.
(j) See Figure 2.10 for the diagram. Note that the autarky price in Moon is 1 wine per cloth,
and Moon can produce either 500 wine or 500 cloth (or a linear combination between the
two). So, for a relative price less than 1, all three countries produce cloth (400 + 900 +
29
Wine
300
Tra
de
Au
150 tar
ky
400 450 900 Cloth
Figure 2.9: Home PPF, Autarky versus trade
30
W
PW/
P C
RS'
5
4/
3
RD
W
0.38 3/ 8/ (Qw/Qw)
4 9
Figure 2.10: World relative supply and demand curve with three countries
500), so the relative supply of wine is 0. For relative prices between 1 and 1.33, Moon
produces wine (500) and Home and Foreign produce cloth (400 + 900), for a relative
supply of wine of 500/(400 + 900) ≈ 0.38. When the relative price is between 1.33 and
5, Moon and Home produce wine (500 + 300) and Foreign produces cloth (900), for a
relative supply of 8/9. Once the price rises above 5, the relative supply of wine goes to
infinity as all three countries supply wine, but no cloth.
(k) The new equilibrium is reached at a relative price of 4/3 = 1.33 and a relative supply of
1/1.33 = 0.75. This implies that Moon fully specializes in wine (producing 500),
Foreign fully specializes in cloth (producing 900 units) and Home produces both wine
and cloth (238 wine and 83 cloth to be precise). In terms of trade this implies that Moon
will export wine for cloth, Foreign will export cloth for wine. The trade patterns of Home
are a bit more tricky, as it produces both goods, but as the relative demand in Home (and
in the rest of the world) is 0.75, it also has an excess supply of wine and will, like Moon,
trade wine for cloth.
31
32
Chapter 3
The Heckscher–Ohlin model
3.1 Introduction
The Heckscher–Ohlin (HO) model of international trade was originally developed by two
Swedish economists Eli Heckscher and Bertil Ohlin in the early part of the twentieth century.
Like the Ricardian model, it is a comparative advantage model of international trade where
differences between countries are the basis for trade. Unlike the Ricardian model, where
comparative advantage originates in differences in technology between countries, technology
is assumed to be the same across countries in the HO model, with the emphasis instead placed
on differences in factor endowments as the origin of comparative advantage.
The model is explicitly general equilibrium in character and this feature is emphasised
through the linkages between factor prices and choice of inputs, and factor prices and product
prices. Accordingly, the model provides a particularly rich account of the mechanisms by
which trade influences the economy.
A notable insight of the model is that trade in goods can be regarded as a substitute for the
international movement of factors (that is, trade in goods is indirectly trade in factors of
production). This is seen most clearly in the factor price equalisation theorem.

This chapter aims to describe the Hecksher–Ohlin model, its advantages and limitations and
its applications to problems in international economics.

should be able to:
explain the shape of the production possibility frontier with two factors of production
explain how differences in factor endowments can provide a basis for international trade
explain why trade can have profound effects on income distribution
explain the direction of income distribution effects, namely that trade benefits a country’s
abundant factor and worsens the real income of the scarce factor
explain the effect of changed factor endowments on sectoral outputs
explain the limitations of the Heckscher–Ohlin (HO) model as an empirical hypothesis

about the commodity composition of trade.
33
3. The Heckscher–Ohlin model

KOM, Chapter 5 ‘Resources and Trade: The Heckser–Ohlin Model’.
There is an interactive webpage through which you can practise building and
manipulating the Lerner diagram:
http://www-personal.umich.edu/˜alandear/glossary/figs/Lerner/ld.html

FT, Chapter 4 ‘Trade and Resources: The Heckscher–Ohlin Model’.
S(IT), Chapter 60.
Freeman, R. ‘Are your wages set in Beijing?’, Journal of economic perspectives 9(3)
1995, pp.15–32.
Jones, R.W. and J.p.Neary ‘The positive theory of international trade’ in Jones, R.W. and
P.B. Kenen (eds) Handbook of international economics vol. 1: international trade.
(Amsterdam: Elsevier Science B.V., 1998) [ISBN 9780444704221].
Leontief, W. ‘Domestic production and foreign trade: the American capital position
re-examined’, Proceedings of the American philosophical society 97 1953, pp.331–49.
Romalis, J. ‘Factor proportions and the structure of commodity trade’, American
economic review 94 2004, pp.67–97.
Trefler, D. ‘The case of the missing trade and other mysteries’, American economic
review 85 1995, pp.1029–46.


This chapter describes the Heckscher–Ohlin model of trade.
3.2 Chapter content
3.2.1 Assumptions
A limitation of the Ricardian model is that it assumes a single factor of production, usually
taken to be labour or a dose of labour combined with other factors in fixed proportions. This is
firstly unrealistic and secondly, it does not permit the analysis of the impact of trade and trade
policy on income distribution. In contrast, the HO model is what is known as a 2 × 2 × 2
model. That is, it is characterised by the assumptions of two goods, two factors of production
and two countries. Let us assume that there are:
34
w/
r
Food
Manufactures
(K/L)i
0
Figure 3.1: No factor intensity reversals
two goods, say, food (F) and manufactures (M)
two factors of production, labour (L) and capital (K)
two countries, say, Home (H) and Foreign (F).

Further, assume that technologies are identical across countries but different across sectors. In
particular, let manufactures be the relative capital intensive sector and food the relative labour
intensive sector. That is, for all possible relative factor prices, the ratio of capital to labour
employed in the production of manufactures exceeds the ratio of capital to labour employed in
the food sector (see Figure 3.1). While the sectors use factors of production with different
intensities, it is assumed, in contrast to the Ricardian model, that both countries have access to
the same technology (that is, they have the same production functions in both sectors). This is
to concentrate attention on differences in resource endowments as the potential origin of
comparative advantage.
Figure 3.1 illustrates the relationship between relative price of labour to capital (w/r, where w
is the wage rate and r is the rental price of capital) and the capital labour ratio employed in
each sector. As labour becomes more expensive relative to capital, Figure 3.1 shows the
production process of both sectors becomes more capital intensive, but the capital–labour ratio
in manufacturing is always higher than that in food production. In other words, we assume
there are no factor intensity reversals.
The phenomenon in which relative factor intensities change at different factor prices is known
as factor-intensity reversal. Although in theory there can be many factor-intensity reversals it
is debatable whether they are important empirically. The often convenient assumption of no
factor-intensity reversal is sometimes known as the strong factor intensity condition.
Here we impose both the strong factor intensity condition as well as assuming that: perfect
competition prevails in both goods and factor markets and that production functions satisfy
constant returns to scale. The assumption of constant returns to scale is crucial in deriving a
number of results. The two countries are assumed to differ in their endowments of factors. In
35
particular, assume Home is relatively more capital abundant than Foreign. Hence,
(K/L)H > (K/L)F . Finally, consumers of the two countries are assumed to have identical
preferences.
The assumptions of the HO model imply that countries are effectively identical in every
respect except their endowment of factors of production. It is the interaction of different factor
abundances across countries and different factor intensities across sectors that gives rise to a
pattern of comparative advantage and thus a basis for international trade.
3.2.2 Tools and results for a closed economy

The procedure for understanding the workings of the model is similar to that employed in the
Ricardian model. Firstly, we describe the characteristics of an economy that does not trade and
then we consider what happens when two such economies trade with each other.
From goods prices to input choices
The key analytic concepts of the HO model concern the way in which resources (that is,
labour and capital), are allocated between the two sectors, food and manufactures, as well as
the backward linkage to factor prices and the forward linkage to product prices. The most
important single tool of the HO model is the diagram expressing these linkages. In KOM it is
Figure 5-7 ‘From Goods Prices to Input Choices’, p.123 in Section ‘Model of a Two-Factor
Economy’. A version of this diagram is reproduced as Figure 3.2. This figure is based on two
assumptions of the model. These are:
cost minimisation
price equals average cost.

Thus in each sector producers are assumed to minimise costs. This means that at each factor
price ratio (w/r) they choose the factor input ratios (Ki /Li ) which minimises costs. The
assumption of constant returns to scale means that the cost-minimising input ratio is
independent of the scale of production. For further details see KOM Chapter 5 as well as
KOM Appendix to Chapter 5 ‘Factor Prices, Goods Prices, and Production Decisions’,
pp.147-150. To understand the mechanisms behind Figure 3.2 we examine the cost
minimisation decision more carefully. Figure 3.2 illustrates unit-value isoquants for food and
manufactures. These are isoquants, one for each sector, along which the value of output
(revenue) is equal to 1. That is, P M Q M = 1 holds along the M isoquant, which implies the
quantity of manufactures associated with this isoquant is Q M = 1/P M , the inverse of the price
of manufactures. Similarly, PF QF = 1 holds along the F isoquant, which implies the quantity
of food associated with this isoquant is QF = 1/PF , the inverse of the price of food. Notice
the M isoquant is positioned towards the K-axis as it is relatively capital intensive, while F is
positioned towards the L-axis as it is relatively labour intensive.
Firms will choose the factor input ratios (Ki /Li ) M and (Ki /Li )F that minimise the cost of
producing a given value of output. The assumption of perfect competition implies there are
zero profits in equilibrium, so cost is equal to revenue in the production of each sector. Hence,
P M Q M = 1 = wL M + rK M implies zero profit in the M sector and PF QF = 1 = wLF + rKF
implies zero profit in the F sector. Figure 3.3 depicts the Lerner diagram, which illustrates
cost minimisation in both sectors. There is a unique isocost line (wL + rK = 1) that is tangent
36
1/
PM
1/
PF
L
0
Figure 3.2: Unit value isoquants
K
(KM/LM)
Cone of
Diversification
M•
(KF/LF)
1/
PM
•
F
1/
- w/r PF
L
0
Figure 3.3: Lerner diagram: cost minimisation
37
to both isoquants. This determines the (unique) equilibrium factor price ratio (w/r), which
reflects the slope of the isocost line, at which both goods are produced with zero profits. The
prices of the two goods determine the position of the isoquants and cost minimisation pins
down the equilibrium factor price ratio and factor input ratios in the two sectors. The rays
through the origin through points M and F in Figure 3.3 describe the equilibrium techniques
of production for the two sectors. The area enclosed by these two rays is called the cone of
diversification. If the endowment point of the economy lies within this cone, then there is
incomplete specialisation (both goods are produced in positive amounts).
The Stolper–Samuelson (SS) Theorem
We can use the Lerner diagram to examine the implications of price changes on factor prices.
This gives a diagrammatic demonstration of the Stolper–Samuelson (SS) Theorem, one of the
most important results of the HO model. The Stolper–Samuelson Theorem states that if both
goods continue to be produced (incomplete specialisation), an increase in the relative price of
a good will increase the real return of the factor used intensively in the production of that good
and a decrease in the real return to the other factor of production.
To demonstrate the SS Theorem of the HO model consider the implications of an increase in
the price of manufactures from PM to PM 0 , as illustrated in Figure 3.4. When the price of
manufactures rises, the quantity of output needed to generate one unit of revenue falls, shifting
in the M-sector unit-value isoquant inwards. Cost minimisation implies a lower equilibrium
factor price ratio (that is, w/r falls) lowering the relative cost of labour to capital so both food
and manufactures are produced using a less capital intensive technique of production than
before the prices change (this corresponds with the shape of the curves in Figure 3.1). To find
the effect of the price change on w and r independently, consider the intercepts of the isocost
line on the L-axis and K-axis respectively. Recall that the equation for the isocost schedule is
wL + rK = 1. Along the K-axis L = 0, so r = 1/K. The change in the intercept from y to x in
Figure 3.4 therefore corresponds to a fall in K-intercept and hence a rise in r. Similarly,
examination of the intercept along the L-axis yields a fall in w. Hence a rise in the price of
manufactures has been shown to raise the nominal price of capital, the factor used intensively
in manufacturing, and lowers the nominal price of labour, the factor used intensively in the
food sector. To establish that the real wage falls and the real rental rate rises, thereby
completing the proof of the SS Theorem, we need to consider prices. Since the price of food is
unchanged, the real wage and real rental rate have obviously fallen and risen, respectively, in
terms of food. Additionally, the price of manufactures has risen, so the real wage in terms of
manufactures has unambiguously fallen. The conflict arises in the case of rental rates in terms
of manufactures since r has risen but so has the price of manufactures. To resolve this we
appeal to the magnification effect, which is that the change in r is more than proportional to
the change in PM. This can be seen in Figure 3.4 since xy/0y > vz/0z, where the former
reflects the proportional change in r and the latter the proportional change in PM.
Goods prices, factor prices and factor intensity linkages
We can combine the analysis of Figures 3.1–3.4 to construct Figure 3.5, which shows the way
in which resources (that is, labour and capital) are allocated between the two sectors, food and
manufactures, as well as the backward linkage to factor prices and the forward linkage to
product prices. The factor intensity curves in the right-hand half of Figure 3.5 reflect the
38
K (KM/LM)
(KM/LM)'
y •
x •
•
• (KF/LF)
z 1/
• PM
v 1/
PM'
(KF/LF)'
•
•
- w/ 1/
r PF
L
0
Figure 3.4: The Stolper–Samuelson Theorem
w/
r
Food
S
Manufactures
(w/r)0
PF/ K/
PM L
(PF/PM)0 (KF/LF)0 (KM/LM)0
Figure 3.5: Goods prices, factor prices and factor intensity linkages
39
choice of cost-minimising technique. In both sectors, as wages rise relative to rental rates,
producers substitute capital for labour (that is (Ki /Li ) rises), but the capital-labour ratio of
food is always lower than that of manufactures, reflecting the fact that food is the relatively
labour-intensive sector.
In the left-hand half of Figure 3.5 the SS curve, which shows the relationship between goods
prices and factor prices, reflects the Stolper-Samuelson Theorem. Here, it is shown that the
relative wage/land rent ratio rises when the relative food price (in terms of manufacturing)
rises. The SS curve is drawn as a straight line in Figure 3.5. This need not be the case, and in
general it will be non-linear, as in KOM Figures 5-6 ‘Factor Prices and Goods Prices’, p.122,
and 5-7 ‘From Goods Prices to Input Choices’, p.123.
As it stands, Figure 3.5 says nothing about the direction of causality between its components.
The relationships illustrated are simply necessary consequences of the twin assumptions of
cost minimisation and price equals average cost. However, if one of the elements is fixed, say
the goods price ratio, then the mechanism of the SS curve and the sectoral factor-intensity
curves determine the wage-rental ratio and the choice of technique in the two sectors. If,
instead, we held fixed the relative factor price ratio, then the SS curve determines the relative
goods price ratio consistent with the assumptions of the model. The intuition for this follows
from the fact that food is always more labour-intensive than manufacture, and hence, as the
cost of labour rises relative to the cost of capital the unit cost of the labour-intensive good
(food) must rise relative to the land-intensive good (food).
Activity 3.1 As an exercise in the use of Figure 3.1, assume that at low (w/r), food is
relatively labour-intensive but that at high (w/r) this is reversed, and food is relatively
capital-intensive. Redraw Figure 3.1 to reflect this and consider the implications for Figure
3.5. In particular, what does the SS curve look like? What happens to the above-mentioned
linkage between goods prices and factor prices?
Factor endowments and production possibilities
A second important tool of the HO model is the Edgeworth Box diagram (or box-diagram) –
see for example Figure 3.6. The box-diagram shows how a given endowment of resources,
labour and capital, is allocated between sectors when the wage-rental ratio (and implicitly also
the goods-price ratio) is given.
An interesting and famous result employing the box-diagram concerns what happens to
resource allocation and sectoral outputs when the factor-endowment changes. Figure 3.7
illustrates the case where the supply of land (the factors of production are land and labour in
this example, instead of labour and capital) is taken to increase. If goods prices (and hence
factor prices also) are taken to be fixed, then Figure 3.7 shows that an increase in the
endowment of land will lead to an increase in the output of the land-intensive good and a
decrease in the output of the capital intensive good. More generally, it can be shown that if the
endowment of a factor increases (or decreases) then at unchanged goods prices, the output of
good which uses that factor intensively will increase (or decrease) and the output of the other
good will decrease (or increase). This result is known as the Rybczynski Theorem.
The Lerner diagram can be used to construct the Edgeworth box. Consider Figure 3.8, where
E denotes the endowment point of this country (within the cone of diversification).
Employment of labour and capital in the two sectors must sum to the total endowment in the
40
Labour used in food production

Lf
Land used in cloth production
Land used in food production

C
1
Tc Tf
Oc Lc
Labour used in cloth production
Figure 3.6: The allocation of resources
Labour used in food production

Lf2 Lf1 Of2
Of
Land used in cloth production
Land used in food production
C
1
1
Tc Tf1
2
Tc2 Tf2
F2
Oc Lc1
Lc2
Labour used in cloth production
Figure 3.7: An increase in the supply of land
41
K
(KM/LM)
E
•
A
•
M•
(KF/LF)
1/
PM
•
B
•
F
1/
- w/r PF
L
0
Figure 3.8: The Lerner diagram revisited
economy if there is to be full employment. The factor input ratios determined by cost
minimisation (through points M and F) facilitate the construction of the employment vectors
in the two sectors by ‘completing the parallelogram’ to E. Vector OA (employment in the
manufacturing sector) plus vector AE (employment in the food sector) must equal OE, that is,
must exhaust resource endowments in the economy. The employment vectors (from factor
input ratios) can be transferred to the Edgeworth box, whose dimensions reflect the
endowment of labour and capital in the economy, as illustrated in Figure 3.9. The Edgeworth
box can be used to demonstrate the Rybczynski Theorem. Holding relative goods prices
constant implies that relative factor prices and the factor input ratios are also fixed (from
Figure 3.5). An increase in the endowment of, say, labour, expands the width of the box, as
illustrated in Figure 3.10. With constant factor input ratios, it is straightforward to find the new
allocation of labour and capital between the two sectors by extending employment vectors
from the origin and the new endowment point E 0 . Comparing A with A0 shows that there is
more employment of both factors in the food sector, causing an expansion of the food sector,
and less employment of both factors in the manufacturing sector, which causes the
manufacturing sector to shrink. This demonstrates the Rybczynski Theorem. The box-diagram
can also be used to derive a country’s production possibility curve. It is then possible to see
that if the endowment of a factor grows, its production possibility curve will be shifted
outward in a manner that is biased towards the good which uses the growing factor intensively.
This is of interest in its own right but can also be used to compare production possibilities of
different countries with different factor endowments. Thus a country which is overall
relatively well-endowed with labour as compared with another country will possess a
production possibility curve which is biased towards food, the labour-intensive good. This is
illustrated in Figure 3.11 below, where two production possibility curves are depicted. As
Home is capital-abundant relative to Foreign, its PPF is biased towards manufactures, while
the Foreign PPF is biased towards cloth.
Activity 3.2 Using Figure 3.11 show that at the same relative goods prices the
labour-abundant country will produce a larger quantity of food relative to manufactures.
Hence show that the labour-abundant country’s relative supply curve of food lies below the
42
(KF/LF)
A•
(KM/LM)
0
L
Figure 3.9: From Lerner diagram to Edgeworth box
E E'
(KF/LF)
A
•
A' •
(KM/LM)
0
L ΔL
Figure 3.10: The Rybczynski Theorem
43
Food
Foreign PPF
Home PPF
0 Manufactures
Figure 3.11: Biased production probabilities
relative supply curve of the capital-abundant country (Hint: see the example in KOM with
food and cloth and examine KOM Figures 5-8 ‘Resources and Production Possibilities’,
p.125, and 5-9 ‘Trade Leads to a Convergence of Relative Prices’, p.126.)
3.2.3 Trade, income distribution and factor price equalisation
The pattern of trade
The impact of trade in the HO model may be analysed by first considering what prices would
be in the two countries in the absence of trade (that is, pre-trade or autarky prices). For this we
need to make some assumptions about demand conditions in the two countries. Usually it is
assumed that demand conditions are ‘similar’ in the two countries but for easy exposition it is
convenient to assume that they are identical. This may be represented in the KOM framework
as identical relative demand curves and the same pattern of indifference curves in the PPF
diagram.
It is then easy to see from Figure 3.12 below that the autarky relative price of manufactures
will be low in the capital-abundant Home country while the relative price of food will be low
in the labour-abundant Foreign country. Accordingly, the labour-abundant country will find it
profitable to export food, while the capital-abundant country will find it advantageous to
export manufactures.
Trade will tend to equalise goods prices in the two countries, thereby raising the price of food
in the labour-abundant country and raising the relative price of manufactures in the
capital-abundant country. As a consequence, in the trading equilibrium, Home will be more
specialised in manufactures than in autarky (production moves from A to B with trade); and
similarly, Foreign will be more specialised in food than in autarky (production moves from A0
to B0 with trade). These arguments can be summarised thus: a country will tend to specialise
and export those goods that intensively use the factor with which it is abundantly endowed.
This proposition is sometimes known as the Heckscher–Ohlin Theorem and represents a core
44
Food Food
Home Foreign
(PM/PF)W
(PM/PF)H •
B'
•C •
•
C'
A'
IFT IFT
• IA IA
A
•
B (PM/PF)W
(PM/PF)F
0 Manufactures 0 Manufactures
Figure 3.12: Autarky and free trade equilibrium
PM/
PF
(PF/PM)H
(PF/PM)W
(PF/PM)F
S
w/
r
0 (w/r)F (w/r)W (w/r)H
Figure 3.13: Goods and factor price equalisation
insight of the HO model, namely that when technology is internationally identical it is

differences in relative resource endowments that are the origin of differences in relative costs
and hence of comparative advantage.
Income distribution and factor price equalisation
Figure 3.13 below reproduces the SS curve from the left-hand segment of Figure 3.5. If Home
and Foreign have access to the same technology then they will have the same SS curve, but
capital-abundant Home has a higher autarky relative wage and a higher relative price of food
than Foreign.
Activity 3.3 Explain why identical technology for both goods in both countries implies
that the SS curve is the same in both countries.
45
Free trade in goods will equalise goods prices in the two countries at, say, (PF /P M )W , which
from Figure 3.13 we see must also equalise factor prices at (w/r)W . This is a remarkable result
and is known as the Factor Price Equalisation Theorem. It shows that trade in goods can act as
a complete substitute for the international mobility of factors; that trade in goods represents an
implicit trade in factors of production.
Activity 3.4 In the real world factor prices are clearly not internationally equalised.
What are the empirical and the theoretical reasons why factor price equalisation might fail?
(Hint: when considering theoretical reasons investigate what happens to the SS curve when
the strong factor-intensity condition fails to hold.)
From Figure 3.13 you can also see that in the labour-abundant country, trade has the effect of
raising the wage-rental rate ratio, and in the capital-abundant country trade has the effect of
lowering the wage-rental rate ratio. This links back to the Stolper-Samuelson Theorem
discussed earlier in the chapter.
3.2.4 Empirical evidence
The hypothesis of the Heckscher–Ohlin Theorem that countries tend to export goods that use
their abundant factors intensively, has been one of the most tested hypotheses in the whole of
economics. In the most famous result, Leontief (1953) found that US exports appeared to be
more labour-intensive than US imports. This result appeared to contradict the intuition that the
US was a capital-abundant country relative to the rest of the world; a finding that quickly
became known as the Leontief paradox. Subsequently, the Leontief tests and other variants
have been widely repeated and a number of explanations have been put forward to explain the
finding. Studies that looked at an international sample found results broadly similar to
Leontief (1953). Furthermore, Trefler (1995) shows that the actual volume of trade between
countries is considerably less than that predicted by the HO Theorem. Thus relative factor
endowments represent a weak or partial explanation of the observed commodity composition
of international trade.
One key explanation in the literature for the Leontief paradox lies in the assumption by the
HO Theorem that production technologies are the same across countries. This is clearly not
true empirically: the US, and western countries in general, have much higher levels of
production technology than developing economies. This is reflected in the fact that the US
exports are made with much more skilled labour than its imports.
All this does not mean that the HO Theorem is useless. For instance, the HO Theorem
correctly predicts the pattern of trade between the industrialised and developing countries,
with developing countries trading their mainly labour-intensive products against
capital-intensive products from industrialised countries.
Activity 3.5 Consider KOM Figure 5-13 ‘Changing Patterns of Chinese Exports over
Time’, p.141. How can you explain the shift in US imports from China? How does this
shift fit with the predictions made by the HO model?
46

In this chapter, we have discussed the Heckscher–Ohlin model, including its limitations. This
model is important and significant for the chapters that follow.

explain the shape of the production possibility frontier with two factors of production
explain how differences in factor endowments can provide a basis for international trade
explain why trade can have profound effects on income distribution
explain the direction of income distribution effects, namely that trade benefits a country’s
abundant factor and worsens the real income of the scarce factor
explain the effect of changed factor endowments on sectoral outputs
explain the limitations of the Heckscher–Ohlin (HO) model as an empirical hypothesis

about the commodity composition of trade.
1. Consider a standard Hecksher–Ohlin world, with the following endowment of production

factors.
Home Foreign
Labour 45 20
Capital 15 10
There are two goods: Computers, which are capital intensive, and T-shirts, which are
labour intensive.
(a) Based on the table above, explain what are the expected patterns of trade in this
world.
(b) Based on your answer above, explain who, in this example, stands to gain from free
trade and who stands to lose.
(c) Assume for a moment that the relative price of computers is fixed at say (Pc/Pt) and
there is a sudden increase in the available labour in Home. Explain what will happen
to the production possibility frontier and Home’s production of Computers and
T-shirts.
47
2. Suppose the world is made of two countries: Home and Foreign. Home is a small
labour-abundant country, while Foreign is capital-abundant. Both Home and Foreign
produce two goods: food and cloth. Food production is labour-intensive and cloth
production is capital-intensive. What is the effect of the introduction of an export subsidy
in the Home country on the return to each factor of production in the Home country?

1. Approaching the question
(a) Note that Home is more labour-abundant than Foreign. Therefore we expect Home
to export T-shirts (labour intensive) to Foreign and import Computers from Foreign.
(b) In an HO world, factor prices will equalise due to free trade. Thus owners of the
abundant factor gain from trade, owners of the scarce factor lose. In this case that
means that Home workers and Foreign capitalists benefit from trade, and Home
Capitalists and Foreign workers will lose from trade.
(c) The PPI will shift outwards; Home will shift production towards the factor that has
increased, leading to an increase in the production of T-shirts, and a decrease in the
production of Computers. See also KOM Figure 5-8 ‘Resources and Production
Possibilities’, p.125, and the discussion about biased expansion of production
possibilities.
2. Let Good 1 be relatively labour intensive and Good 2 be relatively capital intensive. The
Heckscher–Ohlin Theorem states that a country will export the good that uses relatively
intensively its relatively abundant factor of production. Since H is assumed to be labour
abundant it will export the labour-intensive good (Good 1) and import the relatively
capital-intensive good (Good 2). World prices are fixed at (P1 /P2 )w . Calling t the
subsidy, Pd1 and Pd2 the domestic prices of Good 1 and 2 in country H gives:
Pd2 = (1 − t)Pw2 (3.1)
Pd1 = Pw1 ; (3.2)

divide equation 3.2 by equation 3.1 to get:
!d !w
P1 Pw1 P1
= w > (3.3)
P2 (1 − t)P2 P2
Hence an import subsidy increases the relative domestic price of Good 1. The
Stolper-Samuelson Theorem states that an increase in the price of a good will result in an
increase in the price of the factor used intensively in its production, in relative, nominal
and real terms, and a decrease in the price of the other factor, assuming both goods
continue to be produced. Furthermore, the increase in the price of the factor used
relatively intensively will be more than proportional to the original increase in the price
of the good (magnification effect). Thus an import subsidy, which increases the domestic
relative price of the exported labour-intensive Good 1, will increase the relative, nominal
and real wage and will decrease the relative, nominal and real rental rate.
48
Chapter 4
The specific factors model
4.1 Introduction
In contrast to the Ricardian and Heckscher–Ohlin (HO) models, the specific factors model
assumes that some factors are not all fully mobile between sectors. One factor of production,
say labour, is assumed to be mobile, while other factors of production are assumed specific to
a sector because it is embodied in, say, a form of equipment, such as a machine; the specific
factors have no use in other sectors and are thus not mobile. However, in the long-run, as the
equipment is amortised, the capital it embodies can be switched to other sectors. Once specific
factors are considered, analysis of the short-term effects of trade and endowment changes is
made possible.
The model also takes into account diminishing returns to a factor. This then gives rise to the
familiar production possibility set/frontier with the usual curved shape, reflecting a
diminishing marginal rate of transformation, such as in the HO model and in contrast to the
constant marginal rate of transformation assumed by the Ricardian model of Chapter 2 of the
subject guide.

This chapter aims to discuss the specific factors model and how it relates to the Ricardian and
the HO model.

should be able to:
explain the mobile factor market diagram
use the mobile factor market diagram to illustrate the effects of trade on labour allocation,
outputs and on income distribution
use the mobile factor market diagram to illustrate the effects of simple trade policy
instruments on labour allocation, outputs and on income distribution
contrast the effects of trade liberalisation on factor incomes in the Heckscher–Ohlin and
specific factors model
define and explain the distributional effects of international migration.
49
4. The specific factors model

KOM, Chapter 4 ‘Specific Factors and Income Distribution’.

FT, Chapter 3 ‘Gains and losses from trade in the specific-factors model’.
S(IF), Chapter 70-20 to 70-30:

Borjas, G. ‘The economics of immigration’, Journal of Economic Literature, Vol. 32(4),

December 1994, pp.1667–1717.
Burtless G. ‘International trade and the rise in earnings inequality’, Journal of Economic
Literature 3(2) 1995, pp.800–16.
Neary, p.‘Short-run capital specificity and the pure theory of international trade’,
Economic Journal 88(351) 1978, pp.488–510.


This chapter discusses the specific factors model to trade.
4.2 Chapter content
4.2.1 Assumptions
The model assumes two goods and three factors of production. One factor of production is
assumed to be fully mobile between the two goods sectors. The other two factors are each
regarded as ‘specific’ to each of the two goods sectors and can only be employed in that
sector. There are fixed endowments of each factor.
One can interpret the model in several ways. The most common interpretation is that the
mobile factor is homogeneous labour and the specific factors are capital and land; or two
different types of capital (two different machines, each specific to a sector). Suppose the
labour market is assumed to be competitive and hence wages in the two sectors are equalised.
Thus if the two goods are ‘food’ and ‘manufacturing’ then ‘capital’ might be the factor
specific to manufacturing and ‘land’ might be the factor specific to food. By definition, a
specific factor is immobile between sectors. Thus, in the example above, capital cannot be
employed in the food sector and land cannot be employed in the manufacturing sector.
An alternative interpretation is to assume capital, K, is the mobile factor of production used in
both sectors and the two specific factors are skilled labour, LS , and unskilled labour, LU .
50
Suppose the two sectors are ‘textiles’ , T , and ‘software’, S . Textiles are manufactured using
capital and unskilled labour and software is developed using capital and skilled labour. With a
competitive capital market, the rental rate equalises between the two sectors. Skilled workers
receive the skilled wage, wS , while unskilled workers receive the unskilled wage, wU . For the
rest of the chapter we will consider this case. It is of particular interest as it can shed light on
how international trade can affect the wage gap between skilled and unskilled workers in the
short run. In the long run, workers can train to become skilled workers, so they can become
mobile between sectors, as is assumed in the HO model. Contrasting the results of the specific
factors model and the HO model sheds light on the short- and long-run effects of trade on
factor prices, and can inform the debate on the phenomenon of rising wage inequality
experienced in the US and other countries.
4.2.2 Tools and results

Under the assumptions of the model, production in each sector can be represented as
depending on the amount of the variable: mobile factor capital. Given a fixed amount of the
specific factor, this implies diminishing returns to capital. As already noted, this implies a
standard textbook concave production possibility curve.
However, the most important theoretical construct or tool of the specific factors model is the
mobile factor market diagram, which shows how capital is allocated between sectors for given
technology and international prices (note that when labour is assumed to be the mobile factor,
the diagram reflects labour market equilibrium and shows wage equalisation). This is given in
Figure 4.1 below. The two curves in the diagram represent the marginal revenue product of
capital in the textile sector (PT × MPKT ) and in the software sector (PS × MPKS ). These
curves also represent the demand curves for capital in each sector. The total (fixed) supply of
capital in the economy is represented by the length of the horizontal axis in Figure 4.1. Capital
market equilibrium occurs when the rental rate, r, equates supply and demand for capital and
this is represented by the point of intersection of the two marginal revenue product curves.
The equilibrium rental rate is r∗ , the amount of capital allocated to the textile sector is KT and
the amount of capital allocated to software is KS .
4.2.3 Effects of trade

Figure 4.1 can be thought of as representing, in the first instance, a closed economy or autarky
equilibrium. Suppose trade is now possible. Trade will take place provided world prices are
different from autarky prices and the country will export the good which is expensive abroad
(cheap at home) and import the other good (expensive at home but cheap abroad). In a trading
equilibrium, world prices replace autarky prices; in other words the relative price of the export
good will tend to rise and the relative price of the import good will tend to fall, as compared
with the autarky equilibrium.
Figure 4.2 analyses the effects of a rise in the price of software. This exercise can be
interpreted as analysing the effects of a rise in the relative price of software, with the price of
textiles held constant (numeraire, or unit of account). If software happens to be the export
good, then this exercise can also be interpreted as analysing the effects of trade, where the
opening up of trade leads to a rise in the price of the export good relative to the price of the
import good. This could reflect the US, for example, trading with China. With relatively more
skilled to unskilled workers, the US has a comparative advantage in software development
51
r r
A
r* •
KdT = PT.MPKT KdS = PS.MPKS
0S 0T
KS KT
Figure 4.1: Capital market equilibrium (mobile factor)
relative to China, whose relatively large number of unskilled workers gives a comparative
advantage in textile production. When the two open to trade, the US exports software and
imports textiles from China.
Figure 4.2 shows that a rise in the price of software increases the marginal revenue product of
capital in the software sector, and thus shifts the demand for capital in the software sector
rightwards. Equilibrium in the capital market moves from A to B. This leads to a reallocation
of capital from textiles to software and, with fixed amounts of specific factors, implies an
increase in the output of software and a decrease in the output of textiles. The increase in the
supply of the mobile factor in one sector raises the marginal product of the specific factor in
that sector: here, the increase in capital in the software sector makes skilled workers better off;
the decrease in capital in the textiles sector makes unskilled workers worse off.
The nominal rental rate increases as a result of a higher price of software, but what about the
real rental rate of capital? As the price of textiles is constant, the real rental rate rises with
respect to textile price (r/PT ). In contrast, the real rental rate falls with respect to the price of
software, (r/PS ), which itself has risen. This can be seen in Figure 4.2, where the proportional
change in the price of software, reflected by (yB /zB ), is less than the proportional change in the
rental rate, reflected by (xB /zB ). The effect on the real rental rate on capital is thus ambiguous
because the real rental rate falls in terms of the export good but rises in terms of the import
good. Hence the effect on real rental rates depends on the consumption pattern of capitalists.
Rising wage inequality
Figure 4.2 shows that if a country trades and exports the good in which skilled labour is the
specific factor, then the return to skilled labour rises and unskilled labour falls in the short run
(the long-run effects are reflected by the Stolper–Samuelson Theorem of the HO as described
in Chapter 3 of the subject guide). The implication is that trade expands the wage gap between
skilled and unskilled labour. This is of interest because it offers a possible explanation for the
52
r r
B
•
A
• • x
• y
(KdS) '= PS'.MPKS
KdS = PS.MPKS
Kd T = PT.MPKT
z
0S 0T
K
Figure 4.2: The effects of trade
widening income gap between skilled and unskilled workers experienced by the United States
during the 1980s. However, empirical evidence points to skill-biased technological change as
the primary factor behind the increase in US wage inequality over the past thirty years and
trade as a secondary rather than a primary factor.
Activity 4.1
1. In Figure 4.2 the opening up of trade has been depicted in terms of a rise in the price
of software (the export good), while keeping the price of textiles constant (numeraire).
Since free trade will raise the relative price of the export good to the import good, we
could instead keep the price of software fixed and lower the price of textiles (the
import good). Use the capital market clearing diagram to show that a fall in the price
of textiles has the same effects on capital allocation, outputs, and income distribution
as a rise in the price of software.
2. Compare and contrast the income distribution effects of trade in the specific factors
and HO models.
4.2.4 The pattern of trade
The specific factors model does not offer any very sharp predictions about the pattern of trade.
However, loosely speaking, comparative advantage depends on either relative endowments of
factors or on differences in technology. Thus the specific factors model can be interpreted as a
hybrid of the Ricardian model (differences in technology) and the Heckscher–Ohlin model
(differences in factor endowments). Since explaining the pattern of trade is not the major aim
of the specific factors model, it has not attracted empirical testing.
53
Activity 4.2
1. Undertake a variety of exercises involving manipulation of Figure 4.1 in response to

different parameter changes. In particular:
(a) the effects of changes in factor endowments on capital allocation, on outputs and
on income distribution
(b) the effects of an import tariff on capital allocation, outputs and income
distribution
(c) the effects of an export tax on capital allocation, outputs and income distribution
(d) a comparison of the effects of an import tariff and an export tax.
2. Identify two real-world examples where you believe the specific factors model
provides insights.

This chapter has discussed the specific factors trade model and how it relates to the Ricardian
and HO models.

explain the mobile factor market diagram
use the mobile factor market diagram to illustrate the effects of trade on labour allocation,
outputs and on income distribution
use the mobile factor market diagram to illustrate the effects of simple trade policy
instruments on labour allocation, outputs and on income distribution
contrast the effects of trade liberalisation on factor incomes in the Heckscher–Ohlin and
specific factors models
define and explain the distributional effects of international migration.

1. Consider the case of Thailand, a small open economy that faces constant goods prices.
Assume that there are two sectors, manufacturing and farming. There are three
productive factors. Labour is employed in both sectors and is freely mobile between
54
Wm Wf
VPML1f
VPML2f
Wage in the manufacturing sector
Wage in the farming sector

A
W1
B
W2
Figure 4.3: The effect of a flood
them. Capital is used only in manufacturing and land only in farming. After the recent
floods a relevant part of arable land has been destroyed: discuss the effect on wages and
the incomes of capital and land owners.
2. Compare and contrast the Ricardian and specific factors models.

1. In a small open economy factor prices and labour allocation are determined as follows:
In each sector i ∈ {m, f }, labour is demanded up to the point where the value
marginal product of labour equals the wage rate:
pi ∂F p (K, Li )
V MPLi ≡ pi MPLi ≡ = w.
∂Li
Labour is mobile so the wage must be the same in both sectors:
pMPLm = w = p f MLP f .
Labour is fully employed: Lm + L f = L.

Graphically, the equilibrium is at point E in Figure 4.3 below where for each sector:
the area under the V MPL schedule is the value of total output
the return to the specific factor is the value of total output minus the wage bill.
Because of the floods the land endowment of the economy decreases. The fall in T
decreases the marginal product of labour in the farming sector. The new equilibrium
wage is lower and labour moves to the manufacturing sector. Under the small open
economy assumption, the price of both sectors remains constant. Given that labour moves
55
to manufacturing, the marginal product of capital increases (hence r rises); thus, the
income of capital owners
r × K = pm × MPKm × K
increases. As labour in farming decreases, the value marginal product of land, v, goes
down, but the reduction in land has a positive effect on v so that the overall effect on the
value marginal product of land is ambiguous. However, under reasonable assumptions,
given that T diminishes the overall effect on the income of landowners (v × T ) is negative.
2. Comparing different models is the sort of question that Examiners often ask. Models may
be compared in terms of any or all of the following:
assumptions
purposes
results.
A list of assumptions is usually not interesting, but here we have a question where it is
relevant, at least insofar as the assumptions of the two models are different. So you
should spell out the differences.
The purposes of the two models are different. The Ricardian model focuses on
determinants of the pattern of trade while the specific factors model focuses on how trade
affects income distribution.
Differences in assumptions and purposes lead to differences in the kind of results which
the models generate and these should be outlined.
Finally, note that you could also be asked, for instance, to compare the model with the
Heckscher–Ohlin model covered in Chapter 3 of the subject guide.
56
Chapter 5
The standard trade model
5.1 Introduction
In the models covered in previous chapters – Ricardian, Heckscher–Ohlin and specific factors
– a major emphasis has been on identifying the underlying causes of comparative advantage.
For instance, in the Ricardian model, comparative advantage depends on productivity
differences, while in the HO model it depends on factor endowments. The other area of
concern in the previous chapters has been analysis of the mechanisms by which trade affects
income distribution (for example the Stolper-Samuelson Theorem or the analysis of income
distribution using the specific factors model).
In other words, so far we have looked at differences between models in order to theorise
different causes of trade, or differences in the way that trade affects factor rewards and income
distribution. However, all three models considered so far actually share significant common
features, and for many purposes you do not need to use the detailed supply-side assumptions
of each of the individual models, which are crucial in determining trade patterns or income
distribution. The common features of the different models may be collected together to form
what KOM have termed the Standard Trade model (sometimes referred to as the Neoclassical
Trade model). This consists of a set of techniques and tools that may be used to analyse a
variety of trade and trade policy problems. Such problems include the welfare effects of
changes in the terms of trade, growth and trade, including the possibility of immiserising
growth, and the transfer problem.

This chapter aims to discuss the standard trade model, its advantages and limitations and its
applications to problems in international economics.

should be able to:
explain the common features of the Ricardian, HO and specific factors models
use the RS-RD diagram to do simple comparative statics (for example the effect on
international prices of a tariff, or of growth) in one of the economies
explain and use offer curves
explain the decomposition of the gains from trade into production and consumption
effects.
57
5. The standard trade model

KOM, Chapter 6, ‘The Standard Trade Model’.
KOM, online Appendix B to Chapter 6 of the 10th edition, ‘Representing International

Equilibrium with Offer Curves’:
https://pub.maruzen.co.jp/space/International_economics/appendix/
pdf/Krugman10_appendix06B.pdf

Bhagwati, J. ‘Immiserizing Growth’ in Caves, R. and H. Johnson (eds) Readings in
International Economics. (American Economic Association, 1968) [ISBN
9780043820087].
Rodrik, D. and F. Rodriguez ‘Trade Policy and Economic Growth: A Skeptic’s Guide to
the Cross-National Evidence’, NBER Working Paper 7081 1999.


This chapter discusses the standard trade model.
5.2 Chapter content
5.2.1 Techniques of the standard trade model

The principal common features that collectively make up the tool kit of the standard trade
model are as follows:
The productive potential of an economy can be represented by its production possibility

curve. Differences in production possibilities give rise to different autarky prices, which
in turn determine comparative advantage and trade patterns.
Goods and factor markets are competitive, which means that all economic agents such as
firms, households and suppliers of factor services are price takers in the markets in which
they operate.
Movement along the production possibility frontier at different relative goods prices
determines a country’s relative supply curve.
Autarky and world equilibrium can be described in terms of the intersection of the
relevant relative demand (RD) and relative supply (RS) curves. Generally speaking, the
world relative supply curve will lie between the relative supply curves of the individual
58
countries. A variety of comparative statics experiments may be performed by considering

how parameter changes shift the RD and RS curves.
For an individual country, trade and trading possibilities can be illustrated using the
production possibility curve diagram combined with an indifference curve diagram as in
KOM Figures 6-3 ‘Production, Consumption and Trade in the Standard Model’, p.155,
and 6-4 ‘Effects of a Rise in the Relative Price of Cloth and Gains from Trade’, p.156.
This diagram can also be used to illustrate the gains from trade (see analysis below).
An alternative to the RD/RS diagram to show how international prices are determined is
the use of so-called offer curves. This is the traditional way of illustrating international
price equilibrium and goes back to Marshall and others in the nineteenth century.
Activity 5.1 In both HO and specific factors models the production possibility curves
have the same shape (for example as in Figure 5.1). However, the reason for this shape is
different in each model. What is the explanation in each case?
5.2.2 The gains from trade

The production possibility/indifference curve diagram is particularly useful in decomposing
the gains from trade into consumption and production effects, as illustrated in Figure 5.1.
Autarky
Suppose there are two countries, Home and Foreign, which can produce/consume/trade in two
goods: manufactures, M, and food, F.
The autarky equilibrium for Home occurs at the tangency point of the production possibility
frontier and the indifference curve IA at point A where production of both goods equals
consumption. The tangent line passing through this point represents income, and the slope of
which represents relative autarky prices in Home, (P M /PF )H , where P M and PF are the prices
of manufactures and food respectively and the superscript H refers to the fact that the relative
prices are Home relative prices.
Trade
Suppose (P M /PF )W represents world relative prices. At these prices, the optimal production
point of the economy, denoted by D in Figure 5.1, is where the line with slope equal to the
relative world prices is tangent to the PPF. Consumers choose the consumption of food and
manufactures, C, to maximise utility subject to the income line or budget constraint, which is
represented by the tangent line through D. Consumption point C under free trade corresponds
to a higher indifference curve, IFT . The gains from trade are reflected by the movement from
lower indifference curve IA to higher indifference curve IFT .
The total gains from trade (when consumption moves from A to C), can be decomposed into
two constituent parts. Suppose that when Home opens to free trade its production remains at
point A initially because in the short run it is not possible to change it. National income at
world prices is now given by the steeper price line through A (parallel to the world price line
through D), which also represents trading possibilities at world prices. At these prices food is
59
Food
• C
•B
.
•A
IFT
IB
IA
•D
(PM/PF)H
(PM/P F)
W
0
Manufactures
Figure 5.1: Gains from trade
relatively cheaper than under autarky and hence food is imported and manufactures exported.
The consumption point moves to B and hence the country moves to the higher indifference
curve IB from IA . This increase in welfare is called the consumption gain from trade, or the
gain from exchange. The economy experiences gains purely from the fact that it can trade at
more favourable prices than in autarky, even when production is at the autarky level. In the
longer run it will be possible to change production, and the higher world price of
manufactures will lead to an expansion of the manufacturing sector and a contraction of the
food sector. Production will settle at D. This in turn allows consumption at C, thereby
achieving indifference curve IFT from IB . The increase in welfare achieved in moving from
curve IB to IF T reflects the production gain from trade, or the gain from specialisation.
The total gains from trade are thus the sum of these two components. The consumption gain
arises simply from the possibility of trading at prices which are different from autarky. The
production gain arises from the possibility to specialise according to comparative advantage.
Offer curves
Figure 5.1 illustrates the autarky and free trade equilibria but does not offer an explanation as
to where the relative world price ratio comes from. In other words, the figure illustrates the
sources of gains from trade when relative world prices differ from autarkic relative prices but
does not explain how free trade world prices are determined. To determine relative world
prices in the free trade equilibrium we first need to construct the offer curves of Home and
Foreign.
A country’s offer curve describes the country’s willingness to trade at different relative price
ratios and is constructed from the PPF/indifference curve diagram. The left-hand panel of
Figure 5.2 illustrates the PPF of Home, where indifference curve IA , which is tangential to the
PPF, reflects the autarky level of welfare. The line tangent to both IA and the PPF at the
autarky equilibrium reflects autarky relative prices, (P M /PF )H . At this relative price ratio,
Home has no imports or exports.
60
Food H Imports of Food

(PM/ PF)
2
•
(PM/PF)1
TOT2
(PM/PF)H OCH TOT1
• • TOTH
I2
•
I1
• •
IA
•
0 Manufactures 0 H Exports of Manufactures
Figure 5.2: Construction of an offer curve
Consider two different higher relative price ratios, (P M /PF )1 and (P M /PF )2 . With relative
price line (P M /PF )1 , Home exports manufactures and imports food, attaining indifference
curve I1 . Comparing production and consumption allows us to create the dark shaded trade
triangle. The base of the triangle reflects exports of manufactures, the height reflects food
imports, while the hypotenuse reflects the relative price of manufactures, or terms of trade,
that generates these trade flows. Similarly, relative price line (P M /PF )2 generates trade flows
represented by the lightly shaded trade triangle.
The trade triangles constructed in the left-hand panel of Figure 5.2 can now be used to
construct the Home country’s offer curve (OC H ) in the right hand panel of Figure 5.2. The
rays from the origin reflect the different relative price, or terms of trade, lines. The trade
triangles allow the Home country’s offer curve to be traced, reflecting Home’s exports and
imports at different relative price levels. Analysis similar to that of Figure 5.2 can be carried
out to construct the offer curve of Foreign (OC H ). This reflects Foreign’s willingness to export
food and import manufactures at different relative prices.
Relative world prices are such that the world market clears. In a two-country framework, this
implies Home’s exports of manufactures (food imports) must equal Foreign’s imports of
manufacturing (food exports). The unique relative price that clears the world market is
determined where OC H and OC F intersect, as illustrated in Figure 5.3. The line from the
origin through this intersection point has a slope equal to the equilibrium world relative price
ratio (P M /PF )W .
Activity 5.2 Consider the offer curve depiction of international price equilibrium.
Suppose the foreign country imposes an import tariff. Explain how the foreign country’s
offer curve is affected and sketch it. Discuss the effect on world relative prices.
61
F Exports of Food
H Imports of Food
OCH (PM/PF)W
• OCF
0
H Exports of Manufactures
F Imports of Manufactures
Figure 5.3: Determination of world relative prices
5.2.3 International borrowing and lending as intertemporal trade

For some purposes it is helpful to look at international lending and borrowing as the trading of
resources between different time periods. Thus borrowing can be thought of as the purchase of
present consumption (or resources) in exchange for future consumption (or resources); lending
is the sale of present consumption in exchange for future consumption. In this framework, the
price of future consumption in terms of present consumption is 1/(1 + r), where r is the real
interest rate. The notion of international borrowing and lending as intertemporal trade is also
highlighted in the Part 2 of this subject guide, which deals with international finance.

This chapter has discussed the standard trade model.

explain the common features of the Ricardian, HO and specific factors models
use the RS-RD diagram to do simple comparative statics (for example the effect on
international prices of a tariff, or of growth) in one of the economies
explain and use offer curves
explain the decomposition of the gains from trade into production and consumption
effects.
62

1. Consider the standard trade model with two goods and two factors, labour and capital.
Suppose that a country experiences an increase in its capital stock. How would the
Production Possibilities Frontier change as a result?
2. How would you analyse the effects of economic growth in an open economy?

1. The PPF will shift outward: the Y intercept shifts upwards and the X intercept shifts to
the right. The relative size of these two movements will depend on the relative capital
intensity of each good. Here we assume that good X is labour intensive and good Y
capital intensive. As Y is assumed to be K-intensive relative to X, the economy produces
proportionally more of Y than X: the Y intercept shifts up by a greater percentage than the
X-intercept shifts right (that is, a skewed shift of the PPF).
2. The material you need for answering this question is contained in KOM Chapter 6. From
the Rybczynski Theorem we know that growth may be biased towards export goods or
towards import goods with different implications for the terms of trade. Thus in an open
economy growth has two possible effects:
The primary effect which shifts the production possibility curve outward.
A secondary effect which depends on the terms of trade.
It is possible that the secondary effect is negative and this leads to the possibility of
immiserising growth. You might also consider how growth in the rest of the world affects
the ‘home country’.
63
64
Chapter 6
Factor movements
6.1 Introduction
International trade theory, as developed in previous chapters, assumes that factors of
production are immobile between countries. This chapter considers some of the issues that
arise when this assumption is removed. Basic economic principles suggest that if returns to
capital are different across countries, then capital will flow from low return regions to high
return ones. Similarly, labour will tend to move from low wage regions to high wage ones.
Such considerations suggest that factor mobility will tend to reduce international differences
in factor rewards. Moreover, in the absence of relocation costs and other frictions, we would
expect that perfectly free factor mobility would result in equalised factor rewards.

This chapter aims to enable you to understand the role of international factor movements in
international trade and their role in the convergence of factor prices.

should be able to:
explain how international factor movements lead to the convergence of factor prices
define and explain the distributional effects of both international migration and
international capital movements
explain why FDI occurs
describe the effects of FDI on both home and host countries.

Older versions of KOM had a chapter entitled ‘Factor Movements’, but this chapter has been
removed as of the ninth edition and spread over a number of other chapters. As such there is
no single chapter that contains most of the required literature for this chapter of the subject
guide. KOM Chapter 4 discusses international labour mobility, KOM Chapter 5 highlights the
equalisation of factor prices with factor mobility, KOM Chapter 6 discusses the notion of
international borrowing and lending as intertemporal trade, while KOM Chapter 8 discusses
the issues regarding FDI. All reading other than KOM Chapter 8, has been part of the required
reading of earlier chapters of this subject guide.
65
6. Factor movements
KOM, Chapter 4 ‘specific factors and Income Distribution’; Chapter 5 ‘Resources and
Trade: The Heckser-Ohlin Model’; Chapter 6 ‘The Standard Trade Model’; and Chapter
8 ‘Firms in the Global Economy: Export Decisions, Outsourcing, and Multinational
Enterprises’.

Feenstra, R.C. ‘Integration of trade and disintegration of production in the global
economy’, Journal of Economic Perspectives 12(4) 1998, pp.3150.
Markusen, J.R. ‘The boundaries of multinational enterprises and the theory of
international trade’, Journal of Economic Perspectives 9(2) 1995, pp.16989.
Borjas, G. ‘The economics of immigration’, Journal of Economic Literature, 1994, Vol.
32(4), pp.16671717.


This chapter discusses international factor movements, including the migration of labour and
foreign direct investment (FDI).
6.2 Chapter content

One issue you have already encountered concerns the question of the extent to which trade
and factor mobility are substitutes. As was shown in the Chapter 3 of the subject guide on the
HO model, under some rather stringent assumptions, free trade in goods would lead to
factor-price equalisation.
Activity 6.1 In practice we do not observe anything like factor-price equalisation. Why
is this so?
Another issue is that differences between factors (that is labour and capital) present different
problems. The costs and benefits of migration (labour mobility) and of foreign investment
(capital mobility) from the point of view of both sending and receiving countries are rather
different.
Other issues include the theorisation of international lending and borrowing as intertemporal
trade and also the role of multinational firms.
6.2.1 International mobility of labour

Many features of labour mobility can be analysed using basic diagrams such as KOM Figure
4-14 ‘Causes and Effects of International Labor Mobility’, p.101. Within this simple
66
framework international migration takes place whenever wages are different across countries,
and it has at least the following effects:
international equalisation of wages
increase in economic efficiency (world output)
strong distributional effects.

The distributional effects are very important and go a long way to explain why labour
migration is such a sensitive issue despite the fact that it enhances world economic efficiency.
In particular, it is clear that the gainers are the migrants themselves, workers in the ‘sending’
country and owners of complementary factors of production (‘capitalists’) in the host country.
The workers of the host country are losers. Borjas (1994) provides a survey of the empirical
evidence.
Activity 6.2 How might the conclusions on the distributional effects of migration be
modified if migrants bring significant amounts of capital with them?
In a world of nation states, international migration of labour presents another problem. When
considering ‘national welfare’, where should costs and benefits accruing to the migrants be
counted or allocated? Should migrants be considered as belonging to the sending country or to
the host country? Obviously, there is no clear-cut answer.
6.2.2 International mobility of capital

Just like labour, capital will also move in response to international differences in rewards,
provided it is allowed to. Indeed capital has none of the ‘cultural inertia’ that may inhibit the
international movement of workers. In today’s global capital market, capital flows are highly
responsive to perceived differences in rates of return. In a frictionless market, the effects of
capital mobility can be studied with the aid of a diagram which is basically identical to the one
used above for labour mobility. The effects are rather similar too, but with capital and labour
transposed. Thus free capital mobility will have the following effects:
equalisation of rates of return
increase in world efficiency
distributional effects.
Now, the gainers are: the owners of the foreign investment, workers and other complementary
factors of production in the host country; while the losers are: workers in the sending country
and capitalists in the host country.
Control and multinational enterprises
Some foreign investment occurs simply to take advantage of different rates of return in
different countries on what are otherwise identical assets. This is known as portfolio
investment. However, quite often a foreign enterprise will seek to acquire control of
productive assets in another country by purchase of equity or shares or even by directly
67
6. Factor movements
creating new productive assets in another country. Such capital movement is known as foreign
direct investment (FDI) and is typically done by a firm which wishes to expand productive
capacity to another country. Such firms are known as multinational enterprises (MNEs).
FDI has, over time, become increasingly important as the balance between direct and portfolio
investment has shifted. A key issue in the theory of multinational enterprises and their role in
FDI concerns the reason why a firm located in one country should wish to set up production
facilities in another when it has the alternative option of exporting or of allowing local
producers to produce under licence.
A good framework for analysing the motivation for FDI is where the letters refer to the
Ownership, Locational and Internalisation advantages of FDI2 (the OLI paradigm). The OLI
paradigm suggests that all three advantages should be present if FDI is to be observed. FDI is
often associated with technology transfer and, indeed, this is precisely what internalisation is
often about.
It is sometimes also useful to distinguish between horizontal FDI – which involves a firm
setting up a new branch in another country – and vertical FDI – where a firm creates an
upstream or downstream subsidiary in another country. Take the example of a Saudi oil
company: if the Saudi oil company starts drilling for oil in, say, Nigeria, this would be
considered horizontal FDI; if the Saudi oil company extends its business by buying up British
petrol stations, this would be considered vertical FDI.
Activity 6.3
1. Identify some examples of large FDIs in your country. Are they of the horizontal or
vertical type?
2. Identify the ownership, locational and internalisation advantages of each case. Is there
any evidence of technology transfer?
6.2.3 International borrowing and lending as intertemporal trade
For some purposes it is helpful to look at international lending and borrowing as the trading of
resources between different time periods. Thus borrowing can be thought of as the purchase of
present consumption (or resources) in exchange for future consumption (or resources); and
lending is the sale of present consumption in exchange for future consumption. In this
framework, the price of future consumption in terms of present consumption is 1/(1 + rr ),
where rr is the real interest rate. Part 2 (and in particular Chapter 20) of the subject guide
expands on the notion of international borrowing and lending as intertemporal trade.
In this chapter we have discussed issues surrounding the mobility of factors.
68
6.4. Reminder of learning outcomes

explain how international factor movements lead to the convergence of factor prices
define and explain the distributional effects of both international migration and
international capital movements
explain why FDI occurs
describe the effects of FDI on both home and host countries.

1. Using the specific factors model, consider the case of a single good that is produced using
land as a fixed factor and labour as a mobile factor. Assume there are two countries,
Home and Foreign, with Home being rich in labour and Foreign being rich in land.
Explain how international labour mobility will affect factor prices and output in both
countries. Discuss which people lose and gain from the international mobility of labour.
2. What theoretical reasons would you suggest for FDI? What are the effects of FDI for the
host country?

1. See KOM Figure 4-13 ‘Causes and Effects of International Labor Mobility’, p.101, for a
graphical representation of the effects of international labour mobility on the marginal
product of labour. A good answer would highlight that in this model, international
mobility of labour will:
(a) lead to convergence of real wages between Home and Foreign
(b) increase the output of the world as a whole, but will lead to a decrease in the output
of Home, as workers emigrate to Foreign
(c) hurt some people. In particular, as the marginal product of labour will go down in
Foreign following the immigration of labour, Foreign workers lose out (but Foreign
landowners gain); conversely, in Home, the emigration of labour from Home hurts
Home landowners (but Home workers gain).
2. The key issue that should be addressed in this question is why does foreign investment
take place instead of simply exporting the product or alternatively allowing its product to
be produced under licence? Here the discussion of the multinational enterprise in KOM
Chapter 8 ‘Firms in the Global Economy: Export Decisions, Outsourcing, and
Multinational Enterprises’ is relevant as well as a discussion of the effects on both the
home and the host countries.
69
6. Factor movements
70
Chapter 7
Imperfect competition and other
alternative trade models
7.1 Introduction
The models studied in Chapters 2 to 5 of this subject guide might be termed ‘traditional’. All
of them appeal to comparative advantage as the motivation for international trade, and all have
been tested in a variety of ways and have been found to be wanting. A crucial assumption in
traditional models is constant returns to scale. Dropping this assumption and allowing
increasing returns to scale leads to a quite different class of trade models which explain some
of the features of international trade that appear to lie outside the domain of traditional
models. In particular, traditional models cannot account for the presence of intra-industry
trade where this is defined as the simultaneous import and export by a country of goods in the
same industry (for instance motor vehicles).
This chapter aims to discuss the failings of traditional trade models and identify some
important features of international trade that are not captured by traditional trade models, such
as intra-industry trade.
should be able to:
explain why traditional models of trade fail to account for important features of
international trade
explain why there may be a basis for trade even when autarky prices are identical
explain what is meant by intra-industry trade, how it is measured and how it might be
theorised by different models
explain different sources of the gains from trade (for example variety, pro-competitive
effects, rent-shifting)
link the mechanisms behind the trade models covered and the commodity composition of
trade for a country that you are familiar with.
71
7. Imperfect competition and other alternative trade models

KOM, Chapter 7 ‘External Economies of Scale and the International Location of
Production’ and Chapter 8 ‘Firms in the Global Economy: Export Decisions,
Outsourcing, and Multinational Enterprises’.

FT, Chapter 6 ‘Increasing Returns to Scale and Monopolistic Competition’.
S(IF), Chapter 80:
Venables, A.J., A. Smith, p.Krugman and R. Kanbur ‘Trade and Industrial Policy under
Imperfect Competition’, Economic Policy 1(3) 1986, pp.621–72.


This chapter highlights some features of international trade that are not well explained by
traditional trade models.
7.2 Chapter content
7.2.1 Alternative models

As Chapters 2 and 3 of the subject guide have highlighted, there is only limited empirical
evidence for the Ricardian and HO trade models. Although the models make some predictions
that are validated, there are many areas where the models fall short.
The following are some of the empirically observed features of the international economy that
are inconsistent with either the results or the assumptions of traditional trade models:
Intra-industry trade: this is very important in international trade; it is the fastest

growing component of world trade and cannot be explained by HO or Ricardian models
Distribution effects: HO and specific factors models predict that opening-up of trade will
have strong distribution effects. This appears to be contradicted in the great expansion of
international trade in Western Europe.
Trade between similar countries: most of the world trade appears to be between
countries with similar technologies and similar factor endowments.
Competitive markets: many important traded goods are produced in markets in which
there are just a small number of global firms (for example, motor vehicles, aircraft or
electronics).
72
A variety of alternative models has been developed to address some of the perceived
deficiencies of traditional models. The most important of the new theories are:
Monopolistic competition models: based on different motivations for product

differentiation; for example, the Krugman model is based upon the idea that product
differentiation originates in a desire for variety.
Oligopoly or reciprocal dumping: for example, the Brander-Krugman model in which

intra-industry trade is simply a consequence of an oligopolistic market structure.
Economies of scale: here the pattern of trade may be a consequence of historical

accident (that is, ‘first start’) and hence may not be Pareto-efficient.
Technology models: technology gap and product cycle models theorise why technology
differences may persist.
Intra-industry trade
Intra-industry trade has been defined above as trade that takes place within the same industry.
A classic example of a sector where intra-industry trade is observed is the motor industry.
However, many other manufactures are produced in differentiated varieties and hence give rise
to such trade. By contrast inter-industry trade is defined as trade in which imports and exports
originate in different industries (for example, agricultural goods and manufactures). The
standard measure of the degree of intra-industry trade within a given industry is the
Grubel-Lloyd index. This is defined as:
(Xi + Mi ) − |Xi − Mi |
IIT = (7.1)
(Xi + Mi)
where |Xi − Mi| denotes the absolute value of (Xi − Mi). The index takes on a value of 1 when
industry imports and exports exactly match and a value of 0 when one observes either only
exports or only imports.
Measured intra-industry trade appears to be of growing importance in the international
economy. It is clear that traditional models cannot account for or explain intra-industry trade
since, by assumption, simultaneous import and export of the same good would never be
observed. The growing empirical importance of intra-industry trade has led to a variety of
initiatives to develop alternative theories which do explain it.
Activity 7.1 Why does the measurement of intra-industry trade using the Grubel-Lloyd
index depend on the definition of an industry?
7.2.2 The Krugman monopolistic competition model of trade

The Krugman model of monopolistic competition seeks to address, in some measure, all four
pieces of ‘indirect’ evidence against the traditional models mentioned above. The key features
of the Krugman model are:
product differentiation
73
internal economies of scale.

The standard methodology is employed. First, identify the closed economy equilibrium and
then consider what happens when the possibility of trade is introduced.
It is assumed that consumers have a desire for variety in the goods they consume that is, in
principle, unbounded. This leads to the emergence of many varieties within the same industry,
for example varieties of toothpaste or varieties of coloured shirts.
What prevents the emergence of infinite varieties? The answer is internal economies of scale,
usually in the form of fixed costs. The presence of fixed costs means the number of varieties
that can be produced while covering costs (including normal profit) is bounded by the size of
the market. The effect of international trade is to increase the size of each country’s market as
compared with autarky.
The formal model assumes a number of factors, such as identical costs for all firms, which
make the model more tractable but are not necessary for the logic of the argument.
Demand function facing an individual firm
The quantity demanded from an individual firm, x, may be expressed as:

" #
1
x=S − b (p − p) , (7.2)
n
where S is the size of the market, n is the number of firms, p is the price charged by individual
firm and p is the average price charged by competitors.
The Average cost of firms equals
F
AC =
+ c, (7.3)
x
where F is the fixed cost and c is a constant marginal cost.
Market equilibrium in a closed economy
We assume that all firms are identical, that is they produce ‘differentiated’ goods under
essentially identical cost conditions (for example, ‘green shirts’ and ‘red shirts’). This means
that the market equilibrium will be symmetric (that is, all firms will produce the same quantity
of output and sell it for the same price). Hence the average price p will be the common price
for all firms and hence from the demand function each firm will have a 1/n share of the
market, where n is the number of firms (and also the number of differentiated products) in
industry equilibrium.
Thus, for a closed economy, we need to solve for the equilibrium industry price, p∗ , and the
equilibrium number of firms, n∗ . This may be done in three steps.
Step 1: We need to derive a relationship between the average cost of the representative firm
and the number of firms. By definition:
F
AC = + c. (7.4)
x
But we know that in industry equilibrium, the market is equally shared between the firms
(such that x = S /n). Hence
nF
AC = + c. (7.5)
S
74
AC
CC
nF/S
c
Figure 7.1: The CC curve
The relationship of equation 7.5 is illustrated as CC in Figure 7.1.

Step 2: We now need to derive a relationship between p and n. This may be done by deriving
the profit maximising price and quantity for the representative firm. Recall that the demand
facing an individual firm is given by:
S
x= + S bp − [S b] p. (7.6)
n
Rearranging, this yields a linear relationship between x and p,
" #
1
x=S − b (p − p) . (7.7)
n
For a linear demand function (that is, of the form x = α − βp) it can be shown that marginal
revenue is given by:
x
MR = p − . (7.8)
β
In this case β = S b and hence
x
MR = p − (7.9)
Sb
Marginal cost is given by c. Profit maximisation requires MR = MC hence we have
x
p− = c, (7.10)
Sb
or, rearranging
x
p=c+ (7.11)
Sb
However, symmetry implies that x = S /n. Substituting yields:
1
p= p=c+ (7.12)
bn
The relationship of equation 7.12 between p and n is plotted as PP in Figure 7.2.
Step 3: Industry equilibrium is obtained by imposing the further condition that there should be
no incentive for firms to either enter the industry or to exit from it. When this is the case the
number of firms remains unchanged and the industry is said to be in equilibrium. Industry
equilibrium occurs when the profits of the representative firm are zero (that is, p = p∗ = AC).
This is illustrated in Figure 7.3 by the intersection of the CC and PP curves. Note that when
the number of firms is less than the equilibrium number n∗ , we would have p > AC and entry
to the industry would occur. On the other hand, when there are too many firms p < AC and
firms would exit the industry. This completes the closed economy analysis.
75
p p = 1/bn + c
PP
c
Figure 7.2: The PP curve
p
CC
p*
PP
c
n* n
Figure 7.3: Equilibrium p and n
The effect of international trade
International trade has the effect of increasing the size of the market S . A larger S implies that
the CC curve becomes flatter. This is illustrated in Figure 7.4 where the post-trade equilibrium
is at the intersection of the new CC curve and the unchanged PP curve. The market is now an
international market with a larger number of firms (and hence varieties) and each differentiated
product will sell at a lower price than before. Thus, suppose in the absence of trade each
market could support only one producer (for example, white shirts), but that the combined
market can support three (for example, white, green and red shirts). In the combined market
there is an increase in the number of varieties available to consumers in both economies.
p
CC
C'C'
p*
p' PP
c
n* n' n
Figure 7.4: Trade and expansion of the market
76
The pattern of trade
Because of the symmetry assumptions (which make the model tractable), the Krugman model
is limited in what can be said about the precise pattern of trade (that is, which country will
produce which varieties). We simply know that, with trade, there will be an integrated market
with more firms than was the case in either of the segmented markets. Hence there will be
more varieties available to consumers than was the case before, but the precise distribution of
varieties between the countries is not determinate.
It would not be difficult to introduce ‘differences’ between the economies in order to make a
determinate trade pattern, but this would make the model much more complicated without
adding much to its explanatory power.
Note that this type of industry, and hence this type of trade, can coexist with trade that is
motivated by differences in resource endowments.
Conformity with the evidence
1. The model generates intra-industry trade.
2. The opening of trade does not bring significant distributional effects as in, say, the HO
model.
3. Trade can occur even if countries are very similar.
4. The model incorporates non-perfectly competitive goods markets.
The gains from trade
It is important to note that in the Krugman model the source of gains from trade is quite
different from the traditional models. Here, trade generates two types of gain:
more variety because a larger market can sustain more differentiated products
lower prices because each variety is produced on a larger scale than under autarky and
hence fixed costs are spread over a larger output.
7.2.3 Other models

In the search for realism and relevance in international trade theory, economists have explored
a number of other approaches/models. These include alternative specifications of product
differentiation; models of oligopoly, sometimes called reciprocal dumping; models based on
technology differences and the dynamics of technological change; and models based on
external economies of scale.
Each of these models offers some interesting insight, although most remain peripheral to the
main body of international trade theory. One interesting aspect of some of these models is that
they provide counter-examples to the proposition that there are always mutual gains from
trade; for example, in the reciprocal dumping model discussed in the next section.
77
An interesting insight comes when there are external economies of scale. In this case there
will very likely be a ‘first starter’ advantage and KOM neatly show that this may lead to an
inefficient pattern of specialisation. This may be used as a justification for one of the classic
arguments for protection, namely the infant-industry argument (see also Chapter 9 of the
subject guide).
7.2.4 Reciprocal dumping
For example, in the Reciprocal dumping model developed by Brander and Krugman in 1983
(international oligopoly with transport costs) trade leads to inefficient cross-hauling (that is, to
identical commodities moving in both directions in international trade). This is a negative
effect. On the other hand, as compared with autarky, when each firm is a domestic monopolist,
each market is more competitive, with higher sales and lower prices. This is an example of the
pro-competitive impact of free international trade and is a positive effect. A third effect is that
the exporting producer captures some monopoly rents from the domestic monopolist. This is a
gain to the exporting country but a loss for the importing one. The net gains to the trading
partners may be positive or negative.
To illustrate these effects consider Figures 7.5 and 7.6, where the former analyses reciprocal
dumping in the absence of transport costs while the latter includes transport costs.
Suppose there are two segmented markets, Home and Foreign, each of which has a domestic
monopolist for the production of a homogeneous good whose output is denoted by Q. For
simplicity, assume the two markets are identical in all respects. Figure 5.5 reflects the Home
(or Foreign) market. The domestic monopolist faces demand curve D, with associated
marginal revenue curve MR, and a constant marginal cost of production c. In autarky, the
profit maximising monopolist produces the monopoly quantity Q M in each market, where
MR = c, sold at the monopoly price P M .
When the two countries open to trade, the firms compete in quantities in each market, thus
operating as Cournot duopolists. Let QC denote total industry output under Cournot
competition, which is associated with market price PC , which is below the monopoly price.
The symmetric firms share each market, selling QC /2 in each market. Thus each firm sells
QC /2 domestically, while exporting QC /2 to the other market: namely, cross-hauling. The
Cournot duopoly structure of each market gives rise to two-way trade between the two
markets as firms compete in quantities.
Consider the welfare implications. The lower price in each market generates a gain in
consumer surplus of (A + B). Each firm receives profits equal to area (A + C + D) under
autarky but free trade profits are area C from domestic sales and areas (D + E) from export
sales. The net change in producer surplus for each monopolist is thus (E − A). Hence, the
overall welfare change in each market is (B + E). This is unambiguously positive and reflects
the pro-competitive effect as duopoly improves efficiency in the market (lowering the
deadweight loss generated by the monopolist).
Now suppose shipping goods between the two markets involves a transport cost T , so the
marginal cost of exported units is effectively (c + T ), while the marginal cost of domestic sales
remains at c, as illustrated in Figure 7.6. This implies that cross-hauling of goods gives rise to
an inefficiency as a result of the resources lost through transportation. The lower price in each
market still gives rise to a gain in consumer surplus of (A + B). Each firm receives profits
equal to area (A + C + D + F + G) under autarky but free trade profits are area (C + F) from
78
PM
A B
PC
C D E
c
D
MR
Q
0
½QC QM QC
Figure 7.5: Cross-hauling without transport costs
domestic sales and areas (D + E) from export sales. The net change in producer surplus for
each monopolist is thus (E − A − G) in Figure 7.6. Hence, the overall welfare change in each
market is (B + E − G), which is ambiguous in general. Area (B + E) reflects the
pro-competitive effect, while the loss of G reflects the transport cost inefficiency. Hence, there
is an overall loss from opening to trade in the reciprocal dumping model if G > B + E.
Activity 7.2
1. How does the number of firms vary with the size of the market in the Krugman model
of monopolistic competition?
2. Calculate the Grubel-Lloyd index of intra-industry trade for some of your country’s
traded good industries.
3. Identify the five most important export and import commodities in your country.
Which of the trade models provides the best explanation for the direction of trade of
each of these goods?
4. Consider the reciprocal dumping model discussed above. Discuss how the welfare
implications of opening to trade change if one market is larger than the other (see
Venables, Smith, Krugman and Kanbur (1986) for further analysis using this
framework).

This chapter has highlighted some features of international trade that are not well explained by
traditional trade models.
79
PM
A B
PC
C D E
c+T
F G H
c
D
MR
Q
0
½QC QM QC
Figure 7.6: Cross-hauling with transport costs

explain why traditional models of trade fail to account for important features of
international trade
explain why there may be a basis for trade even when autarky prices are identical
explain what is meant by intra-industry trade, how it is measured and how it might be
theorised by different models
explain different sources of the gains from trade (for example, variety, pro-competitive
effects, rent-shifting)
link the mechanisms behind the trade models covered and the commodity composition of
trade for a country that you are familiar with.
1. Indicate whether the following statement is true, false or uncertain. Explain your answer.
‘In the Krugman model, if the size of the market doubles, the equilibrium number of
firms will also double.’
2. What is intra-industry trade? How would you measure it and how would you explain it?
80

1. The statement is false.
This question concerns a property of the equilibrium of the Krugman model and can be
answered in two ways. One way is to explicitly solve for the equilibrium number of
firms. By setting p = AC we can solve for the number of firms in terms of the size of the
market and other parameters. This yields:
r
S
n= .
bF
Clearly an increase in S will lead to a less than proportionate increase in n.
The same conclusion can be reached by more intuitive arguments. Inspection of Figure
7.4 above shows that when the size of the market increases, part of the effect is to lower
price and this means that all varieties are produced and consumed in larger quantities.
Thus part of the increase in the size of the market is diverted from generating more
varieties.
2. See the section on intra-industry trade in this subject guide and KOM for a description
and related measurements.
81
82
Chapter 8
Instruments of trade policy
8.1 Introduction
Trade policy (sometimes also known as commercial policy) is concerned with public
(government) intervention in international trade. Intervention can take a variety of forms.
Governments normally control national borders and can therefore impose a variety of
requirements on goods and services as they cross the national border. Border taxes such as
tariffs are one example but many others are often applied. Sometimes goods need import or
export licenses or documentation concerning the nature of the goods. For example, a country
may impose sanitary requirements on livestock crossing its border. These are all examples of
direct or indirect instruments of trade policy (that is, specific measures applied to cross-border
transactions).
At a more general level, government intervention may take the form of entering into
international treaties or organisations which constrain the freedom to set a fully independent
trade policy. Examples include joining the World Trade Organization (WTO) or participating
in a regional trading agreement such as the European Union (EU) or the Association of South
East Asian Nations (ASEAN).

This chapter aims to discuss the various instruments of trade policy, how they work, and their
advantages and limitations.

should be able to explain the following, both verbally and diagrammatically:
the price and quantity effects of imposing (or removing) a tariff
the welfare costs and benefits of a tariff for the tariff-imposing country and its trading
partner
the partial and general equilibrium diagrammatic representation of trade policy

instruments
how to compare a tariff with other instruments of trade policy
why import and export taxes have similar effects
how a large country might gain from the imposition of a tariff
83
8. Instruments of trade policy
why the nominal rate of protection in an industry may not fully capture the degree of
actual protection it enjoys.

KOM, Chapter 9 ‘The Instruments of Trade Policy’ and Chapter 10 ‘The Political
Economy of Trade Policy’.
KOM, online Appendix A of Chapter 9 of the 10th edition, ‘Tariff Analysis in General
Equilibrium’:
https://pub.maruzen.co.jp/space/International_economics/appendix/
pdf/Krugman10_appendix09A.pdf

FT, Chapter 8 ‘Import Tariffs and Quotas Under Perfect Competition’, Chapter 9 ‘Import
Tariffs and Quotas Under Imperfect Competition’, and Chapter 10 ‘Export Subsidies in
Agriculture and High-Technology Industries’.
S(IT), Chapters 90 and 95:


This chapter discusses instruments of trade policy.
8.2 Chapter content
8.2.1 A taxonomy of trade policy instruments

Listed overleaf are the main forms of trade policy instrument.
Tariffs
• Tariffs are taxes on imports and may be levied as a percentage of the border price, in
which case the tariff is known as ad valorem; or as a fixed sum per unit, in which
case the tariff is known as specific.
• Sometimes more complicated forms of tariff have been imposed. For example, the
purpose of a tariff may be to ensure a given price of the good in the home market. If
the world (border) price fluctuates then the tariff must be adjusted to compensate for
movements in the border price. Such a tariff is called a variable levy and was widely
used in the EU as part of its Common Agricultural Policy (CAP).
84
Non-tariff barriers to trade (NTBs)

• Other trade taxes (for instance, export taxes)
• Quantitative restrictions (QRs) (for instance, quotas and voluntary export restraints –
VERs)
• Other less direct and less transparent measures (for instance, local content
requirements, industrial policy, government procurement restrictions and
documentation procedures).
Activity 8.1
1. For your country, which are the most important commodities subject to trade barriers?
What are those barriers?
2. What are the most important trade barriers facing your country’s exports?
3. Which barriers do you think are more restrictive?
8.2.2 Trade policy issues

The analysis of trade policy involves both the effects of the measure on economic variables
and also on how the gain or burden of the impact of the measure is distributed. These effects
may be summarised as:
Effects of trade measures

• On prices
• On outputs
• On imports, exports and consumption.
Distribution effects
• Who gains and loses?
• What are the net effects?
Methodology
Tariffs are regarded as the basic, traditional, most transparent instrument of trade policy. Other
measures are often evaluated in terms of how they compare with tariffs. Sometimes it is
possible to calculate the tariff equivalents of NTBs; that is, the tariff which would have the
same effect as a given instrument.
The effect of a trade policy instrument can be analysed in terms of its impact on consumers’
surplus, on producers’ surplus and on government revenues. While simple in its construction,
partial equilibrium supply and demand analysis is sufficiently powerful for identifying the
welfare effects of trade policy instruments. This approach developed more or less from first
principles in KOM and the analysis is extended to other instruments in KOM.
85
PW + t
t A B C D
PW
S
D
Q
0
SW St Dt DW
Figure 8.1: Welfare effects of a tariff in a small country
8.2.3 Partial equilibrium analysis

Partial equilibrium analysis of trade policy examines the effects of trade policy on the
equilibrium of a single market, assuming perfect competition. The implications of trade policy
differ depending on whether the country in question is small or large.
Import tariff: small country analysis
A country is small if its activities do not affect world prices. Hence, small country analysis in
partial equilibrium makes use of the simple supply–demand diagram, keeping world prices
exogenous. A tariff or quota can be shown to be unambiguously welfare-reducing for a
country, as their implementation generates deadweight losses only. For an example of a quota
and discussion of quotas in the EU oilseeds market, see KOM Chapter 9 ‘The Instruments of
Trade Policy’, Case Study ‘Tariff-Rate Quota Origin and its Application in Practice with
Oilseeds’, pp.258–61. The production and consumption distortions arising from a tariff are
illustrated in KOM Figure 10-1 ‘The Efficiency Case for Free Trade’, p.275.
Figure 8.1 illustrates the welfare effects of a tariff when implemented by a small country. The
world price PW is exogenous and the free trade equilibrium level of imports is (DW − S W ).
When tariff t is imposed the domestic price rises to (PW + t), raising domestic production to S t
and lowering demand to Dt , thereby lowering imports to (Dt − S t ). The welfare implications
are a loss in consumer surplus (A + B + C + D), a gain in producer surplus of A and
government revenue of C. The net welfare effect is unambiguously negative and equal to
−(B + D), where dead weight loss triangle B corresponds to the production distortion and dead
weight loss triangle D to the consumption distortion.
For a small country that auctions its import licenses in a competitive market, a tariff and a
quota have equivalent effects. In virtually all other cases they do not. An especially important
case of non-equivalence is when the domestic market for the importable is served by a
domestic monopolist, the analysis of which can be found later in this chapter.
86
P P
S D
MD
0 Q 0 Imports
Figure 8.2: The Import Demand schedule (MD)
Activity 8.2 Consider the following data about the demand for widgets:
With tariff Without tariff
World price 1.5 A
C/ unit 1.5 A
C/ unit
EU tariff 0.15AC/ unit 0AC/ unit
EU internal price 1.65 A
C/ unit 1.5 A
C/ unit
EU consumption 2m units 2.3 m units
EU production 1.6m units 1.0 m units
Draw a supply and demand diagram on the basis of the above data about the demand for
widgets. Indicate imports with and without the tariff. Then calculate:
1. The gain to EU consumers from removing the tariff on widgets.
2. The loss to EU producers from removing the tariff.
3. The loss of tariff revenue when the tariff is removed.
4. The net effect on the EU as a whole.
Import tariff: large country analysis
In contrast, a large country is able to affect world prices by implementing trade policies. This
generates a ‘terms of trade’ effect that may benefit or harm the country, depending on the
setting. To determine the impact of trade policy on world price, trade flows, prices and welfare
we need to construct the import demand schedule, MD, and the export supply schedule, XS .
Suppose there are two countries, Home and Foreign, producing and consuming a good, whose
quantity is measured by Q and where Foreign has the comparative advantage in its production.
The left-hand panel of Figure 8.2 depicts the demand, D, and supply, S curves in Home. At
any price below the autarky price (where D = S ) Home will import the good and the level of
imports is measured by the horizontal distance between D and S . The import demand
schedule, MD, on the right-hand panel traces the level of imports demanded by Home as a
function of price, where this level corresponds to imports in the left-hand panel. The left-hand
panel of Figure 8.3 depicts demand, D, and supply, S , for the good in Foreign, where the
87
P P
XS
S D
0 Q 0 Exports
Figure 8.3: The Export Supply schedule (XS )
Home World Foreign

P P P
D S XS
D S
PW PW PW
MD
0 Q 0 M, X 0 Q
SH DH X=M DF SF
Figure 8.4: Determination of world price (partial equilibrium)
autarky price is lower than that in Home, reflecting the comparative advantage of Foreign. At
any price above the autarky price, Foreign exports the good, where exports are measured by
the horizontal distance between S and D and also correspond to the export supply schedule,
XS , traced in the right-hand panel. The world price of the good is that which clears the world
market, ensuring that imports demanded by Home equal exports supplied by Foreign. This is
illustrated in Figure 8.4, where the left- and right-hand panels depict the domestic markets for
Home and Foreign, respectively, while the middle panel illustrates the MD and XS schedules
and the determination of free trade price PW. The three-panel framework offers an efficient
means of evaluating the welfare implications of a tariff on the world price, trade flows and
welfare at Home and in Foreign. Figure 8.5 illustrates the effects of Home imposing a tariff t.
The tariff reduces Home’s import demand, shifting MD down to MD0 by a vertical distance of
t. With lower demand for traded goods, the world price of the good falls from PW to P0 W ,
which induces a decline in Foreign exports (to X t from free trade exports X 0 ). The domestic
price in Home is P0W + t = PH , which induces a fall in Home’s imports (to M t from free trade
imports M 0 ). Figure 8.6 depicts the Home market equilibrium in close-up.The welfare
implications are a loss in consumer surplus (a + b + c + d), a gain in producer surplus of a and
government revenue of (c + e). The net welfare effect is thus (e − b − d), which is ambiguous.
Dead weight loss triangles b and d correspond to the production and consumption distortions,
respectively, while the benefit e reflects the positive terms of trade effect on welfare in the case
88
Home World Foreign

P P P
D S XS
D S
PH PW '+ t X0
PW
PW PW
PW ' PW '
t MD
M0
MD'
0 Q 0 M, X 0 Q
Mt Xt
Figure 8.5: The effects of a tariff (t) with two large countries
PW '+ t
a b c d
PW
e
PW'
S
D
Q
0
SW St Dt DW
Figure 8.6: Welfare effects of a tariff in a large country
of a tariff. Intuitively, the tariff lowers the price of the import good, thereby improving the
terms of trade. For small tariff levels, the net welfare effect on a large country is positive (the
positive terms of trade effect outweighs the production and consumption distortions). The
optimum tariff is the tariff rate that just balances the terms of trade and distortion effects to
maximise overall welfare. Note that the optimal tariff is always relatively ‘small’. Figure 8.7
depicts the Foreign market equilibrium in close-up.The welfare implications following the
decline in world price is a gain in consumer surplus of ( f + g), while producer surplus declines
by ( f + g + h), giving an overall welfare decline in Foreign of size h. Note that while Home
may gain from a small tariff, Foreign unambiguously loses as a result of the terms of trade
effect. The Home tariff is thus a ‘beggar-thy-neighbour’ policy. Moreover, the losses of
Foreign exceed the net gain to Home of a small tariff, so world welfare is unambiguously
lowered by the tariff.
Note that we assume there is no retaliation by Foreign firms. If there were retaliation then both
countries unambiguously lose.
89
PW
f g h
PW'
S D
Q
0
DW Dt St SW
Figure 8.7: Welfare effects of a tariff on the Foreign country
Home World Foreign

P P P
D S XS
XS' D S
s
PW '+ s
PW
PW PW
PW' PW '
MD
M0
0 Q 0 M, X 0 Q
Ms Xs
X0
Figure 8.8: The effects of an export subsidy with two large countries
Activity 8.3 Using the data on widgets from the previous activity, suppose that instead
of a constant world price, the imposition of a tariff by the EU reduces the world price to
1.45 euro, EU consumption becomes 2.1m and production is 1.4m. Illustrate this on a
supply/demand diagram and calculate the net effect of the tariff on the EU.
Implementation of an export tariff: large country analysis
Figure 8.8 illustrates the effects of an export subsidy, s, introduced by Foreign. The XS curve
shifts down by s to XS 0 , inducing a decline in the world price from PW to P0W and creating a
wedge between the Home and Foreign prices.
Activity 8.4 Is it ever welfare-improving for a country to implement an export subsidy,

assuming perfect competition? (Hint: use Figure 8.8 to show that the terms of trade effect
reinforces the production and consumption distortions to reduce welfare.)
90
8.2.4 General equilibrium analysis
The main results that emerge from the partial equilibrium analysis can be shown to hold more
generally under general equilibrium. Tariff analysis in general equilibrium can be found in the
online Appendix A of Chapter 9 of the 10th edition (2014) KOM ‘Tariff Analysis in General
Equilibrium’, where the effects in both small and large countries are considered.
Import tariff: small country analysis
The effects of an import tariff on a small country are illustrated in KOM (2014) Figure 9A-2
‘A Tariff in a Small Country’, and can be compared with the free trade equilibrium of KOM
(2014) Figure 9A-1 ‘Free Trade Equilibrium for a Small Country’ (both figures can be found
in the online Appendix A of Chapter 9 of the 10th edition (2014) of KOM – see Essential
Reading for this chapter). A small country cannot affect world prices, by assumption, so faces
a given world relative price line (the steep line through production and consumption points Q2
and D2, respectively). Once a tariff is imposed on the imported good, a wedge is created
between world and domestic relative prices, distorting both the consumption and production
decision. All tariff revenue is assumed to be redistributed to the consumer, so consumers
choose their consumption bundle optimally from an expanded budget and optimise their
consumption subject to the shallower domestic prices (tangency point between the highest
possible indifference curve and domestic relative prices). Trade must still be balanced at world
prices, so the consumption bundle D2 under the tariff must also lie (though not tangentially) on
the world relative price line through the production point Q2, along which the value of imports
equals the value of exports at world prices. There is an unambiguous welfare reduction from
the implementation of the tariff, relative to free trade, as reflected by the fact that consumption
in the tariff-ridden economy is on a lower indifference curve than under free trade.
Import tariff: large country analysis
The implementation of the import tariff by a large country will have an impact on relative
world prices (or the terms of trade). Offer curves can be used to show how world relative
prices respond to a tariff. This is illustrated in Figure 8.9, for two countries (Home and
Foreign) where Home exports manufactures and imports food. Free trade world prices are
determined by point A, where the offer curves of the two countries meet. When a tariff is
introduced by Home, its willingness to trade manufactures for goods decreases as a result of
the tariff, so OCH shifts to OCH 0 . The new world market equilibrium is at point B, which
implies a rise in the relative price of manufactures, or a fall in the relative price of the
imported good on which the tariff is levied. Figure 8.10 illustrates the general equilibrium
effects of a tariff for a large country. At initial world prices (P M /PF )W production of the
economy is at point A and free trade consumption at B. If the country levies a tariff on food,
then as shown in Figure 8.9, the relative world price of manufactures rises to (P M /PF )0W and
the tariff creates a wedge between the new world prices and domestic relative price of
manufactures (P M /PF )H , such that domestic relative prices are lower than initial world prices.
Production is distorted as consumers respond to the domestic price and choose at point C
(compared to point A under free trade). The steep line through C reflects feasible consumption
bundles at new world prices, such that trade is in fact balanced at new world prices. The
consumption point must lie along this line. Consumers optimise on the basis of domestic
91
F Exports of Food
H Imports of Food
(PM/PF)W'
OCH
OCH' (PM/PF)W
• OCF
A
B
•
0
H Exports of Manufactures
F Imports of Manufactures
Figure 8.9: World relative prices under a tariff (general equilibrium)
Food
B• D
•
IT
IFT
•
C
•
A
(PM/PF)H
(PM/PF)W
(PM/PF)W '
0 Manufactures
Figure 8.10: A welfare improving tariff (large country case)
92
prices, however, so will choose the point of tangency between the highest attainable
indifference curve and their budget line, which reflects domestic prices but is expanded as a
result of the assumed redistribution of tariff revenue from the government to consumers.
Hence, two conditions have to be met: (1) feasibility, such that trade is balanced at world
price; and (2) optimality, such that consumers are choosing the best possible bundle given the
domestic prices they face. Consumption point D in Figure 8.10 satisfies both these conditions,
as it lies on the new world relative price line through C (trade balance line) and reflects a point
of tangency between indifference curve IT and the (expanded) budget line.
In the large country case, there are conflicting effects on welfare. The consumption and
production distortions arising from the tariff work to lower welfare, while the improved terms
of trade that Home faces as a result of the tariff is welfare-improving. The net effect is
ambiguous. Figure 8.10 illustrates the case where the import tariff is welfare-improving
overall, as the welfare level associated with IT exceeds the free trade welfare level reflected by
IFT . Crucially, the analysis assumes there will be no retaliation by Foreign.
Activity 8.5
1. Use a PPF diagram to show that Foreign is unambiguously worse off as a result of the
tariff imposed in Home.
2. Show, using a general equilibrium diagram, that an export subsidy could worsen
domestic welfare to below the autarkic welfare level.
8.2.5 Equivalence of a tariff and an export tax
The Lerner Symmetry Theorem states that in a two-country, two-good model an import tariff
and an export tax have exactly the same effect, both for small and large countries. Similarly,
an import subsidy and an export subsidy have identical effects.
Consider first a small country, Home, H, which imports manufacturing and exports food.
Home is small and thus a ‘price taker’, so world relative prices of manufacturing to food are
fixed.
If H imposes an ad valorem import tariff, t, then PHM = (1 + t)PWM and PF = PF . The relative
H W
price of manufacturing is thus given by: (P M /PF ) = (1 + t)(P M /PF ) . If H imposes an ad

H W
valorem export tax of equal magnitude, then PHM = PW M and PF = PF /(1 + t), which also yields
H W
a relative price of manufacturing (P M /PF ) = (1 + t)(P M /PF ) .

H W
Thus the domestic price ratios under the two policies are equal, given world prices. It follows
that changes in patterns of consumption, production and thus trade volumes are the same with
both policies, making the two policies identical. Hence we have Lerner Symmetry.
If Home were a large country then the implementation of these policies would also give rise to
a terms of trade effect. Since both policies give rise to the same changes in patterns of
consumption and production for a given world price ratio, the offer curve of the Home country
will shift in an identical fashion under both policies. Hence the change in the terms of trade
will be the same under both policies. Hence we have Lerner Symmetry for large countries also.
93
MC
PM
Pq
PW + t
t
PW
q
MR D
MRR DR
Q
0
Sq SM SW St Dt DW
Figure 8.11: A tariff versus an equivalent quota under a domestic monopoly
8.2.6 Analysis of a tariff and quota with a domestic monopolist
An especially important case of non-equivalence of a tariff and an equivalent quota is when

the domestic market for the importable is served by a domestic monopolist. Figure 8.11
illustrates the case of a domestic monopolist facing demand curve D (with associated marginal
revenue curve MR) and marginal cost MC. In the absence of foreign competition (autarky
case), the monopolist maximises profit by setting MC = MR, with P M and S M denoting the
monopoly price and quantity.
Suppose the economy opens to trade and the world price of the good is PW . Assume a small
country setting so world price is not affected by any trade policy decisions. With free trade, the
monopolist’s price-setting power is destroyed by foreign competition as no sales can be made
at a price above the world price (and there is no incentive to price beneath it). The free trade
supply of the domestic firm, S W , can be found by reading off the MC curve, which
corresponds to the supply curve of the firm. It may seem counter-intuitive to find that the
domestic monopolist increases supply of the good after a fall in price. This is due to the
monopoly distortion under autarky whereby the monopolist was restricting quantity. With free
trade the monopolist behaves competitively and the distortion is eliminated. Reading off the
demand curve gives the level of domestic demand under free trade, DW , with imports making
up the difference between supply and demand.
Consider the effects of an import tariff t in this setting. The domestic price increases to
(PW + t), raising domestic supply and lowering domestic demand and imports. The distance
denoted by q in Figure 8.11 corresponds to the level of imports under the import tariff t. Thus
q is also the size of the quota level that is equivalent to t in its impact on trade volume.
Under the equivalent quota, the monopolist retains some market power in the domestic market
due to the restriction in the number of goods that can be imported. DR reflects the residual
demand for good Q, once the quota q has been satisfied (with MRR reflecting the associated
marginal revenue curve), over which the monopolist is a price-setter. Setting MC = MRR
gives rise to a domestic price of Pq > PW + t. Hence, the effects of tariff t and quota q are not
94
identical, with the monopolist being more protected under the quota (higher price charged and
larger profits earned).
8.2.7 Effective protection

When there are intermediate as well as final goods, nominal rates of protection on final goods
do not give a true picture of the protective effect of the full tax and tariff structure. In order to
get a full picture it is necessary to take into account the influence of tariffs, taxes and other
restrictions on intermediate goods. For this the concept of effective protection has been
developed. The rate of effective protection, e, is defined as:
V − V∗
e= , (8.1)
V∗
where V is value added in a particular activity at domestic prices (that is, at prices which
include the effects of tariffs and other trade restrictions), and V ∗ is value added in the same
sector calculated at world prices (that is, excluding the effects of tariffs, etc). Thus the effective
rate of protection can be interpreted as the extent to which the whole tariff structure protects
value added in a particular activity.
More concretely, if ci j is the share of the ith good in the input costs of the jth good, then we
have: P
t j i ci j ti
ej = P , (8.2)
1 − j ci j
where the ts are the tariff rates. It is evident that if ti = t j for all i, then we must have e j = t j ;
that is, nominal and effective rates are the same.
On the other hand, if tariffs on intermediate goods, ti , are on average below t j , the tariff on the
final good, then e j > t j . In other words, in this case the effective rate of protection exceeds the
nominal rate. Tariff structures often have the property that:
raw materials have zero or very low tariffs
less finished goods have lower tariffs than final goods.

Such a tariff structure is called cascading and leads to effective rates of protection that are
substantially higher than nominal rates.
The simple formula offered above needs to be modified in the presence of non-traded goods
and non-tariff barriers to trade.
Although effective rate calculations are broadly informative about the protective content of a
tariff structure, they have a somewhat misleading air of precision. In particular, the coefficients
ci j are themselves likely to respond to changes in tariffs. Accordingly, actual V ∗ may be quite
different from what is implied by constant ci j .

In this chapter we have considered and discussed various instruments of trade policy, their
effects, as well as their advantages and limitations.
95

Having completed this chapter, and the Essential readings and activities, you should be able to
explain the following, both verbally and diagrammatically:
the price and quantity effects of imposing (or removing) a tariff
the welfare costs and benefits of a tariff for the tariff-imposing country and its trading
partner
the partial and general equilibrium diagrammatic representation of trade policy

instruments
how to compare a tariff with other instruments of trade policy
why import and export taxes have similar effects
how a large country might gain from the imposition of a tariff
why the nominal rate of protection in an industry may not fully capture the degree of
actual protection it enjoys.

1. Consider a domestic monopolist in a small country facing demand curve Q = 30 − P,
where Q is quantity demanded of a good and P is its price level. Further suppose the cost
function of the firm as a function of quantity Q is given by C(Q) = 5Q + 3/2Q2.
(a) Find the equation for the monopolist’s marginal cost of production (MC) and
marginal revenue (MR).
(b) Illustrate the demand curve, MR and MC curves on a diagram and indicate the price
charged and quantity sold by the domestic monopolist under autarky. Compute the
autarky price and quantity. What is the profit made by the monopolist?
(c) Suppose the country now opens to trade and the world price is PW = 14. Find
domestic supply, demand and the level of imports and indicate these on your
diagram. What is the domestic firm’s profit under free trade?
(d) Now suppose an import tariff t is introduced. Find domestic supply, demand and the
level of imports in terms of tariff level t. Find the prohibitive tariff.
(e) Let t = 3. Compute domestic supply, demand and the level of imports and add these
to your diagram. What is the domestic firm’s profit under this tariff?
(f) Now suppose an import quota q is introduced such that imports up to level q can be
purchased by domestic consumers at the world price. Any remaining demand can be
satisfied exclusively by the domestic monopolist.
(g) Find the residual demand the monopolist faces under the quota. Hence find the price
the monopolist will set and domestic sales in terms of q.
96
(h) Find the quota level that is equivalent to the tariff t = 3 and compute the domestic
price, sales and the domestic monopolist’s profit level under this quota. Indicate the
equilibrium under this quota in your diagram. Contrast your results with those found
in (e). Why is the monopolist able to earn higher profits under the quota?
2. Suppose a quota is replaced by a tariff that yields the same domestic price as the quota.
Discuss the effects of this policy change on the national welfare of the tariff-imposing
country.

1. (a) Rearrange the demand curve to find (linear) inverse demand: P(Q) = 30 − Q. It
follows that marginal revenue is given by:
MR(Q) = 30 − 2Q.
To find marginal cost differentiate the cost function with respect to Q. It follows that:
∂C(Q)
= MC(Q) = 5 + 3Q.
∂Q
(b) Illustrate the demand curve, MR and MC curves on a diagram such as Figure 8.11.
The monopolist sets MC = MR to maximise profits. Hence:
5 + 3Q = 30 − 2Q.
Solving yields the monopoly quantity in autarky, Q M = 5. Substituting back into

demand or supply yields a monopoly price P M = 25. Monopoly profits are
Π = Revenue − Cost = P(Q) · Q − C(Q). In the autarky equilibrium:
ΠA = 5 × 25 − [5 × 5 + 1.5 × 25] = 62.5.
(c) At PW = 14, demand is 16. The MC curve is the supply curve of the firm, so
MC = 14 = 5 + 3Q solves to give a domestic supply under free trade of 3. Imports
are thus 13. The firm’s profits under free trade can now be computed:
ΠFT = 3 × 14 − [5 × 3 + 1.5 × 9] = 13.5.
Under free trade, the domestic monopolist is a price taker and profits are lower than
in autarky due to foreign competition.
(d) When import tariff t is introduced, the domestic price is PW + t = 14 + t. The supply
of the domestic monopolist can again be found from the MC curve. Hence:
14 + t = 5 + 3Q.
Solving gives domestic supply in terms of tariff t: Qs = 3 + t/3. To find demand,

substitute the domestic price into the demand curve to find: Qd = 16 − t.
Imports are given by (Qd − Q s ) = 13 − 4t/3.
Under the prohibitive tariff, t P , imports are zero, so 13 − 4tP/3 = 0. Solving gives
t P = 9.75.
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(e) Substituting t = 3 into the expressions found in (d) yields a domestic price of 17,
domestic supply at 4 and demand at 13. The import level under the tariff is thus
reduced to 9. The firm’s profit under the tariff is 24. While the domestic monopolist
remains a price-taker, the tariff allows him to charge a higher price than under free
trade thereby generating a higher level of profit.
(f) Let residual demand be denoted by QR = (Q − q) = 30 − P − q. Rearranging for P
gives the inverse residual demand from which the residual MR can be computed. It
follows that:
MRR = 30 − q − 2Q. The domestic monopolist chooses his domestic price to
maximise profits on the basis of residual demand, hence MC = MRR . Hence:
5 + 3Q = 30 − q − 2Q.
Solving yields an expression for domestic supply in terms of quota level q:
Q s = 5 − q/5.
Substituting back into the residual demand curve yields an expression for the
domestic price set by the monopolist in terms of quota level q:
Pq = 25 − 4q/5.
(g) Under tariff t = 3 the import level is 9. The quota that is equivalent to this tariff is
thus a quota level q = 9. Substituting q = 9 into the expressions found in (f) yields a
domestic price of 16.8 and domestic sales at 3.2. The firm’s profit under the quota is
25.6. Comparing these results with those found in (e) reveals that the domestic price
and the monopolist’s profits are higher under the quota than under the equivalent
tariff. This is illustrated diagrammatically in Figure 8.11. Intuitively, under the quota
the monopolist retains some market power and thus behaves as a price-setter,
restricting supply and raising price, while in contrast the tariff does not afford the
monopolist any market power.
2. Here you are asked to compare a quota and a tariff with the difference that what is held
constant between the two regimes is the level of domestic prices. At least three alternative
scenarios are possible:
(i) Domestic market competitive, import licenses competitively auctioned.
(ii) Domestic market competitive, import licenses distributed by some other mechanism.
(iii) Domestic market non-competitive (for instance served by a domestic monopolist).
In Case (i), the quota and the tariff are equivalent; in Case (ii), the tariff and the quota
must also be equivalent in terms of their effects on the level of imports, consumption and
domestic production, but there may be a difference in the distribution of quota rents; and
in Case (iii), the switch to a tariff will lead to more production by the domestic
monopolist and less imports. This may worsen national welfare. To analyse this case use
the apparatus of the Appendix to KOM Chapter 9 (11th edition, 2018, ‘Tariffs and Import
Quotas in the Presence of Monopoly’), pp.270–74, but in the comparison between quota
and tariff hold domestic price rather than imports constant.
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Chapter 9
Economic arguments for protection
and the political economy of trade
policy
9.1 Introduction
The basic tariff analysis of the previous chapter shows that for a small country, imposing a
tariff will reduce national welfare calculated as the sum of consumers’ and producers’
surpluses plus the revenue effects of the tariff. Most other forms of trade policy instrument (for
instance quotas or VERs) are typically worse than a tariff in their distortive effect.
Nevertheless, historically trade restrictions of all kinds have been quite extensive and in many
parts of the world they remain widespread. Accordingly, economists have attempted to provide
justifications and/or explanations for the existence and persistence of protection. One category
of arguments are termed the economic arguments for protection (namely, arguments which
justify, say, a tariff, on economic grounds). A further category of theories seeks to explain why
self-interest may lead to the emergence and persistence of protection through the political
process, even though net national welfare (or economic efficiency) may be reduced as a
consequence. Such theories form what might be called the political economy of protectionism.

This chapter aims to:
discuss the economic arguments for protection, and the political economy of trade policy
explain the theoretical justification for multinational trade policy agreements.

should be able to:
explain the optimum tariff argument and its limitations

explain the domestic distortions argument and its limitations
explain what is meant by strategic trade policy and also explain its limitations as a recipe
for action
explain how protectionist policies may emerge in a democracy
99
9. Economic arguments for protection and the political economy of trade policy
explain the theoretical justification for multilateral trade policy agreements.
KOM, Chapter 10 ‘The Political Economy of Trade Policy’ and Chapter 12

‘Controversies in Trade Policy’.
S(IT), Chapters 100, 105 and 120:

Baldwin, R.W. ‘The political economy of trade policy’, The Journal of economic
perspectives 3(4) 1989, pp.119–35.
Baldwin, R. and p.Krugman ‘Industrial policy and international competition in

wide-bodied jet aircraft’ in Robert E. Baldwin (ed.) Trade policy issues and empirical
analysis, national bureau of economic research (NBER) conference report series
(pp.45–71). (Chicago: University of Chicago Press, 1988) [ISBN 9780226036076].
Brander, J.A. and B.J. Spencer ‘Export subsidies and international market share rivalry’,
Journal of international economics, 18(1) 1985, pp.83–100.
Dixit, A. (1988) ‘Tariffs and Subsidies under Oligopoly: The Case of the U.S Automobile
Industry’ in Kierzkowski, H. (ed.) Protection and competition in international trade:
essays in honor of W.M. Corden (pp.112–27). (Oxford and New York: Blackwell, 1987).
Eaton, J. and G. Grossman ‘Optimal trade and industrial policy under oligopoly’, The
quarterly journal of economics, 101(2) 1986, pp.383–406.
Rivoli, p.The travels of a T-Shirt in the global economy. (Hoboken, NJ: Wiley, 2014)
second edition [ISBN 9781118950142].
This chapter discusses the political economy of trade policy.
100
9.2 Chapter content
9.2.1 Economic arguments for protection

The optimum tariff argument
The optimum tariff (or terms of trade argument) has already been discussed in the previous
chapter and is sometimes regarded as the only genuinely valid economic argument for trade
restrictions. If a country has monopoly power in the international economy, then national
welfare can surely be improved by manipulating the terms of trade in a favourable direction. It
should be noted that such a tariff is optimal only for the tariff-imposing country. World
efficiency is reduced and the tariff-imposing country gains at the expense of its trading
partners.
In its pure form, the optimum tariff remains a theoretical possibility rather than a serious guide
for practical trade policy. For small countries the optimum tariff is by definition zero and for
large countries such a policy would invite retaliation from other large countries, leading to a
trade war. In a trade war it is very likely that all participants would lose. The most notable
example of terms of trade manipulation in the recent history of the international economy has
been the policy of OPEC oil producers to raise oil prices by means of an implicit export tax.
Market failure arguments for protection
The presence of market failure in the home economy (the presence of domestic distortions)
can be shown to sometimes provide an opportunity for a welfare-enhancing tariff. The reason
why a tariff may enhance welfare in the presence of domestic market failure is that the market
failure may distort the pattern of comparative advantage and specialisation (that is, the country
may be specialising in the ‘wrong goods’). A tariff can redress the balance towards ‘true
comparative advantage’.
The classic example of a market failure argument is the ‘infant industry argument’ in which
the market failure arises in the inability of a sector to finance a learning or development period
because of capital market imperfections. The tariff protects the infant industry during its
learning period and in theory is removed once the industry is competitive in world markets.
Whenever a domestic distortions argument justifies intervention, protection is always a
second- or third-best policy. Tackling the market failure directly is always superior to
supporting the affected industry, and production subsidies or taxes are always superior to trade
measures. Thus in the infant industry case the ‘first-best’ policy is to correct the capital market
failure and the ‘second-best’ is to subsidise the infant industry.
Activity 9.1 Complete Problems 3 and 4 of KOM Chapter 10, p.306.
Strategic trade policy
Strategic trade policy has two strands:
1. The idea of competition between nations and consideration of policies that might support
such competition such as industrial policy, national champions, the pursuit of high
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value-added activities.
2. Policy intervention to shift profits in non-competitive markets.

Politicians often talk in terms of ‘our competitors’ in the same way that a firm might do so and
industrial policy is often seen as a means by which industries might be promoted in the pursuit
of such competition between nations. How desirable it is to promote an industry by
intervention depends, economically speaking, on the presence or not of some kind of market
failure in that industry. In the absence of evidence of clear market failure the development of
the industry is best left to market forces. KOM Chapter 12 ‘Controversies in Trade Policy’
offers a first rate discussion of the issues involved, including a discussion of some important
case studies of strategic trade policy such as Japanese targeting of steel in the 1960s and
1970s, and semi-conductors in the mid-1970s, and European support for Airbus. The net result
of such a discussion is that the case for intervention is somewhat less than proven.
Theoretically more interesting than the competition between nations theme, is the idea that
when international markets are not perfectly competitive, trade and/or industrial policy may be
used to shift profits away from foreign firms towards domestic ones. The classic example is
the Brander and Spencer (1985) model in which two firms from different countries compete as
Cournot duopolists in a third country market. In this case a production subsidy to the ‘home’
firm induces it to expand output and capture both market share and profits (Eaton and
Grossman, 1986).
Figures 9.1 and 9.2 make use of the well-known reaction function diagram for Cournot
competition to show the incentives for strategic trade policy that countries may face. Consider
two countries, Home and Foreign, each of which has a domestic firm (denoted by A and B,
respectively). The two firms choose quantity levels, qA and qB , respectively, to compete in a
third market, each taking the quantity of the other as given. Assuming symmetric marginal
costs, the two firms share the market equally under the free trade, Cournot equilibrium,
denoted by point C where the reaction functions of the two firms, RA and RB , intersect.
Now consider the effects of an export subsidy on firm A’s exports to the third market,
implemented by Home. This effectively lowers the marginal costs of firm A relative to firm B,
shifting firm A’s reaction function from RA to R0A . The new Nash equilibrium is at X, where
firm A’s market share is greater than 50 per cent and profit is shifted from firm B to firm A. As
quantities are strategic substitutes, the best response of firm B to an increase in output of firm
A is to shrink qB . The move from A to B corresponds to a fall in profits for firm B and a gain
for firm A. There exists an optimal export subsidy that maximises the net effect of profits
shifted and cost to the Home government. The Cournot competition setting therefore provides
incentives for the use of export subsidies as a strategic trade policy instrument.
However, the incentives to implement export subsidies are symmetric to the two governments,
so given the Cournot choice of output by the Home firm, it is in the interests of Foreign to set
an export subsidy to benefit firm B. The effect of both countries implementing an export
subsidy is illustrated in Figure 9.2, where both reaction functions are shifted and the Nash
equilibrium is at Y. When both countries implement an export subsidy, neither firm succeeds
in garnering a larger market share over the other and the net effect of the joint implementation
of export subsidies is welfare reducing. The incentives faced by Home and Foreign can be
described as having a Prisoners’ Dilemma structure, as it is a dominant strategy to implement
an export subsidy, but the joint effect of export subsidies is worse for both countries than if
they pursued free trade. As such, the strategic trade policy literature offers an explanation for
the implementation of certain policies, such as export subsidies, that cannot be explained
102
qB
q A= q B
RA'
RA
qM
C
•
•X
RB
qA
0
qM
Figure 9.1: Strategic effect of an export subsidy under Cournot competition
qB
q A= q B
RA'
RA
qM Y
•
C
•
X
• RB'
RB
qA
0
qM
Figure 9.2: A Prisoners’ Dilemma structure in the choice of export subsidies
103
pB
RA RA'
p A= p B
RB
X
•
B•
pA
0
Figure 9.3: Strategic effect of an export tax under Bertrand competition
under perfect competition, but not a justification for the use of strategic trade protection. The
free trade equilibrium remains superior.
A problem with this kind of model appears to be that changes in assumptions about the
underlying competitive situation lead to quite different strategic policy prescriptions. Eaton
and Grossman (1986) found that if the two firms competing in a third country market compete
on price (Bertrand competition) then the optimal intervention is an export tax; while if they
compete in the ‘home’ market the optimal intervention is an import tariff.
Figures 9.3 and 9.4 illustrate the strategic incentives to implement export taxes under Bertrand
competition (assuming heterogeneous goods). Under price competition, the reaction functions
of the two firms are upward sloping, indicating that prices are strategic complements. That is,
the best response of a firm to a price increase by its rival is to also increase its price. The free
trade equilibrium is the Bertrand equilibrium, denoted by point B where the reaction functions
of the two firms meet. Assuming symmetric costs, the two firms set equal prices in the
Bertrand equilibrium. Now consider an export tax implemented by Home on the exports of
firm A. This effectively raises the marginal costs of firm A, shifting firm A’s reaction function
from RA to R0A . For any given price set by firm B, firm A’s best response is to choose a higher
price than before the tax. The Nash equilibrium is at X, at which firm A has higher profits than
at the Bertrand equilibrium.
However, the incentives are symmetric, so the Foreign country also has an incentive to impose
an export tax on firm B’s exports. The joint effect of symmetric export taxes is that both firms
set equal, but higher, prices than at the free trade equilibrium, while the export taxes are
jointly sub-optimal relative to the free trade equilibrium. The analysis under Cournot and
Bertrand illustrates two important limitations of strategic trade policy as a justification for
trade protection. First, that while individually rational, strategic trade policy incentives are
jointly sub-optimal; and second, that the results are not robust to changing assumptions
regarding the nature of competition between firms.
Activity 9.2 For any country or industrial sector you are familiar with, identify two
industries in which international competition is of the oligopolistic type.
104
pB
RA RA'
p A= p B RB'
Y•
RB
X
•
B•
pA
0
Figure 9.4: A Prisoners’ Dilemma structure in the choice of export taxes under Bertrand
competition
9.2.2 The political economy of protection
Despite the ‘economic arguments’ for protection, such as the optimum tariff argument, or the
domestic distortions argument, or the more modern strategic trade policy argument, the
consensus among economists remains that the case for trade policy intervention is weak.
Partly, the informational requirements of strategic trade policy are always likely to make the
optimal policy difficult to identify. Moreover, free trade is always pro-competitive (that is,
promotes competition). Thus within the profession there is generally a presumption in favour
of free trade.
Nevertheless, in the real world, many countries continue to follow protectionist policies.
Although tariffs in industrialised countries have been much reduced since the end of the
Second World War (for example, the average US tariff has fallen from 60 per cent in the 1930s
to less than 10 per cent today) they have often been replaced by less transparent policies.
Many developing countries continue to operate commercial policies that are distortive. For
example, KOM Table 10-2 ‘Welfare Costs of U.S. Protection’, p.287, reports that in the U.S.
the estimated welfare costs of trade protection is projected to be 2.6 billion dollars, down from
an estimated cost of 14.1 billion dollars in 2002.
Political models of protection
The analysis of the effects of trade policy in the previous chapter showed that imposition of,
say, a tariff, will benefit some groups of society (producers of the protected good); and will
make others worse off (consumers of the protected good). Other trade policy instruments will
have a similarly differentiated impact across groups. Once a trade policy instrument is in
place, its removal will also create gainers (consumers) and losers (producers). We know that
for a small country, a trade restriction generates a net loss of national welfare (sum of
consumers’ and producers’ surpluses plus government revenue is negative) and hence its
removal would generate a net gain. This raises two questions:
105
1. Why are trade restrictions imposed in the first place?
2. Why are they not removed if national welfare would be improved by their removal?
Political models of protection are an attempt to provide some answers. These models
recognise that in practice, developments in trade and trade policy can have significant
distributional effects and that tax policy is unlikely to be used in such a way that the ‘gainers
compensate the losers’. Thus the degree of trade policy intervention that emerges in a country
is endogenous and represents the outcome of the political process, which is based on the
balance between the private gains of a policy to a particular group and that group’s weight in
the political process. For example, in many countries agriculture seems to enjoy a favoured
position in the political process.
One simple theorisation of endogenous protection is based on the median voter model. Here,
the basic idea is that political competition will tend to produce the outcome preferred by the
median voter. In a democracy, it might be thought that the preferences of the majority should
prevail. In the case of trade policy, this would mean that the political process should generate
free trade since consumers (the gainers from free trade) are much in the majority. The problem
here is that the gains to each consumer from the removal of a tariff may be insufficient to
justify any individual lobbying. Moreover, consumers may be unaware of how trade policy
affects them, and as a consequence, although the collective gain to consumers may be large,
no action is taken by consumers to promote their collective interests. This has been termed the
‘problem of collective action’.
Activity 9.3 For your country, identify the most heavily protected sectors, taking all
protective measures into account. What in your judgment is the motivation for the
protection in each case?
Rent-seeking
Quantitative trade restrictions typically generate ‘rents’; for example, the quota rents
associated with an import quota. The presence of such rents creates an incentive to devote
resources to appropriating them. Such activity is known as rent-seeking and represents a waste
of resources from the point of view of society although it may be highly rewarding to the
individual. Rent-seeking was a feature of Communist economies which were subject to
extensive quantitative controls and has often remained a feature of post-Communist
economies in transition. For example, in Russia it is widely believed that often more effort has
gone into how the assets of state-owned enterprises should be divided rather than to the task of
restructuring them to ensure efficient production in the future.
International negotiations/organisations
One of the reasons for the reduction in tariffs since the Second World War has been the
influence of the General Agreement on Tariffs and Trade (GATT) and its series of multilateral
trade negotiations.
Over the course of the Uruguay Round of negotiations (1986–1994) the GATT was replaced
by the World Trade Organization (WTO) and many new trade liberalisation initiatives were
introduced. These included a commitment to phase out the system of quotas on world trade in
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textiles and garments, known as the Multi-Fibre Arrangement (MFA), which restricted the
amount developing countries could export to developed countries. The MFA, introduced in
1974, finally expired on 1 January 2005. The Uruguay Round agreement also introduced new
dispute settlement procedures and an agreement on trade rules for services – the General
Agreement on Trade in Services (GATS).
Multilateral negotiation is important in this context because individual countries acting on
their own may generate a collectively sub-optimal trade policy and a multilateral agreement is
a form of pre-commitment to a collectively optimal policy.
The Doha Round is the ninth round of trade negotiations under the WTO. The round was
inaugurated in Doha in 2001. However, disagreement between developed and developing
countries over agricultural trade liberalisation has stalled the progress of the round. Even
though several attempts have been made to revive the Doha trade negotiations, no resolution
had been reached as per 2014; for the first time since the inauguration of the GATT a round of
trade negotiations has failed with no end in sight. Part of the disagreement centres around
protection of the agricultural sector. Progress on agriculture will harm politically powerful
farmers in Europe, Japan and other countries where agricultural prices are far above world
levels. The losses incurred are expected to be more than offset by the gains to consumers in
these countries. However, the gains will be spread broadly across the population, while the
losses incurred are concentrated to specific groups of the population.
Activity 9.4 Using appropriate diagrams, analyse the economic implications of

liberalisation of trade in agricultural commodities for developing and developed countries.
Choose a developing and a developed country and discuss how consumers and producers
will be affected by such liberalisation. Why has progress in negotiations towards such
liberalisation been so slow?
9.2.3 The anti-globalisation movement – the ‘globalisation

backlash’
The latter part of the 1990s witnessed the rapid growth of the anti-globalisation movement that
emphasises the harmful effects of world trade on workers in developing countries; notably,
low wages and poor working conditions. The activists pointed the finger of responsibility at
those multinational enterprises operating factories in developing countries, producing low-cost
consumer goods for Western markets.
Thousands of activists demonstrated and disrupted the WTO meetings in Seattle in November
1999. Although the meeting would probably have failed even in the absence of the activists
(due to disagreement over the direction of a new trade round), the activists achieved the
appearance of having disrupted a WTO meeting. In the years that followed, further
demonstrations took place during meetings of the World Bank, IMF and at the G8 summit
meeting in Genoa. In its entirety, the movement against globalisation has come to be known as
the globalisation backlash. The standard economist’s argument in answer to the
anti-globalisation movement is that despite the low wages earned, the workers in developing
countries are better off than they would be if globalisation had not taken place.
Rivoli (2009) is an interesting book, written for the non-specialist, that discusses the effects of
globalisation by following the travels of a professor’s T-shirt.
107
Activity 9.5 Assess the claim that low wages cannot be sustained in developing
countries (for example, China) as they grow through the process of globalisation; refer to a
suitable framework or model covered in the course to support your analysis.

In this chapter, we have considered the economic arguments for protection, the political
economy of trade policy, as well as the theoretical justification for multilateral trade policy
agreements.

explain the optimum tariff argument and its limitations
explain the domestic distortions argument and its limitations
explain what is meant by strategic trade policy and also explain its limitations as a recipe
for action
explain how protectionist policies may emerge in a democracy
explain the theoretical justification for multilateral trade policy agreements.

1. Explain why, in a duopolistic market, it may be welfare-improving for an economy to
introduce export subsidy. When would the introduction of an export tax be the optimal
policy intervention?
2. Discuss to what extent political economy models explain the incidence and character of
protection.

1. In a monopolistic market with Cournot competition, it might be optimal to introduce an
export subsidy to guarantee greater market shares to the domestic firm. The subsidy
lowers the marginal cost of firm A and this implies an increase of production of firm A.
The best reaction of firm B is to reduce its production and let the price increase. Hence
the profits of firm A benefit as both quantities and prices increase. See Figure 9.1 for an
illustration.
108
2. This question requires a critical evaluation of political economy models of protection in

terms of their predictive power. That is, how well do they explain the sectoral incidence
of protection and also the type of instruments used? You should certainly include the
‘median voter’ model and you might consider the type of instrument used for protection.
109
110
Chapter 10
Preferential trading arrangements,
customs unions and economic
integration
10.1 Introduction
A preferential trading arrangement (PTA) is an agreement between two or more partners to

reduce or eliminate trade barriers between themselves (if barriers are eliminated it becomes a
free trade area, FTA) while each retains barriers against third parties. Thus, a PTA represents a
discriminatory change in trade policy, thereby contradicting the basic aim of
non-discrimination embodied in the most favoured nation (MFN) principle. However, where a
preferential agreement involves substantial elimination of trade restrictions between the
partners it is allowed by WTO rules (Article 24 permits this). This is because there is a belief
that such agreements normally represent a step towards multilateral liberalisation.
Although not a new concept (in the nineteenth and early twentieth centuries, colonial empires
typically operated extensive trade preferences as did Germany and Central Europe in the
1930s), PTAs have in recent years proliferated in the international economy. Between 1990
and 1997, 87 PTAs were notified to the WTO. In Europe, PTAs include the long-standing
European Union (EU) and European Free Trade Area (EFTA), as well as more recent
agreements such as the Baltic Free Trade Agreement (BFTA), the Central European Free
Trade Agreement (CEFTA) and numerous bilateral free trade agreements. In North America
there is the North American Free Trade Agreement (NAFTA) and in South America, the
Common Market of the Southern Cone (MERCOSUR – ‘Mercado Comun del Sur’); while in
Asia, regional agreements include the Association of South East Asian Nations (ASEAN) and
the Asia Pacific Economic Co-operation (APEC).
In some cases a PTA may be a stepping stone to further and deeper integration. Thus the EU
started as a customs union but developed to become a common market with its 1992 Single
Market programme (a common market allows free movement of labour and capital) and with
the Single Currency is proceeding to still deeper integration. The free trade agreements created
between the EU and a number of Central and Eastern European countries in the early and
mid-1990s have proved to be the first stages of an EU-accession process. On the other hand,
regional agreements in Asia and the Americas have been slow to lead to deeper integration.
This chapter aims to enable you to understand preferential trading agreements, customs unions
and economic integration, as well as the links between them.
111
10. Preferential trading arrangements, customs unions and economic integration

should be able to:
explain how the benefits and costs of a PTA can be analysed in terms of trade creation
and trade diversion
outline other beneficial effects of regional integration
describe differing degrees of integration and why they exist
apply these concepts to PTAs in your region.

KOM, Chapter 10 ‘The Political Economy of Trade Policy’.

FT, Chapter 11 ‘International Agreements: Trade, Labor, and the Environment’.
S(IF), Chapters 110-2 and 125: http://internationalecon.com/Trade/Tch110/Tch110.php
Panagariya, A. ‘Preferential Trade Liberalization: The Traditional Theory and New
Developments’, Journal of Economic Literature 38(2) 2000, pp.287–331.
Bagwell, K. and R.W. Staiger ‘Will Preferential Agreements Undermine the Multilateral
Trading System?’, Economic Journal, 108(449) 1998, pp.1162–82.
Krugman, p.‘Is Bilateralism Bad?’ in E. Helpman and A. Razin (eds) International Trade
and Trade Policy. (Cambridge, Mass: MIT Press, 1991) [ISBN 9780262081993]; 2010
edition (MIT Press) [ISBN 9780262513807].

Cooper, C.A. and B.F. Massell ‘Toward a General Theory of Customs Unions for
Developing Countries’, Journal of Political Economy, 73(5) 1965, pp.461–76.
Kemp, M.C. and H.Y. Wan, Jr. ‘An Elementary Proposition Concerning the Formation of
Customs Unions’, Journal of International Economics, 6 1976, pp.95–97.
Wonnacott, p.and R. Wonnacott ‘Is Unilateral Tariff Reduction Preferable to a Customs
Union? The Curious Case of the Missing Foreign Tariffs’, The American Economic
Review, 71(4) 1981, pp.704–14.

This chapter discusses preferential trading arrangements, customs unions and economic
integration.
112
10.2 Chapter content
10.2.1 Basic theory

The theory of preferential trading arrangements originates with the classic theory of customs
unions. A customs union involves two steps:
1. Elimination of tariffs and other trade barriers between two or more partner countries.
2. Formation of a common external tariff against the rest of the world.

Thus, as compared with standard trade policy analysis, a customs union involves the following
features:
Three countries are included, rather than just two or one.
The analysis is an exercise in the theory of the second-best because it involves the
removal of some distortions (trade barriers between partners) while others remain or are
increased (the common external tariff).
Its formation cannot be interpreted as a straightforward movement in the direction of free

trade.
Activity 10.1 There exist several cartels of countries that try to prevent the actual or
perceived downward push on the prices of their exported commodities, the OPEC oil cartel
being the most well known. How could such cartels help their constituent countries?
Explain the similarities and differences between cartels and monopolies. Discuss why
these cartels may struggle to succeed in the long run.
10.2.2 Trade creation and trade diversion

The formation of a customs union will tend to lower some prices (for instance on imports
from partner countries) and may raise others (for instance on imports from third parties).
These price effects will tend to encourage trade between partner countries and discourage
trade with third parties. Such switching of product origin may take two forms:
1. A higher cost domestic supplier may be replaced by a lower cost foreign supplier – this
effect is known as trade creation.
2. A lower cost foreign supplier may be replaced by a higher cost foreign supplier – this
effect is known as trade diversion.
Trade creation is illustrated in Figure 10.1, using a partial equilibrium framework, in which a
country importing good X forms a customs union with country A, eliminating tariff T between
the two countries. Evaluating the change in consumer surplus (a + b + c + d + e + f + g + h),
producer surplus (−a − e) and government revenue (−c − g) yields a positive net welfare effect
of (b + f + d + h).
Trade diversion is illustrated in Figure 10.2, where the customs union is now assumed to be
with Country B. While Country B is less efficient than Country A in producing good X, the
113
PX
PB + T
PA + T
a b c d
PB
e f g h
PA
S D
0 Q0 Q1 Q2 Q3 Quantity of X
Figure 10.1: Trade creation
PX
PB + T
PA + T
a b c d
PB
g
PA
S D
0 Q4 Q1 Q2 Q5 Quantity of X
Figure 10.2: Trade diversion
tariff-ridden price of A exceeds that of B, so imports are switched from Country A to Country
B. Evaluating the change in consumer surplus (a + b + c + d), producer surplus (−a) and
government revenue (−c − g) yields an ambiguous net welfare effect of (b + d − g).
The diagrammatic analysis confirms the commonly used rule-of-thumb that countries that
trade the most prior to the formation of the customs union are most likely to benefit from its
formation.
The Cooper-Massell argument
Early theorists thought that the formation of customs unions could be explained in terms of
such net benefit calculations. However, Cooper and Massell (1965) showed that whenever a
customs union was beneficial for, say, the home country, its good effects, that is trade creation,
could be achieved without the bad effects (trade diversion) by a means of a suitable unilateral
tariff cut. In other words, if the net effect of the union was beneficial for a country then it could
114
do even better without joining the union. Thus, Cooper and Massell (ibid.) argued, the
motivation for customs union formation must lie elsewhere than in their static net benefit
effects.
The Kemp-Wan argument
Another way of considering the effects of a customs union is to pose the following question.
Can a group of countries that initially impose a variety of tariffs against each other, form a
welfare-improving customs union? The Kemp-Wan argument (Kemp and Wan, 1976) says yes
– provided they set a suitable common external tariff and that lump-sum transfers can be used
within the union to compensate losers. It also follows from this argument that the enlargement
of a customs union will be beneficial, provided the correct common external tariff is set and
that losers can be compensated by means of lump-sum transfers.
Activity 10.2 Why is it not possible to apply the Kemp-Wan argument to looser forms
of PTA? Does the Kemp-Wan argument have any practical relevance?
10.2.3 Terms of trade effects

Clearly, the formation of a large union may have consequences for the terms of trade. While
one cannot be precise about how the terms of trade will be affected, there is a presumption that
the formation of a union will lead to a switch in trade with the rest of the world to intra-union
trade. This is likely to improve the terms of trade of the union as a whole although the terms of
individual partners may worsen.
The interests of exporters
At a basic level the formation of the union increases market access for home exporters in
partner country markets. Thus what may appear as trade diversion from the point of view of
one of the partners appears as an increased export opportunity for the other. Thus to some
extent trade diversion may be offset when considering the union as a whole. A more
sophisticated version of an improved export access argument has been suggested by
Wonnacott and Wonnacott (1981). In this argument the presence of tariffs imposed by third
countries (or transport costs to or from third country markets) implies a wedge between the
prices at which union members can import and export a good on the world market. If, prior to
the formation of the union, tariffs are set at levels that are less than the third country tariff
wedge, then there may be scope for mutual tariff concessions which are welfare-enhancing.
This is a theoretical example of a benefit generated by customs union formation that cannot be
achieved by unilateral tariff reductions. However, the idea that a customs union increases the
market access of home exporters is often regarded as a benefit of joining, and the Wonnacott
and Wonnacott (ibid.) argument provides a formalisation of this belief.
10.2.4 Other effects

Other possible beneficial effects of customs union formation include:
Economies of scale: a customs union offers the opportunity to trade freely in a larger
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market thereby enabling exploitation of economies of scale.
Intra-industry trade: the larger market of a customs union enables the production of more
varieties of differentiated goods, thereby increasing choice.
Dynamic effects: the effect of a union is generally pro-competitive; that is, it would tend
to increase the degree of competition in partner country markets, thereby improving
economic efficiency and enhancing investment in R&D.
10.2.5 Other levels of integration
A customs union represents just one possible level of integration, with the emphasis on a
tariff-free circulation of goods within the union and a common external tariff. A customs union
would normally also aim at eliminating non-tariff barriers to trade. Other forms of PTA are
also possible representing either higher (tighter) levels of integration or lower (looser) levels.
The European Union (EU), in 2014 consisting of 28 members, is a single market in which
there is free movement of factors of production as well as of goods, and seems to be on the
path to becoming a full economic union. Most of its core members have joined a monetary
union and adopted the euro, something which is explored in more depth in Chapter 19 of the
subject guide.
Looser forms of PTA involve the implementation of preferential trade measures without the
creation of a common external tariff, and perhaps without even totally eliminating mutual
trade barriers. Examples in Eastern Europe include the Baltic Free Trade Agreement (BFTA)
involving the three Baltic states and the Central European Free Trade Agreement (CEFTA). In
North America there is the North American Free Trade Agreement (NAFTA). In Asia both the
Association of South East Asian Nations (ASEAN) and the Asia Pacific Economic
Co-operation (APEC) are examples of much looser arrangements than are found in, say, the
EU. A looser form of PTA will generally imply a tendency for less trade to be switched
towards the partner countries and away from the rest of the world, although in any particular
case the effects depend on the extent of trade barrier reductions as well as on their form. Are
PTAs generally welfare-enhancing?
Since trade diversion is possible in any PTA, there is no certainty that the creation of such an
arrangement will improve world welfare or even the joint welfare of the partners. However,
taking all the effects together, there is a presumption that in PTAs which survive (and many
have not survived), the scale and pro-competitive effects offset any adverse trade diversion
effects. Some PTAs in Africa and Latin America which were created purely to promote
industrialisation within a protected ‘home market’, but which were inconsistent with the
comparative advantage of partners, have simply withered away.
Activity 10.3
1. Why are looser forms of PTA more common than customs unions?
2. Consider a regional PTA you are familiar with. Identify the main changes in trade
flow it has induced. Have they been trade-creating or trade-diverting?
116

In this chapter, we have discussed preferential trading agreements (PTAs), the benefits of
regional integration, and how these represent a step towards multilateral liberalisation.

explain how the benefits and costs of a PTA can be analysed in terms of trade creation
and trade diversion
outline other beneficial effects of regional integration
describe differing degrees of integration and why they exist
apply these concepts to PTAs in your region.

1. Consider a country (Home) whose domestic demand and supply for t-shirts are given by:
Qd = 15 − P
Qs = P − 5
Assume perfect competition.
(a) Find the autarky equilibrium price for t-shirts and the quantity demanded (and
supplied). Now suppose the Home economy has two potential trading partners,
Countries A and B, from which it can import t-shirts at prices PA = 5 and PB = 6,
respectively. A tariff of £2 is introduced on all imports.
(b) Draw a diagram to illustrate the open economy equilibrium (with the tariff). From
which country will Home import t-shirts? How many will be imported and how
much tariff revenue will the Home government raise?
(c) Now suppose Home and Country B form a free trade area. Illustrate the effects of
this on your diagram from (b). Evaluate the welfare effects of this liberalisation for
Home. Will Home still import t-shirts from the same source as before the
liberalisation?
(d) Suppose that Home forms a FTA with Country A instead. Draw a new diagram to
illustrate the welfare implications of this liberalisation. Evaluate the net welfare
change and contrast your result with that found in (c).
(e) Opponents of the FTA between Home and Country A argue that Home will be worse
off as a result since the Home t-shirt industry shuts down following liberalisation.
Do you agree with their argument?
117
2. Explain and discuss the following statement: ‘The difference between a customs union
and a free trade area is that one is difficult to create but easy to administer while the other
is just the opposite.’

1. (a) Autarky equilibrium is where Qd = Q s . Solving 15 − P = P − 5 yields equilibrium
price P∗ = 10. Substituting back into demand and supply yields equilibrium quantity
Q∗ = 5.
(b) Since PA + t < PB + t < 10, Home will import t-shirts from Country A at a price
PA + t = 7. The domestic price of t-shirts falls to £7 and domestic production shrinks
to 2. Consumers demand 8 units at this price, so imports of t-shirts are 6. The
government raises £2 per t-shirt, yielding total revenue from the tariff of £12.
Draw a diagram labelling the prices and quantities carefully, as in Figure 10.3.
Rearrange the equations to find the inverse supply and demand curves, so as to
sketch more accurately.
(c) The FTA between Home and Country B implies the tariff is lifted from goods
imported from Country B, but is maintained on goods from Country A. T-shirts from
Country B are now £6, while those from Country A are priced at £7. Home switches
from a more efficient foreign producer to a less efficient foreign producer, that is a
trade diversion. Candidates should discuss how the liberalisation increases trade but
also causes trade diversion, which is a welfare-reducing effect. In general, there is an
ambiguity as to whether the trade creation effect outweighs the trade diversion
effect, but given the information provided it is possible to calculate whether the net
welfare change is positive or negative.
At the lower price of £6, demand for t-shirts is 9, while supply is 1, so the level of
imports rises from 6 to 8. This is illustrated in Figure 10.3.
Consider the change in consumer surplus, producer surplus and government
revenue. Consumers gain from the lower prices, while producers lose and the
government forgoes the revenue it would have earned. There is a trade creation
effect, corresponding to the two triangles in Figure 10.3, and a trade diversion effect
(a welfare loss) corresponding to the rectangle in Figure 10.3. The trade creation
triangles have an aggregate area of 1, while the trade diversion rectangle has an area
of 6. The net welfare effect of this liberalisation for Home is thus a loss of 5.
(d) If Home forms a FTA with Country A then Home will continue to source t-shirts
from Country A, the more efficient producer. Hence there is no trade diversion in this
case. The price of t-shirts falls to £5, at which demand for t-shirts rises to 10, but
there is no domestic supply. Domestic demand is satisfied entirely by imports from
Country A. This is illustrated in Figure 10.4. There is only a trade creation effect in
this case, corresponding to the two shaded triangles in Figure 10.4. These each have
area 2, resulting in a net welfare gain of 4.
(e) The argument is false since it focuses exclusively on the production side of the
market. Welfare is evaluated by examining the net effect on producers, consumers
and the government. While the domestic t-shirt industry shuts down (as shown in
(d)), there are efficiency gains from trade liberalisation as there is a switch from less
efficient domestic production to more efficient foreign production, which allows
118
Figure 10.3: FTA with Country B
Figure 10.4: FTA with Country A
119
consumers to enjoy consumption at a lower price, generating a welfare gain larger

than the loss to producers and government.
2. See KOM and the subject guide for details on customs unions and free trade areas.

Activity 10.1
Cartels like OPEC are expected to shift the exporters’ terms of trade in their favour. Also
they are expected to produce the maximum profit that the market will bear. Importing
countries may benefit from the price stability generated by the cartel. Cartels are like
monopolies in that their total output is the same as that which would be generated by a single
monopoly. They differ from monopolies in that the monopoly profits need to be divided
among the producing countries, which have different cost structures. One of the problems that
arise is that individual member countries may try to exceed the agreed upon quotas in an
attempt to extract more profits; this would put pressure on the whole system.
120
Chapter 11
Trade policy in developing economies
11.1 Introduction
Many developing countries – and also countries in transition from planned to market
economies – have had, and in some cases still have, economies that are much more ‘distorted’
than industrialised ones. Examples of distortions include tax and tariff structures that generate
negative value added at world prices, and the presence of segmented or dual labour markets.
Also, there is a large dispersion in income per capita between the industrialised world and
developing economies. KOM Table 11-1 ‘Gross Domestic Product Per Capita, 2016’, p.312,
provides an overview of the GDP per capita for a selection of countries. The question arises
whether the presence of economic distortions and the large dispersion in income requires a
special approach to trade policy.
A major debate in development economics has concerned the role which trade policy can play
in promoting development. For a while in the post-Second World War period those who
advocated import substitution as a strategy for industrialisation appeared to have ascendancy,
but more recently opinion has shifted very strongly in favour of a policy of export orientation.
This chapter aims to discuss issues in trade policy relevant to developing economies.
should be able to:
explain why a dual economy offers a possible justification for trade protection and the
Harris-Todaro counter-argument
discuss why developing countries that rely on primary products have been pessimistic
about the level and volatility of their terms of trade
critically discuss the merits and problems of import-substitution as a policy to escape

from terms of trade problems
critically discuss how far export-orientation has proved to be a more successful

development strategy.
121
11. Trade policy in developing economies

KOM, Chapter 11 ‘Trade Policy in Developing Countries’.

Harris, J.R. and M.p.Todaro ‘Migration, Unemployment and Development: a Two-Sector
Analysis’, American Economic Review, 60(1) 1970, pp.126–42.
World Bank The East Asian Miracle: Economic Growth and Public Policy (World Bank
Policy Research Report). (New York: Oxford University Press, 1993) [ISBN
9780195209938].
Stiglitz, J.E. and S. Yusuf (eds) Rethinking the East Asian Miracle. (New York: Oxford
University Press, 2004) [ISBN 9780195216004].


This chapter discusses trade policy in developing countries.
11.2.1 The dual economy, trade policy and the Harris-Todaro

model
Dualism
In a number of less-developed economies (LDCs) and possibly some transition economies, it

is believed that the labour market and the economy as a whole is segmented between, on the
one hand, a traditional sector (typically found in rural areas) and, on the other, a modern sector
(typically found in the cities). One manifestation of this segmentation is the persistence of
differentials in wages and marginal productivity of labour between the sectors. Dualism or
segmentation means that such differentials are not competed away.
In an undistorted economy such differentials would not be expected to persist, but if they do
then a transfer of workers from the traditional sector to the modern sector should increase both
economic efficiency and output.
This can also be illustrated using simple algebra. Let w M be the wage (and marginal
productivity) of a worker in the modern sector and let wT be the wage and productivity in the
traditional sector. A worker transferred from the traditional sector to the modern sector would
generate an increase in output equal to:
w M − wT > 0 (11.1)
122
The existence and persistence of a differential implies that transfer of workers from the
traditional to the modern sector is beneficial to national output, but does not occur because of
the dual economy distortion. Trade policy aimed at boosting output and employment in the
modern sector would, on this reasoning, generate a positive effect on national welfare. Thus, it
is argued, a tariff, by protecting output in the modern sector, would induce an expansion of that
sector, which, in turn would induce movement of workers from traditional to modern sectors.
The Harris-Todaro argument
This appears to be a standard domestic distortions argument for a tariff and is subject to the
usual caveats about being a second-best policy. However, in this instance, even the basic
argument has been challenged, with the point that the wedge between w M and wT is not just an
arbitrary structural feature, but reflects the fact that a move to the modern sector entails a
probability of being unemployed. This can be formalised in the idea that equilibrium between
sectors is determined by the equality of expected wages in the modern sector and the wage in
the traditional sector. Thus equilibrium may be written as:
(1 − p)w M + pb = wT (11.2)
where p is the probability of being unemployed in the modern sector and b is income received
if unemployed (for example, unemployment benefit). For simplicity we assume b = 0 and also
that the probability of being unemployed is perceived as being equal to the unemployment rate
u. Thus equation 11.2 may be rewritten as:
(1 − u)w M = wT (11.3)
Now suppose that dLT of labour migrates from the traditional sector to the modern, some of
the migrants will get jobs in the modern sector, dL M , and some will move into unemployment,
dU. Thus:
dLT = dLM + dU. (11.4)
The change in output following this migration is:
dQ = w M dL M − wT dLT (11.5)
Substituting from equation 11.4 we get:
dQ = w M (dLT − dU.) − wT dLT (11.6)
or
dQ/dLT = w M (1 − dU/dLT ) − wT (11.7)
If dU/dLT = u (that is, if a marginal change in migration results in unemployment at the
average rate of unemployment), then equation 11.7 can be written as:
dQ/dLT = w M (1 − u) − wT (11.8)
However, from equation 11.3 the right-hand side of equation 11.2 equals zero and hence the
creation of a new modern sector job will not raise output.
In other words, the existence of the productivity differential in equation 11.1 is not sufficient to
support a policy of job creation in the modern sector, since it implicitly ignores the fact that a
123
new modern sector job attracts migration in excess of the available work and that this excess
ends up unemployed. If unemployment benefits, b, are positive, then the equilibrium condition
equation 11.2 together with equation 11.8 implies that the creation of an additional modern
sector job would actually reduce output.
Activity 11.1 In any economy with which you are familiar investigate whether an
urban/rural wage gap has existed in recent years. What has been the pattern of urban/rural
employment/migration? How well does the Harris-Todaro model explain this experience?
11.2.2 Import-substitution as a development policy

The import-substitution approach to development which arose in the years after the Second
World War was influenced by a combination of views that included the following:
promotion of a strong manufacturing sector was key to development
expansion of exports offered only limited potential for development, the so-called export
pessimism
validity of the infant-industry argument.
Activity 11.2 Why might import-substitution be more successful in a large country as

compared with a small one?
Export pessimism
Export pessimism originated in a number of beliefs that included:
a secular deterioration in the terms of trade of primary products as against industrial

products for structural reasons
elasticity pessimism – the view that both the income and price elasticity of demand for
LDC exports is low
the view that successful export performance by developing countries would provoke a
protectionist reaction from developed countries.
Thus the core of the import-substitution development strategy lay in the promotion of
domestic manufacturing by means of a variety of controls on imports of manufactures. This
has been criticised on the grounds that it had the effect of seriously distorting the economy, to
the point even where import-substitution, with its emphasis on the promotion of domestic
manufacturing is thought to have contributed to the creation of dualism.
11.2.3 Export-oriented development

The success of East Asian economies, notably Singapore, Hong Kong, Korea and Taiwan, in
achieving sustained economic growth has focused attention on a development strategy based
on outward or export-orientation. All of these economies are much more open than many
124
other developing economies, and high rates of economic growth have been accompanied by
the rapid expansion of trade rather than by import-substitution.
Although export-orientation is an outward-looking strategy, it is far from being a free trade
strategy and many of the export-oriented economies have retained significant import
protection as well as measures to actively promote exports. Precisely what is cause and what is
effect in the export-orientation story remains a matter of debate.
Activity 11.3 Consider three economies that you are familiar with: calculate the share
of exports as a percentage of GDP for the last 10 years. Explain the differences. (Data on
trade and GDP are available in national statistical publications. Nowadays many of these
are online. You might also consult the WTO, World Bank and IMF websites.)

In this chapter, we have discussed the issues surrounding trade policy for developing
economies.

explain why a dual economy offers a possible justification for trade protection and the
Harris-Todaro counter-argument
discuss why developing countries that rely on primary products have been pessimistic
about the level and volatility of their terms of trade
critically discuss the merits and problems of import-substitution as a policy to escape

from terms of trade problems
critically discuss how far export-orientation has proved to be a more successful

development strategy.

1. Let LDC be a developing country characterised by a segmented economy. A traditional
sector coexists with a modern sector. Segmentation is reflected in persisting differentials
in wages and marginal productivity of labour in the two sectors. Mr. B., president of
LDC, suggests the introduction of trade tariffs to protect the modern sector. He claims
that this policy will increase LDC production as the modern sector will expand, creating
new jobs at the expenses of the traditional sector. Is he right? Suppose you are the
Secretary of State for work. What type of concern would you express about this policy?
125
2. Discuss to what extent the East Asian economic miracle proves the case for an open trade
policy.

1. Candidates are expected here to explain the Harris-Todaro argument. The main points of
the Harris-Todaro argument are:
(a) Difference in wages not only reflects differences in productivity; it also reflects the
possibility of remaining unemployed when moving from the traditional sector to the
modern one.
(b) When the unemployment salary is positive, the creation of an additional job in the
modern sector might actually reduce output, by increasing unemployment.
2. The question invites you to critically evaluate the role of trade policy as a cause of the
East Asian economic success. KOM offers a discussion. World Bank (1993) and Stiglitz
and Yusuf (2004) provide further detail.
126
Part 2
International finance
127
Introduction to international finance
Foreign exchange rate markets are the largest financial market in the world, where billions of
dollars change hands daily. Many economies have moved towards financial liberalisation and
cross-border financial flows are higher than at almost any other point in history. At the same
time we observe the regular occurrence of currency crises, that on occasion inflict large
economic costs on their respective countries.
As such, international finance forms an important topic within the field of economics. It has to
be noted, however, that we have a far from complete understanding of the behaviour of
exchange rates and the movement of capital across borders. For example, Obstfeld and Rogoff
(2001) list six major puzzles in the field of international finance. These puzzles highlight the
sometimes large discrepancy between economic theory and economic reality. This is why
some of the predictions of economic theory fail to hold up empirically, for reasons that are
often not understood and despite a large body of literature in the area.
Chapters 12 to 14 provide the basis for much of the analysis of Part 1 of the subject guide.
National income accounting and the balance of payments are the subject matter for Chapter
12. Chapter 13 provides an introduction to the foreign exchange markets and highlights some
of the important linkages that exist between the foreign exchange market and domestic asset
markets, while Chapter 14 explores the relation between domestic prices and exchange rates.
Having established the basic building blocks of exchange rates and exchange rate
determination, the rest of the subject guide explores different topics within the realm of
international finance. Chapter 15 discusses the relation between exchange rates and output: in
much analysis, it is possible to separate the ‘real’ from the ‘monetary’; however, sometimes
this is not the case and in the international economy one of the channels through which
monetary events are transmitted to the real economy is through the exchange rate.
Although the world’s major currencies – including the US dollar, euro, Japanese yen, British
pound, and Swiss franc – float against each other, many less important currencies are pegged
to a major currency (or in some cases, a basket of major currencies). The mechanics of fixing
an exchange rate and some of the problems involved are covered in Chapter 16 of the subject
guide. Sometimes fixed exchange rates collapse, resulting in a currency crisis; Chapter 17
deals with the causes and consequences of these currency crises.
Chapter 18 provides a historical overview of the different international monetary arrangements
that have been prevalent in the last century: the gold standard and the Bretton Woods system.
Chapter 19 discusses optimum currency areas through the example of the Eurozone.
Lastly, Chapter 20 deals with international capital markets which provide links to earlier
chapters, such as those dealing with the foreign exchange market and with international factor
movements.
129
130
Chapter 12
National income accounting and the
balance of payments
12.1 Introduction
To understand the economic linkages between a country and the rest of the world, we need to
understand the concepts of national income accounting and balance of payments accounting.
When an economy is closed, there are a number of important aggregate flows to consider, such
as national output, consumption and investments. If the economy is open a number of
additional flows become important. The balance of payments captures these international
flows and consists of three main parts: The current account captures the imports to and exports
from a country as well as the income received from foreign investments. The financial account
tracks the flow of investments into and out of the country, including any interventions by the
central bank. The capital account measures unilateral transfers such as debt forgiveness. When
looking at the national income account, it is important to take these international flows into
consideration.

This chaper aims to:
discuss the links between income accounting and balance of payments accounting
consider how income accounting and balance of payments accounting apply in the real
world; for example, in working out a country’s net foreign wealth.

should be able to:
use the current account balance to extend national income accounting to open economies
discuss the way in which an international transaction enters the balance of payments
accounts
describe how trade in goods and services affect the current account and the financial
account
explain the current account as the change in a country’s net foreign wealth.
131
12. National income accounting and the balance of payments

KOM, Chapter 13, ‘National Income Accounting and the Balance of Payments’.

FT, Chapter 16 ‘National and International Accounts: Income, Wealth, and the Balance
of Payments’.
S(IF), Chapters 5 and 6:

http://internationalecon.com/Finance/Fch5/Fch5.php
International Monetary Fund. Balance of Payments and International Investment Position

Manual. (Washington, D.C.: International Monetary Fund, 2009) sixth edition [ISBN
9781589068124].
Lane, p.and G.-M. Milesi-Ferretti ‘The External Wealth of Nations Mark II: Revised and
Extended Estimates of Foreign Assets and Liabilities, 1970–2004’, Journal of
International Economics 73 (2007), pp.475–545.


This chapter will look at the concepts of national income accounting and balance of payments
accounting.
12.2.1 National income account

The national income account breaks down the national income of a country into its
components. From your basic macroeconomics, you should know that in a closed economy,
national income can be split into consumption, C, investment, I, and government spending, G.
As savings, S , are defined as the portion of national income that is not consumed by either
individuals, C, or the government, G, the only way an economy can save, S , is by investing in
the local economy. Therefore, in a closed economy, it must be true that:
Y ≡C +I +G (12.1)
S ≡ Y − C − G ≡ I. (12.2)
In an open economy, we also have to take into consideration trade between countries. Goods
and services that a country buys in from abroad are called imports, while goods and services
produced in that country that are sold to other countries are called exports. Since imports do
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Figure 12.1: UK national income and its components, 2001.
not generate any domestic national income (they will earn income for the country that
produced them), they must be subtracted from the income, Y. In a similar logic exports must
be added to the national income. The difference between exports, EX, and imports, I M, is
called the current account. In an open economy the national income identity thus becomes:
Y ≡ C + I + G + (EX − I M) . (12.3)
| {z }
CA
As an example of the breakdown of output into the components shown in equation 12.3 see
Figure 12.1, which shows the national accounts for the UK in 2001.
Activity 12.1 Use KOM to outline the differences and links between National income,
GNP and GDP.
Savings and the current account
Whereas in the closed economy, a country’s savings were equal to its investments, this need
no longer be true in an open economy. If a country imports more goods than it exports, that is
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it runs a current account deficit (CA < 0), it is effectively borrowing from abroad in order to
consume more today than it produces. Equivalently, when a country runs a current account
surplus it is consuming less than it produces and is effectively lending to foreign countries.
Thus the current account can also be interpreted as the change in the net foreign wealth of a
country.
Thus national savings can now be split into:
S ≡ I + CA. (12.4)
This follows from the fact that:
S ≡ Y − (C + G) (12.5)
and rewriting equation 12.3, we know that:
Y − (C + G) = I + CA. (12.6)
Activity 12.2 From the data in Figure 12.1, calculate the national savings in the UK
economy for 2001 as a percentage of national income.
Private and government saving
National savings, S , can be decomposed into private saving, S p , and government saving, S g .
Private saving is equal to disposable income: national income minus taxes and consumption.
Government saving is simply government revenue, that is taxes, minus government spending.
So we can write:
Sp ≡ Y −T −C (12.7a)
S g ≡ T − G. (12.7b)
Total national savings can then be expressed as:
S ≡ S p + S g ≡ Y − T − C + T − G ≡ Y − C − G ≡ I + CA (12.8)
Also, equation 12.8 can be rewritten to obtain:
S p ≡ I + CA + (G − T ). (12.9)
The last term of equation 12.9, (G − T ), is the negative of government saving, otherwise
known as the budget deficit. If private saving and domestic investment remain unchanged at
approximately equal levels, then an increase in government spending (from a position of a
balanced budget) leading to a budget deficit, must be accompanied by a current account
deficit. A reduction in total saving means that the country must be borrowing from abroad in
order to keep investment at the original level (that is it must run a current account deficit). This
was the case seen in the USA in the 1980s when under President Reagan’s administration,
huge government budget and current account deficits were seen. However, it is not necessarily
the case that such twin deficits will occur simultaneously. Equation 12.9 is an identity and
does not represent any causal relationship between the current account and the budget deficit.
For example, under the Maastricht treaty, the different members of the European Union, EU,
had to reduce their budget deficits in order to be allowed to adopt the new European single
currency in January 1999. From equation 12.9, a reduction of budget deficits might have been
expected to be accompanied by a move towards current account surpluses, or at least
reductions in current account deficits. This did not happen for many EU countries. Instead, the
reduced government deficits were accompanied by a reduction in private saving, with very
little change in the current account figures.
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12.2.2 The balance of payments
The current account is a record of all transactions in goods and services between a country and
its trading partners. But what exactly happens when a transaction occurs? This is the core of
balance of payments (BoP) accounting. Transactions in the balance of payments are mainly
grouped into two types: the current account which contains the purchase and sales of goods
and services and the financial account which contains purchase and sales of financial assets.
For example, suppose Jacques has his own vineyard in France and Clare, who lives in the UK,
wants to buy a crate of wine from Jacques. Clare pays for the wine with a £500 cheque and
receives the crate of wine. Since Clare is a resident of the UK, this transaction shows up as
(debit) £500 in the UK’s current account. When Jacques cashes in the cheque and deposits it
into his UK bank account, it also shows up as a (credit) £500 in the UK’s financial account. It
shows up positive because the UK has effectively ‘sold’ bank deposits worth £500 to someone
abroad. Likewise for France, the transaction shows up as a positive entry in the current
account (export of wine) and a negative entry in the financial account (import of financial
assets). It is important to note that every transaction enters twice into the balance of payments.
For every good imported there must be an asset exported. The sum of the current account and
the financial account must sum up to zero (technically, there is a third group of transactions,
the capital account, but these transactions tend to be negligible). Thus the BoP must always
balance! Thus it is pretty meaningless to say that the BoP is in deficit, since by definition it
should be zero. Of course, it is quite likely that the current account is either in deficit
(importing more than exporting) or in surplus (exporting more than importing). But if a
country runs a current account deficit, it must run a financial account surplus and vice versa.
The current account can be further subdivided into four types of transactions: (i) trade in
goods (merchandise trade), (ii) trade in services, (iii) income, and (iv) current transfers. The
first two types, trade in goods and services, have already been discussed above, and are what
most people think of when they talk about the current account. The net trade in goods and
services is sometimes also referred to as the trade balance. However, the current account also
includes income from financial assets and unilateral current transfers. Income on foreign
investments is included in the current account, rather than the financial account, as it can be
thought of as a service provided by the foreign investments. The last item included in the
current account is unilateral transactions such as government grants, private gifts and direct
foreign aid. The financial account measures the difference between acquisition and sale of
assets from foreigners. There are many different ways to split the different types of
transactions in the financial account. One way is to distinguish between foreign direct
investment (FDI) – where foreigners invest into a country with the intent to exercise
management control – and portfolio investment. Another is to split the financial account
according to the identity of the investor: primarily private financial flows, commercial bank
financial flows and central bank financial flows.
The capital account is a relatively new addition to balance of payments accounting. The
capital account was created to account for the debt forgiveness for some highly indebted
developing countries. It also includes the transfer of capital assets caused by migration and
other unilateral transfers of capital goods. For many countries such as the USA and the UK,
the fraction of capital account transactions is very small compared to the transactions in the
current account and the financial account. The name of the new account is rather unfortunate
as previously the term capital account was widely used to refer to the balance of private capital
flows; that is, the financial account minus central bank financial flows. When a textbook or
135
news article mentions the capital account, make sure to verify if they are referring to the new
definition of the capital account as containing unilateral long-term transfers, or the old
meaning of net private capital flows.
Of special mention when talking about the balance of payments are official reserve
transactions. As you know from basic macroeconomics, the central bank of a country is
responsible for managing the supply of money. The assets of a central bank are referred to as
official reserves. While historically a large part of the official reserves were held in gold,
nowadays most central banks hold a large part of their reserves in foreign assets, the so-called
foreign exchange reserves. Foreign exchange reserves are mostly in the form of foreign
government debt; in particular, US Treasury bills. When a central bank buys or sells foreign
exchange reserves in private markets this is called official foreign exchange intervention. The
level of net central bank financial flows is called the official settlements balance. It is, rather
confusingly, also sometimes referred to as the balance of payments. As we will see in the
chapter on exchange rate regimes, official transactions are of particular importance when a
country is running a peg.
Activity 12.3 Complete problems 3, 5 and 6 of KOM Chapter 13, p.375.
In this chapter, we have considered the relationship between national income accounting and
balance of payments accounting. We have shown how the trade in goods and services affects
the current account and the financial account. Thus, as we have seen, the current account is the
change in a country’s net foreign wealth. National income accounting and balance of
payments accounting form an important foundation of international finance and are therefore
significant for the chapters that follow.
use the current account balance to extend national income accounting to open economies
discuss the way in which an international transaction enters the balance of payments
accounts
describe how trade in goods and services affect the current account and the financial
account
explain the current account as the change in a country’s net foreign wealth.
136

1. In 2013 the Manana Islands had a current account deficit of £1 billion and a nonreserve
financial account surplus of £800 million. Manana’s capital account is in a £50 million
surplus. In addition, Manana’s factories located in foreign countries earn £700 million.
Manana has a trade deficit of £400 million. Assume Manana neither gives nor receives
unilateral transfers.
(a) What happened to Manana’s net foreign assets during 2013? Did it acquire or lose
foreign assets during the year?
(b) Compute the official settlements balance (OSB). What happened to the central
bank’s (foreign) reserves?
(c) Compute net factor income from abroad (NFIA). How much income did foreign
factors of production earn in Manana during 2013?
2. People sometimes talk about ‘twin deficits’, where the twins are the current account and
the government budget deficit. Explain how these two deficits are related economically so
that changes in one are reflected in changes in the other.

1. Note that KA = +50M, CA = −1, 000M, T B = −400M, (FA − OS B) = 800M and factor
income from abroad = 700M.
(a) The surplus in the nonreserve financial account shows that Manana has lost foreign
assets during the year, to the tune of 800M.
(b) Note that CA + KA + FA = 0, so FA = 1, 000M − 50M = 950M. The financial
account, FA can be subdivided into the official settlement balance, OS B, and the
non-reserve part of the financial account, NRFA: FA = NRFA + OS B. Thus the
OS B equals 950M − 800M = 150M. The central bank lost 150M of foreign reserves.
(c) Let NFIA be net factor income from abroad. Note that CA = T B + NFIA. Thus
NFIA = CA − T B = −1, 000M + 400M = −600M. Net factor income is a negative
600M. This means that factor payments to foreigners is equal to
700M + 600M = 1, 300M.
2. To answer this question, first show how the deficits are related, using national income
accounting. Recall that:
CA = X − M
Y = C + I + G + CA
Y − C − G = S = I + CA.
Now we decompose savings, S , into private and governmental savings:
S = S p + S g = (Y − T − C) + (T − G).
Note that:
S g = (T − G) = −(G − T ),
137
so substituting we get:
S p + S g = I + CA
CA = S p − I − (G − T ).
Interpretation: For a given level of S p and I, an increase in the budget deficit must be
accompanied by a decrease in the CA surplus (or increase in the CA deficit). For
example, consider an increase in government expenditure, G, such as the building of a
bridge. If imported materials, etc. are employed for the construction of the bridge there is
an increase in M giving rise to the twin deficits phenomenon. Empirical studies reveal a
correlation between the budget deficit and the CA deficit. However, the relationship is not
as simple as it looks; S p , S g , I and CA are jointly determined so the relationship does not
give a clear theoretical causal link.
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Chapter 13
An introduction to foreign exchange
markets
13.1 Introduction
The foreign exchange market is at the core of international finance. The existence of national
currencies means that transactions across national boundaries necessitate that parties to such
transactions exchange domestic currency for foreign currencies. A sale of a German car, in
euros, to a Chinese importer will create a demand for euros and a supply of Chinese yuan. The
currency corollaries of real transactions take place in foreign exchange markets. Although we
often talk about the foreign exchange market (singular) there are in fact many different
markets as there are many different currencies. Combined, the foreign exchange markets form
the largest financial market in the world. The markets in US dollars, euros and Japanese yen
are enormous global markets, with daily turnover of hundreds of billions of US dollars per
day. The markets of many other currencies are much smaller and can be quite thin.
This chapter aims to discuss the exchange rate markets, recognising their significance in
forming the largest financial market in the world.
should be able to:
explain the meaning of nominal, real exchange rates and effective exchange rates
use the concept of triangular arbitrage to determine cross rates
describe the difference between spot and forward exchange rates
use parity conditions to describe the relation between interest rates and exchange rates
explain changes in the exchange rate using the asset approach
discuss how changes in the supply of money affect exchange rates
explain why exchange rates can overshoot in the short run.
139
13. An introduction to foreign exchange markets

KOM, Chapter 14 ‘Exchange Rates and the Foreign Exchange Market: An Asset
Approach’ and Chapter 15 ‘Money, Interest Rates, and Exchange Rates’.

FT, Chapter 13 ‘Introduction to Exchange Rates and the Foreign Exchange Market’ and
Chapter 15 ‘Exchange Rates II: The Asset Approach in the Short Run’.

C, Chapter 3 ‘Financial Markets in the Open Economy’ and Chapter 7 ‘Sticky pPices: the
Dornbusch Model’.


This chapter provides an introduction to exchange rate markets.
13.2.1 Foreign exchange markets

Basic definitions
The exchange rate is the price of some foreign currency expressed in terms of the domestic
(home) currency. Throughout this subject guide we will refer to the exchange rate as S , from
Spot rate; note that some textbooks, like KOM, use the notation E to refer to the spot
exchange rate. Because an exchange rate is the relative price of two currencies it may be
expressed in two different ways:
1. The number of domestic currency units that can be exchanged per unit of foreign
currency, S (local/foreign). This is referred to as the direct notation. For example, if the
USA is considered the home country, the dollar/euro exchange rate might be expressed as
1.35 $/A
C, that is $1.35 per euro.
2. The number of foreign currency units that can be exchanged per unit of domestic
currency units, S (foreign/local). This is referred to as the indirect notation. From the
previous example, the 1.35 $/A C exchange rate can also be expressed as 0.74 A C/$, that is
A
C0.74 per dollar.
140
It is essential to check whether a source is using direct or indirect notation for the exchange
rate to avoid confusion. In this syllabus, and in KOM, the direct notation is followed, unless
indicated otherwise; that is, the exchange rate will be defined as S (local/foreign).
If you check the exchange rates at your local bank (or if you examine the financial pages of
the newspaper) you will notice that there is a difference between the rate you have to pay for
buying foreign currency and the rate you receive for selling foreign currency. Typically the
rate at which the bank buys a currency, the bid rate, will be lower than the rate at which it sells
a currency, the ask rate. The difference between the two rates is called the bid-ask spread and
is what gives traders in foreign currency a profit. Although important at the micro level, the
spread generally has no macro significance. Thus, henceforth we shall focus on the mid-price,
which we will simply refer to as the exchange rate, and ignore the spread.
Cross exchange rates and arbitrage
Consider a person who wants to exchange Russian ruble for Thai baht. One way is to find a
bank that is willing to quote a ruble/baht exchange rate and directly exchange the ruble to baht.
However, if the foreign exchange market of a currency pair is thin, it may be easier to make an
indirect trade: exchanging the ruble into US dollars and then exchanging the dollars into baht.
An exchange rate of a currency pair that does not include the US dollar (like the ruble/baht
exchange rate) is sometimes referred to as a cross exchange rate. The above example indicates
that there exists a relation between the exchange rates of two currencies expressed against the
dollar and their cross rate. For example, the ruble/baht exchange rate can be calculated as:
S (ruble/baht) = S (ruble/$) × S ($/baht). (13.1)
If the ruble/baht exchange rate is different from the relation implied by equation 13.1,
arbitrage profits exist. The exploitation of differences in cross-rates and exchange rates
expressed against the dollar is referred to as triangular arbitrage. If transaction costs are
present, then the relation given in equation 13.1 is only approximate and arbitrage profits can
only be made if the discrepancy is larger than the transaction costs involved.
Activity 13.1 Complete the table with exchange rates. The exchange rates are defined as
S (column/row).
US dollar British pound Japanese yen Swiss franc
(per 100 yen)
US dollar 1 0.60
British pound 1.48
Japanese yen 0.97
Swiss franc
Spot and forward exchange rates
In the discussion so far it was implicitly assumed that the exchange rate transactions discussed
were taking place on the spot: the exchange rate quoted between the two parties was for
immediate delivery of the foreign currency. These exchange rates are called spot exchange
rates (hence the notation S for the exchange rate). Some transactions are not agreed upon for
immediate delivery, however, but for a specified future date, such as 30 or 90 days in the
141
future. The exchange rates quoted for such future transactions are called forward rates,
denoted by F.
Other commonly traded exchange rate products are swaps, options and futures. Swaps involve
the sale of a currency combined with the forward repurchase of that currency. Foreign
exchange options work in a very similar way to stock options. For example, a foreign
exchange call option gives the right but not the obligation to buy a specified amount of foreign
currency at a specified price at maturity (or up to maturity if it is an American style option). A
futures contract is a standardised contract similar to a forward contract.
Appreciations and depreciations
Like many financial topics, the way an exchange rates moves is often of equal interest as the
actual level of the exchange rate itself. The literature and financial press use a range of
terminology to describe movements in the exchange rate market. Consider the euro/dollar
exchange rate. On 1st April 2013 the euro traded at 0.779 A C/$, while a year later on 1st April
2014 the euro traded at 0.725 A C/$. The euro/dollar exchange rate is lower, making it cheaper
to buy dollars with your euros. This is called an appreciation (or strengthening) of the euro
(vis-à-vis the dollar). If the exchange rate would instead have gone up, so that it becomes
more expensive to buy dollars with euros, it is called a depreciation (or weakening) of the euro
(vis-à-vis the dollar). If exchange rates are pegged, rather than floating, appreciations are
referred to as revaluations and depreciations as devaluations. As exchange rates are the
relative price of two currencies, people sometimes get confused about the terminology. An
appreciation of the euro (vis-à-vis the dollar) implies a depreciation of the dollar (vis-à-vis the
euro) and vice versa.
Nominal versus real exchange rates
The international value of this currency is one element in determining a country’s

competitiveness in the international economy; another is the price of its goods and services.
The nominal exchange rate, S , discussed so far, together with relative price levels combine to
form what is known as the real exchange rate, Q. Let P and P∗ be the domestic and foreign
price levels respectively; the real exchange rate is then defined as:
S P∗
Q= . (13.2)
P
A real exchange rate of 1 implies that domestic goods are equally expensive as foreign goods,
expressed in domestic currency units. Values of the real exchange rate above 1 indicate that
foreign goods are relatively more expensive, while values of the real exchange rate below 1
indicate that foreign goods are relatively cheaper. If we take logs of equation 13.2, the
expression of the log real exchange rate becomes:
q = s + (p∗ − p), (13.3)
where lowercase letters denote logs of the original variables.
Multilateral exchange rates
Exchange rates are normally expressed as bilateral exchange rates; that is, the exchange rate
between a single currency pair. However, sometimes it is more interesting to know how the
142
value of a currency has changed against other currencies in general, rather than against a
single other currency. In order to make statements about general exchange rate movements, it
is instructive to build a currency index. One index that is commonly used is called the nominal
effective exchange rate (NEER) index. The NEER is usually calculated as the weighted sum of
the bilateral exchange rates, where the weights attached to each particular bilateral exchange
rate is given by the share of trade with that country. Another commonly used index is the real
effective exchange rate (REER) index, which is calculated in a similar fashion as the NEER,
but with real exchange rates replacing the nominal bilateral exchange rates.
13.2.2 Parity conditions

At the core of exchange rate determination are a number of basic equilibrium conditions that
describe the relation between several important variables related to exchange rates. This
section describes the relation between interest rates and the spot and forward rate. The relation
between prices on the one hand and exchange rates and interest rates on the other are explored
in the next chapter.
Uncovered interest parity
Assets with similar risk characteristics can be expected to yield similar rates of return, if
expressed in the same currency. Thus for people to be indifferent between holding foreign or
domestic assets, the expected rates of return, expressed in the home currency, must be equal.
The return on a foreign currency denominated asset is composed of the return, expressed in
foreign currency terms, and the change in the exchange rate,
Et S t+1
1 + Rt = (1 + R∗t ) (13.4)
St
Et S t+1 − S t
Rt ≈ R∗t + , (13.5)
St
where Rt is the net return on an asset, asterisks denote foreign variables and Et S t+1 is the best
possible expectation of the future exchange rate S t+1 , formed at time t; Et is referred to as an
expectations operator. In many economic applications, equations can be simplified by taking
the natural logs. If we take the natural logs of equation 13.4 and denote the logs of the original
variables with lowercase letters (that is ln(S t ) ≡ st and ln(1 + Rt ) ≡ rt ≈ Rt ) , we obtain
Et st+1 − st = Et ∆st+1 = rt − rt∗ , (13.6)
where ∆st+1 is the change in s from period t to t + 1; that is, ∆st+1 = st+1 − st . The symbol ∆ is
referred to as a difference operator. Equation 13.6 implies that the expected change in the
exchange rate should be equal to the difference in expected returns on the home and foreign
assets. This concept is known as the uncovered interest parity (UIP).
Note that UIP is not an arbitrage relation but based on risky investments. As such, the above
definition of UIP is based on the assumption that the two currency deposits are perfect
substitutes that have similar risk characteristics. If the two assets are imperfect substitutes
an extra term, the risk premium needs to be added to the UIP relation to account for the
difference in riskiness of the two currency deposits. UIP is then defined as
Et ∆st+1 = αt + (rt − rt∗ ), (13.7)
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where αt is a risk premium. KOM, and many other sources, simplify the UIP relation by
omitting the risk premium. The UIP predicts that if the home country has a higher interest rate
than the foreign country, the exchange rate will go up over time; that is, the currency will
depreciate over time at a rate equal to the interest differential. Conversely, if the domestic
interest rate is lower than the foreign interest rate, the currency will appreciate over time;
again, at a rate equal to the interest differential.
Covered interest parity
Whereas the UIP is an equilibrium condition in the spot market itself, the covered interest
parity (CIP) defines an equilibrium condition between forward markets and spot markets. The
covered gross return (1 + R) on a foreign deposit is given by:
(1 + R∗t )Ft
1 + Rt = , (13.8)
St
or its approximation
Ft − S t
Rt ≈ R∗t . (13.9)
St
Taking natural logs and rearranging the terms, CIP is given by:
ft − st = rt − rt∗ . (13.10)
That is, the forward premium, ft − st , is equal to the interest differential. Unlike the UIP, the
CIP is an arbitrage relation. Therefore no risk premium is generally included in the CIP
relation.
The CIP and the UIP look very similar; the UIP given in equation 13.6 states that the expected
change in the exchange rate is equal to the interest differential (plus risk premium), while the
CIP given in equation 13.10 states that the forward premium is equal to the interest
differential. CIP is an arbitrage condition, so riskless profits can be made from deviations from
CIP (after adjusting for limits to arbitrage such as transaction costs).
Combining equation 13.6 and 13.10, assuming the risk premium to be equal to zero, gives a
relation between the forward premium and the expected change in the exchange rate.
ft − st = Et ∆st+1 . (13.11)
This relation is known as the forward rate unbiasedness hypothesis (FRUH) and states that the
forward premium should be equal to the expected change in the exchange rate. Alternatively it
can be stated that the forward rate is equal to the expected future spot rate.
Figure 13.1 includes the PPP and Fisher effect, which are described in the next chapter.
Activity 13.2 Assume you are a US investor faced with the following market
information: the current spot rate is 1.59 $/£, the one year forward rate is 1.61 $/£. You can
borrow and lend in pounds at a rate of 1.1% and borrow and lend in dollars at 3.2%. Devise
a trading strategy that yields a risk free payoff of 100$ one year from now. (Hint: use CIP.)
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Fisher equation
π − π* i − i*
Relative PPP
P CIP
UI
∆s f−s
Forward rate unbiasedness
hypothesis
Figure 13.1: Parity conditions
Empirical evidence on interest parity
There is overwhelming evidence that CIP holds very well. This should not come as a big
surprise, given that any deviations from CIP would enable riskless profits. Thus any deviations
from CIP would be swiftly arbitraged away by savvy investors. An advantage of the fact that
CIP holds almost perfectly, that is ( ft − st ) = rt − rt∗ , is that UIP and FRUH are almost
equivalent conditions. Although UIP is one of the cornerstones of international finance, there
is a large empirical literature showing that UIP does not hold most of the time. As forward
rates are easier to measure than interest rate differentials, many studies looking at UIP use
forward rates to proxy interest rate differentials, but these papers find, unsurprisingly, that
there is also very little evidence in favour of FRUH.
The failure of UIP and FRUH has given rise to a risky investment strategy called the carry
trade, where investors borrow in currencies that have low interest rates – such as the Japanese
yen – and invest the money in currencies that have relatively high interest rates – such as the
Australian dollar.
Activity 13.3 Reading KOM, define the carry trade. Name some currencies that are
used in the carry trade and explain why those currencies are used.
13.2.3 The asset approach to exchange rates
The UIP indicates that the current spot exchange rate is determined both by interest rates as
well as expected future exchange rates. For now, we take the future expected exchange rate as
a given; in the next two chapters we will explore further how these expectations are formed.
For now, let us focus on how changes in interest rates and future expected exchange rate affect
the current spot exchange rate. Rewriting the UIP relation of equation 13.6 with respect to st
gives
st = Et st+1 − rt + rt∗ . (13.12)
145
Consider first what happens to st if there is a sudden increase in the home interest rate, rt .
Equation 13.12 shows that if the home interest rate goes up, then the current spot rate, st , goes
down implying an appreciation of the domestic currency. Figure 14-5 ‘Effect of a Rise in the
Dollar Interest Rate’ in KOM provides a visualisation of this effect. Conversely, an increase in
the foreign exchange rate, rt∗ , makes the domestic currency less attractive and leads to a
depreciation of the domestic currency as shown in KOM figure 14-6 ‘Effect of a Rise in the
Euro Interest Rate’.
Lastly, consider what happens to the spot exchange rate if there is the expectation of future
exchange rate changes. If the interest differential, (rt − rt∗ ), has stayed unchanged, then the
current spot rate should move one-for-one with the change in the expected future exchange
rate. This implies that if the expectation of the future exchange rate is revised upwards, it leads
to a current depreciation of the domestic currency and vice versa.
13.2.4 The demand for money

As we will see throughout this syllabus, money has an important impact on exchange rates. As
such it is vital to understand the relation between money and exchange rates. The real money
demand of a currency, Md /P, can be expressed as a function of real output and interest rates
Md
= L(Y, R), (13.13)
P
where the value of L(Y, R) rises when Y rises and falls when R rises. In equilibrium, money
supply must equal money demand, a condition on the money market that money demand must
equal money supply,
Md = M s = M. (13.14)
One useful functional form of real money balances, one that we will use again in the next
chapter, is derived by assuming that the log of the real money balance is a linear function of
the log of real output and interest rates.
mt − pt = αyt − βrt , (13.15)
where lowercase letters denote logs of variables; for example, y ≡ ln(Y); α and β are
parameters.
Money supply and the exchange rate in the short run
In the short run, prices are often assumed to be fixed. If we also take money supply and output
as a given, then interest rates will have to move in order to ensure that the money market is in
equilibrium. KOM Figure 15-3 ‘Determination of the Equilibrium Interest Rate’ shows, for a
given price and output level, how this equilibrium can be achieved by a change in the interest
rate. In this framework, an increase in the real money balances of a country, will lead to a
decrease in the equilibrium interest rate, while an increase in real output will lead to an
increase in the equilibrium interest rate.
Recall from equation 13.12 that, given a fixed foreign interest rate and expected future
exchange rate, a decrease in domestic interest rates will lead to a depreciation of the domestic
currency. Hence, an increase in the domestic money supply will cause a depreciation. This
effect is illustrated in KOM Figure 15-8 ‘Effect on the Dollar/Euro Exchange Rate of an
Increase in the U.S. Money Supply’.
146
Money supply and the exchange rate in the long run
The previous section highlighted how money affects the exchange rate in the short run.
However, in the long run a change in the level of the money supply does not have an effect on
interest rates, but rather feeds through in prices (for more on the relation between money and
prices, see Chapter 14 of the subject guide). As prices adjust, real money balances and the
interest rates revert back to their original level. If the increase in the money supply is
permanent, this will also have an effect on the expectation of the future exchange rate. KOM
figure 15-12 ‘Short-Run and Long-Run Effects of an Increase in the U.S. Money Supply
(Given Real Output, Y)’ gives a detailed graphical representation of these effects.
13.2.5 Exchange rate overshooting (Dornbusch model)

The difference in the short run and long run effects of an increase in the money supply leads to
a phenomenon called exchange rate overshooting. The core of the overshooting result is as
follows: a permanent increase in the money supply should increase the price level and
depreciate the exchange rate in exactly the same proportion. Suppose however, that in the
short run prices are sticky and move only slowly to the new long-run level. In the long run,
prices and the exchange rate are both expected to settle at the levels predicted by the monetary
model. However, what happens to the exchange rate in the adjustment period? The Dornbusch
overshooting model shows that the exchange rate depreciates more in the short run than
predicted by the monetary model: it overshoots.
The intuition of this is as follows: in the short run, the increase in the money supply increases
real money balances and hence lowers domestic interest rates. Suppose domestic interest rates
were equal to world interest rates before the policy change. Now domestic rates must be below
world rates and UIP implies that asset markets thus expect that the domestic currency should
start appreciating over time. The only way this can be reconciled with a long run depreciation
is for the current spot rate to depreciate by more than the long run equilibrium. This result is
illustrated KOM figure 15-13 ‘Time Paths of U.S. Economic Variables After a Permanent
Increase in the U.S. Money Supply’.

In this chapter, we have discussed the exchange rate markets and their significance in forming
the largest financial markets in the world.

explain the meaning of nominal, real exchange rates and effective exchange rates
use the concept of triangular arbitrage to determine cross rates
describe the difference between spot and forward exchange rates
147
use parity conditions to describe the relation between interest rates and exchange rates
explain changes in the exchange rate using the asset approach
discuss how changes in the supply of money affect exchange rates
explain why exchange rates can overshoot in the short run.
1. Suppose that in London S (£/$) = 0.6, while in New York S (Y/$) = 120 and in Tokyo
S (Y/$) = 180.
(a) Is it possible to exploit any arbitrage opportunity? Why?
(b) Starting with £1,000,000 suggest a strategy from which you can profit (assume that
transaction costs are negligible).
2. What do we mean by overshooting of the nominal exchange rate? Describe the

assumption of the Dornbusch’s overshooting model and explain the adjustment
mechanism following a permanent increase in money supply.
1. A good answer would point out that an arbitrage opportunity arises when the system of
exchange rates is internally inconsistent. That is, assuming negligible transaction costs,
one can end up with more money than one started with by exchanging one’s currency
with foreign currency and back again. Under the assumption of negligible transaction
costs any arbitrage opportunity will be exploited through buying and selling of currencies
since such opportunities yield a riskless profit (unlike profits earned by speculation which
are associated with risk where the extent of investor speculation depends on risk
preference). With significant transaction costs, arbitrage opportunities will be exploited
up to the point where the marginal benefit of taking the opportunity is equal to the
marginal transaction cost involved. The exploitation of an arbitrage opportunity induces
adjustment in the exchange rates until the internal inconsistency and thus arbitrage
opportunity disappears.
(a) Under negligible transaction costs, there is no arbitrage opportunity when:
S (Y/$) = S (Y/£) × S (£/$).
Checking to see whether the relationship holds we find that:
S (Y/$) = 120 , S (Y/£) × S (£/$) = 108.
Therefore we can find a profitable strategy.
148
(b) Starting with £1,000,000 one can convert the £ to dollars yielding $1,666,666.667.
Converting the dollars to yen yields Y200,000,000 which, when converted back into
£, gives £1,111,111.111, an amount greater than the original. This strategy of
converting pounds to dollars to yen and back to pounds will be repeated until there is
no further arbitrage opportunity.
2. The Dornbusch overshooting model shows that the exchange rate depreciates/appreciates
more in the short run than predicted by the monetary model; that is, it overshoots. The
main assumption of the Dornbusch overshooting model is that in the short run prices are
sticky and move only slowly to the new long-run level, while in the long run they are
flexible.
Dornbusch and a permanent increase in the money supply: We know that aggregate
demand has to be equal to y in the long run. Since r∗ hasn’t changed, we know that in the
long-run equilibrium, r = r∗ : our IS and LM curves need to go back to the original
equilibrium. In particular, the increase in money supply requires a proportional increase
in the price level. Since the IS curve depends only on the real exchange rate, this means
that the real exchange rate has to return to the initial equilibrium. Impact effect: (keep in
mind that goods markets adjust slowly while financial markets adjust instantaneously),
the increase in money supply determines a decrease in the domestic interest rates
(liquidity effect) in order to accommodate the excess supply of real money balances (the
excess supply arises because of sticky prices). Uncovered interest parity implies that the
fall in the domestic interest rate is compatible only if there is an equilibrating change in
the nominal exchange rate. In order to keep domestic assets in their portfolio, households
should expect the nominal exchange rate to appreciate along the path that goes to the
long-run equilibrium. In order to generate expectation of appreciation, the nominal
exchange rate over depreciates (overshooting), so that the domestic currency is so
undervalued that it is expected to appreciate in the future. Given the depreciation of the
nominal exchange rate the IS curve shifts outward. This result is illustrated in KOM
figure 15-13 ‘Time Paths of U.S. Economic Variables After a Permanent Increase in the
U.S. Money Supply’.

Activity 13.1
To fill out the table, first realise that for n currencies, there are really only (n-1) free exchange
rates. All the other exchange rates can be derived from those (n-1). One starting place is to try
and find expressions for the exchange rates in domestic currency per dollar.
All elements on the diagonal are equal to 1.
The pound/dollar exchange rate is given as 0.6.
The yen/dollar exchange rate can be found by inverting the yen/dollar exchange rate to
obtain 1.03 dollar per 100 yen.
The dollar/franc exchange rate can be found by calculating the cross rate
S (Fr/$) = S (Fr/£) × S (£/$) to obtain 0.89 franc per dollar.
149
The empty fields above the diagonal can be calculated as cross rates and the empty fields
below the diagonal are the inverses of the values you have noted down above the
diagonal.
Activity 13.3
Using CIP we can see that

F
1 + r = 1.032 > (1 + r∗ ) = 1.024.
S
The dollar yield is higher than the covered yield that can be obtained by investing in the UK.
Thus the general arbitrage strategy will be:
1. Borrow pounds.
2. Sell pounds in the spot market for dollars.
3. Invest the dollars in t-bills.
4. Buy pounds forward by selling the receipts of the t-bills.
5. Repay the loan.

Assume I invest $100, what profits will I make?
1. Borrow £62.89, buy $100 using the spot market (@ S ($£) = 1.59).
2. Sell $102.37 to buy £63.58 forward (@ F($£) = 1.61). The investment pays $103.2, so
you made a profit of $0.83 in t = 1.
To get $100 profit a year from now, we need to invest 100/0.0083 = $1,2072.89. Note that this
would constitute a profit of $100/1.024 = $ 97.68 in today’s money.
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Chapter 14
Prices and the exchange rate
14.1 Introduction
In the previous chapter we introduced a number of important concepts used in international
finance, in particular the concept of an exchange rate as the relative price between two
currencies. In this chapter we will outline some models that explain how exchange rates are
determined and how exchange rates are linked to other economic variables. In particular we
will focus in this chapter on the relation between prices and exchange rates, through the
concept of purchasing power parity.

This chapter aims to discuss the relationhips between domestic and foreign price levels and
the exchange rate.

should be able to:
describe the relationship between the nominal exchange rate and the price levels as set
out in purchasing power parity, explaining why the relationship should hold
describe the differences between the law of one price, absolute PPP and relative PPP
describe what empirical evidence exists for the various forms of purchasing power parity
and provide the main reasons why PPP may fail
describe the implications of PPP of non-tradable goods, as outlined in the

Balassa-Samuelson theory
describe how the flexible price monetary model works
discuss how monetary factors and changes in output supply and demand affect exchange
rates in the long run.
KOM, Chapter 16 ‘Price levels and the exchange rate in the long run’.
151
14. Prices and the exchange rate
FT, Chapter 14 ‘Exchange rates I: The monetary approach in the long run’ and Chapter
22 ‘Topics in international macroeconomics’.
C, Chapter 2 ‘Prices in the open economy: purchasing power parity’ and Chapter 5
‘Flexible prices: the monetary model’.
S(IF), Chapter 30:

Dornbusch, R. ‘Purchasing power parity’, in Newman, P., M. Milgate and J. Eatwell (eds)
The new Palgrave dictionary of money and finance. (London: Macmillan, 1992) [ISBN
9780333527221].
Froot, K. and K. Rogoff ‘Perspectives on PPP and long-run real exchange rates’ in
Grossman, G.M. and K. Rogoff (eds) Handbook of international economics 3.
(Amsterdam: North Holland Press, 1994) [ISBN 9780444828644].
Hutton, J. ‘Real exchange rates’, in Newman, P., M. Milgate and J. Eatwell (eds) The new
Palgrave dictionary of money and finance. (London: Macmillan, 1992) [ISBN
9780333527221].
Mishkin, F. ‘Are real interest rates equal across countries? An empirical investigation of
international parity conditions’, Journal of finance 39(5) 1984, pp.1345–57.
Taylor, A. and M. Taylor ‘The purchasing power parity debate’, Journal of economic
perspectives 18 (Fall 2004), pp.135–58.


This chapter describes the relation between domestic and foreign price levels and the
exchange rate.
14.2.1 The law of one price

The law of one price (LoOP) essentially states that a commodity or good should cost the same
in two countries when converted into the same currency. If a television set in the USA costs
$600, then such funds should be able to exactly cover the cost of buying the same television
set in another country. With exchange rates of 1.6 dollars per pound and 1.1 dollars per euro,
152
Figure 14.1: Law of one price for television sets in the US and UK
for example, the television set should cost £375 in the UK and A
C545 in Germany or France. If
the law of one prices holds, then it must be true that
Pit = S t P∗it , (14.1)
where Pit is the price of good i at time t in the home country and P∗it is the price of good i at
time t in the foreign country, expressed in foreign currency units. As before, S t is the spot
exchange rate, expressed as local currency per unit of foreign currency. Equation 14.1 is an
arbitrage condition that should hold in equilibrium. If at any time the equation did not hold,
arbitrageurs would exploit the deviation, driving the system back towards its equilibrium.
Suppose, for example, that the television set mentioned above costs £350. At an exchange rate
of 1.6 $/£ this translates to $560, which is cheaper than the $600 that the television set costs in
the USA. In this situation, UK television producers would try to sell their TVs in the USA
rather than the UK, as the profits are larger there. Likewise, US consumers would stop buying
television sets in the USA and instead try to buy them in the UK at a reduced price. In the
USA the increase in supply (from UK firms) and drop in demand (from US consumers) will
drive down dollar prices. At the same time pound prices will go up in the UK as a response to
the decrease in supply and increase in demand. The changes in demand and supply will
continue until the equilibrium condition of equation 14.1 is restored. This effect is shown
diagrammatically in Figure 14.1.
14.2.2 Purchasing power parity

The law of one price shows the relationship between the exchange rate and relative prices for a
single good. A similar expression to equation 14.1 can be obtained if we aggregate over all
goods, in which case the nominal exchange rate is a ratio of price indices in the domestic and
foreign countries.
α i Pi t
Pn
S t = Pt /(Pt ) = Pni=1
∗
, (14.2)
i=1 αi Pi t
∗
where αi is the weight of good i in the reference basket of goods. If natural logs are taken of
equation 14.2 (and denote logs of variables by lowercase letters), absolute PPP can be
expressed as:
st = pt − p∗t (14.3)
153
Purchasing power parity (PPP) states that the purchasing power of a sum of money in one
country should be able to purchase the same basket of goods no matter from where the
consumption basket was bought. The version of PPP given in equation 14.3 is called absolute
purchasing power parity. If the law of one price holds for every good and the price index is
formed in the same way from both countries then PPP must hold. Even if the law of one price
does not hold exactly in every market for every good, it may still be the case that absolute PPP
holds as it measures the weighted average of the individual goods.
Relative purchasing power parity
A more general, and weaker, version of purchasing power parity, called relative PPP, relates
exchange rate changes to the ratio of domestic and foreign price changes. Expressing equation
14.3 in terms of period to period changes gives,
st − st−1 = (pt − pt−1 ) − (p∗t − p∗t−1 ) (14.4a)
∆st = πt − π∗t , (14.4b)
where the log first difference of the price level, πt = ∆pt = (pt − pt−1 ), can be interpreted as the
rate of domestic inflation. Likewise, π∗t , can be interpreted as the rate of inflation in the foreign
country. Relative PPP states that the exchange rate must change by the same rate as the
inflation differential. If inflation at home is higher than abroad, the currency will depreciate,
while if it is lower than abroad the currency will appreciate.
Relative PPP is often a more relevant concept than absolute PPp.For instance, absolute PPP
only makes sense if we compare the exchange rate adjusted prices of two identical baskets of
goods; however, there is no internationally recognised basket of goods: most governments
create their own reference basket of goods and report price levels based on this reference
basket. Thus we cannot easily compare price levels reported by different countries, as they
refer to different baskets of goods, making it difficult to ascertain whether absolute PPP holds
or not. Inflation rates – that is, changes in the price levels of the baskets – are much less
sensitive to the composition of the individual baskets; thus relative PPP remains relevant even
if countries report price levels and inflation based on different baskets of goods. Another
reason why relative PPP is more relevant in practice than absolute PPP lies in the fact that it is
a weaker condition, as you will see by doing Activity 14.1. Thus relative PPP may hold even if
absolute PPP does not.
Activity 14.1 If absolute PPP held, what is the value of the real exchange rate? If
relative PPP held, what can you say about the rate of change of the real exchange rate?
Fisher effect
The PPP relations provided in equations 14.3 and 14.4b are backwards looking, in that they
explain how the spot exchange rate has changed in the past. However, we can also use PPP to
make predictions about future changes in the exchange rate. One way to look at relative PPP is
to use it to form expectations about the future. We can define the expectations version of
relative PPP as:
Et ∆st+1 = Et πt+1 − Et π∗t+1 . (14.5)
That is, if people expect relative PPP to hold in the future, then the expected change in the
exchange rate will be equal to the differential in expected inflation rates.
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The expected version of relative PPP can be combined with UIP to reveal a long run relation
between inflation rates and interest rates. Recall from Chapter 13 of the subject guide that UIP
is given by:
Et ∆st+1 = rt − rt∗ . (14.6)
Substituting equation 14.6 into 14.5 gives
rt − rt∗ = Et πt+1 − Et π∗t+1 . (14.7)
This equation is sometimes known as the Fisher effect and states that the interest differential
should be equal to the difference in expected inflation rates.
Activity 14.2 Prove that if both UIP and relative PPP hold, real interest rates will be
equal across countries.
Empirical evidence on PPP and the law of one price
Given the importance of PPP in economic modelling, it is only natural to ask oneself how well
PPP holds in reality. The short answer is, not very well at all. There are several clear problems
with the law of one price which limit the extent to which one would expect PPP to hold:
1. Trade barriers: the law of one price assumes that there are no barriers to trade; however,
in reality there are plenty of barriers to trade including transportation costs and
restrictions on trade such as those discussed in Part 1 of the subject guide. Some goods
are not traded at all, something we will discuss in the next section.
2. Imperfect competition: the existence of monopolies or oligopolies exacerbates the
problem of trade barriers, as monopolists seek to exploit the existing barriers to increase
profits, weakening the link between prices and exchange rates further.
3. Basket composition: As already mentioned, different countries measure price levels
based on different baskets of goods. This means that we cannot easily use official data to
measure absolute PPP; although the problem is less pronounced for relative PPP, the fact
that inflation is not defined over the same basket of goods in different countries will
weaken the empirical evidence of relative PPP, if official data is used.
As such it is no surprise that the empirical literature has found little evidence for the law of
one price and PPP to hold. For instance, as you can easily verify yourself, manufactured goods
trade for widely different exchange rate adjusted prices in different countries. In another, by
now well-known, example The Economist, a weekly newspaper, reports on the so-called Big
Mac index, in which it shows that there is a large variation in the exchange rate adjusted price
of hamburgers in different countries. All the evidence is showing widespread and persistent
deviations from the law of one price. As absolute PPP is founded on the principle of the law of
one price, it is not surprising that the academic literature has also found very little evidence
has been in favour of absolute PPp.Combining the stylised facts that both PPP and UIP do not
hold very well empirically, Mishkin (1984) reports that, unsurprisingly, there is also little
empirical evidence that the Fisher effect holds; namely, he finds substantial variation in the
real interest rate across countries.
However, the empirical evidence is not all gloom and doom for PPP: relative PPP can
sometimes provide a reasonable approximation to the data. Froot and Rogoff (1994) provide
155
evidence that the real exchange rate is stationary over long horizons; that is, although there are
persistent deviations from PPP, some of these deviations tend to diminish over time, slowly.
KOM Figure 16-2 ‘The Yen/Dollar Exchange Rate and Relative Japan-U.S. Price Levels’
show the relation between the yen/dollar exchange rate and price levels in Japan and the USA;
here it can be seen that the exchange rate never exactly reflects relative price levels, but instead
seems to fluctuate around the relative price levels, as if the relative price level is acting as a
long-run anchor for the exchange rate. Thus, PPP should not be seen as a short-run
phenomenon, but as a long-run phenomenon (Taylor and Taylor, 2004).
14.2.3 Balassa-Samuelson effect

Balassa and Samuelson tried to address the observation that PPP may be a reasonable
assumption to make for tradable goods, but not for non-tradable goods. In the model below,
we will assume that the USA is the domestic country with a general price level equal to P,
while the euro area is the foreign country with a general price level equal to P∗ . The exchange
C), will be expressed in dollars per euro. Now assume that, in the USA, a fraction α
rate, S($/A
of the goods is non-tradable and has price level PN and a fraction (1 − α) of the goods is
tradable and has price level PT . Similarly in the euro area prices levels are P∗N and P∗T for
non-tradable and tradable goods, and the fraction of non-tradables is denoted by γ. General
price levels can now be calculated as:
P = αPN + (1 − α)PT (14.8a)

P∗ = γP∗N + (1 − γ)P∗T . (14.8b)
Relative price levels can be obtained by dividing 14.8a by 14.8b to get
PT α PT + (1 − α)
PN
P αPN + (1 − α)PT
= = ∗ · P∗ . (14.9)
P∗ γP∗N + (1 − γ)P∗T PT γ N∗ + (1 − γ)
P T
Now assume that PPP only holds for traded goods, but not for non-traded goods. That is, we
adapt equation 14.2 to get the adjusted PPP relation:
PT
S = . (14.10)
P∗T
Substituting 14.10 into 14.9 and rearranging the terms we obtain:
P∗
P γ PN∗ + (1 − γ)
S = · PNT . (14.11)
P α P + (1 − α)
∗
T
Recall from Chapter 13 of the subject guide that the real exchange rate is defined as:
P∗
Q=S . (14.12)
P
Substituting equation 14.12 into equation 14.11 we get an expression of the real exchange rate
as a function of the price levels of the tradeable and non-tradeable goods
P∗
γ PN∗ + (1 − γ)
Q= T
. (14.13)
α PPNT + (1 − α)
156
Notice that equation 14.13 implies that it is no longer necessary for the real exchange rate Q to
be unity, as postulated by absolute PPP, or even constant over time, as postulated by relative
PPP.
How can the Balassa-Samuelson effect help us think about real exchange rates? Consider what
happens if the productivity of traded goods increases in the USA. The increased productivity
will shift the supply schedule outwards and hence cause the price of US traded goods, PT , to
fall. All else equal, this will cause not only the nominal exchange rate to decrease, shown in
equation 14.11, but also the real exchange rate to decrease, as shown in equation 14.12. Hence
the productivity shift implies an appreciation for the dollar in both nominal and real terms.
The Balassa-Samuelson effect can also explain why price levels are systematically lower in
poor countries than in rich ones. Remember that PPP holds in the tradeable sector. If poor
countries have lower productivity in the tradeable sector than rich countries, the countries’
wage level has to be lowered in order to be able to compete internationally in the tradeable
sector. These lower wages will also apply to the non-tradeable sector, even though
productivity in the non-tradeable sector is equally high as in the developed world (for instance,
the quality of a haircut does not vary a lot from country to country). Hence the price level of
the non-tradeable sector will be lower in poor countries than in rich countries, which will also
depress the overall price level and cause a weak (high) real exchange rate.
14.2.4 The flexible price monetary model

Now that we have introduced PPP, we have all the building blocks needed to create the
monetary model, one of the more well-known models of exchange rate determination. To
understand how it works, we need to start again with the analysis of money demand. Recall
from Chapter 13 of the subject guide that real money balances are a function of real output
and interest rates.
mt − pt = αyt − βrt . (14.14)
If we assume the elasticity parameters α and β to be equal across countries, the real demand
for foreign money will be
m∗t − p∗t = αy∗t − βrt∗ , (14.15)
where asterisks, again, denote foreign variables. Subtracting equation 14.15 from 14.14 and
rearranging the terms yields
(pt − p∗t ) = (mt − m∗t ) − α(yt − y∗t ) + β(rt − rt∗ ). (14.16)
To make equation 14.16 into a model for exchange rate determination we need to impose
absolute PPP as an equilibrium condition. Substituting the absolute PPP condition of equation
14.3 into equation 14.16 yields a first model of exchange rate determination
st = (mt − m∗t ) − α(yt − y∗t ) + β(rt − rt∗ ), (14.17)
with the log exchange rate, st , defined, as before, as local currency per unit of foreign
currency. This equation implies that, all else equal:
1. A permanent increase in the domestic money supply leads to a depreciation of the home
currency.
2. An increase in domestic interest rates leads to a depreciation of the home currency.
157
3. An increase in domestic output leads to an appreciation of the home currency.

Sometimes the rate of change of the exchange rate is of more interest than the level. An
expression for the rate of change can be obtained by taking the first difference of equation
14.17
∆st = (∆mt − ∆m∗t ) − α(∆yt − ∆y∗t ) + β(∆rt − ∆rt∗ ). (14.18)
A change in the growth of money
To understand the flexible price monetary model better, it is instructive to go through an

example. Let the United Kingdom be the domestic country, and the Eurozone the foreign
country. For simplicity, assume that all Eurozone variables are constant and both Eurozone
inflation and interest rates are equal to 0. Now consider what the predictions of the flexible
price monetary model are if the UK unexpectedly and permanently increases the growth rate
of its money supply from µ to (µ + ∆µ). Note that the example refers to a permanent increase
in the growth rate of the money supply, rather than a one off permanent increase in the level of
the money supply. KOM Figure 16-1 ‘Long-Run Time Paths of U.S. Economic Variables
After a Permanent Increase in the Growth Rate of the U.S. Money Supply’ gives a graphical
representation of this example.
In the monetary model, real output is unaffected by monetary policy. Instead, expected growth
in the money supply translates directly into expected inflation such that µ = π and
(µ + ∆µ) = (π + ∆π). Equation 14.18 predicts that, all else constant, the exchange rate will
depreciate at the same rate as the growth in money supplies. This implies that the UK pound
will experience a higher rate of depreciation, moving from rate π to (π + ∆π). The next step is
rather less intuitive: as can be seen using the Fisher effect of equation 14.7, the increase in UK
expected inflation will lead to an increase in the interest differential (rt − rt∗ ). This jump in the
interest differential causes an upward jump in both the price level, to restore equilibrium in the
money market, and an upward jump in the exchange rate, to restore equilibrium in the
exchange rate market. Hence, a permanent increase in the growth of money supplies is
predicted to result in both an immediate depreciation of the pound as well as an increase in the
future rate of depreciation of the pound. The effects of a change in the growth rate of money is
given in Figure 14.2.
Activity 14.3
1. Assume you are the newly appointed central banker of a country that wishes to reduce
its inflation from 4% to 2.5% per annum. You wish to adopt an exchange rate target
relative to the US dollar. US expected inflation is 1.5%. Compute the target
appreciation/depreciation of the home currency needed to achieve the inflation target.
What is the immediate effect on the exchange rate if the exchange rate target is
implemented?
2. In Chapter 13 of the subject guide, when discussing UIP, it was stated that an increase
in the domestic interest rate could lead to an immediate appreciation, followed by an
increase in the rate of depreciation of the currency. In this chapter, when discussing
the monetary model, Figure 14.2 shows an increase in the interest rate which is
associated with an immediate depreciation of the currency, followed by an increase in
the rate of depreciation of the currency. How can you explain the different conclusions
158
Figure 14.2: Money supply growth and the exchange rate
reached in Chapters 13 and 14 of the subject guide on the relation between an increase
in the interest rate on exchange rates?
Fundamentals and expectations
With the use of the UIP condition, the monetary model can also be used to show how
expectations play a role in the determination of exchange rates. Recall from Chapter 13 of the
subject guide that the UIP condition, expressed in logs, can be written as
Et ∆st+1 = Et st+1 − st = rt − rt∗ . (14.19)
Also, define for convenience the quantity zt as a composite ‘fundamental’
zt = (mt − m∗t ) − α(yt − y∗t ). (14.20)
Substituting equations 14.19 and 14.20 into equation 14.17 yields
st = zt + β(Et st+1 − s). (14.21)
Rearranging the terms of equation 14.21 gives us

1 β
st = zt + Et st+1 . (14.22)
1+β 1+β
Equation 14.22 tells us that the current spot rate can be interpreted as a weighted average
between the current fundamentals and the future expected spot rate. Using rational
expectations, we can go even further. Using equation 14.22 we can also form expressions for
the future expected exchange rates. For example
1 β
Et st+1 = Et zt+1 + Et st+2 , (14.23)
1+β 1+β
159
and in general
1 β
Et st+n = Et zt+n + Et st+n+1 . (14.24)
1+β 1+β
Substituting the expectation of period t + 1 given in equation 14.23 into 14.22 gives
β β
!
1 1
st = zt + Et zt+1 + Et st+2 . (14.25)
1+β 1+β 1+β 1+β
Then we can form an expression for Et st+2 and substitute that into equation 14.25, and then
also form an expression for Et st+3 and substitute that into the equation, etc; if we keep doing
this, then we find that st can be expressed as:
∞ !j
1 X β
st = Et zt+ j . (14.26)
1 + β j=0 1 + β
This tells us that the current spot rate is equal to the weighted sum of future expected
fundamentals. This interpretation can be compared to the fact that a stock price can be seen as
the net present value of its future expected dividends. To interpret equation 14.26, realise that
higher values of zt are associated with relatively weaker domestic fundamentals; equation
14.20 tells us, for example, that all else equal if domestic output yt goes up (a strengthening of
fundamentals) then zt goes down. Thus equation 14.26 shows that if expectations of future
domestic output are revised upwards (that is, fundamentals are now predicted to be stronger
than before) this leads to an appreciation of the exchange rate now.
14.2.5 The real exchange rate

The monetary model described above relies on PPP to hold. However, as we have seen the
empirical evidence of PPP is scant. To create a more realistic model of nominal exchange
rates, it is important to consider changes in the real exchange rate, caused by, for instance,
changes in relative output demand or output supply. Recalling the definition of the (log) real
exchange rate of Chapter 12, the nominal exchange rate can be written as a function of the real
exchange rate plus the relative price levels:
st = qt + (pt − p∗t ). (14.27)
If equation 14.27 is substituted into the monetary model given in equation 14.15 the model for
the exchange rate becomes:
st = (mt − m∗t ) − α(yt − y∗t ) + β(rt − rt∗ ) + qt . (14.28)
This is an augmented version of the monetary model. This augmentation allows us to also
make predictions about changes in real output demand and supply changes. Consider the
following two examples:
1. An increase in the relative output demand for domestic goods. An increase in the
relative demand for domestic goods will lead to an appreciation of the real exchange rate
(that is, a fall in q). Equation 14.28 tells us that the real appreciation will be associated
with an equal long run appreciation of the nominal exchange rate, s.
160
2. An increase in the relative output supply. The effects of an increase in domestic output
are twofold. On the one hand, the increase in output will lead to an excess supply of
domestic goods, leading to a depreciation of the real exchange rate and an upwards
pressure on the nominal exchange rate. On the other hand, the increase in output, y, leads
to a higher demand for real money balances, which exerts a downwards pressure on the
nominal exchange rate. Thus the total effect on the nominal exchange rate is ambiguous.
The real exchange rate and interest rates
Allowing for deviations from PPP also changes the Fisher effect. Using equation 14.27 to
form expectations for the change in the exchange rate, we can obtain,
Et ∆st+1 = Et ∆qt+1 + (Et πt+1 − Et π∗t+1 ). (14.29)
Combining equation 14.29 with the UIP given in equation 14.6 gives us
rt − rt∗ = Et ∆qt+1 + (Et πt+1 − Et π∗t+1 ). (14.30)
The interest differential can thus be interpreted as the sum of two components: the expected
change in the exchange rate and the difference in expected inflation rates. Rewriting the terms
of equation 14.30 gives what is known as the real interest rate parity
(rt − Et πt+1 ) − (rt∗ − Et π∗t+1 ) = Et ∆qt+1 . (14.31)
Where (rt − Et πt+1 ) is the expected real interest rate. Equation 14.31 tells us that differences in
domestic and foreign expected real interest rates are associated with expected changes in the
real exchange rate.

In this chapter we have described the relation between domestic and foreign price levels and
the exchange rate.

describe the relationship between the nominal exchange rate and the price levels as set
out in purchasing power parity, explaining why the relationship should hold
describe the differences between the law of one price, absolute PPP and relative PPP
describe what empirical evidence exists for the various forms of purchasing power parity
and provide the main reasons why PPP may fail
describe the implications of PPP of non-tradable goods, as outlined in the
Balassa-Samuelson theory
describe how the flexible price monetary model works
discuss how monetary factors and changes in output supply and demand affect exchange
rates in the long run.
161

1. Balassa-Samuelson. Note that in the question PN and PT denote the prices of
non-tradables and tradables respectively and asterisks denote foreign variables.
(a) Give a brief summary of the Balassa-Samuelson model (you are expected to write
down the key equations of the model). Discuss the assumptions of the model.
(b) Use the Balassa-Samuelson model to show that developing countries are expected to
have lower wages and general price levels.
(c) Show that if the law of one price holds for traded goods and if P∗N /P∗T is
approximately constant, then variation in the real exchange rate can be mainly
explained by variations in the ratio PN /PT .
(d) If the foreign country is a developed country, how reasonable is the assumption that
P∗N /P∗T is approximately constant?
2. Briefly describe the monetary approach to exchange rate determination. Explain what
happens when there is an exogenous decrease in real income under a floating and a fixed
exchange rate regime. Could monetary policy be used to restore the initial equilibrium in
the price level? If so, how?

1. Approaching the question
(a) The presence of non-traded goods suggests that international variations in the prices
of non-tradeable goods could be a source of international differences in price levels
between a rich and a poor country. We will assume that there are two countries and
they produce two goods: a tradeable (T ) and non-tradeable (N). The key
assumptions are that:
labour is the only factor of production and is perfectly mobile within countries
but completely immobile between countries;
countries are equally productive in the N sector, but Foreign (*), the rich
country, is more productive in the T sector:
YN = AN LN , and YN∗ = A∗N L∗N
YT = AT LT , and YT∗ = A∗T LT∗ ,
where AN = A∗N but AT < A∗T .
the law of one price holds for tradeable. (Note that we have not specified
anything in terms of the demand side of the model.)
We assume that the domestic price level P is given by:
P = αPN + (1 − α)PT .
And that the foreign price level is given by:
P = γP∗N + (1 − γ)P∗T .
162
The real exchange rate is defined as:
Q ≡ S P∗ /P.
If LoOP holds for traded goods, but not necessarily for non-traded goods, we can
write the real exchange rate as
P∗
γ PN∗ + (1 − γ)
Q= T
.
α PPNT + (1 − α)
(b) Note that profit maximisation by firms in all sectors implies that prices are equal to
marginal costs:
Wi /Ai = Pi .
Labour mobility within countries ensures wage equalisation between sectors in each
country:
WN = WT and WN∗ = WT∗ .
This implies that
PN /PT = AT /AN and P∗N /P∗T = A∗T /A∗N .
By assumption we have AN < A∗N and AT = A∗T , so that
PN /PT < P∗N /P∗T = (S P∗N )/(S P∗T ),
and if the law of one price holds for traded goods (that is, PT = S P∗T ) it follows
PN < S P∗N .
The price level of the non-tradeable is higher in the rich country and PPP does not
hold. Low wages in poor countries (due to low productivity in the tradeable sectors)
result in relatively low prices in non-tradeable sectors, as productivity in these
sectors is approximately the same as in rich countries. It is plausible to assume that
international productivity differences are sharper in traded than in non-tradeable
goods.
(c) From inspection it follows that if P∗N /P∗T is approximately constant then variations in
the real exchange rate can be explained in terms of variations in the ratio PN /PT .
(d) If the foreign country is a developed country, it is likely to experience slower
technological change than some developing countries. If this is the case then the
relative price between its tradeable and non-tradeable goods will be fairly stable
compared to the developing country.
2. The monetary approach to exchange rate determination models the exchange rate through
the relative real money demand in the two countries. Money demand in the two countries
is given by
mt − pt = αyt − βrt and m∗t − p∗t = αy∗t − βrt∗ .
If it is assumed that prices are flexible and PPP holds, then combining the two equations
leads to an expression of the exchange rate as a function of relative money supplies,
relative output and the interest differential.
st = (mt − m∗t ) − α(yt − y∗t ) + β(rt − rt∗ )
163
Under a floating exchange rate regime we have that a decrease in real income implies a
lower demand for money, other things being equal. If interest rates are assumed, domestic
prices should be higher. On the external side, this increase in the price level is matched by
a depreciation of the nominal exchange rate needed in order for PPP to hold. Under a
floating exchange rate regime, the monetary authority can, if it wants, restore the initial
price level by decreasing money supply (for details, see below).
Consider a decrease in real income level in the fixed case. For given domestic prices, the
demand of real money balances is lower; in order to restore equilibrium there is an
upwards pressure on prices and the exchange rate. In order to defend the peg, the central
bank will have to sell foreign reserves up to the point where overall money supply has
decreased enough to match the new lower demand. That is, under the fixed exchange rate,
the central bank has no choice but to reduce money supplies in order to maintain the peg.
(Note: You should include graphs to support your answer to this question).

Activity 14.2
To see this, first derive the Fisher effect using equations 14.5 and 14.6. After the Fisher effect
has been derived it can be rewritten to show that
(rt − Et πt+1 ) = (rt∗ − Et π∗t+1 ).
This shows that real interests are equal in both countries.
Activity 14.3
We can use relative PPP to calculate the exchange rate target, Et ∆st+1 = Et πt+1 − Et π∗t+1 . Here:
0.025 0.015 = 0.01. The target should be set at a depreciation of 1 per cent per annum.
The implementation of this policy will lead to an immediate appreciation of the home
currency. To see this, use the Fisher effect of equation 14.7 to realise that if domestic expected
inflation will go down by 1.5 percentage points, the interest differential will go down by 1.5
percentage points as well. Equation 14.18 shows that the reduction in domestic interest rates
will cause a one time immediate appreciation of the home currency.
The answer lies in the way that expectations were handled. In Chapter 13 of the subject guide,
the expected future exchange rate was assumed constant. In this chapter, expectations are
dynamic: the immediate deprecation is caused by a shift in the expected future exchange rate,
caused by the shift in monetary policy.
164
Chapter 15
Output and the exchange rate
15.1 Introduction
In the previous chapter we saw how monetary policy could have temporary real effects on an
economy through the real exchange rate. If the price levels at home and abroad are sticky, then
changes in the nominal exchange rate will imply changes in the real exchange rate and this
will lead to variations in national income from changes in exports and imports. In this chapter
we will analyse in more detail how national income is affected by monetary and fiscal policy
in an open economy but in order to do so we need to introduce a new modelling paradigm, the
AA–DD model. This will be the emphasis in the first part of this chapter. In the second part
we will look at the Mundell-Fleming model which has for a long time been the standard
approach to open economy macroeconomics. The focus of the Mundell-Fleming on fixed
prices, expectations and exchange rates makes it less relevant in today’s world. However, as it
has long played a central role in open macroeconomics it is important to understand how it
works and how it is different from the AA–DD model.
This chapter aims to discuss the AA–DD and Mundell-Fleming models and the relationship
between them.
should be able to:
derive the AA and DD schedules, explaining what they represent and what factors can
cause them to shift
explain how changes in monetary and fiscal policy affect the schedules in the AA–DD
model, and hence analyse the effects of such policies on output and exchange rates
discriminate between what happens in the short run and in the long run, noting how the
long-run equilibrium is achieved after a permanent change in policy
explain how competitive devaluations work and why no country benefits in this situation
outline the relationship between the MundellFleming and AA–DD models.
165
15. Output and the exchange rate

The main model introduced,the AA–DD model, is covered in KOM. The Mundell-Fleming
model is covered in Copeland.
KOM, Chapter 17 ‘Output and the Exchange Rate in the Short Run’.
C, Chapter 6 ‘Fixed Prices: the Mundell-Fleming model’.

KOM, Online appendix A to Chapter 17 of the 10th edition (2014), ‘The IS-LM Model
and the DD-AA Model’: https://pub.maruzen.co.jp/space/International_
economics/appendix/pdf/Krugman10_appendix17A.pdf
FT, Chapter 17 ‘Balance of Payments I: The Gains from Financial Globalization’ and
Chapter 18 ‘Balance of Payments II: Output, Exchange Rates, and Macroeconomic
Policies in the Short Run’.

C, Chapter 10 ‘General Equilibrium Models’.
De Grauwe, p.International Money: Post-War Trends and Theories. (Oxford: Oxford

University Press, 1996) second edition [ISBN 9780198775133].

Mankiw, N., Macroeconomics. (London: Palgrave Macmillan, 2007) [ISBN
9780230225084].

This chapter looks at the relationship between output and exchange rates.
15.2.1 The AA–DD paradigm

The standard macro model that has been used to consider the real side of the economy has
been that of IS-LM. Here, we introduce a similar model but instead of looking at goods’
market clearing and money market clearing in output and interest rate space, we consider the
combinations of output and the nominal exchange rate that clear the goods and asset markets
(in particular the money and foreign exchange markets). In the subsection below we will see
how these market-clearing conditions are derived for a small open economy.
166
DD, goods market clearing
In Chapter 12 of the subject guide we saw that aggregate demand in an economy could be split
into consumption, investment, government spending and net exports (that is, the current
account). Here, we will assume that investment and government spending are autonomous;
that consumption depends positively on disposable income (national income minus taxes); and
that the current account depends negatively on national income and positively on the real
exchange rate.
The current account is assumed to be a negative function of income because an increase in
income will lead to an increase in the demand for all goods, both domestic and foreign. The
extra demand for imported goods will lead to a worsening of the current account.
The relation between the current account and the real exchange is less straightforward as it has
several opposing effects on the exchange rate. Consider the case of a real depreciation. First,
the real depreciation will make domestic goods cheaper relative to foreign goods, causing the
demand for exports to increase: an improvement in the current account. Second, the volume of
imports will decrease, as demand shifts away from relatively expensive foreign goods to
domestic goods: again an improvement in the current account. Third, the domestic currency
price of imports increases as imports have become relatively more expensive; for a given
amount of imports this implies a worsening of the current account.
Whether the current account as a whole improves or worsens after a real depreciation depends
whether the volume effects or the value effect dominates, which in turn depends on the
elasticity of imports and exports. The conditions under which the volume effects dominate the
value effect are called the Marshall-Lerner conditions and are described in detail in
Appendix 2 to KOM Chapter 17. For now, we will assume that the conditions are met and that
a real depreciation will lead to a net improvement of the current account (later on in this
chapter, we will discuss so-called J-curve effects which appear when the Marshall-Lerner
conditions are not met in the short run).
The assumptions made above mean that an increase in output has two countervailing effects
on aggregate demand: it will have a positive effect on demand through an increase in domestic
spending (that is, increased consumption), but a negative effect on demand through the
increase in net imports (that is, a decrease in the current account balance). In this analysis we
will assume that the positive effect will be bigger than the negative effect, making the total
effect of disposable income on aggregate demand positive, but less than one-for-one. Thus
aggregate demand, D, will depend positively on four factors: the real exchange rate, Q,
disposable income, (Y − T ), investments, I, and government spending, G.
D = D(Q, (Y − T ), I, G) (15.1)
In equilibrium, aggregate demand should equal real output, Y. In the short run prices are
assumed fixed. Then, for given levels variables other than demand and output, KOM Figure
17-2 ‘The Determination of Output in the Short Run’ shows how output is determined in the
short run to clear the goods market. This figure can also be used to analyse the short run effect
of the real exchange rate on output. Note that if we assume prices fixed, any changes in the
nominal exchange rate will feed one-for-one into the real exchange rate. So depreciation of the
nominal exchange rate will cause a real depreciation of the domestic currency which will shift
demand upwards, increasing the short run equilibrium output. Figure 15.1 shows how the DD
schedule is upwards sloping: for demand to be in equilibrium, an increase in domestic output
167
Figure 15.1: Equilibrium in the goods market
is accompanied by an increase in the nominal exchange rate. The DD schedule is shifted to the
right by a number of factors:
1. An increase in government spending, G.
2. A decrease in taxes, T .
3. An increase in investments, I.
4. An increase in foreign prices, P∗ .
5. A decrease in domestic prices, P.

Furthermore, the following two factors also impact the DD schedule.
6. Changes in the consumption function.
7. Relative demand for domestic goods.

To understand the effects of these two factors, imagine first an increase in the domestic
propensity to consume. If part of the increased consumption is spent on domestic output,
aggregate demand will increase, shifting the DD schedule to the right. Second, an increase in
the relative demand for domestic goods increases net exports as domestic consumers consume
less foreign products and foreign consumers increase their consumption of goods produced by
Home. This shifts the DD schedule to the right.
AA, asset market clearing
Just as the DD schedule gives the combinations of the nominal exchange rate and output that
clear the goods market, the AA schedule gives the combinations of these variables that clear
the international asset markets. Remember from Chapter 14 of the subject guide that the
domestic demand for real money balances is increasing in output and decreasing in interest
rates.
(mt − pt ) = αyt − βrt (15.2)
168
A' UIP schedule

S1
r = r* + ∆S
Exchange rate
B'
S2
Domestic
interest rate
O r
r1 r2 Md(r, y1)
money holdings
Real domestic
Md(r, y2)
A B
m–p
Figure 15.2: Asset market equilibrium under floating exchange rates
If we substitute the UIP condition discussed in Chapter 13 of the subject guide into equation
15.2 we obtain
(mt − pt ) = αyt − β(rt∗ + Est+1 − st ) (15.3)
Equation 15.3 tells us that if money supplies and prices are fixed in the short run, then an
increase in output should be accompanied by an increase in interest rates to maintain the
equilibrium in the money market. If we assume the foreign interest rate and the future expected
exchange rate to be fixed, then equation 15.3 tells us that the increase in output (and increase
in the domestic interest rate) is accompanied with an appreciation of the nominal exchange
rate. Thus the AA schedule is downwards sloping: for asset markets to be in equilibrium, an
increase in domestic output is accompanied by a decrease in the nominal exchange rate. This
is shown in Figure 15.2. The AA schedule is shifted upwards by a number of factors.
1. An increase in domestic money supplies, M.
2. A decrease in domestic prices, P.
3. An increase in the expected future exchange rate, E(S ).
4. An increase in the foreign interest rate, R∗ .

Furthermore, the following factor also affects the AA schedule.
5. A change in the real money demand.

To see the effects of a change in the real money demand, imagine that domestic residents
change their preferences and now want to hold lower real money balances at a given level of
output or a given interest rate; in terms of equation 15.2: a lower α or a higher β. This change
in preferences implies a lower equilibrium interest rate for a given level of output and thus an
upwards shift of the AA schedule.
169
15.2.2 Short and long-run equilibria for an open economy
The above section outlines how the AA schedule is downwards sloping and the DD schedule
is upwards sloping. By combining the AA and DD schedule together, we can find the
short-run equilibrium levels of the exchange rate and output. KOM Figure 17-9 ‘How the
Economy Reaches Its Short-Run Equilibrium’ shows a graphical example of how an
equilibrium is reached in the AA–DD framework.
Now that we have established how we can use the AA–DD framework to find the equilibrium
exchange rate and output, let us turn to the question of how the exchange rate and output are
affected by temporary and permanent changes in monetary policy, a change in the supply of
money and fiscal policy, a change in either government spending or taxes. As we are interested
in domestic policies we will, unless otherwise specified, assume that foreign variables, such as
foreign output, prices and interest rates, are constant. We also assume that prices are fixed in
the short-run.
Temporary changes in monetary and fiscal policy
A temporary change in policy is defined as a change that is expected to be reversed in the near
future. As such, it is a change in policy that does not have an effect on the future expected
exchange rate, Est+1 . As the policy changes are temporary, the effects are limited to the
short-run. In the long run the exchange rate and output will revert back to their old
equilibrium.
Let us first consider the effects of monetary policy. A temporary expansionary monetary
policy affects output and the exchange rate through a shift in the AA schedule. As we have
discussed above, the increase in money supplies leads to an upwards shift of the AA schedule,
thus temporarily increasing output and a depreciation of the exchange rate.
In contrast, a temporary expansionary fiscal policy affects the DD schedule. Both increased
government spending and decreased taxes will shift the DD schedule to the right. This implies
a temporarily increased output and an appreciation of the exchange rate. Note that both
expansionary monetary and fiscal policy have a positive effect on output, but differ in their
effect on the exchange rate: expansionary monetary policy exerts upwards pressure on the
exchange rate, while expansionary fiscal policy exerts downwards pressure on the exchange
rate.
Activity 15.1 Consider the following two situations.
1. A temporary decrease in the domestic propensity to consume.
2. A temporary increase in the foreign interest rate.

Use the AA-DD framework to evaluate the effect on output and the exchange rate of both
these situations. If the government is committed to maintaining both full employment and
stable exchange rates, which temporary policies would you recommend in both situations?
170
Figure 15.3: Short and long-run effects of a permanent increase in the money supply
Permanent changes in monetary and fiscal policy
A permanent change in policy is defined as a change that is not expected to be reversed. Unlike
temporary changes, permanent changes do have an impact on the future expected exchange
rate. As these expectations have an important role in exchange rate determination, the effects
of permanent changes are quite different from those of temporary changes. To simplify
matters, we assume that initially the economy is in equilibrium and the exchange rate constant.
The latter, in combination with UIP, implies that domestic and foreign interest rates are equal.
Let us start with analysing the effects of a permanent increase in the money supply. We have
seen before that a temporary increase in the money supply shifts the AA schedule upwards in
the short-run. It turns out that the AA schedule shifts even further out in the case of a
permanent change in the supply of money. This happens because in addition to the increase in
the supply of money, the future exchange rate is expected to depreciate. This expected
depreciation can be framed in terms of the monetary model, explained in Chapter 14 of the
subject guide and comes as a result of PPP and the expected increase in domestic price levels
as a result of the permanent monetary expansion. Thus, in the short-run, both the increase in
output and the depreciation of the exchange rate are larger for a permanent than for a
temporary increase in the supply of money.
In the long-run, prices will rise to reflect the increase in the supply of money. This will cause
both the AA schedule to move downwards – as the real quantity of money returns to its
original level – and the DD schedule to move to the left – as domestic goods become less
competitive due to the increase in prices – until output has fallen back to its equilibrium level.
The exchange rate will also decrease again, but will still end up above the original value. A
graphical representation of the short and long-run effects of a permanent increase in the supply
of money is given in Figure 15.3.
Now consider the effects of a permanent increase in government spending. From previous
discussions, we know that the increase in government spending will shift the DD schedule
rightwards. If this were to be the only effect (as it would if the increase in government
spending were temporary), the economy would face a small temporary increase in output
171
DD1
DD2
S1 A
B'
2
S B
AA1
AA2
Figure 15.4: Effects of a permanent increase in government spending
together with a temporary appreciation of the domestic currency.

However, if the fiscal expansion is permanent, exchange rate expectations change to
incorporate the expected long-run appreciation of the currency, leading to a downwards shift in
the AA schedule. As it turns out this downwards shift in the AA curve completely offsets the
gains in output caused by the shift in the DD schedule. Thus the fiscal expansion leads only to
an appreciation of the exchange rate, but not to any increase in output. Figure 15.4 shows this
graphically, with the equilibrium shifting from point A to point B. Compare this with the
effects of a temporary expansion of fiscal policy which is denoted by point C in the graph.
This result is a striking one: in an open economy, permanent fiscal policy is ineffective, as the
increased demand for domestic goods due to the fiscal expansion is exactly crowded out by
lower net export demand for domestic goods as their relative prices rise due to the
appreciation.
Activity 15.2 Consider a permanent increase in the supply of money. Compare the
predictions of the AA-DD model and the Dornbusch overshooting model.
15.2.3 Further issues in the AA–DD framework
Problems with policy formulation
In the section above, it may have looked as if it is straightforward to maintain output at the full
employment level with the use of fiscal and monetary policy. However, this is rather
misleading. As any policymaker will tell you, it is far from easy to keep the macroeconomy on
the straight and narrow. First there is the danger that policies will be used not only to bring
back output to its natural level, but to try and push output above its natural level; for instance,
before elections.
172
If workers and firms anticipate expansionary policies in advance, they will adapt their
expectations accordingly. They will increase their wage demands and prices of goods in the
expectation of the policy change. This in turn will lead to price inflation, before the policy is
even implemented. In this case, the government will have to resort to expansionary policies,
merely to reduce the negative effects on output by the inflation caused by the expectation of an
expansionary policy. This may lead to an inflation bias: a situation in which there is high
inflation, but no increase in output. Second, although in the model it is clear whether a shock
originated in the goods market or the asset market, in reality it is often complicated to discern
the exact source of economic shocks. Third, changes in fiscal policy tend to be implemented
much slower than changes in monetary policy. As such, governments may be encouraged to
use monetary policy even if, theoretically, fiscal policy may have been more effective. Fourth,
fiscal imbalances need to be corrected at some point, limiting the flexibility of fiscal policy.
Fifth, policy makers have to rely on information that is both imperfect and often delivered with
some delay. All these imperfections and uncertainties make it very difficult to find the optimal
policy response and can cause even the best thought out policies to be quite far from the mark.
Macroeconomic policies and the current account
So far we have only considered the effects of policy on the nominal exchange rate and output.
However, policy makers are often also concerned about the level of the current account: an
excessively large current account deficit (or surplus) can have undesirable effects on national
welfare. The AA–DD model predicts that, all else equal, a real depreciation of the currency
leads to an improvement of the current account. Thus a monetary expansion causes the current
account balance to increase in the short run, while expansionary fiscal policy causes the
current account balance to decrease in the short run. KOM Figure 17-17 ‘How
Macroeconomic Policies Affect the Current Account’ shows graphically how changes in
monetary and fiscal policy affect the current account.
The adjustment in the current account may not happen instantaneously. Indeed, it could
happen that the current account actually worsens immediately after a real currency
depreciation if the Marshall-Lerner conditions are not met, and will only start to improve after
several months. This effect is sometimes called the J-curve. Empirical evidence suggests that
J-curve effects occur in many countries and last somewhere between half a year and a year.
Take the example of a monetary expansion: the monetary expansion causes a depreciation; if
there are J-curve effects this depreciation causes an initial worsening of the current account
and a temporary reduction in it before the expansion in output materialises. Note that the
temporary reduction in output puts pressure on the currency to depreciate further to clear the
domestic money market. The temporary extra depreciation of the currency associated with the
J-curve effects will exacerbate the phenomenon of exchange rate overshooting, which was
discussed in Chapter 13 of the subject guide.
Liquidity traps
During the discussion of the AA schedule, we have maintained that an increase in the supply
of money feeds into the exchange rate through the reduction in the domestic interest rate.
However, interest rates are bounded from below at 0. Once a country hits the lower bounds of
the domestic interest rate, it may find itself in what economists call a liquidity trap.If we take
173
UIP and set the domestic interest rate to 0,
rt = 0 = (Et st+1 − st ) + rt∗ , (15.4)
then the equilibrium exchange rate can be written as
st = Et st+1 + rt∗ . (15.5)
That is, if exchange rate expectations are fixed the exchange rate can no longer be depreciated
further by increasing the supply of money as the domestic interest rate can no longer fall
further in response. The AA schedule can be adjusted to take the interest zero lower-bound
into account, as is done in KOM Figure 17-19 ‘A Low-Output Liquidity Trap’. In this case,
any effect of monetary policy on the exchange rate will have to come through its effect on the
exchange rate expectation: recall that a credible permanent expansion of monetary policy
affects both current interest rates and expectations of the future exchange rate. Thus, if a
monetary authority can credibly commit to a permanent monetary expansion, they may be
able to depreciate the currency, and increase output. However, markets may not believe the
policies to be permanent and may expect the monetary authorities to reverse their policies in
the face of large depreciations and/or high inflation; this could potentially reduce the effect of
monetary policy on expectations and thus limit the effectiveness of monetary policy.
The events in Japan in the 1990s and recent events in the USA and Europe have shown that it
is not unthinkable to reach this lower bound. The liquidity trap described above – and the
associated reduced effectiveness of conventional monetary policy – explains why, in the
aftermath of the credit crisis, the Federal Reserve System and other central banks have
resorted to unconventional monetary policies after hitting the zero lower bound.
15.2.4 Competitive devaluations

We have seen that a monetary expansion has a positive effect on domestic output in the
short-run and no long-run effects on domestic output. However, we have ignored so far the
effects of the monetary expansion on foreign output. Assume for simplicity a two world
country. The depreciation in the domestic currency caused by the monetary expansion must
necessarily imply an appreciation in the foreign currency. As we will see, this leads to a
temporary decrease in the output of the foreign country. As the expansion in monetary policy
makes the domestic economy better off at the expense of that of the foreign economy, the
policy is sometimes referred to as a ‘beggar thy neighbour’ policy.
Consider an example where the UK permanently increases its money supply. This causes the
UK’s AA schedule to shift out and leads to the effects given in Figure 15.3. But what happens
in the foreign country, which we assume to be the Eurozone? This is shown in Figure 15.5.
Make sure to pay particular attention to the definition of the exchange rate. In the top right
panel the UK is the domestic country, so there the exchange rate is defined in pounds per euro,
C . In the bottom right panel the Eurozone is the domestic country, so there the exchange
S £/A
rate is defined in euro per pound, S A C/£ . An increase in S £/A
C of course implies, by deduction, a
decrease in S A C/£ . The increase in the UK money supply lowers UK interest rates but since UK
interest rates are the ‘foreign’ rates from the perspective of the Eurozone, this causes the
Eurozone AA schedule to shift downwards. The equilibrium in both countries moves from
∗
point A to point B with the pound depreciated. Note that UK output has increased from YUK to
0 ∗ 0
YUK while output in the Eurozone has decreased from YEU to YEU . Expansionary UK policy
174
Figure 15.5: Competitive devaluations: UK expansionary monetary policy
175
has increased UK output but at the cost of lower output for the Eurozone. In the long-run, UK
prices rise to match the increase in the money supply, shifting both the AA and DD schedule
to the left to AAUK,3 and DDUK,2 , respectively. The rise in UK prices makes Eurozone goods
more competitive causing the DD schedule to shift right for the Eurozone to DDEU,2 .
Furthermore, the drop in UK interest rates causes the Eurozone’s AA schedule to shift right to
AAEU,3 . Thus, in the long-run, output is restored to the full employment levels for both the UK
and the Eurozone and the real exchange rate has remained unchanged. The increase in UK
money supply has translated in a one-for-one increase in UK prices and a permanent
depreciation of the UK pound.
When the ECB observes the UK central bank increasing the money supply, it could easily
counteract by increasing its own money supply, so as to increase its own output at the cost of
UK output. This can lead to a series of competitive devaluations with no long-run effects for
either the UK or the Eurozone output but with an increase in output and exchange rate
volatility as output shifts from one country to another. This is one reason why one may prefer
fixed exchange rates. Not only does such a fixed exchange rate regime encourage trade by
reducing exchange rate uncertainty, it also prevents the monetary authorities from using
monetary policy to devalue the exchange rate in an attempt to create temporary increases in
output. The topic of fixed exchange rates is the focus of the next chapter.
15.2.5 The Mundell-Fleming model

It is instructive to compare the AA–DD model to another model that has been very influential
in the exchange rate literature, the Mundell-Fleming (M-F) model. The M-F model was
developed in the period that Bretton Woods (which is described in more detail in Chapter 18
of the subject guide) was still in place and most exchange rates were fixed. Not surprisingly
most of the M-F model was centred on its conclusions about fixed exchange rates. The M-F
model is not well covered in KOM, but C Chapter 6 offers an extensive treatment of the M-F
model. The M-F model can be regarded as an extension of the standard ISLM capital macro
model to an open economy by the addition of a third equation representing the external sector
or balance of payments, the BP curve. Therefore the M-F model is also referred to as the
IS-LM-BP model. For more information on the IS-LM model, see any good macroeconomics
textbook, such as for instance Mankiw (2007).
There are three main differences between the AA–DD model described above and the M-F
model. First, the M-F model assumes static exchange rate expectations; that is, Est+1 = st .
Second, M-F assumes prices are fixed, while the AA–DD allows for flexible prices in the
long-run. Third, while the AA-DD model assumes real interest rates do not affect aggregate
demand, M-F follows the IS-LM framework and assumes that aggregate demand is inversely
related to real interest rates, making aggregate demand a function of the following variables
D = D(Q, (Y − T ), I(r), G) (15.6)
The first two differences entail restrictions on the M-F model that make it less suitable to deal
with floating exchange rates. We have seen in the AA–DD model that expectations play an
important role in the determination of floating exchange rates. Also, over longer horizons the
assumption of fixed prices is not a very reasonable one. With regards to the third difference,
the sensitivity of aggregate demand to real interest rates, the AA–DD model can be adapted to
incorporate this assumption (see the online appendix of KOM Chapter 17).
176
S
LM1 LM2
Nominal exchange rate
S1 A
S2 B
IS1
Y1 Y2 Y
Output
Figure 15.6: A monetary expansion under floating exchange rates and perfect capital mobility
The M-F model consists of a set of three equations but four unknowns (y, r, s, b): output, the
interest rate, the exchange rate, and the official settlement balance. To solve the system, one of
those variables needs to be fixed. In the case of floating exchange it is most common to fix the
official settlement balance, b, to 0, such that the current account must equal the financial
account. In the case of fixed exchange rates it is natural to fix the exchange rate s to some
exogenous level s.
M-F and floating exchange rates
Like the AA–DD model, the M-F model can be used to evaluate effectiveness of monetary and
fiscal policy. Under a floating exchange rate, M-F predicts that an increase in the money
supply causes a depreciation of the nominal exchange rate and an increase in output. However
as M-F assumes fixed prices, it cannot distinguish between long and short run effects and it
also does not produce an overshooting effect of the exchange rate. The fact that expectations
are assumed static means that the exchange rate is predicted to move less under the M-F
model than the AA–DD model. For a fiscal expansion under a floating exchange rate the M-F
model predicts an appreciation of the nominal exchange rate, but no effect on output. For
graphical representations of these effects see Figures 15.6 and 15.7.
M-F and imperfect capital mobility
So far in this Chapter, or indeed in the entire Part 2 of the subject guide until now, we have
assumed perfect capital mobility, such that UIP can be expected to hold. However, although
this assumption is reasonable for most large developed countries at the moment, this is not
such a natural assumption for smaller developing countries; indeed, it was not a natural
assumption to make for large parts of the last century, as Chapter 18 of the subject guide will
177
S
LM1
S2 B
S1 A
IS2
IS1
Y
Output
Figure 15.7: A Fiscal expansion under floating exchange rates and perfect capital mobility
highlight. M-F is well suited to deal with the case of imperfect capital mobility, a discussion
of which is provided in Chapter 6 of Copeland. Activity 15.3 asks you to analyse fiscal and
monetary policy in a framework of imperfect capital mobility.
Activity 15.3 Think about how the impact of monetary and fiscal policy change when
there is an imperfect degree of capital mobility. Using Copeland Chapter 6, illustrate how
monetary and fiscal policy affect output under a floating exchange rate and imperfect
capital mobility. How do your results change from Figures 15.6 and 15.7?

In this chapter, we have discussed the AA–DD model and Mundell-Fleming models, as well
as the differences and relationships between them.

derive the AA and DD schedules, explaining what they represent and what factors can
cause them to shift
explain how changes in monetary and fiscal policy affect the schedules in the AA–DD
model, and hence analyse the effects of such policies on output and exchange rates
discriminate between what happens in the short run and in the long run, noting how the
long-run equilibrium is achieved after a permanent change in policy
178
explain how competitive devaluations work and why no country benefits in this situation
outline the relationship between the Mundell-Fleming and AA–DD models.

1. Assume prices are sticky. Suppose Australia and New Zealand both produce only shoes,
and Indonesia produces only chemicals. Are changes in the Australian money supply
likely to have a larger impact on the demand for Zealand goods or on the demand for
Indonesian goods? Explain why.
2. Compare and contrast the Mundell-Fleming and AA–DD models.

1. If Australia increases its money supply, the Australian dollar will depreciate against both
the New Zealand dollar and the Indonesian Rupiah. If Australia and New Zealand
produce only shoes, then this will cause Australian shoes to become cheaper than New
Zealand shoes in the Indonesian market. The demand for shoes from New Zealand will
collapse as Indonesians buy only Australian shoes. The depreciation of the Australian
dollar will cause Indonesian chemicals to become more expensive in Australia but since
Indonesia is the sole producer of chemicals, demand for its goods are not as likely to be
affected. The Australian depreciation is then more likely to affect the demand for New
Zealand goods than Indonesian goods.
2. See the notes on Mundell-Fleming for a comparison between the two models.

Activity 15.3
1. A temporary increase in the propensity to consume will cause the DD curve to shift to the
right, causing a temporary appreciation of the currency and an increase in output above
full-employment levels. The graphical representation of this is equivalent to that of a
temporary fiscal expansion. This also strongly hints at the optimal policy: a temporary
contraction in fiscal policy will restore the initial equilibrium.
2. A temporary increase in the foreign exchange rate will shift the AA curve to the left as
domestic deposits become less attractive. This leads to a temporary depreciation and a
decline of output below full-employment levels. The graphical representation of this is
equivalent to that of a temporary contraction in money supplies. This suggests that the
optimal policy response is a temporary expansion of the domestic money supply to shift
the AA curve back rightwards and restore the initial equilibrium.
179
180
Chapter 16
Fixed exchange rates
16.1 Introduction
Currently, most large industrialised countries allow their currencies to float freely in the
foreign exchange market. However, as we will see in Chapter 18 these currencies have been
pegged to each other for a large part of the last 100 years. Also, there are still many
developing countries that choose to peg their currency. Even when not formally fixing the
exchange rate, countries often attempt to intervene in the foreign exchange market to smooth
out unwelcome exchange rate movements, sometimes referred to as the ‘fear of floating’ (see
Calvo and Reinhart, 2002).
When a currency is pegged to another, this is done by a commitment on the part of the
monetary authority to buy and sell the currency at the pegged rate. Such interventions have
implications for the money supply. Sometimes, the monetary implications are not regarded as
welcome by the monetary authorities and they attempt to sterilise the intervention. For
example, before the creation of the euro, the German Bundesbank (central bank) operated a
system of monetary targets and foreign exchange market intervention would always be
sterilised if it was inconsistent with the bank’s monetary target. An important question is
whether sterilised intervention can be effective.

This chapter aims to discuss fixed exchange rates, including the development of currency
crises.

should be able to:
describe how exchange rates are fixed

explain what is meant by sterilisation and discuss its effectiveness
discuss the effects of stabilisation policies under a fixed exchange rate, using the AA–DD
framework and the M-F framework.

The main theories of fixed exchange rates are covered in Chapter 18 of KOM. Chapter 6 of C,
which was also Essential reading for Chapter 15 of the subject guide, covers the predictions of
181
16. Fixed exchange rates
the Mundell-Fleming model under fixed exchange rates.
KOM, Chapter 18 ‘Fixed Exchange Rates and Foreign Exchange Intervention’.


FT, Chapter 19 ‘Fixed Versus Floating: International Monetary Experience’.
Calvo, G. and C. Reinhart ‘Fear of Floating’, The Quarterly Journal of Economics 117(2)
2002, pp.379–408.
Frankel, J., ‘No Single Currency Regime is Right for All Countries at All Times’,
Princeton Essays in International Finance 215 August 1999.


This chapter looks at fixed exchange rate regimes.
16.2.1 Different exchange rate regimes

When we talk about fixed exchange rates, it may seem as if there is a binary choice between
having either a freely floating exchange rate or a fully fixed peg. In reality there is a wide
variety of different intermediate regimes. For instance, many countries do not peg their
currency, but still intervene regularly in the foreign exchange market to try and maintain a
degree of exchange rate stability, something referred to as a managed, or ‘dirty’, float. On top
of a simple peg, the following are alternate ways of pegging an exchange rate.
Crawling peg
Sometimes a country wishes to stipulate a stable path of the exchange rate, rather than a fixed
value. This is commonly referred to as a crawling peg. A country can for example announce
that it will let its currency depreciate 10 per cent per annum against the dollar. This type of
exchange rate regime has been adopted in the past by several Latin American countries. By
2012 only three countries declared they were operating a crawling peg: Bolivia, Nicaragua and
Botswana.
182
Pegging in a band
It is possible to declare a peg, but allow limited exchange rate flexibility in a band around that
peg, say 2.5 per cent above and below the declared peg. The central bank then will mainly
intervene in the foreign exchange market if the exchange rate hits either the top or the bottom
of the bands. In preparation for the euro (see Chapter 19 of the subject guide), many European
countries fixed their currencies in a band against the ECU/euro.
Pegging against a basket of currencies
In some countries the currency is pegged against a basket of currencies, rather than a single
currency. Intervention to support the peg might at first sight seem complicated. However, in
order to support the rate it is only necessary to intervene in one of the markets. This may be
shown as follows. Suppose the peg is given by:
J
X
s= α j s j, (16.1)
j=1
where the s j are the exchange rates of the basket currencies and the α j are the weights.
Suppose the intervention currency has the index 1 then, for j , 1,
X sj !
s = s1 αj , (16.2)
s1
where the s j /s1 are the cross-rates against the intervention currency and note that s1 /s1 = 1.
Rearranging equation 16.2 yields
s
s1 = P s j , (16.3)
α j s1
which gives the target exchange rate for the intervention currency in terms of the desired peg
and the cross-rates with the intervention currency. An alternative to pegging to a basket is to
peg the currency to a composite currency, such as the special drawing rights (SDR)
maintained by the IMF. Also, a country need not always reveal the exact weights and
currencies in the basket. China, for instance, has pegged its currency against an undisclosed,
potentially changing, basket of currencies.
Activity 16.1 Assume Hong Kong has pegged its currency against a basket including
two currencies: the US dollar, with weight α, and the euro, with weight (1 − α). Explain
how intervention in the US dollar market will clear the market for the euro.
Currency boards
A currency board is a fixed exchange rate regime, where the monetary authorities provide full
convertibility of the domestic currency into the reserve currency, and hold sufficient reserves
to make good on this commitment. Hong Kong currently maintains a currency board; other
famous examples of currency boards include Argentina’s currency board (1991–2001) and the
currency boards maintained by eastern European countries such as Lithuania, Estonia and
Bulgaria after the collapse of the Soviet Union.
183
16.2.2 Intervention, the money supply and sterilisation

How exchange rates are fixed
In a market economy it is not possible to decree a fixed exchange rate by law. The desire or
intention to fix or peg the exchange rate needs to be supported by a commitment to buy and
sell domestic currency at the chosen rate. This means that whenever an excess supply of
domestic currency – and an excess demand for foreign currency – appears at the fixed rate, the
monetary authority (usually the central bank) must step in and sell foreign currency, while an
excess supply of foreign currency means it must step in and buy foreign exchange. Such
transactions are called foreign exchange market interventions.
When looking at central bank interventions, it is important to understand the structure of the
central bank balance sheet. Like other balance sheets, it is defined in terms of double entry
book-keeping. On the liability side of a central bank balance sheet we normally find,
predominantly, deposits held by private banks (also referred to as bank reserves) and the
amount of cash in circulation. On the asset side we normally find, predominantly, foreign
reserves and domestic credit. Foreign reserves are mostly composed of foreign bonds and
foreign currency deposits, often in major so-called reserve currencies such as the US dollar,
euro, British pound and Japanese yen; however, foreign reserves also include, for historical
reasons, gold reserves. Domestic credit is defined here as central bank holdings of government
bonds and loans to private banks. (There is also the issue of how to account for the interest
earned on the central bank assets, and interest paid on bank deposits held; these amounts tend
to make up a small percentage of the central banks’ balance sheet and are thus ignored for the
purpose of this chapter.)
Activity 16.2 Go to money supply figures for your country, which are normally
published by the central bank or monetary authority, and identify the asset and liability
sides of the consolidated balance sheet of the banking system.
When the exchange rate is under pressure to depreciate, there is an excess supply of domestic
currency. In this case the central bank intervention takes the form of selling foreign exchange
reserves. Using the central bank’s balance sheet, we see that when the central bank sells
foreign reserves, and leaves its holding of domestic credit constant, this decrease in the asset
side of the balance sheet must also create a decrease in the liability side of the balance sheet:
assuming bank deposits are constant, this will come through a decrease in the cash in
circulation, reducing the excess supply of domestic currency until there is no longer a pressure
on the currency to depreciate. Likewise, in the case of a pressure to appreciate, intervention
takes the form of ‘buying’ foreign reserves, expanding the supply of domestic currency in the
process.
To see how exchange rate intervention works consider the effects of an exogenous increase in
domestic output. As shown in Figure 16.1, the increase in output will increase the real demand
for money, shifting the Md curve outwards. However, the domestic interest rate can, under a
peg, not adjust to restore equilibrium in the money market as the domestic interest rate is tied
to the world interest rate: under a peg UIP implies that r = r∗ . Instead, the central bank will
have to adjust the nominal money supply to ensure an equilibrium. If the supply of money
were to stay unchanged, the new equilibrium interest rate would be given by point C.
However, as the UIP schedule shows, this would lead to an appreciation of the currency. As
184
UIP schedule
r = r * + (S – S)
Exchange rate
A'
S
C'
Domestic
interest rate
r*
0
Md(r, y1)
Real domestic money holdings
Md(r, y2)
m1 – p A
C
m2 – p
B
m–p
Figure 16.1: Asset market equilibrium under fixed exchange rates
the central bank is committed to maintain the peg, it will have to increase the supply of money
to M2 by acquiring additional foreign reserves to achieve a new equilibrium at point B, which
leaves the exchange rate at the old level of s.
Sterilised intervention
Often central banks are reluctant to accept the monetary implications of foreign exchange
market intervention and they seek to reverse the money supply effects by offsetting actions in
financial markets. Thus, if the central bank finds it has to sell foreign reserves it can offset the
reduction in the money supply by buying domestic assets (namely, by increasing the domestic
credit component of the money supply). Alternatively, it can offset the purchase of foreign
reserves in the foreign exchange market by reducing domestic credit. These offsetting
domestic credit operations are known as sterilisation, and foreign exchange market
intervention that is accompanied by sterilisation is known as sterilised intervention.
An important question is whether sterilised intervention can be effective in influencing the
exchange rate. The answer to the question depends upon the degree of substitutability between
domestic and foreign assets. If they are perfect substitutes (that is, the risk premium term in
the UIP equation is zero), then a sterilised intervention will leave interest rates unchanged and
hence cannot affect the exchange rate. In this case, sterilised intervention is pointless since it
achieves nothing except a change in the composition of central bank assets and a nominal
185
change in the composition of private sector portfolios.

If domestic and foreign assets are imperfect substitutes then sterilised intervention may be
effective. The intuition for effectiveness is that changes in portfolio composition are
accompanied by changes in the required risk-adjusted rate of return on domestic assets. For
example, suppose the monetary authority intervenes to prevent the exchange rate from
appreciating, and suppose it offsets the expansionary monetary effect of this by selling
domestic bonds (reducing domestic credit). In order to persuade the public to hold more
domestic bonds, the risk-adjusted rate of return on domestic bonds has to rise. If the interest
rate is constant (by the assumption of sterilisation) then this must be accomplished by a jump
(depreciation) in the exchange rate to create the expectation of a subsequent appreciation (with
the expected exchange rate assumed unchanged). Thus, in the face of a tendency to
appreciation, sterilised intervention creates a force for depreciation, thereby leaving the rate
unchanged (if the objective is to support a pegged rate). A graphical representation of this
effect is given by KOM Figure 18-7 ‘Effect of a Sterilized Central Bank Purchase of Foreign
Assets Under Imperfect Asset Substitutability’, p.556.
The evidence on the effectiveness of sterilised intervention is mixed. However, there is a view
that, in respect to the major world currencies, the scale of any feasible intervention is small
relative to the size of private sector capital flows. Thus the most important impact of
intervention may work through the signal which intervention sends to markets about the
intentions of monetary authorities.
Activity 16.3 Suppose a central bank wishes to use sterilised intervention to prevent a
depreciation of its currency. Explain carefully how this works.
16.2.3 Stabilisation policies under a fixed exchange rate
In Chapter 15 of the subject guide we considered the effects of stabilisation policies on the
exchange rate and output. There we concluded, using the AA–DD model, that if the exchange
rate is an expansion of the money supply, this can have a temporary positive impact on output,
while fiscal policy is only effective if it is temporary. In this section, we revisit the AA–DD
model and see what the effects of stabilisation policies are if the country maintains a fixed
exchange rate regime. As you will see, the results are very different from those in Chapter 15
of the subject guide.
Monetary policy
Consider first an expansion of the money supply, for instance, because the central bank has
expanded its holding of domestic assets. Consider Figure 16.2. Under a floating exchange the
AA curve would shift outwards and a new equilibrium would be reached at A0 , leading to a
depreciation (increase in the exchange rate) and an increase in output. However, under a fixed
exchange rate, the central bank wants to hold the exchange rate fixed at s and thus will
intervene in the exchange rate market to countervail the depreciationary pressure. This will
reduce the foreign reserves of the central bank until the AA curve is back at its original
position. Thus monetary policy is ineffective as a stabilisation policy.
186
S
DD
Exchange rate
A1
A
S
AA1
AA
Y
Output
Figure 16.2: Monetary expansion under a fixed exchange rate
Fiscal policy
Now consider the effects of a fiscal expansion, portrayed in Figure 16.3. Recall from Chapter
15 of the subject guide that if a fiscal expansion is temporary (namely, it does not affect
exchange rate expectations), it would increase output and lead to a (temporary) appreciation
by shifting the DD curve outwards, leading to equilibrium B0 . However, as the central bank
now wants to maintain the fixed exchange rate, it will have to intervene in the foreign
exchange market to counter the appreciation by buying extra foreign reserves. This will shift
the AA curve outwards to AAB , further increasing the increase in output to Y2 while keeping
the exchange rate constant at s. Thus fiscal policy is more effective under a fixed than under a
floating exchange rate regime.
Changing the peg
If a country is maintaining a fixed exchange rate regime, it has one additional policy tool
available: changing the rate at which the currency is pegged. If the domestic currency price of
foreign currency is increased this is called a devaluation; if the domestic currency price of
foreign currency is decreased it is called a revaluation. Figure 16.4 shows that after the
devaluation, from s to s0 the equilibrium shifts along the DD schedule from point A to B,
temporarily increasing output. The increase in output causes an excess demand for real money
balances, forcing the central bank to buy extra foreign reserves to restore balance in the money
market. This shifts the AA curve outwards to AA2 .
187
S
DDA
DDB
Exchange rate
A B
S
B'
AAB
AAA
Y
Y1 Y'2 Y2
Output
Figure 16.3: Fiscal expansion under a fixed exchange rate
DD
B
Exchange rate
S'
A
S
AA2
AA1
Y1 Y2 Y
Output
Figure 16.4: The effects of a devaluation
188
Currency boards
In some cases, a normal exchange rate peg may lack credibility. For example, in some
economies there is a widespread belief that governments may find it hard to resist monetising
their fiscal deficits. A possible way of ‘tying the hands’ of the government is by creating a
currency board arrangement. In a currency board, changes in the money supply are entirely
determined by the balance of payments, preventing the monetary authorities from engaging in
monetary policy and the monetisation of fiscal deficits. An advantage of a currency board is
that it can, in principle, never run out of foreign reserves following a speculative attack (see
also Chapter 17 of the subject guide) as the currency is fully backed; however, the failure of
Argentina’s currency board in 2001–2002 shows that even currency boards are not entirely
secure.
Mundell-Fleming and fixed exchange rates
Under fixed exchange rates, exchange rate expectations play, naturally, a much smaller role
than under floating exchange rates. As such, the predictions of the Mundell-Fleming (M-F)
model are quite close to those of the AA–DD model described above. When the exchange rate
is fixed, the M-F predicts that monetary policy is impotent if capital is perfectly mobile, as
shown in Figure 16.5. The increase in the money supply will shift the LM curve out. However,
the central bank will have to step in to prevent the exchange rate depreciating, reducing its
money supplies back to the original levels as it sells off part of its foreign reserves and returns
the system back to the old equilibrium in terms of the exchange rate and output. Fiscal policy,
on the other hand, is predicted to be very effective under fixed exchange rates. Figure 16.6
examines these effects. Starting from the initial equilibrium A, the IS shifts out with an
increase in government spending, causing the domestic interest rate to rise above the world
interest rate. This attracts massive capital inflows putting pressure on the exchange rate to
appreciate. To maintain the peg, the government must purchase foreign reserves and thus
increase the money supply. Hence the LM curve also moves outwards, to equilibrate the
system and restore interest rate parity at point B, with an increase in output as a result.
Activity 16.4 Think about how the impact of monetary and fiscal policy change when
there is an imperfect degree of capital mobility. Using Copeland Chapter 6, illustrate how
monetary and fiscal policy affect output under a fixed exchange rate and imperfect capital
mobility. How do your results change from Figures 16.5 and 16.6?

In this chapter, we have discussed fixed exchange rates.

describe how exchange rates are fixed
189
LM1 LM2
A
S
IS
Y
Y1
Output
Figure 16.5: A monetary expansion under fixed exchange rates and perfect capital mobility
LM1 LM2
A B
S
IS2
IS1
Y
Y1 Y2
Output
Figure 16.6: A fiscal expansion under fixed exchange rates and perfect capital mobility
190
explain what is meant by sterilisation and discuss its effectiveness
discuss the effects of stabilisation policies under a fixed exchange rate, using the AA–DD
framework and the M-F framework.

1. Explain why fiscal policy is more effective under fixed exchange rates than floating, and
explain why monetary policy is more effective under floating exchange rates than fixed.
Explain the intuition, as well as providing a graphical analysis.
2. Compare the currency board regime with a fixed exchange rate regime. Describe the main
characteristics of the two, emphasising the costs and benefits of adopting the two regimes.

1. See the section on ‘Stabilisation policies under a fixed exchange rate’ in this chapter for
an analysis using the AA–DD framework. A similar analysis using the Mundell-Fleming
framework can be found in Chapter 15 of the subject guide.
2. To use monetary policy to affect output, a good answer would at least highlight the
following:
Define the two regimes:
Currency board: a monetary institution that only issues domestic currency that is
fully backed by foreign assets. The domestic currency is convertible into a foreign
anchor currency at a fixed rate and on demand.
Fixed exchange rate: The domestic currency is convertible into a foreign anchor
currency at a fixed rate and on demand. However, the central bank does not hold
foreign reserves in a 1 to 1 ratio and may hold domestic assets on its balance sheet.
Characteristics of a currency board:
Convertibility: a currency board maintains full and unlimited convertibility
between its notes and coins and the anchor currency at a fixed rate. Foreign reserves
are composed by low-risk, interest bearing bonds and other assets denominated in
the anchor currency. Currency board foreign reserves are equal to 100 per cent or
more of its notes and coins in circulations, as set by law. A currency board generates
profits (seignorage) from the difference between interest earned on its reserve assets
and expense in maintaining its liabilities (notes and coins in circulation). A currency
board does not act as a lender of last resort to protect domestic banks from losses.
No discretion in monetary policy: market forces determine money supply. The
only function of a currency board is to exchange notes and coins for the anchor
currency at the fixed rate. The currency board does not lend to domestic banks or to
the government. A fixed rate between the domestic currency and foreign anchor
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currency tends to keep interest rates and inflation in the currency board country
roughly the same as those in the anchor currency country.
The implications for a fixed exchange rate are similar, but the central bank can issue
money (a little more discretion in monetary policy).
Costs and benefits of a currency board over a normal fixed exchange rate: The main
advantage of a currency board is that it removes all discretion from a central
bank/monetary authority. Formulating a currency board should prevent a central bank
from monetising domestic credit, thus creating a first generation currency crisis. (Note
that the failure of the Argentinean currency board shows that even currency boards are
not entirely immune to this.) This is also the main cost of the currency board: a currency
board fully commits the central bank to maintaining the peg and prevents it from
achieving other desirable policy objectives, such as acting as a lender of last resort to the
banking system.
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Chapter 17
Currency crises
17.1 Introduction
Currency crises are a recurring phenomenon of the international financial system. A crisis can
affect an individual country, as happened in Mexico in 1994, or an exchange rate system as in
the European Monetary System in 1992 or the Bretton Woods system in the late 1960s and
early 1970s. As such, it is not surprising that a substantial amount of research has gone into
explaining the causes and consequences of currency crises. The prevalent crisis models can
roughly be divided into three generations of crisis models, each with its own set of
explanations of why crises happen and what the economic effects are of currency crises. Each
generation of crisis models is hallmarked by a particular crisis, or set of crises, which inspired
the stylised facts captured in each generation of models.

This chapter aims to discuss alternative explanations for the development of currency crises
and discuss their relevance in explaining recent crises.

should be able to:
identify three types of currency crisis and explain what the causes and consequences of
these types of crisis are
discuss the relevance of each generation of crisis model in explaining recent currency
crises.

The theory of currency crises is covered in Chapter 18 of KOM, which is also required reading
for Chapter 16 of the subject guide. Historical examples and the effects of currency crises are
covered in Chapter 22 of KOM. Chapter 20 of FT provides a more in depth analysis of
currency crises.
KOM, Chapter 18 ‘Fixed Exchange Rates and Foreign Exchange Intervention’ and
Chapter 22 ‘Developing Countries: Growth, Crisis, and Reform’.
C, Chapter 15 ‘Crises and Credibility’.
193
17. Currency crises
FT, Chapter 20 ‘Exchange Rate Crises: How Pegs Work and How They Break’.
Calvo, G. and C. Reinhart ‘Fear of Floating’, The Quarterly Journal of Economics 117(2)
2002, pp.379–408.
Krugman, P. ‘Balance Sheets, the Transfer Problem, and Financial Crises’, International
Tax and Public Finance 6(4), 1999, pp.459–72.
Obstfeld, M. and K.S. Rogoff ‘The Mirage of Fixed Exchange Rates’, Journal of
Economic Perspectives 9(4) 1995, pp.73–96.


This chapter looks at the causes and consequences of currency crises.
17.2.1 First generation: inconsistent policies

The first generation of crisis models focus on the role of the government and monetary
authorities in a currency crisis. If a country is running a fiscal deficit, it may be tempted to
solve the deficit by ‘printing money’; in this situation the monetary authorities (either
voluntary or forced by the government) fund the fiscal deficit by buying domestic government
debt by issuing money, a situation referred to as the monetisation of fiscal deficits or the
monetisation of domestic credit. Although this may seem like an easy way to finance
government expenditures, we know from Chapter 14 of the subject guide that the increased
rate of money growth will lead to higher inflation and a higher rate of depreciation of the
currency.
The first generation crisis model sets out to show that a peg is unsustainable if a central bank
is monetising domestic credit. The prediction of the model is that such a crisis is inevitable but
will have little real economic effect. Indeed, the crisis is entirely modelled as a monetary
phenomenon and real effects play no role at all in the model. In a nutshell, under a peg, if a
central bank continues to monetise domestic credit, it will have to sell off foreign reserves to
keep the money supply constant. When the central bank runs out of reserves, it will be forced
to let the currency float. Investors will anticipate the floating and mount a speculative attack
shortly before the central bank runs out of reserves, triggering a currency crisis.
To see how a first general crisis works in more detail consider a two country world with Home
and Foreign. For simplicity assume that real variables are constant throughout the analysis. Let
both domestic output,Y, foreign output, Y ∗ and foreign money supplies M ∗ , be equal to one, so
194
that both lnY = y = 0, y∗ = 0, m∗ = 0. Let the foreign interest rate, r∗ , also be equal to zero.
Note that none of these assumptions are necessary, but they make the analysis a bit easier.
At the centre of the model will be a domestic central bank which monetises domestic credit at
a fixed rate, µ. The central bank holds both domestic credit, B, and foreign reserves, F,
making the money supply equal to (in levels, not logs)
Mts = Bt + Ft . (17.1)
The monetisation of debt by the central bank implies that:

Bt − Bt−1
≈ ln Bt − ln Bt−1 = ∆bt = µ. (17.2)
Bt−1
The central bank decides to peg the exchange rate at a fixed level, s. When it runs out of
reserves it will let the currency float, but it will keep monetising domestic credit at the same
rate as before.
The exchange rate dynamics are given by the monetary model, discussed in Chapter 14 of the
subject guide,
st = (mt − m∗t ) − α(yt − y∗t ) + β(rt − rt∗ ). (17.3)
For this model we can simplify equation 17.3 by plugging in the assumed values of m∗t , yt and
y∗t (alternatively, you can group these variables into a constant k and add it to the equation
separately). Also we can use the UIP relation (see Chapter 13 of the subject guide) to replace
the interest differential with the expected change in the exchange rate. This reduces the model
of the exchange rate to
st = mt + βE∆st+1 . (17.4)
If the exchange rate is fixed the expected change in the exchange rate will be E∆st = 0. So
under the peg, the exchange rate will be determined by
st = mt . (17.5)
Now we need to consider what the exchange rate will be under a floating regime. First, we
have assumed that the central bank will only let the currency float when it has run out of
reserves, so we have that mt = bt , and thus that the money supply will grow as quickly as
domestic credit, at a rate µ. Recall from Chapter 14 of the subject guide that in the monetary
model money growth is passed on one to one to inflation and hence feeds directly into
expected changes in the exchange rate. This implies that under a floating exchange rate we
have E∆st = µ. Thus
s̃t = bt + βµ, (17.6)
where s̃ denotes the (shadow) exchange rate: the equilibrium exchange rate that would prevail
if the currency were floating (and the central bank holds no foreign reserves). Figure 17.1
illustrates the time paths of the pegged and floating exchange rate regimes. The main insight
of Figure 17.1 is that the currency crisis occurs at date T , where the shadow exchange rate is
equal to the exchange rate peg. That is, the crisis occurs before reserves run out. When the
crisis occurs, all reserves are sold in an attempt to defend the peg (due to the assumption of
complete commitment to the peg) and so reserves collapse at date T . Interestingly, the first
generation crisis model predicts that there will not be any large depreciation at the time of the
crisis. Instead, the transition from the pegged regime to the floating regime will be a smooth
one. Real variables like output remain unaffected as well. At the time of the crisis, both
195
17. Currency crises
S
Shadow float
~
S
ath
ep
tim
Peg
S
T t
Crisis
Figure 17.1: Time path of the exchange rate under a first generation currency crisis
domestic inflation and the domestic interest rate will jump up to µ and stay constant
afterwards. The exchange rate will afterwards steadily depreciate at rate µ as the domestic
money supply and domestic price levels grow at rate µ. A graphical representation of these
effects can be found in C, Figure 15-1 ‘Collapse in the first-generation model’ (or FT Figure
20-14 ‘An Exchange Rate Crisis Due to Inconsistent Fiscal Policies: Perfect-Foresight Case’).
Activity 17.1 The country of Vesuvia has currently pegged its currency, the vesuv, to
the euro at s = 10. The log of the money supply, m0 , is also equal to 10, while the log of
domestic credit initially held by the central bank, b0 is equal to 6. The central bank is
expanding its holdings of domestic credit by 50 per cent per year (that is, µ = 0.5). Assume
that the elasticity of money demand with respect to interest rates is 1, that is, β = 1 in
equation 17.3).
1. Given the data in the question, at which time will a speculative attack occur?
2. Draw the time path of the exchange rate, money supply, price levels and the interest
rate. Clearly indicate when the crisis occurs and how the variables behave at the time
of the crisis.
3. Use the figure of the exchange rate you drew in 2. to explain why the currency crisis
must occur at date T . (Hint: suppose the crisis were to occur at a date before T and
examine the incentives of an individual investor. Is it in his or her interest to also sell
the currency on that date? Follow the same exercise for a date after T.)
17.2.2 Second generation: contingent policies

The European crisis of 1992 was not the result of an obvious inconsistency between exchange
rates and economic fundamentals. This led to further research and a variety of second
generation models.
196
A key difference between the first and second generation currency crises models is that
governments in the second generation are assumed to be constantly evaluating the pros and
cons of defending versus abandoning a peg; whereas in the first generation complete
commitment to the peg is assumed. The cost of defending a peg – in the face of a speculative
attack – is the reserves needed in order to defend it. The benefits lie in maintaining credibility
in the fixed exchange rate regime. Consider an exogenous shock to expectations (due to a
political crisis, rumours, or other exogenous event), which leads investors to believe the peg is
more likely to be abandoned than before. As speculators act on their expectations and sell the
currency, the reserves needed in order to defend the peg rise. This alters the cost-benefit
analysis of the policy-maker and may undermine the fixed exchange rate regime, generating a
crisis due to self-fulfilling expectations. In other words, a policy maker who intended to
defend the peg may choose not to defend the peg when expectations move against him, as a
result of the increase in reserves required to maintain the peg. This sort of reasoning points to
the importance of maintaining credibility and highlights the notion that a country may
experience a crisis even when its fundamentals are sound.
17.2.3 Third generation: financial fragilities
A recurring feature of currency crises that is addressed in third generation crises, but cannot be
well explained in terms of earlier generation crisis models, is that they tend to spread from one
country to another. This is known as contagion. The Asian financial crisis of 1997 which
inspired most third generation crisis models is the most severe recent example of contagion:
the crisis moved rather rapidly from Thailand to Malaysia to the Philippines to Indonesia to
South Korea, to eventually engulf all the Asian tigers.
The third generation of currency crisis models focus on financial fragility and moral hazard as
a cause of currency crises. For instance, if governments offer implicit (or indeed explicit)
promises to bail-out banks in the event of failure, then banks have an incentive to undertake
riskier projects/give out riskier loans, on the expectation that they will be bailed out in the
event of a poor outcome. The resulting banking crises might then spill over into the currency
markets (see, for example, Krugman, 1999).
Another channel through which currency crises can be triggered is fragility in the balance
sheets of firms. Many emerging economies borrow heavily from abroad. Often these loans are
denominated in foreign currencies, such as the US dollar, a phenomenon referred to as the
‘original sin’. A depreciation of the currency would lead to large losses for those firms that
have their liabilities in dollars but have domestic currency denominated assets. This setup may
create a situation with multiple equilibria and self-fulfilling crises. If foreign investors believe
an economy will go into crisis and withdraw their funding, this can trigger a depreciation of
the currency. This depreciation triggers capital losses and potential bankruptcy of local firms
that borrowed abroad, sparking a recession that validates the initial expectations of foreign
investors.
While first generation crises are predictable ahead of time, are isolated to one country and do
not need to have large real effects, third generation crises are unpredictable, can easily spread
to other countries through changes in expectations and have potentially large real economic
effects.
197
17. Currency crises

This chapter discusses currency crises.

identify three types of currency crisis and explain what the causes and consequences of
these types of crisis are
discuss the relevance of each generation of crisis model in explaining recent currency
crises.

1. Describe in detail how a currency crisis can be a self-fulfilling crisis.
2. A sudden loss of access to all foreign sources of funds invariably leads to sharp
contractions in a country’s output and employment. Explain how the current account
identity necessitates these contractions.

1. A good answer points out that both second and third generation crises can be
self-fulfilling, in the sense that an expected devaluation of a currency leads to the
breaking of the peg. There are many different specific examples that can be described in
detail. For example, taking the mechanics of a third generation crisis: consider an
economy in which domestic commercial banks’ liabilities are mainly short-term deposits,
and in which many of the banks’ loans to businesses are likely to go unpaid in the event
of a recession. If the market suspects there will be devaluation, interest rates will rise,
banks’ borrowing costs go up, and banks’ assets have lower value if a recession hits. To
prevent financial collapse, the central bank will lend money to banks and will no longer
be able to keep the exchange rate from rising. Thus, the emergence of devaluation
expectations eventually leads to a devaluation of currency (self-fulfilling). Other
examples could have focused on the role of contingent monetary policy (2nd generation
crisis) or the role of foreign currency denominated debt which becomes more expensive
after a devaluation (third generation crisis).
2. Recall that the current account identity states that S − I = CA. Imagine that a country is
running a current account deficit (that is, borrowing from abroad) a certain amount of its
GNP when foreign lenders suddenly become scared of default and cut off all new loans.
This action causes the current account balance to be at least 0 due to either a rise in
198
saving or a fall in investment (or a combination of both). The required sharp fall in
aggregate demand necessarily depresses the country’s output dramatically.

Activity 17.1
Note that s = 10, m0 = 10, b0 = 6, µ = 0.5, β = 1 and that bt = b0 + µt.

To find the time of the attack, we need to find the time when the fundamental value of the peg
is equal to that of the shadow float, s = s̃t . That is
s = b0 + µt + βµ.
Solving this equation for t, yields
t = (s − b0 − βµ)/µ.
Filling in the numbers provided gives us the time of the attack as:
T = (10 − 6 − 0.5)/0.5 = 7.
See C Figure 15-1 ‘Collapse in the first-generation model’ (or FT Figure 20-14 ‘An Exchange
Rate Crisis Due to Inconsistent Fiscal Policies: Perfect-Foresight Case’).
A good answer will point out that if the peg is attacked prior to date T , the currency is
expected to appreciate. As the speculators have just exchanged their vesuvs for euros, this
would lead to a capital loss for the speculators, making the attack unprofitable. Therefore
speculators will postpone an attack to T or later. If speculators attack after T , the currency is
expected to depreciate, leading to capital gains for the speculators. The longer speculators wait
with the attack, the larger the capital gain will be. However, consider two speculators, A and
B. Let us say speculator B believes A will attack the currency at time T + 2. Speculator B will
try to attack slightly earlier, say at T + 1, so that he gets all the profits himself. As speculator
A anticipates this, she will attack even earlier, etc. This logic can be extended to show that as
soon as there is a profit to be made, namely at time T , the speculators will attack. Thus in this
perfect information world, the attack can take place no earlier and no later than time T .
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17. Currency crises
200
Chapter 18
Monetary systems
18.1 Introduction
In Chapter 16 of the subject guide we briefly discussed the advantages and disadvantages of
having a fixed exchange rate compared to a floating exchange rate. Fixed exchange rates offer
greater stability in that individuals and firms will know what the exchange rate is going to be
in the future, so making investment and purchasing decisions easier and encouraging trade
between nations. Fixed exchange rates also impose a degree of monetary control in that they
do not allow individual countries to participate in devaluations, which ultimately lead to
greater output volatility and higher inflation as a result of the monetary expansions.
However, flexible exchange rates have the benefit of giving the monetary authorities another
tool for trying to achieve internal equilibrium. Whereas monetary policy has to be used by the
authorities to defend and control the value of their currency in comparison with foreign money
in fixed exchange rates, with flexible exchange rates it can be used to counter negative shocks
or for other internal objectives. International monetary arrangements have fluctuated between
fixed and floating exchange rate regimes in the last 100 or so years and it is the aim of this
chapter to review and evaluate some of these different regimes.
The period between 1870 and 1914 is generally known as the classical or international Gold
Standard era. The international Gold Standard was suspended with the onset of hostilities in
the First World War, but between 1918 and 1939 there was a failed attempt to restore it in a
modified form. The Gold Standard was a fixed exchange rate system in which gold provided
the ‘nominal anchor’. Subsequent attempts to ‘create’ a successor have all attempted to restore
some kind of fixed exchange rate system.
From 1946 to 1973 the rules of the international monetary system were embodied in the
system created at Bretton Woods after the Second World War and known therefore as the
Bretton Woods system. After the final breakdown of Bretton Woods in 1973 subsequent
attempts to create a new global system failed, although a number of regional monetary
arrangements have operated with varying degrees of success, most notably the European
Monetary System (EMS) which is the topic of Chapter 19 of the subject guide.
This chapter aims to discuss various monetary systems, including their advantages and
limitations.
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18. Monetary systems

should be able to:
discuss the impossible trinity faced by policy makers and the trade-offs involved in
choosing a monetary arrangement
discuss the workings of the Gold Standard, explaining how external equilibrium is
achieved and how the price level is determined
define what the Bretton Woods system was and explain how it worked and why it
ultimately collapsed.

KOM, Chapter 19 ‘International Monetary Systems: An Historical Overview’.

FT, Chapter 19 ‘Fixed Versus Floating: International Monetary Systems’.
S(IF), Chapter 110:

De Cecco, M. ‘Gold Standard’, in Newman, P., M. Milgate and J. Eatwell (eds) The New
Palgrave Dictionary of Money and Finance. (London: Macmillan, 1992) [ISBN
9780333527221].


This chapter provides an overview of prominent international monetary systems prevalent in
the last century.
18.2.1 The impossible trinity

Consider the following three policy goals a central bank may want to pursue:
1. Free capital flows.
2. Fixed exchange rates/Exchange rate stability.
202
Policy choice
Capital controls
Example: Bretton Woods
y
lic
Fix
po
ed
ry
eta
exc
n
han
mo
g
n
er
eig
ate
ver
s
So
Free flow of capital
Policy choice Policy choice

Floating exchange rates No monetary autonomy
Example: Interbellum/now Example: Gold Standard
Figure 18.1: The impossible trinity
3. Sovereign monetary policy.

It can be shown that a small open economy can only achieve, at best, two out of the three
policy objectives. This important result in international finance is called the impossible trinity
or trilemma. Thus a monetary regime will have to choose which of the three policy goals to
sacrifice. As Figure 18.1 summarises, over time, different international monetary
arrangements have made different choices. The Gold Standard sacrificed monetary autonomy
to promote stable exchange rates and free mobility of capital; Bretton Woods tried to achieve
stable exchange rates and sovereign monetary policy at the cost of capital mobility; the current
system, dominated by freely floating exchange rates, prioritises free capital flows and
sovereign monetary policy at the cost of less stable exchange rates.
18.2.2 The Gold Standard, circa 1870 to 1914
If inflation was a monetary phenomenon, only arising because of a continued and gradual
increase in the nominal money supply, then an easy and obvious way to limit inflation would
be to fix the value of money against some real quantity, the production and supply of which is
not likely to be particularly volatile. This is the idea behind the Gold Standard, whereby each
country would fix the value of its domestic currency to gold and promise to convert between
gold and this money on demand. If a nation’s currency is backed by gold reserves then the
money supply can only increase (causing inflation) if the amount of gold, held in the form of
reserves, increases.
Denote the price of gold against a particular currency by Pg (for example £4.11 per ounce of
gold) and let G denote the quantity of gold held as reserves. The stock of gold in nominal
terms is therefore PgG and if the gold-reserve ratio is denoted as r, then the monetary base, or
203
high-powered money, H, will be given by:
H = (PgG)/r. (18.1)
Under the rules of the Gold Standard, the price of gold, Pg , and the gold-reserve ratio, r, were
fixed so for a given quantity of gold, G, this would determine the monetary base and hence the
stock of money in the economy. The exchange rate between two monies would be determined
as the ratio of the two money prices of gold.
S = Pg /P∗g , (18.2)
where S , the exchange rate, is the domestic price of foreign currency and P∗g is the price of
gold in foreign money. Essentially, the exchange rate is given by the law of one price for gold,
with equation 18.2 being driven together by arbitrage in the gold markets in each country (see
Chapter 14 of the subject guide). Since p and p∗ are fixed this should lead to stable exchange
rates between countries, facilitating international trade. Since money is backed by gold, a real
commodity whose supply is limited, this will also limit the growth rate of money and inflation.
Thus the Gold Standard should see both stable exchange rates and price levels.
External equilibrium and the Gold Standard
The Gold Standard should not only see stable prices and exchange rates, it should also bring
about equilibrium in the current account through automatic stabilisers. These in-built
stabilising mechanisms should cause persistent, and possibly unstable, current account deficits
and surpluses to decrease. Suppose one country was running a current account deficit. If the
financial account was closed, such deficits could only be financed by the shipping of gold to
those countries from where the economy was a net importer. This would result in a reduction
in domestic gold reserves (that is, a fall in G). This reduces the money base (see equation
18.1) and hence reduces the money supply and the price level in the economy. Lower prices
make domestic goods cheaper in international markets, encouraging exports and discouraging
imports, reducing the current account deficit in the process. Therefore, the current account
should not move to unsustainable negative or positive levels.
The demise of the Gold Standard
The Gold Standard lasted until the start of the First World War. Despite the theoretical appeals
of the regime, briefly outlined above, it was in practice not as successful as one might have
expected. Average inflation was indeed low, but there were frequent large price rises and falls
making the average low inflation of the time appear quite deceptive. The USA returned to the
Gold Standard in 1919 after the First World War and a number of other countries, including
the UK, rejoined in 1925. However, the UK wanted to fix its exchange rate at the original
pre-war rate despite having experienced substantial inflation since 1914, largely due to the
printing of money during the war to finance the war effort. In order to convert pounds to gold
at the original rate, rather than devaluing the pound, the UK would have to see a considerable
fall in its price level. However, such deflation involved taking the UK into a recession. This
episode highlighted the inflexibilities and drawbacks of such a rigidly fixed exchange rate
regime. Because of these rigidities, the Gold Standard was also blamed for exacerbating and
prolonging the effects of the Great Depression at the end of the 1920s and early 1930s. To deal
with these rigidities, a more flexible monetary system was devised at the end of the Second
204
World War, called the Bretton Woods exchange rate system, named after the place where the
agreement was signed in 1944.
Activity 18.1
1. The mechanism described above should see the maintenance of external equilibrium
(balance of payments) but the arguments can also be used to show how prices can be
kept in check. Consider a case where the domestic economy was experiencing higher
inflation. How, using the above equilibrating mechanism, will prices be brought back
in line?
2. Do you think it would be possible and/or desirable to go back to a Gold Standard

today?
18.2.3 Bretton Woods, 1944 to 1971

Due to the beggar-thy-neighbour and other trade-switching practices in the inter-war period, a
system of greater international cooperation was sought at the end of the Second World War.
This came in the form of a fixed exchange rate regime that was not as rigid as the Gold
Standard discussed above. Under Bretton Woods, all countries would fix their currencies
against gold but only the US currency would be directly convertible, at $35 per ounce. Other
countries would peg their currency against the dollar. Central Banks then tended to hold their
reserves in the form of dollar assets rather than gold, as these could earn a positive rate of
return.
Bretton Woods was more flexible than the Gold Standard since provisions for realignments of
currency values against the dollar were written in the agreement. If a country experienced
persistent balance of payments disequilibria in the form of current account deficits, then it
could devalue its currency against the dollar (and hence against other countries if other rates
were kept fixed) in order to make its exports more competitive and reduce the deficits. It could
also borrow from the newly formed International Monetary Fund (IMF) to help finance these
current account deficits.
US and world inflation
Since most exchange rates were pegged to the dollar, the price levels in the USA and the rest
of the world were closely related. Suppose, for example, the USA experienced relatively high
inflation. With the exchange rates fixed, its goods would become less competitive in
international markets and so a current account deficit would be seen. Equivalently, current
account surpluses would be experienced in the rest of the world and the dollar reserves in
these Central Banks would accumulate, leading to increasing money supplies outside the
USA. These growing money supplies would lead to price inflation. Hence US inflation was
‘exported’ to the rest of the world.
The collapse of the Bretton Woods system
One of the reasons why the Bretton Woods system collapsed was the continued monetary
expansion in the USA in order to finance the Vietnam war. The USA effectively printed dollars
205
to help pay for the war effort and the large current account deficits that the USA experienced
in the early 1960s caused the dollar reserves in the rest of the world to increase. It soon
became clear that the USA would face serious difficulties when converting the growing dollar
liabilities (caused by the monetary expansion) into gold at the existing rate of $35 per ounce.
There came a point when the total dollar liabilities held in the reserves of foreign Central
Banks became greater than the dollar value of gold held by the USA. The USA would then not
be able to convert dollars into gold at the rate set out in the original Bretton Woods agreement.
In 1967 many Central Banks agreed not to convert their dollars into gold in an attempt to
restore confidence in the faltering exchange rate regime. Also at this time, despite running
large current account deficits, suggesting the USA should devalue against other currencies, the
USA found itself revaluing the dollar against troublesome currencies following the current
account deficits in the UK (1967) and France (1968). By 1970 it was commonly perceived that
the dollar was overvalued against gold and speculators took positions against the dollar in an
attempt to make money when the dollar devalued. This extra dollar-selling pressure put the US
currency under greater strain and on 15 August 1971, President Nixon officially announced
that dollars would no longer be convertible with gold at the rate of $35 per ounce. This
effectively ended the Bretton Woods regime, although one could argue that the agreement by
other Central Banks not to convert their dollars into gold had ended the convertibility pledge a
number of years earlier.
The USA tried (in vain) to keep the convertibility pledge of $35 per ounce but did not wish to
devalue the dollar for a number of reasons. First, it had encouraged other Central Banks not to
convert their dollars into gold in 1967. Devaluing the dollar against gold would cause other
nations to hold devalued reserves and cause them to incur large capital losses. Second, the US
current account deficits suggested that the dollar was overvalued against other nations’
currencies and not against gold. Devaluing against gold would not solve the current account
deficits since it would not cause US goods to become any more or less competitive against
goods from elsewhere. And third, confidence in the entire Bretton Woods system would
collapse if the dollar devalued against gold. Devaluation would simply spark further
destabilising speculation in the currency markets. The problems and workings of the Bretton
Woods system are highlighted in the activity below.
Activity 18.2 After the Second World War, the Bretton Woods system was established
in order to promote international trade by avoiding exchange rate volatility. In this system,
the USA promised to sell gold (to other governments) at a constant price of $35 per ounce.
All other countries in the system fixed their exchange rates relative to the dollar, so keeping
their reserves in the form of the US currency.
1. How does the fixing of the price of the dollar relative to gold affect the money market
equilibrium in the USA?
2. France also signed up to the Bretton Woods agreement. How does its participation
affect its money market equilibrium?
3. If France and the USA fix the price of gold and the exchange rate, what would be the
inflation rate in both countries? Explain.
4. In the 1960s the US government implemented an expansionary monetary policy in

order to finance the Vietnam war. The USA printed more money, and the price level in
206
the USA increased. If France then continued to fix the exchange rate to the dollar,
what happened to the French money supply?
For some time, the French maintained the fixed exchange rate policy. But they soon came
to dislike the inflation it caused. President Pompidou of France then decided to exchange
its dollar reserves for gold.
5. If the USA prints more money, and the French fix their exchange rate to the dollar,
what happens to the market price of gold?
6. Why would the French want to convert dollars for gold? What would happen to the
American reserves of gold in this case? (Use money market equilibrium to explain).
7. Do you think it would be possible for the USA to keep its promise to exchange the
dollars held by the French for gold? What if many countries followed France’s
example? What options did the US government have in this situation?
8. Nixon decided not to change France’s dollars for gold at the promised price. Instead,
he decided to devalue the dollar, declaring that the USA would charge $70 per ounce.
What options did France have after the dollar devaluation? Does Nixon’s devaluation
seem a possible long-term solution to the change in the value of the dollar?

In this chapter, we have discussed two historically important monetary systems, including
their advantages and limitations.

discuss the impossible trinity faced by policy makers and the trade-offs involved in
choosing a monetary arrangement
discuss the workings of the Gold Standard, explaining how external equilibrium is
achieved and how the price level is determined
define what the Bretton Woods system was and explain how it worked and why it
ultimately collapsed.

1. Explain why under the Gold Standard a perpetual current account surplus or a perpetual
current account deficit would be impossible.
207
2. In an open economy setting, with flexible exchange rates, one particular Taylor rule for
interest rates may be of the form
Rt = a + vπ πt + vy yt + v s st ,
where yt is detrended output, πt is domestic inflation, st is the nominal exchange rate and
Rt is the nominal interest rate. Why should the authorities change the interest rate to
respond to the exchange rate? What sign do you think v s should take?
1. Since gold specie inflows drive up domestic prices and restore equilibrium in the balance
of payments, any surplus eventually eliminates itself. A shortage of currency leads to low
domestic prices and a foreign payments surplus, and any deficit eventually eliminates
itself.
2. If the domestic currency depreciates, this will cause domestically produced goods to
become cheaper in international markets and for foreign goods to become more
expensive in the domestic market. If domestically produced goods become cheaper
abroad, demand for these goods is likely to rise. A depreciating currency may then lead to
an overheating economy so the monetary authorities may then increase interest rates in
order to dampen these expansionary effects. Since foreign goods become more expensive
in the domestic market, the depreciation is likely to increase inflation as input prices and
the prices of final goods imported from abroad increase. A rise in interest rates will then
help reduce this inflation, again by reducing domestic demand; ve would therefore, in this
case, be positive.

Activity 18.2
1. The fixity of the dollar price of gold sets an upper limit on the feasible money supply in
the USA. The maximum US money supply, Mmax is given by:
Mmax = PgG,
where Pg is the price of gold, fixed at $35 per ounce and G is the quantity of gold held by
the Treasury. The US money market equilibrium is then illustrated by Figure 18.2.
2. Fixing the exchange rate, at S determines the domestic (French) interest rate (as equal to
the US rate) and hence determines the French money supply for any given y.
3. If the US price level increased, this would cause French goods to become more
competitive, resulting in a French (US) current account surplus (deficit). The French
Central Bank will see its dollar reserves increase, causing a rise in its money supply,
which ultimately leads to price inflation in France. With a fixed exchange rate, inflation in
the two areas will be equal. See also your notes on relative PPP from Chapter 14 of the
subject guide.
208
Figure 18.2: US Money market equilibrium under a Gold Standard
4. The US monetary expansion would shift the money supply schedule in Figure 18.2 to the
right, lowering US interest rates. From the French perspective, a lower US (foreign)
interest rate necessitates a lower French interest rate and hence a greater level of the
money supply in order to clear the French money market.
5. The market price of gold remains fixed at $35 per ounce. However, the relative price of
gold in terms of other goods is forced to a lower level. The monetary expansion raises the
dollar price of a basket of goods, B. The relative price of gold is then given by:
Relative price of gold =($/gold)/($/basket) = gold/basket
The number of dollars per gold is fixed at $35 per ounce but the dollars per basket of
goods increases. The relative price of gold then falls; an ounce of gold can be exchanged
for fewer baskets of goods.
6. If France bought gold for dollars then the stock of gold in the USA would fall. The
maximum money supply in the USA would necessarily fall since G is now lower. The
upper limit on the money supply shifts to the left in Figure 18.2 which would necessitate
a fall in the US money supply if the USA were to commit to its convertibility pledge. The
falling US money supply would increase US (foreign) interest rates. This leads to a
higher French interest rate and a lower money supply and so reduces the inflationary
pressure in France, as desired.
7. The USA could convert for France but not for the rest of the world. Dollar liabilities had
reached a point that was greater than Mmax ! This is also called the Triffin Dilemma,
named after the person who first pointed out this paradox.
8. In order to reduce inflation in France, the French president could:

(a) deflate by using fiscal policy, leading to French unemployment
(b) permit France to keep the dollars in its reserves, leading to higher inflation
209
(c) permit France to convert at the rate of $70 per ounce but receive only half as much
gold as they would at the official $35 rate, experiencing a large capital loss.
Alternatively, France could float its currency and appreciate the franc.
210
Chapter 19
Optimum currency areas
19.1 Introduction
An optimum currency area (OCA) is an economic area in which a single currency would
maximise economic efficiency. The conclusions of the literature are that a set of economies
comprise an OCA if they have strong intra-regional trade links, high correlation of demand
and supply shocks, and in which labour, capital and other factors of production move
relatively freely (KOM Chapter 21, listed in the Essential reading below, provides a good
overview, but the acknowledged classic in this area is De Grauwe (2012)). This section will
discuss optimum currency areas through the example of the European Monetary Union.

This chapter aims to discuss the advantages and disadvantages of a monetary union, using the
Eurozone as an example.

should be able to:
list and assess the advantages and disadvantages of monetary union
discuss the events that led to the creation of the euro.

KOM, Chapter 21 ‘Optimum Currency Areas and the Euro’.
C, Chapter 16 ‘Optimum Currency Areas and Monetary Union’.

FT, Chapter 21 ‘The Euro’.
S(IF), Chapter 100:

De Grauwe, p.The Economics of Monetary Integration. (Oxford: Oxford University

Press, 2012) ninth edition [ISBN 9780199605576].
211
19. Optimum currency areas


This chapter uses the example of the euro to discuss issues surrounding optimum currency
areas.
19.2.1 European Monetary Union

Following the collapse of the Bretton Woods system, many of the European countries
instigated a move to fix their exchange rates against one another. This ultimately led to the
introduction of a single European currency, the euro, on 1 January 1999. At its inception there
was no agreement that the creation of the Exchange Rate Mechanism (ERM) would ultimately
lead to the creation of a single European currency. However, opinion changed in the 1980s and
in 1992 the Treaty of Economic and Political Union was signed at Maastricht, which, among
other things, established specific convergence criteria for the EU to move to a single currency.
The euro was introduced in 1999 as a unit of account and in 2002 as paper currency, initially
adopted by 12 countries. Since the start of the euro, several additional countries have joined
the monetary union, and several other countries are in the process of (trying to) adopt the euro.
As of 1 January 2015, the Eurozone has 18 member states; for a current list of members of the
Eurozone, see
http://www.eurozone.europa.eu/euro-area/euro-area-member-states/.
A number of smaller countries, such as Andorra, have the right to use euro-coins, but are not
full members of the Eurozone.
During the credit crisis, the Eurozone has come under considerable stress as several member
states experienced severe economic problems, to a large extent created by a weak banking
system. Particularly the sovereign debt default in Greece, and the subsequent bailouts by the
‘Troika’ of the European Union (EU), European Central Bank (ECB), and International
Monetary Fund (IMF) raised considerable questions about the sustainability of the euro. KOM
Chapter 21 and De Grauwe (2012) provide an overview of some of the challenges faced by the
Eurozone in the wake of the euro crisis.
Convergence criteria
The Maastricht treaty outlined five main areas of macroeconomic convergence that member
states needed to adhere to before they could enter into the European Monetary Union (EMU).
1. The country must have maintained a stable exchange rate within the ERM for a
sufficiently long period (two years for most members of the euro).
2. Inflation must not exceed by more than 1.5 per cent the average of the EU member states
with the lowest inflation.
212
3. Long term interest rates (on a 10 year reference bond) must not exceed by more than 2
per cent the average of the EU member states with the lowest inflation (see also point 1
above).
4. The country must have a government budget deficit of less than 3 per cent of GDP.
5. The country must have a public debt below 60 per cent of GDP.
It is clearly desirable that countries are able to maintain a stable exchange rate within the
monetary system, because after they have joined the common currency, adjusting the
exchange rate (for instance, to address a current account imbalance) is no longer an option.
Likewise, convergence of inflation rates and interest rates is important to ensure that no
significant current account deficits occur after joining the common currency.
One problem of the Eurozone is that fiscal policy is still in the hands of domestic
governments, while these governments no longer have access to their own monetary policy.
Therefore, two conditions have been included to ensure fiscal probity of member states: one
on the size of the budget deficit and one on the total size of the government debt. For
prospective joiners of the Eurozone, the ECB publishes a regular convergence report to track
how these member states perform as measured by the Maastricht convergence criteria.
Even after joining the euro, member states were expected to adhere to the convergence criteria
outlined above, especially the deficit and debt ceilings. In 1998 the EMU member states
signed the Stability and Growth Pact (SGP) to further limit the fiscal freedom of member
states. There is disagreement among economists over the extent to which these criteria need to
be strictly adhered to. Indeed, the budget deficit rule especially has been breached by a large
number of member states, especially in the wake of the credit crisis. Furthermore, several
countries have breached the debt ceiling of 60 per cent. Not surprisingly, the EU has shown
some flexibility in the interpretation of the rules.
19.2.2 The costs of a common currency
The sections on the costs and benefits of a common currency are largely based on C Chapter
16 (Copeland).
The costs of creating a monetary union with a common currency stem from the fact that in
such circumstances a nation relinquishes the right to pursue an independent monetary policy
in the domestic economy and the ability to adjust the exchange rate, so as to offset a loss of
competitiveness in the international economy. Thus, the loss of the monetary policy tool may
lead to a loss in economic stability. Instead the country will have to rely on other economic
stabilisers, such as a high wage flexibility and/or a high mobility of labour to mitigate the loss
of monetary autonomy.
However, there is now widespread agreement that in the long run, discretionary monetary
policy leads only to increased inflation and, when information lags are short (nominal
rigidities are weak), the short run gains from discretionary monetary policy are unlikely to be
greater than the costs of greater inflation. Also, the gains of monetary policy are often as the
result of some beggar-thy-neighbour policies, where the expansion in output is mainly as a
result of a depreciation of the currency, increasing domestic output at the cost of a decrease in
foreign output. As discussed in Chapter 15 of the subject guide this is essentially a zero-sum
game, which may result in an unproductive tit-for-tat of competitive devaluations.
213
Wage flexibility
If wages are flexible in both countries, then increased employment in country A will result in
the wage rate in that country being bid upwards because of increased demand for labour. As
higher wages transpose into higher prices, exports from country A will become less
competitive and, as they fall, output and employment in country A will fall. Exactly the
opposite happens in country B. The increase in unemployment results in a reduction in wages
in country B. As lower wages transpose into lower prices, exports from country B will
increase and so output and employment in country B will rise. This process of adjustment will
continue until external equilibrium is restored.
Mobility of labour
In the absence of the ability to devalue a currency to restore external equilibrium and reduce
real wages, another way has to be found to deal with regional unemployment. As we have
seen, wage flexibility is part of the solution, and mobility of labour is another part of the
solution. If labour is mobile between regions the higher demand for labour in country A will
result in workers moving from country B where demand for labour has fallen. In these
circumstances, movement of labour removes the need for adjustments in the wage rate.
Inflation in country A is no longer a problem because the influx of workers from country B
results in an increase in output and unemployment is no longer a problem in country B
because of the exodus of workers to country A.
In the Eurozone, the Schengen agreement, which allows for the free movement of residents
within most of the EU, has removed many of the legal barriers to mobility of labour; however,
many indirect barriers remain. In particular, language barriers and cultural differences between
European countries limit the extent to which labour is mobile.
Asymmetric shocks
If the countries of a monetary union are prone to different shocks, perhaps because they
concentrate on the production of different goods and services or the set-up of labour market
institutions within each country are different, then the cost of a common currency may be
large. One country may experience a negative shock, sending it into recession, while other
members of the union may be relatively unscathed.
Monetary policy cannot be used to counter the shock since with a single currency, monetary
control is completely handed over to a central body – the ECB in the case of Europe – which
decides policy in the interests of the entire area, not for individual member states. Monetary
easing may not be appropriate if the shock only hits one member country.
Activity 19.1
1. What obstacles are there to wage flexibility?
2. What problems are there with allowing output to fall until balance of payments
equilibrium is restored?
214
19.2.3 Benefits of a common currency
In general, the benefits of adopting a common currency derive from the elimination of
transaction costs (associated with exchanging national currencies) and from the elimination of
risk (stemming from unanticipated movements in exchange rates).
Transaction costs
In part, gains from eliminating transaction costs are easily observed and quantifiable.
Whenever domestic residents visit a foreign country either as tourists or on business, or
whenever firms invest abroad or purchase goods and services abroad, transaction costs from
converting domestic currency into foreign currency are incurred. The creation of a common
currency would eliminate these transaction costs and in 1990 the EC Commission estimated
that this would lead to savings of between 0.25 per cent and 0.5 per cent of community GDP.
Another way in which society will gain from the elimination of transaction costs is from the
increased competition that will follow because the scope for price discrimination will be
reduced. When prices are quoted in a common currency, any price difference in different parts
of the community will be immediately obvious to consumers. If a single currency exists, the
transaction costs associated with purchases in different parts of the community will be reduced
and the welfare of society will be increased accordingly as competition forces prices down.
Exchange rate uncertainty
The elimination of exchange rate uncertainty would result in a major welfare gain to society. It
is often alleged that producers in particular are risk-averse and that, by making revenue more
certain, investment and production will be encouraged. In fact, it is by no means certain that
this is the case and the outcome depends partly on the way a nation’s currency moves on the
foreign exchange market against other currencies. There is certainly greater risk when
exchange rates fluctuate than exists when there is a single currency.
The price mechanism
The price mechanism is an elaborate system of communications through which consumers

and producers convey information to each other. Consumers convey information about their
preferences for certain goods over other goods shown by the amount they purchase at different
prices; and producers convey information about the availability of their products shown by the
amounts they make available at different prices. It is possible to argue that so long as certain
conditions are met, in a world of certainty the price mechanism will be used efficiently so that
resources will be allocated optimally. However, in a world of uncertainty we cannot be certain
that decisions about production, consumption and investment will be optimal. For example,
any decision to invest abroad or to buy or sell outside the domestic economy is based on an
expected return. An unanticipated change in the exchange rate can reduce the profits available
from such transactions. In this sense, exchange rate uncertainty reduces the usefulness of
information conveyed through the price mechanism, which impairs its ability to allocate
resources optimally. The implication is that exchange rate uncertainty results in a welfare loss
to society.
215
Competitive devaluations
In Chapter 15 of the subject guide it was suggested that governments might have an incentive
to renege on policy promises and adjust monetary policy to exploit some short-run trade-off
between inflation and unemployment. Nations can implement beggar-thy-neighbour policies
to switch output from abroad to the domestic economy. When there is a common currency,
monetary policy is set from the centre and national governments lose the ability to vary
monetary policy. Since the European Central Bank is independent of national governments,
the time consistency of monetary policy would be assured. Essentially, a common currency
removes the ability of each nation to use monetary policy to implement beggar-thy-neighbour
policies.
Activity 19.2
1. Why was stability in certain key macroeconomic aggregates a desirable prerequisite

for a transition to the EMU?
2. What factors determine whether a group of countries would be better off having a
single currency rather than each country having its own currency?
3. During the Maastricht treaty negotiations, Germany insisted that there must be a limit
on the debts and budget deficits of countries joining the European Monetary Union.
Why did Germany want to impose these limits?

This chapter has discussed the advantages and disadvantages of monetary unions, through the
example of the Eurozone.

list and assess the advantages and disadvantages of monetary union.
1. Assess the relative advantages and disadvantages for a small open economy of joining a
monetary union.
2. Discuss the extent to which the Eurozone is an optimum currency.
216

1. Section 19.2.1 of this chapter provides a discussion on the advantages and disadvantages
of joining a monetary union.
2. This is a very open question that does not have a single correct answer. A good answer
would list arguments for both sides of the statement and then would make a coherent
conclusion either way. The reasoning here is more important than the final answer.
On the one hand, the area’s economy is closely integrated with its own: most EU
members export from 10 to 20 per cent of their output to other EU members; also, many
legal barriers to the movement of capital and labour within the Eurozone have been
removed. On the other hand, there are many signs that the Eurozone might not be an
optimum currency area, yet: although there is substantial intra-Eurozone trade, PPP does
not seem to hold well within the Eurozone; also, there are a lot of indirect barriers to the
movement of labour, such as language and cultural differences; furthermore, fiscal policy
is still conducted mainly at the country level, and not at the level of the Eurozone. For
more information see the Case Study ‘Is Europe an Optimum Currency Area?’ in KOM
Chapter 21. All in all, it is quite probable that the euro was founded not on the belief that
the Eurozone was an optimum currency area at the time, but that it would evolve into one
over time, and the euro was seen as an important step towards the goal of European
integration.
217
218
Chapter 20
International capital markets
20.1 Introduction
Since the late 1960s there has been a phenomenal internationalisation of financial activity,
accompanied by enormous growth in international transactions in assets. International
transactions in assets take place in what is known as the international capital market. The
international capital market is made up of an interconnected network of individual markets
and institutions located in many different countries. These markets trade in assets such as
government securities, corporate bonds, bank deposits, equities and mortgages. An increasing
variety of financial derivatives are also traded. A number of questions arise concerning the
development of the international capital market:
Why has the international capital market grown so fast?

How well has the international capital market performed?
What has been the role of the international capital market in recent international financial
crises?

This chapter aims to discuss international capital markets, and consider how these relate to
recent international financial crises.

should be able to:
explain the motivation for international trade in assets

describe the major developments in international capital markets, including offshore
banking and eurocurrencies
discuss how the performance of both the international capital market and the foreign
exchange market might be evaluated.

Chapter 20 of KOM provides an overview of financial globalisation. KOM also provides some
insights into market efficiency and excess volatility; however, for a detailed discussion of these
219
20. International capital markets
latter two topics, you will need to read Chapters 11 to 13 of C.
KOM, Chapter 20 ‘Financial globalization: opportunity and crisis’.
C, Chapter 11 ‘Market efficiency and rational expectations’, Chapter 12 ‘The “news”

model, exchange rate volatility and forecasting’ and Chapter 13 ‘The risk premium’.

FT, Chapter 22 ‘Topics in international macroeconomics’.
Engel, C. ‘The forward discount anomaly and the risk premium: A survey of recent
evidence’, Journal of empirical finance 3 (1996), pp.123–92.
Feldstein, M. and C. Horioka ‘Domestic saving and international capital flows’,

Economic journal 90 (June 1980), pp.314–29.
Griffin, J. and G.A. Karloyi ‘Another look at the role of the industrial structure of markets
for international diversification strategies’, Journal of financial economics 50(3) (1998,
December), pp.351–73.
Lewis, K. ‘Trying to explain home bias in equities and consumption’, Journal of

economic literature 37(2) (1999), pp.571–608.
Rodrik, D. ‘How far will international economic integration go?’, Journal of economic
perspectives 14(1) (2000), pp.177–86.


This chapter looks at international capital markets.
20.2.1 Growth of the international capital market

The gains from trade in assets
In Part 1 of the subject guide it was suggested that capital flows can be explained in part as
intertemporal trade in goods and services. In other words, if a country runs a current account
deficit this can be financed by the sale of, say, bonds which are financial claims on goods and
services in the future. There are mutual gains to be had from this kind of trade. Typically, the
deficit country will have good investment opportunities but inadequate domestic savings and
hence will find it advantageous to borrow on the international capital market to finance its
220
development, while the lending country gains by obtaining a higher rate of return than is
available at home.
However, inspection of a country’s balance of payments accounts would normally reveal that
the volume of transactions in assets far exceeds what is needed to finance a current account
deficit or surplus. Thus, in practice most international capital flows represent the
international exchange of assets for other assets, rather than intertemporal trade.
Activity 20.1 Inspect the balance of payments accounts of your – or any other – country
and identify the main financial account transactions. What proportion of these were ‘used’
to cover a current account deficit or surplus?
What motivates international exchange of assets and what are the gains from it? The answer is
that it permits portfolio diversification (that is, the opening of international capital markets
allows economic agents to hold a mix of assets that reduces the riskiness of the return on their
wealth). If asset returns are uncertain, and the pattern of returns in one country is different
from those in another, then an exchange of assets – so that agents in both countries hold a mix
of assets from both countries – will reduce the risk for both parties to the exchange, while
keeping expected returns unchanged.
Why have international capital markets grown so much?
A major factor in the growth of international capital markets has been the gradual removal of
capital controls from the late 1960s onwards. Following the end of the Second World War,
almost all countries imposed extensive controls on both current and capital account
transactions. In developed countries, most current account transactions were free of
restrictions by 1961. In many countries, capital account controls remained on the books but
were little or only intermittently used in the 1960s. However, the widespread removal of
formal capital controls was enabled when most of the world moved to a system of floating
exchange rates in the early 1970s, following the breakdown of the Bretton Woods system.
Recall from the previous chapter that the Bretton Woods system tried to combine fixed
exchange rates with monetary independence, supported by capital controls. However, the
increasing unwillingness both to constrain international capital flows and to import the
monetary policy of the USA imposed strains on the system. Thus the breakdown of the fixed
exchange rate system permitted the full removal of capital controls while at the same time
countries were free to pursue a domestically oriented monetary policy.
While the removal of capital controls has been a necessary condition for the development of
international capital markets, paradoxically, a major positive factor behind certain
developments has been the existence of domestic regulation and the desire of financial
institutions to evade such regulations. In particular, the desire by United States’ banks to
circumvent domestic banking regulations in the 1960s led to the growth of offshore banking
and to the development of what has come to be known as eurocurrencies. Offshore banking
refers to business that banks undertake outside the jurisdiction of their home country and
eurocurrencies are deposits denominated in a currency other than the home currency of the
bank. The term ‘euro’ in the name predates the advent of the Single European Currency and
hence is not connected with that; rather it is to do with the fact that the original eurocurrency
activity concerned dollars deposited in Europe: London, in particular. Dollars deposited
outside the USA became known as eurodollars and as deposits in other currencies grew, these
221
came to be known as eurocurrencies. Today, trading in eurocurrencies takes place in financial

centres all over the world.
A good account of eurocurrencies, offshore banking and international banking in general can
be found in KOM Chapter 20. This includes a section on the difficulties involved in regulating
international banking, and the wider implications of the failure of financial institutions that are
involved in international capital markets.
Activity 20.2 Consult the monetary statistics of your country and identify the share of
bank deposits in foreign currencies.
20.2.2 Capital market performance

The performance of the international market may be judged according to a number of
alternative criteria. These include:
How far have the gains from trade in assets been exploited in international capital
markets?
How far are foreign exchange markets efficient?
How far are foreign exchange markets excessively volatile?
Evidence on the gains from trade in assets
What is the empirical evidence on the gains from trade in assets? Although the degree of
integration has steadily increased since the fall of Bretton Woods – see Chapter 18 of the
subject guide – markets are still far from completely integrated (see, for instance, the survey
by Rodrik (2000)).
Let us first consider the evidence on intertemporal trade. A possible test of the degree of
exploitation of gains from intertemporal trade is the extent to which national investment rates
are independent of national savings rates. If there is a lot of intertemporal trade, there should
be a low correlation between national savings and national investment. However, the empirical
evidence points to a high correlation between national savings and national investment rates
across countries and hence suggests limited exploitation of the gains from intertemporal trade.
This puzzling finding is known in the academic literature as the Feldstein-Horioka puzzle after
the authors who first highlighted this issue (Feldstein and Horioka, 1980).
Second, consider the gains from the international exchange in assets: namely, international
portfolio diversification. The literature identifies two main sources of international portfolio
diversification: (i) different countries have different industry compositions; (ii) the business
cycles of countries are not very synchronised. There is some debate in the literature as to
which of the two factors is the most important, but the most popular view is that the driving
factor for gains from international portfolio diversification are varying business cycles (Griffin
and Karolyi, 1998). Although the gains from international portfolio diversification are clear, it
is a well reported stylised fact that most investors do not in fact diversify much internationally.
Portfolio theory predicts that in a well diversified portfolio the weights of investments in
countries should be roughly proportional to the size of their economies; that is, most money
should be invested in foreign bonds and equities. However, in most countries the vast majority
222
of wealth is instead invested inside the country itself, rather than abroad. This is sometimes
referred to as ‘Home Bias’ (Lewis, 1999).
As stated before, however, definitely some market integration has taken place over the last
decades. KOM show that onshore-offshore interest rate differentials have all but vanished
since the early 1980s. The existence of such differentials for the same class of asset would be
evidence of unexploited gains from assets.
Activity 20.3 In your country, how big are foreign assets as a proportion of national
wealth? How much of your country’s capital stock is foreign-owned? How do these figures
compare with the size of your economy?
Foreign exchange market efficiency
The foreign exchange market mediates all international asset transactions and hence its
performance contributes to the effectiveness of international capital markets as a whole. A
particular measure of market performance that has received much attention in the context of
foreign exchange markets is market efficiency. A market is said to be efficient if prices fully
reflect all the available information. If asset prices do not reflect the available information then
markets may be providing economic agents with incorrect signals, with negative consequences
for the allocation of resources.
Assessing the evidence on foreign exchange market efficiency is technically and theoretically
challenging, not least because it involves making inferences about people’s inherently
unobservable expectations. As KOM show, the empirical evidence on the efficiency of foreign
exchange markets is mixed.
One puzzling finding, discussed in Chapter 13 of the subject guide, is that UIP does not seem
to hold for most of the time. Another way to look at market efficiency is to use UIP to think of
the interest differential as a forecast of the expected change in the exchange rate. If markets
are efficient, then the forecast error
ut = (st+1 − st ) − (rt − rt∗ ), (20.1)
should not be predictable, in the same way that excess stock returns should be unpredictable in
an efficient stock market. However, this is clearly not the case in reality: there is a large body
of evidence that past forecast errors can predict future forecast errors in the foreign exchange
market. Although it does not constitute direct evidence, this finding is fairly suggestive that
the foreign exchange market is not entirely efficient.
Related to the failure of UIP is the role of risk premia in determining exchange rate
movements. If assets are imperfect substitutes, then the expected return will include a –
potentially time-varying and most likely unobserved – risk premium,
Est+1 − st = αt + (rt − rt∗ ). (20.2)

In this case, deviations from UIP, ut , are composed both of a forecasting error et and the
(unobserved) risk premium αt ,
et + αt = (st+1 − st ) − (rt − rt∗ ). (20.3)
223
Although a lot has been written about the presence/absence of risk premia, the literature has
not yet resolved how important risk premia are and whether they serve as an explanation for
the observed deviations from UIP (Engel (1996) provides a survey on the topic).
Another puzzling finding is that exchange rates tend to be more volatile than many other
economic variables and certainly significantly more volatile than the variables such as money
supplies or output (that is, the so-called ‘fundamentals’), which are thought to determine
exchange rates. A question arises as to whether exchange rate volatility is excessive. However,
assessment of this issue depends upon a satisfactory definition of excess volatility and this
definition has proved hard to find. Several models have been developed to try and explain the
excess volatility in exchange rates, most notably the exchange rate overshooting model
discussed in Chapter 13 of the subject guide.
Activity 20.4 For your country, plot and compare monthly movements in the following
series: money supply, consumer prices, the exchange rate against the US dollar, stock
market indices, the stock market price of a major local company. How volatile is the
exchange rate of your country in comparison to its fundamentals?

In this chapter, we have discussed international capital markets, and have considered how
these relate to the recent international financial crises.

explain the motivation for international trade in assets
describe the major developments in international capital markets, including offshore

banking and eurocurrencies
discuss how the performance of both the international capital market and the foreign
exchange market might be evaluated.
1. Foreign exchange rate efficiency

(a) What is meant by efficient foreign exchange rate markets?
(b) Do huge profits by an individual speculator – such as for example George Soros –
necessarily imply foreign exchange markets are inefficient?
224
(c) Explain why foreign exchange rate markets may be efficient even if it is possible to
make a positive expected return from using forecasting techniques.
2. Sometimes it is claimed that the international equality of real interest rates is the most
accurate barometer of international financial integration. Discuss whether or not this is
the case.

1. A good answer would point out that:
(a) Foreign exchange market efficiency implies that, conditional on an information set,
all relevant information is incorporated in the exchange rate and no abnormal returns
can be obtained by speculating in the foreign exchange market using that
information. As with equity markets, there exist different notions of market
efficiency, each relating to a different information set. For example, weak form
efficiency refers to the case where past information about the exchange rate is priced
in the current exchange rate.
(b) No, markets can still be efficient, even if there are single large investors who are
seen to make large returns. Consider that the returns might be due to: (a) luck; (b)
information held by the investor that is not in included in the general information set
(that is, insider information for a semi-strong efficient market).
(c) The key to answering this part of the question is realising that risk premia might be
present. If risk premia are present, then the forecastable part of the return can be a
reward for risk, rather than an abnormal return. In this case, markets are still
efficient, even though the exchange rate is (partially) forecastable.
2. This question requires an understanding of both the material covered in this chapter as
well as Chapter 14 of the subject guide. A good answer would point out that real interest
rate equality is not an accurate barometer of international financial integration. If there
are real differences between countries’ productivity or trends in world demand that lead
to expected changes in the real exchange rate over time, we may see different real interest
rates despite perfectly functioning integrated financial markets.
225
226
Appendix A
Sample examination paper
Important note: This Sample examination paper reflects the examination and assessment
arrangements for this course in the academic year 2015–2016. The format and structure of the
examination may have changed since the publication of this subject guide. You can find the
most recent examination papers on the VLE where all changes to the format of the
examination are posted.
Time allowed: three hours.
Candidates should answer FOUR of the following TEN questions: QUESTION 1 of Section A
(40 marks), and THREE questions from Section B (20 marks each). Candidates are strongly
advised to divide their time accordingly.
SECTION A Answer all parts of Question 1 (40 marks in total).
1. Consider the following market for the homogenous good, rice, in Home country: The
country’s demand curve for rice is: DH = 27 − 0.75PH , where DH is domestic quantity of
rice demanded and PH is the domestic price of rice. The country’s supply for rice is:
QH = −6 + 0.75PH , where QH is the domestic quantity of rice supplied and PH is the
domestic price of rice.
(a) Determine home import demand for rice. (2 marks)
(b) Let Foreign export supply be defined as the difference between supply (QF ) and
demand (DF ) in the foreign country: (QF − DF ) = −3 + 1.5PF , where PF is the
domestic price of the homogenous good. Find the world’s free trade equilibrium
price and the equilibrium level of Foreign exports. Find also Home consumer’s
surplus and Home producer’s surplus. (3 marks)
(c) Suppose the government in the home country decides to introduce an import quota
q. Let q = 9. What is the import tariff that is equivalent to the quota in terms of its
effects on home imports? (4 marks)
(d) Let the Home country be a big country. What is the new world market clearing price
after Home introduces a tariff t = 4? Draw a diagram for the home country, the
foreign country and the market clearing for import and export market. Does the
introduction of the tariff improve the welfare of Home country? (6 marks)
(e) Suppose now that the big Home country also produces manufactures. Use a general
equilibrium diagram to describe the welfare implications of the introduction of the
tariff on the imported goods. (5 marks)
Consider a small open economy that is pegging its exchange rate by intervening in the
foreign exchange market if necessary; however, the domestic central bank keeps
expanding the domestic credit component of money supply at a constant rate, µ. In the
case of a speculative attack on the currency, the central bank will deplete all its foreign
reserves (and will not replenish them) and will let the currency float from then onwards.
227
A. Sample examination paper
There is perfect capital mobility and output is fixed in both countries, the foreign interest
rate, i∗ is assumed to be zero. Also assume that purchasing power parity holds and that
the log of real money demand depends linearly on the nominal interest rate.
(f) Impose the equilibrium condition in the money market to determine the relationship
between the nominal exchange rate, foreign reserves and the domestic credit
component of money supply. (5 marks)
(g) Define the shadow exchange rate. What is its evolution? (3 marks)
(h) When will investors attack the fixed exchange rate regime? Draw a graph with the
evolution of the shadow exchange rate, the currency peg, s, and the level of the
foreign reserves in a diagram on which you put time on the horizontal axis. Discuss
the path the exchange rate will follow. (5 marks)
(i) Is the above model a good description of the ERM crisis in 1992? If yes, explain
why; if not, give an explanation of the ERM crisis. (5 marks)
(j) Suppose now that the central bank can credibly commit to stop increasing the
domestic component of the money supply when foreign reserves hit the lower bound
(Ft = 0). Is the peg sustainable under this new policy? Explain.
(2 marks)
SECTION B Answer any THREE questions (20 marks per question).
2. Consider the neoclassical model of trade with two countries, two goods and two factors
of production. Markets are perfectly competitive. Use a general equilibrium diagram to
examine whether an import subsidy can improve welfare for a large country. Explain the
economic intuition of your answer.
3. Consider the specific factor model for a small open economy. There is a mobile factor,
labour, and two short-run sector-specific types of capital K1 and K2 . Discuss the short run
implications of an increase in labour endowment L on the allocation of the three
production factors across sectors. Suppose that in the long run K1 and K2 are freely
mobile across sectors. What is the long-run effect of the increase in L on the allocation of
the three production factors?
4. Find a combination of domestic policies reproducing the effects of an export subsidy in a

small open economy. First derive the welfare implications of the export subsidy. Second,
find the fiscal policy that replicates the welfare outcome by introducing a combination of
consumptions and production subsidies/taxes.
5. Are there any arguments in favour of trade protection? Do these arguments change for
small and big countries? Do differences in competitive situations lead to different
strategic policy prescriptions? If protection from trade is bad, why are trade restrictive
policies so widespread?
6. Despite having observed the depreciation of some currency (both in real and nominal
terms), the trade balance and the current account of that country have failed to improve in
the short-run. What could be possible explanations for such patterns?
228
8. Show how, in the flexible-price monetary model, the exchange rate can be expressed as a
function of expectations about future fundamentals. What will happen to the exchange
rate if people’s expectations of future income decreases? What will happen to the
exchange rate if people’s expectations of future money supply decrease? (Try to show
mathematically and explain the intuition.)
9. East Asian countries have accumulated very large stocks of foreign exchange reserves in
the past decade. Explain why, in the context of a first generation model of currency
crises, countries would like to have a large stock of foreign exchange reserves.
(Note: You are expected to provide a graphical analysis as well as an explanation.)
END OF PAPER
229
A. Sample examination paper
230
Appendix B
Sample Examiners’ Commentary
Important note: This sample examination paper and Examiners’ Commentary reflect the
examination and assessment arrangements for this course in the academic year 2015–2016.
The format and structure of the examination may have changed since the publication of this
subject guide. You can find the most recent examination papers on the VLE where all changes
to the format of the examination are posted.
Time allowed: three hours.
Candidates should answer FOUR of the following TEN questions: QUESTION 1 of Section A
(40 marks), and THREE questions from Section B (20 marks each). Candidates are strongly
advised to divide their time accordingly.
SECTION A Answer all parts of Question 1 (40 marks in total).
1. Consider the following market for the homogenous good, rice, in Home country: The
country’s demand curve for rice is: DH = 27 − 0.75PH , where DH is domestic quantity of
rice demanded and PH is the domestic price of rice. The country’s supply for rice is:
QH = −6 + 0.75PH , where QH is the domestic quantity of rice supplied and PH is the
domestic price of rice.
Reading for the first part of this question (a–e)
Chapter 8 of the subject guide.
KOM, Chapter 9 ‘The Instruments of Trade Policy’.
(a) Determine home import demand for rice. (2 marks)

Approaching the question
Solution: DH − QH = 33 − 1.5Pw
Let Foreign export supply be: −(QF − DF ) = −3 + 1.5PF , where PF is the domestic
price of the homogenous good.
(b) Let Foreign export supply be defined as the difference between supply (QF ) and
demand (DF ) in the foreign country: (QF − DF ) = −3 + 1.5PF, where PF is the
domestic price of the homogenous good. Find the world’s free trade equilibrium
price and the equilibrium level of Foreign exports. Find also Home consumer’s
surplus and Home producer’s surplus. (3 marks)
Solution: DH − QH = QF − DF . Hence Pw = 12. Export level = 15. Consumer
surplus: (36 − 12) × 18/2 = 216. Producer surplus: (12 − 8) × 3/2 = 6
(c) Suppose the government in the home country decides to introduce an import quota
q. Let q=9. What is the import tariff that is equivalent to the quota in terms of its
effects on home imports? (4 marks)
231
B. Sample Examiners’ Commentary

Solution: 33 − 1.5 × (pw + t) = 9. Hence, given pw = 12, the optimal tariff level is
t = 4.
(d) Let the Home country be a big country. What is the new world market clearing price
after Home introduces a tariff t = 4? Draw a diagram for the home country, the
foreign country and the market clearing for the import and the export market. Does
the introduction of the tariff improve the welfare of the Home country? (6 marks)
Solution: 33 − 1.5 × (PW + t) = −3 + 1.5PW . Hence 33 − 1.5PW − 6 = −3 + 1.5PW
and PW = 10
Consumer’s surplus = (36 − 14) × 16.5/2 = 181.5
Producer’s surplus = (14 − 8) × 6.5/2 = 19.5
Government surplus = 4 × (16.5 − 6.5) = 42
Hence the aggregate effect is an increase in the country’s welfare: T S = 243 > 232
(e) Suppose now that the big Home country also produces manufactures. Use a general
equilibrium diagram to describe the welfare implications of the introduction of the
tariff on the imported goods. (5 marks)
Consider:
Two countries: i = {H, F}
Two sectors: j = {1, 2}
Suppose H exports good 1 (imports good 2) and F exports good 2 (imports
good 1).
Under an import tax in H: consider an ad valorem import tariff tax
Pd2 = (1 + T )Pw2
!d !w
Pw1
" #
P1 P1
Pd1 = Pw1 → = <
P2 (1 + t)Pw2 P2
Thus, under an import tariff and given world prices, the relative domestic price
of good 1 falls.
Consider a small open economy that is pegging its exchange rate by intervening in the
foreign exchange market if necessary; however, the domestic central bank keeps
expanding the domestic credit component of money supply at a constant rate, µ. In the
case of a speculative attack on the currency, the central bank will deplete all its foreign
reserves (and will not replenish them) and will let the currency float from then onwards.
There is perfect capital mobility and output is fixed in both countries, the foreign interest
rate, r∗ is assumed to be zero. Also assume that purchasing power parity holds and that
the log of real money demand depends linearly on the nominal interest rate.
Reading for the second part of this question (f–i)
Chapters 16 and 17 of the subject guide.
232
(f) Impose the equilibrium condition in the money market to determine the relationship
between the nominal exchange rate, foreign reserves and the domestic credit
component of money supply. (5 marks)
This subquestion and the subquestions that follow effectively ask you to reproduce
the first generation crisis model as described in Chapter 17 of the subject guide as
well as KOM Chapter 18 and FT Chapter 20.
The basic equilibrium condition in the money market is that mdt = mts , and money
demand is given by
mdt = pt − αyt + βrt
where mdt is the log of demand for nominal money; pt , yt and rt are the log of price
levels, log of real output and the domestic interest rate respectively. See Chapter 13
of the subject guide for details on the equilibrium in domestic money markets. Using
the monetary model outlined in Chapter 14 of the subject guide, the exchange rate is
determined by
st = pt − p∗t = k + mt + βrt
where st is the log spot exchange rate, mt the log of money supplies, and rt the
domestic interest rate. The constant k is defined as k = −α(yt − y∗t ) − m∗t − βrt∗ and
groups together all variables that are assumed constant throughout the analysis.
Without loss of generality, k can be assumed zero for compact notation.
Using UIP, we can replace rt with E∆st+1 , the expected change in the exchange rate,
which is zero under the peg (st ).
st = k + mt + βE∆st+1
st = k + mt
Furthermore, we know that nominal money supplies are defined as the sum of
domestic credit held by the central bank and foreign reserves: Mt = Bt + Ft . Thus,
ignoring the constant k for the moment, under the peg, the nominal exchange rate is
determined exclusively by the supply of money; that is, the sum of foreign reserves
and domestic credit held by the central bank.
(g) Define the shadow exchange rate. What is its evolution? (3 marks)
The shadow exchange rate is defined as the rate that will prevail if the currency will
be floating (and by assumption, foreign reserves will be zero). Using the monetary
model from the previous part, and noticing that mt = bt and rt = µ, the shadow
exchange rate is defined as:
s̃t = k + bt + βµ
Thus the shadow exchange rate will steadily increase at rate µ (that is, the domestic
currency will depreciate at rate µ under a floating exchange rate regime).
233
(h) When will investors attack the fixed exchange rate regime? Draw a graph with the
evolution of the shadow exchange rate, the currency peg, s, and the level of the
foreign reserves in a diagram on which you put time on the horizontal axis. Discuss
the path the exchange rate will follow. (5 marks)
Investors will attack the peg when the shadow exchange rate is exactly equal to the
peg. At this point, investors will launch a speculative attack against the central bank,
depleting its foreign reserves, causing a one-off drop in domestic money supplies;
the exchange rate will then start floating, and depreciation at rate µ. Interest rates
and inflation go up by rate µ as well as after the speculative attack. There are no
jumps in the exchange rate itself, and the transition between peg and float is smooth.
The path of the exchange rate is given by Figure 16.5; FT, Chapter 20 also provides
figures for the path of the exchange rate and the fundamentals, during a first
generation exchange rate crisis.
(i) Is the above model a good description of the ERM crisis in 1992? If yes, explain
why; if not, give an explanation of the ERM crisis. (5 marks)
This question tests your ability to link different crisis models to real world crises. In
this case, the events surrounding the ERM crisis of 1992 was largely at odds with the
first generation crisis model, as there was little evidence of expansive monetary
policy by the Bank of England prior to the crisis. Instead, the ERM crisis is better
characterised by a second generation crisis model, which focuses on contingent
monetary policies and their role in self-fulfilling currency crises.
(j) Suppose now that the central bank can credibly commit to stop increasing the
domestic component of the money supply when foreign reserves hit the lower bound
(Ft = 0). Is the peg sustainable under this new policy? Explain. (2 marks)
Yes, the peg is now sustainable. The shadow exchange rate/floating exchange rate
will depreciate at the rate of the increase in the money supply. As such, when the CB
stops increasing the domestic component of the money supply when foreign reserves
are zero, the shadow exchange rate will never go above the pegged rate and there
will be no incentive for investors to attack the peg.
SECTION B
Answer any THREE questions (20 marks per question).
2. Consider the neoclassical model of trade with two countries, two goods and two factors
of production. Markets are perfectly competitive. Use a general equilibrium diagram to
examine whether an import subsidy can improve welfare for a large country. Explain the
economic intuition of your answer.
Reading for this question
KOM, Chapter 9 ‘The Instruments of Trade Policy’.
The implementation of the import tariff by a large country will have an impact on the
relative world prices (or terms of trade). In the large country case there are conflicting
234
effects on welfare. The consumption and production distortions arising from the tariff
work to lower welfare, while the improved terms of trade that home faces as a result of
the tariff is welfare-improving. The net effect is ambiguous.
See Figures 8.9 and 8.10 for a graphical representation of a welfare-improving tariff. The
implementation of the tariff shifts the world prices from (P M /PF )W to (P M /PF ) W . At the
0
same time the introduction of the tariff introduces a wedge between the world prices and
the domestic ones which results in the (P M /PF )H line (that is tangent in point C). When
the tariff is rebated to the consumers the optimal consumption level shifts from B to D
which is in this case welfare improving. It can also be the case that D is below B and the
policy is welfare reducing.
3. Consider the specific factors model for a small open economy. There is a mobile factor,
labour, and two short-run sector-specific types of capital K1 and K2 . Discuss the short run
implications of an increase in labour endowment L on the allocation of the three
production factors across sectors. Suppose that in the long run K1 and K2 are freely
mobile across sectors. What is the long-run effect of the increase in L on the allocation of
the three production factors?
KOM, Chapter 4 ‘Specific Factors and Income Distribution’.
Specific factors model: subject guide, Chapter 4; KOM Chapter 4 ‘Specific Factors and
Income Distribution’. Heckscher–Ohlin model: subject guide, Chapter 3; KOM Chapter 5
‘Resources and Trade: The Heckscher–Ohlin Model’, pp.117–21.
Increase in labour supply is represented by an extension of the horizontal dimension of
the box.
Short run: An increase in L raises employment in both sectors. Given that the two types
of capital are sector-specific, their allocation is not affected in the short run.
Long run: According to the Rybczynsky Theorem, an increase in L raises the amounts
of capital and labour allocated to sector 2 and reduces the amounts allocated to sector 1.
Notice that the short-run and long-run outcomes are also contradictory here.
4. Find a combination of domestic policies reproducing the effects of an export subsidy in a

small open economy. First derive the welfare implications of the export subsidy. Second,
find the fiscal policy that replicates the welfare outcome by introducing a combination of
consumptions and production subsidies/taxes.
Again we assume a small country for simplicity (large country case is a simple extension;
see KOM as well). An export subsidy is a payment to a firm that exports a good. Consider
the diagram below. With the subsidy, when a firm exports the good, it receives a higher
price for that good than when it sells it domestically. Hence the firm’s incentive is to
235
S
Pw + s
a b c d
Pw
D
Q
X1 X0 Q0 Q1
Figure B.1: Welfare effects of an export subsidy
export more of its output, leaving a smaller quantity for domestic consumers. Thus at the
given world free trade price, from the initial equilibrium condition at home, there is now
an excess demand for the good, so the domestic price of the good will rise.
In the diagram, the export subsidy increases exports from (Q0 − X0 ) to (Q1 − X1 ). This
raises domestic price from Pw to Pw + s. As a result of this price increase, domestic
demand for the good falls (from X0 to X1 ) while production rises (from Q0 to Q1 ).
Welfare effects: There will be a loss of consumer surplus equal to (A + B), and a gain in
producer surplus equal to (A + B + C). The cost of the subsidy is (B + C + D), total
exports times per-unit subsidy. Hence the net welfare effect is a loss of (B + D). To
reproduce the effects of this export subsidy using domestic policies, the government
should subsidise producers of the good and tax consumers of the good. The producer
subsidy again raises the price received by producers, hence they will raise production
from Q0 to Q1 . The tax on consumption of the good will reduce consumption from X0 to
X1 . In terms of the welfare effect, the producer subsidy raises producer surplus by
(A + B + C), at the cost of the subsidy of (A + B + C + D). The consumption tax reduces
consumer surplus by (A + B), and raises a tax revenue (A). Therefore the net welfare
effect of combining these two policies is a loss of (B + D), which is the same as the
welfare loss from the export subsidy.
5. Are there any arguments in favour of trade protection? Do these arguments change for
small and big countries? Do differences in competitive situations lead to different
strategic policy prescriptions? If protection from trade is bad, why are trade restrictive
policies so widespread?
236
The only real reason for trade protection is when big countries try to modify the world
terms of trade to their own advantage. So in principle small countries should never
implement protective policies. Still, people have argued there might be other reasons to
justify the resort to trade protection. The most important is when the assumption of
perfect competition is removed. It might be welfare improving to adopt protectionist
policies when there is strategic interaction in oligopolistic markets. In particular:
(a) Export subsidy is advisable when there is Cournot competition.
(b) Import tax is advisable when there is Bertrand competition.
Protectionist policies are implemented because:
(a) Rentiers lobby for these policies while the median voter does not.
(b) Trade restrictions are easy to set and they guarantee a certain stream of government
revenues.
6. Despite having observed the depreciation of some currency (both in real and nominal
terms), the trade balance and the current account of that country have failed to improve in
the short-run. What could be possible explanations for such patterns?
KOM, Chapter 17 ‘Output and the Exchange Rate in the Short Run’ including
Appendix 2 to KOM Chapter 17.
One of the reasons the trade balance fails to improve in the short run is the so-called
J-curve effect. In the short run the depreciation of the currency will increase the price of
imports but the volume of export does not adjust immediately. The Marshall-Lerner
condition defines the restrictions on the trade elasticities for which the trade balance
improves following a real depreciation.
KOM, Chapter 13, ‘National Income Accounting and the Balance of Payments’.
The current account is defined as CA = X − M, giving the following identity:
Y = C + I + G + CA
Y − C − G = S = I + CA.
237
Now we decompose savings S into private and governmental savings:
S = S p + S g = (Y − T − C) + (T − G).
Note that:
S g = (T − G) = −(G − T ) = −(budget deficit).
So substituting we get:
S p + S g = I + CA
CA = S p − I − S p
CA = S p − I − (G − T )
Interpretation:
For a given level of S p and I, an increase in the budget deficit must be accompanied by a
decrease in the CA surplus (or increase in the CA deficit). For example, consider an
increase in government expenditure (G) such as the building of a bridge. If imported
materials, etc. are employed for the construction of the bridge there is an increase in M
giving rise to the twin deficits phenomenon.
Empirical studies reveal a correlation between the budget deficit and the CA deficit.
However, the relationship is not as simple as it looks; S p , S g , I and CA are jointly
determined so the relationship does not give a clear theoretical causal link.
8. Show how, in the flexible-price monetary model, the exchange rate can be expressed as a
function of expectations about future fundamentals. What will happen to the exchange
rate if people’s expectations of future income decreases? What will happen to the
exchange rate if people’s expectations of future money supply decrease? (Try to show
mathematically and explain the intuition.)
KOM, Chapter 16 ‘Price Levels and the Exchange Rate in the Long Run’.
The expression in terms of fundamentals is given in section 14.2.4 of the subject guide.
Exchange rate depends on expectations about future fundamentals through the uncovered
interest parity condition. The subject guide provides the derivation of the equilibrium
exchange rate in this setting. Higher future income causes an appreciation because it
raises future money demand, thus lowers the future price level. Higher future money
supply will raise future price levels and cause current depreciation.
9. East Asian countries have accumulated very large stocks of foreign exchange reserves in
the past decade. Explain why, in the context of a first generation model of currency
crises, countries would like to have a large stock of foreign exchange reserves.
238
In the context of the first generation currency crisis model, foreign reserves are needed in
order for the central bank to intervene in the foreign exchange market to defend the initial
currency parity. The bigger the stock of foreign exchange reserve, the less likely a central
bank will be to face a currency crisis. More generally indeed, a large stock of foreign
exchange gives more room for the central bank in expanding domestic credit during
economic downturns. In other words, a large stock of foreign reserves makes it more
difficult for the shadow exchange rate to equal the peg, and so a currency crisis occurs.
Thus the central bank can use domestic credit to mitigate the cycle, expanding it in
economic downturns and contracting it during expansions.
Importantly, if the central bank expands domestic credit at a steady pace, a currency crisis
will occur no matter how big the stock of foreign reserves is. The stock of foreign
reserves will just determine at what point the attack takes place.
There are at least two other reasons why a country may want to hold a large stock of
foreign reserves. In the second generation models of currency crises holding a large stock
of foreign reserves may be a way to coordinate expectations on the goods equilibrium
and avoid self-fulfilling currency crises.
Accumulating foreign reserves may also be a way to keep a depreciated exchange rate
and boost exports.
(You are expected to provide a graphical analysis as well as an explanation.)
This question can be approached using either the AA–DD framework set out in KOM, or
the Mundell-Fleming framework provided by Copeland; the analysis will be slightly
different, but the conclusions reached as to the effectiveness of fiscal and monetary policy
under fixed and floating exchange rates are very similar. You are not expected here to
contrast the two models, so a good answer would focus on one of the two models, but not
both. This question requires you to compare the results discussed in Chapter 15 of the
subject guide on floating exchange rates with those discussed in Chapter 16 of the subject
guide on fixed exchange rates.
KOM, Chapter 17 ‘Output and the Exchange Rate in the Short Run’ and Chapter 18
‘Fixed Exchange Rates and Foreign Exchange Intervention’.
AA–DD Model
Fiscal policy: Consider first the case of a permanent fiscal expansion under a floating
exchange rate. The fiscal expansion shifts the DD curve to the right which would lead to
an appreciation of the currency and an increase in output, if the AA curve would stay
constant. However, exchange rate expectations change to incorporate the expected
239
long-run appreciation of the currency, leading to a downwards shift in the AA schedule.

As it turns out, this downwards shift in the AA curve completely offsets the gains in
output caused by the shift in the DD schedule. Thus the fiscal expansion leads only to an
appreciation of the exchange rate, but not to any increase in output. Figure 15.4 shows
this graphically, with the equilibrium shifting from point A to point B. Compare this with
the effects of a temporary expansion of fiscal policy which is denoted by point C in the
graph. Thus, under a floating exchange rate, fiscal policy is not very effective.
Now consider the effects of a fiscal expansion under a fixed exchange rate, portrayed in
Figure 16.3. The expansion shifts the DD curve outwards, putting pressure on the
currency to appreciate. However, as the central bank wants to maintain the fixed
exchange rate, it has to intervene in the foreign exchange market to counter the
appreciation by buying extra foreign reserves. This will shift the AA curve outwards to
AAB , further increasing the increase in output to Y2 while keeping the exchange rate
constant at s. Thus fiscal policy is more effective under a fixed than under a floating
exchange rate regime.
Monetary policy: Consider the expansion of the money supply. Under a floating
exchange the AA curve would shift outwards and a new equilibrium would be reached at
A0 , leading to a depreciation of the domestic currency (increase in the exchange rate) and
an increase in output (Figure 15.3 of the subject guide).
However, under a fixed exchange rate, the central bank wants to hold the exchange rate
fixed at s and thus will intervene in the exchange rate market to countervail the
depreciationary pressure. This will reduce the foreign reserves of the central bank until
the AA curve is back at its original position. Thus monetary policy is ineffective as a
stabilisation policy (Figure 16.2 of the subject guide).
Mundell-Fleming
Fiscal policy: An increase in fiscal expenditure (IS shifts right) causes an increase in the
interest rate that partly counteracts its positive impact on output (graphically, this is
captured by the slope of the LM curve). Under a fixed exchange rate arrangement the
central bank has to take action to guarantee that the domestic and the world interest rate
are equal in order to defend the peg. To offset the increase in the interest rate the central
bank will thus engineer an increase in money supply (LM shifts right) so as to equalise
the domestic and world interest rate. The monetary expansion has a positive impact on
output, thus magnifying the initial impact of the increase in government expenditure.
Under a flexible exchange rate the central bank does not have to offset the interest rate
differential and hence only the direct impact of fiscal policy on output is present.
Monetary policy: To see why monetary policy is more effective under a flexible
exchange rate regime suppose that the exchange rate is fixed and that the monetary
authority wants to stimulate output by running an expansionary monetary policy (LM
shifts right). The expansion in money supply will lead to a decrease in the domestic
interest rate and to a negative spread between the domestic and world interest rate. To
maintain the peg the central bank will have to shrink the money supply to its initial level
(LM shifts left) until the interest rate differential is eliminated. In the end there will be no
impact on equilibrium output. Hence, under a fixed exchange rate, monetary policy
cannot be used as an independent tool to affect output (though it has to be used if the
economy is hit by a shock that opens a differential between home and foreign interest
rates).
240
Conversely, under a flexible exchange rate regime the central bank is free to use monetary
policy to affect output. For a graphical representation of these arguments, please see the
sections on Mundell-Fleming in Chapters 15 and 16 of the subject guide.
END OF PAPER
241
242
Appendix C
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246
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International economics

Published by: University of London

1 Introduction to the subject guide 1

Part 1 International trade 11

Introduction to international trade 13

2 The Ricardian model of international trade 15

2.1.5 References cited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

3 The Heckscher–Ohlin model 33

4 The specific factors model 49

4.1.3 Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

5 The standard trade model 57

6.1.2 Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

7 Imperfect competition and other alternative trade models 71

8 Instruments of trade policy 83

8.1.1 Aims of the chapter . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

9.5.2 Guidance on answering Sample examination questions . . . . . . . . . 108

10 Preferential trading arrangements, customs unions and economic integration 111

11 Trade policy in developing economies 121

11.4 Reminder of learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . 125

Part 2 International finance 127

Introduction to international finance 129

12 National income accounting and the balance of payments 131

13 An introduction to foreign exchange markets 139

13.2.2 Parity conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

14 Prices and the exchange rate 151

15 Output and the exchange rate 165

15.1.3 Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166

16 Fixed exchange rates 181

17 Currency crises 193

17.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193

18 Monetary systems 201

19 Optimum currency areas 211

20 International capital markets 219

A Sample examination paper 227

B Sample Examiners’ Commentary 231

1.2 Route map to the course

1.3 Introduction to the subject area

increasing returns and trade;

international factor movements;

growth and trade;

income distribution and trade;

1.5 Aims of this course

provide an account of the sources of the gains from trade

1.6 Learning outcomes for the course

discuss and explain specific policy issues such as ‘environmentalism as protectionism’;

1.7 Overview of learning resources

1.7.1 The subject guide

1.7.2 Essential reading

1.7.3 Further reading

Feenstra, R. and M. Taylor International Economics. (New York: Worth Publishers,

1.7.4 Online study resources

1.7.6 Making use of the Online Library

1.8 Study time

1.9 Examination advice

1.9.1 The examination

Section A requires candidates to answer one compulsory question worth 40 marks

Section B contains 10 predominantly essay-style questions. Candidates are required to

1.9.2 Examination technique

up-to-date information on examination and assessment arrangements for this course

Why do countries trade with each other?

How do countries gain from international trade?

2.1.1 Aims of the chapter

2.1.2 Learning outcomes