Introduction to International Economics

Norbert Wohlgemuth

Winter term 2023

Additional material, available on moodle

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Economics: Theory and Policy

Chapter 1
Introduction
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
“trade wars are good, and easy to win” (@realDonaldTrump)

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

 Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Source: Financial Times, 29 August 2022
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
What Is International Economics About?
• International economics is about how nations interact through trade of
goods and services, flows of money, and investment.
• Nations are now more closely linked than ever before.
• U.S. exports and imports as shares of gross domestic product have been
on an upward trend.
– International trade has roughly tripled in importance compared to the
economy as a whole in the past 50 years.
– But will this trend continue?

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International trade
an “engine of growth”

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Source: http://data.worldbank.org/indicator/NE.IMP.GNFS.ZS
 Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Source: https://data.worldbank.org/indicator/NE.IMP.GNFS.ZS?locations=SG
 Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Source: https://www.imf.org/en/Publications/fandd/issues/2023/06/growing-threats-to-global-trade-goldberg-reed
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
What Is International Economics About?
• Compared to the United States, other countries are even more tied to
international trade.
– Their imports and exports as a share of GDP are substantially higher.
– The United States, due to its size and diversity of resources, relies less
on international trade than almost any other country.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 1.2 Average of Exports and Imports as
Percentages of National Income in 2015

International trade is even more important to most other countries than it is to the United
States.
Source: World Bank

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Globalization Isn’t Dying, It’s Just Evolving

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Source: https://www.bloomberg.com/graphics/2019-globalization/
Globalization Isn’t Dying, It’s Just Evolving

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Source: https://www.bloomberg.com/graphics/2019-globalization/
Globalization Isn’t Dying, It’s Just Evolving

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Source: https://www.bloomberg.com/graphics/2019-globalization/
Globalization Isn’t Dying, It’s Just Evolving

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Source: https://www.bloomberg.com/graphics/2019-globalization/
Globalization Isn’t Dying, It’s Just Evolving

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Source: https://www.bloomberg.com/graphics/2019-globalization/
Globalization Isn’t Dying, It’s Just Evolving

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Source: https://www.bloomberg.com/graphics/2019-globalization/
Globalization Isn’t Dying, It’s Just Evolving

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Source: https://www.bloomberg.com/graphics/2019-globalization/
Globalization Isn’t Dying, It’s Just Evolving

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Source: https://www.bloomberg.com/graphics/2019-globalization/
Globalization Isn’t Dying, It’s Just Evolving

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Source: https://www.bloomberg.com/graphics/2019-globalization/
Globalization Isn’t Dying, It’s Just Evolving

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Source: https://www.bloomberg.com/graphics/2019-globalization/
Globalization Isn’t Dying, It’s Just Evolving

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Source: https://www.bloomberg.com/graphics/2019-globalization/
Gains from Trade (1 of 4)
• That there are gains from trade is probably the most important insight in
international economics.
• Countries selling goods and services to each other almost always
generates mutual benefits.
1. When a buyer and a seller engage in a voluntary transaction, both
can be made better off.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Gains from Trade (2 of 4)
2. How could a country that is the most (least) efficient producer of
everything gain from trade?
▪ Countries use finite resources to produce what they are most
productive at, then trade those products for what they want to
consume.
▪ Countries can specialize in production, while consuming many
goods and services through trade.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Gains from Trade (3 of 4)
3. Trade benefits countries by allowing them to export goods made with
relatively abundant resources and imports goods made with
relatively scarce resources.
4. When countries specialize, they may be more efficient due to larger-
scale production.
5. Countries may also gain by trading current resources for future
resources (international borrowing and lending), and due to
international migration.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Gains from Trade (4 of 4)
• Trade is predicted to benefit countries as a whole in several ways, but
trade may harm particular groups within a country.
– Trade may therefore affect the distribution of income within a
country.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Patterns of Trade
• The pattern of trade describes who sells what to whom.
• Differences in climate and resources explain why Brazil exports coffee
and Saudi Arabia exports oil.
• But why does Japan export automobiles, while the U.S. exports aircraft?
• Why some countries export certain products can stem from differences in:
– Labor productivity
– Relative supplies of capital, labor and land and their use in the
production of different goods and services

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Effects of Government Policies on Trade (1 of 2)
• Policy makers affect trade volume through
– Tariffs: a tax on imports or exports,
– Quotas: a quantity restriction on imports or exports,
– Export subsidies: a payment to producers that export, or
– Through other regulations (ex., product specifications)
that exclude foreign products from the market, but still allow domestic
products.
• What are the costs and benefits of these policies?

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Effects of Government Policies on Trade (2 of 2)
• If a government restricts trade, what are the costs if foreign governments
respond likewise?
• Trade policies are often chosen to cater to special interest groups, rather
than to maximize national welfare.
• Governments tend to adopt tariffs, then negotiate them down in exchange
for reduction in trade barriers of other countries.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Finance Topics
• Exchanging risky assets such as stocks and bonds can benefit all
countries by diversification that reduces the variability of income – another
source of gains from trade.
• Most international trade involves monetary transactions.
• Many monetary events have important consequences for international trade
(and vice versa).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Balance of Payments
• Governments measure the value of exports and imports, as well as the
value of financial assets that flow into and out of their countries.
– Trade deficits may be offset by net inflows of financial assets.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Exchange Rate Determination
• Exchange rates are an important financial issue for most governments.
• Exchange rates measure how much domestic currency can be exchanged
for foreign currency and thus affect how much:
• Some exchange rates change continually (float) while others are fixed for
periods of time.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Policy Coordination
• In an integrated economy, one country’s economic policies usually affect
other countries as well, leading to the need for some degree of policy
coordination.
– Depends on type of exchange rate regime.
• Capital markets, where money is exchanged for promises to pay in the
future, have special concerns in an international setting:
– Currency fluctuations can alter the value paid.
– Countries, especially developing ones, might default on debt.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Trade Versus Finance
• International trade focuses on transactions involving movement of goods and
services across nations.
– International trade theory (Chapters 2–8) and policy (Chapters 9–12).
– International microeconomics.
• International finance focuses on financial or monetary transactions across
nations.
– International monetary theory (Chapters 13–18) and policy (Chapters
19–22).
– International macroeconomics.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Economics: Theory and Policy

Chapter 2
World Trade:
An Overview
Preview
• Largest trading partners of the United States
• Gravity model: Influence of an economy’s size on trade; Distance,
barriers, borders and other trade impediments

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Who Trades with Whom?
• More than 30% of world output is sold across national borders.
• The 5 largest trading partners with the U.S. in 2015 were China, Canada,
Mexico, Japan, and Germany.
• The largest 15 trading partners with the U.S. accounted for 75% of the
value of U.S. trade in 2015.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 2.1 Total U.S. Trade with Major Partners, 2015

U.S. trade—measured as the sum of imports and exports—is mostly

with 15 major partners.
Source: U.S. Department of Commerce.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Size Matters: The Gravity Model (1 of 3)
• 3 of the top 10 trading partners with the U.S. were also the 3 largest
European economies: Germany, the United Kingdom, and France.
• Why does the United States trade more with these European countries than
with others?
– These countries have the largest gross domestic product (GDP), the
value of goods and services
produced in an economy, in Europe.
– Each European country’s share of U.S. trade with Europe is roughly
equal to its share of European GDP.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 2.2 The Size of European Economies, and the Value of
Their Trade with the United States

Figure 2.2 shows the

correspondence
between the size of
different European
economies and those
countries’ trade with
the United States.
Source: U.S. Department of
Commerce, European
Commission.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Size Matters: The Gravity Model (2 of 3)
• The size of an economy is directly related to the volume of imports and
exports.
– Larger economies produce more goods and services, so they have more
to sell in the export market.
– Larger economies generate more income from
the goods and services sold, so they are able to buy more imports.
• Trade between any two countries is larger, the larger is either country.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Size Matters: The Gravity Model (3 of 3)
• The gravity model assumes that size and distance are important for trade
in the following way:
A  Yi  Yj
Tij =
Dij
where A is a constant term
Tij is the value of trade between country i and country j
Yi the GDP of country I, Yj is the GDP of country j
Dij is the distance between country i and country j

• Or more generally A  Yia  Yjb

Tij =
Dijc
where a, b, and c are allowed to differ from 1.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Using the Gravity Model: Looking for Anomalies
• A gravity model fits the data on U.S. trade with European countries well
but not perfectly.
• The Netherlands, Belgium and Ireland trade much more with the United
States than predicted by a gravity model.
– Ireland has strong cultural affinity due to common language and
history of migration.
– The Netherlands and Belgium have transport cost advantages due to
their location.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Impediments to Trade: Distance, Barriers, and Borders
Other things besides size matter for trade:
1. Distance between markets influences transportation costs and therefore the cost
of imports and exports.
2. Cultural affinity: close cultural ties, such as a common language, usually lead to
strong economic ties.
3. Geography: ocean harbors and a lack of mountain barriers make transportation
and trade easier.
4. Multinational corporations: corporations spread across different nations import
and export many goods between their divisions.
5. Borders: crossing borders involves formalities that take time, often different
currencies need to be exchanged, and perhaps monetary costs like tariffs reduce
trade.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Impediments to Trade: Distance, Barriers, and Borders
• The U.S. signed a free trade agreement with Mexico and Canada in 1994, the
North American Free Trade Agreement (NAFTA). The United States-Mexico-
Canada Agreement USMCA took effect on July 1, 2020, replacing NAFTA.
• Because of NAFTA, and because Mexico and Canada are close to the U.S.,
the amount of trade between the U.S. and its northern and southern neighbors
as a fraction of GDP is larger than between the U.S. and European countries.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 2.3 Economic Size and Trade with the United
States
The United States
does markedly more
trade with its
neighbors than it does
with European
economies of the
same size.

Source: U.S. Department of

Commerce, European
Commission.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Economics: Theory and Policy

Chapter 3

Labor Productivity and

Comparative Advantage:
The Ricardian Model
Preview
• Opportunity costs and comparative advantage
• A one-factor economy, the Ricardian model
• Production possibilities
• How world relative demand and supply determine the relative price after
trade
• Gains from trade; Relative wages and trade
• Misconceptions about comparative advantage
• Transportation costs and non-traded goods

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Introduction
• Differences across countries are a key reason why trade occurs:
– The Ricardian model (this chapter) examines differences in the
productivity of labor (due to differences in technology) between
countries.
– The Specific Factors model (Chapter 4) and the Heckscher-Ohlin model
(Chapter 5) examine differences in labor, labor skills, physical capital,
land, or other factors of production between countries.
• Trade may also arise due to economies of scale (larger scale of production
is more efficient).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Concept of Comparative Advantage (1 of 6)
• The opportunity cost of producing something measures the cost of not
being able to produce something else (with the resources used).
• Comparative advantage will be determined by comparing opportunity costs
across countries.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Concept of Comparative Advantage (2 of 6)
• A simple example with roses and computers explains the intuition behind
the concepts of opportunity cost and comparative advantage in the
Ricardian model.
• Suppose a limited number of workers could produce either roses or
computers.
– The opportunity cost of producing computers is the amount of roses
not produced.
– The opportunity cost of producing roses is the amount of computers
not produced.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Concept of Comparative Advantage (3 of 6)
• Suppose that in the United States 10 million roses could be produced with
the same resources as 100,000 computers.
• Suppose that in Colombia 10 million roses could be produced with the
same resources as 30,000 computers.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Concept of Comparative Advantage (4 of 6)
• A country has a comparative advantage in producing a good if the
opportunity cost of producing that good is lower in the country than in other
countries.
• In our example:
– The United States has a comparative advantage in computer
production.
1 computer “costs” 10 000 000 / 100 000 = 100 roses
1 rose “costs” 100 000 / 10 000 000 = 0.01 computers
– Colombia has a comparative advantage in rose production.
1 computer “costs” 10 000 000 / 30 000 = 333 roses
1 rose “costs” 30 000 / 10 000 000 = 0.003 computers

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Concept of Comparative Advantage (5 of 6)
• Suppose initially that Colombia produces computers and the United States
produces roses, and that both countries want to consume computers and
roses.
• Can both countries be made better off?

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Concept of Comparative Advantage (6 of 6)

blank Million Roses Thousand Computers

United States −10 +100
Columbia +10 −30
Total 0 +70

When countries specialize in production in which they

have a comparative advantage, more goods and
services can be produced and consumed.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

A One-Factor Economy (1 of 3)
• We formalize these ideas by constructing a one-factor Ricardian model using
the following assumptions:
1. Labor is the only factor of production.
2. Labor productivity varies across countries due to differences in
technology, but labor productivity in each country is constant.
3. The supply of labor in each country is constant.
4. Two goods: wine and cheese.
5. Competition allows workers to be paid a wage equal to the value of
what they produce, and allows them to work in the industry that pays
the highest wage.
6. Two countries: home and foreign.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
A One-Factor Economy (2 of 3)
• A unit labor requirement indicates the (constant) number of hours of
labor required to produce one unit of output.
– aLC is the unit labor requirement for cheese in the home country. aLC
hours of labor produce one pound of cheese in the home country.
– aLW is the unit labor requirement for wine in the home country. aLW
hours of labor produce one gallon of wine in the home country.
• A high unit labor requirement means low labor productivity.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

A One-Factor Economy (3 of 3)
• Labor supply L indicates the total amount of labor resources − the number of
hours worked (a constant).
• aLC indicates the amount of labor required for each pound of cheese produced
(a constant).
• Cheese production QC indicates how many total pounds of cheese that the
home country produces.
• aLW indicates the amount of labor required for each gallon of wine produced (a
constant).
• Wine production QW indicates how many total gallons of wine that the home
country produces.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Production Possibilities (1 of 6)
• The production possibility frontier (PPF) of an economy shows the
maximum amount of a goods that can be produced for a fixed amount of
resources.
• The production possibility frontier of the home economy is:
aLCQC + aLWQW ≤ L

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Production Possibilities (2 of 6)
L
• Maximum home cheese production is QC = when Qw = 0.
a LC

L
• Maximum home wine production is Qw = when Qc = 0.
a Lw

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Production Possibilities (3 of 6)
• For example, suppose that the home economy’s labor supply is 1,000 hours.
– aLC = 1 hours/lb, so 1 hour of labor produces one pound of cheese in the
home country.
– aLW = 2 hours/gallon, so 2 hours of labor produces one gallon of wine in
the home country.
• The PPF equation aLCQC + aLWQW ≤ L becomes QC + 2QW ≤ 1,000.
• Maximum cheese production is 1,000 pounds.
• Maximum wine production is 500 gallons.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 3.1 Home’s Production Possibility Frontier
The line PF
shows the
maximum
amount of
cheese Home
can produce
aLC given any
aLW production of
wine, and vice
versa.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Production Possibilities (4 of 6)
• The opportunity cost of cheese is how many gallons of wine Home
must stop producing in order to make one more pound of cheese:
aLC
aLW
– The opportunity cost is constant because the unit labor
requirements are both constant.
– The opportunity cost of cheese appears as the absolute value of
the slope of the PPF.
L  a LC 
Qw = −  QC
a Lw  a Lw 

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Production Possibilities (5 of 6)
• Producing an additional pound of cheese requires aLC hours of labor.
• Each hour devoted to cheese production could have been used
instead to produce an amount of wine equal to

 1 
1 hour/(aLW hours/gallon of wine) =   gallons of wine
 aLW 

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Production Possibilities (6 of 6)
• For example, if 1 hour of labor is moved to cheese production, that
additional hour could have produced
 1
1 hour/(2 hours/gallon of wine) =   gallon of wine.
2

• Opportunity cost of producing one pound of cheese is ½ gallon of wine not

produced.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Relative Prices and Supply (1 of 7)
• PC is the price of cheese; PW is the price of wine.
• wC is the wage paid to workers who make cheese,
and wW is the wage paid to workers who make wine.
• Due to competition in the labor and goods markets:
– Hourly wages of cheese makers will equal the value of the cheese
produced in an hour: PC
WC =
aLC

– Hourly wages of wine makers will equal the value of the wine
produced in an hour: Pw
Ww =
aLw

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Relative Prices and Supply (2 of 7)
• Workers will choose to work in the industry that pays the higher
wage.
• If the price of cheese relative to the price of wine exceeds the
opportunity cost of producing cheese
PC aLC
 ,
PW aLW
– Then the wage paid when making cheese will exceed the wage in
wine
PC PW
WC =  = WW
aLC aLW
– So workers will make only cheese (the economy specializes in
cheese production).
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Relative Prices and Supply (3 of 7)
• If the price of cheese relative to the price of wine is less than the
opportunity cost of producing cheese
PC aLC
 ,
PW aLW
– Then the wage in cheese will be less than the wage in wine

PC PW
WC =  = WW
aLC aLW
– So workers will make only wine (the economy specializes in wine
production).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Relative Prices and Supply (4 of 7)
• If the price of cheese relative to the price of wine equals the
opportunity cost of producing cheese
PC aLC
= ,
PW aLW
– Then the wage in cheese will equal the wage in wine

PC PW
WC = = = WW
aLC aLW

– So workers will be willing to make both wine and cheese.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Relative Prices and Supply (5 of 7)
• For example, suppose cheese sells for PC = $4/pound and wine sells
for PW = $7/gallon.
– Wage paid producing cheese is
PC
= ($4/pound)(1 pound/hour) = $4/hour.
aLC
– Wage paid producing wine is
Pw 1 
= ($7/gallon)  gallon/hour  = $3.50/hour.
aLw 2 
– Workers would be willing to make only cheese.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Relative Prices and Supply (6 of 7)
• If the price of cheese drops to PC = $3/pound:
– Wage paid producing cheese drops to

PC
= ($3/pound)(1 pound/hour) = $3/hour.
aLC

– Wage paid producing wine is still $3.50/hour if price of wine is

still $7/gallon.
– Now workers would be willing to make only wine.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Relative Prices and Supply (7 of 7)
• If the home country wants to consume both wine and cheese (in the
absence of international trade), relative prices must adjust so that wages
are equal in the wine and cheese industries.
P P
– If C = W workers will not care whether they work in the
aLC aLW
cheese industry or the wine industry, so that production of
both goods can occur.
– → Production (and consumption) of both goods occurs
when the relative price of a good equals the opportunity cost
of producing that good:
PC a
= LC
PW aLW
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Trade in the Ricardian Model (1 of 3)
• Use “*” to indicate foreign country variables.
• When one country can produce a unit of a good with less labor than
another country, we say that the first country has an absolute advantage
in producing that good.
• If aLC < a*LC , Home labor is more efficient than Foreign in producing
cheese.
• Does that guarantee that Home should export cheese?

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Trade in the Ricardian Model (2 of 3)
• Comparative advantage, not absolute advantage, determines the pattern of
trade!
• Even if a country has an absolute advantage in the production of both goods,
it has a comparative advantage only in the production of one good.
• Suppose that the home country has a comparative advantage in cheese
production: its opportunity cost of producing cheese is lower than in the
foreign country.
• Since the slope of the PPF indicates the opportunity cost of cheese in terms
of wine, Foreign’s PPF is steeper than Home’s.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 3.2 Foreign’s Production Possibility Frontier
Because Foreign’s
relative unit labor
requirement in
cheese is higher
than Home’s (it
needs to give up
many more units of
wine to produce one
more unit of
cheese), its
production
possibility frontier is
steeper.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Trade in the Ricardian Model (3 of 3)
• Before any trade occurs, the relative price of cheese to wine reflects the
opportunity cost of cheese in terms of wine in each country.
• In absence of any trade, the relative price of cheese to wine will be higher in
Foreign than in Home if Foreign has the higher opportunity cost of cheese.
• → It will be profitable to ship cheese from Home to Foreign (and wine from
Foreign to Home) – where does the relative price of cheese to wine settle?

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Determining the Relative Price after Trade (1 of 8)
• To see how all countries can benefit from trade, we need to find relative
prices when trade exists.
• First calculate the world relative supply of cheese:
the quantity of cheese supplied by all countries relative to the quantity of
wine supplied by all countries

QC + Q *C
RS =
QW + Q *W

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Determining the Relative Price after Trade (2 of 8)
• If the relative price of cheese falls below the opportunity cost of
cheese in both countries
PC aLC a *LC
  ,
PW aLW a *Lw

– No cheese would be produced.

– Domestic and foreign workers would be willing to produce only
wine (where wage is higher).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Determining the Relative Price after Trade (3 of 8)
• When the relative price of cheese equals the opportunity cost in the
home country
PC a a*
= LC  LC ,
PW aLW a *Lw

– Domestic workers are indifferent about producing wine or cheese

(wage when producing wine same as wage when producing
cheese).
– Foreign workers produce only wine.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Determining the Relative Price after Trade (4 of 8)
• When the relative price of cheese settles strictly in between the opportunity costs
of cheese
aLC PC a *LC
  ,
aLW PW a *Lw

– Domestic workers produce only cheese (where their wages are higher).
– Foreign workers still produce only wine (where their wages are higher).
– World relative supply of cheese equals Home’s maximum cheese production
divided by Foreign’s maximum wine production

L aLC
.
L * a *LW
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Determining the Relative Price after Trade (5 of 8)
• When the relative price of cheese equals the opportunity cost in the foreign
country
aLC PC a *LC
 = ,
aLW PW a *Lw

– Foreign workers are indifferent about producing wine or cheese (wage

when producing wine same as wage when producing cheese).
– Domestic workers produce only cheese.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Determining the Relative Price after Trade (6 of 8)
• If the relative price of cheese rises above the opportunity cost of
cheese in both countries

aLC a *LC PC
  ,
aLW a *Lw PW

– No wine is produced.
– Domestic and foreign workers are willing to produce only cheese
(where wage is higher).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Determining the Relative Price after Trade (7 of 8)
• World relative supply is a step function (Figure 3.3):
– First step at relative price of cheese equal to Home’s
a 1
opportunity cost LC ,which equals in the example.
aLW 2
– Jumps when world relative supply of cheese equals Home’s maximum cheese
production divided by Foreign’s
L aLC
maximum wine production , which equals 1 in the
example. L * a *LW
– Second step at relative price of cheese equal to Foreign’s opportunity
cost a *LC which equals 2 in the example.
,
a *LW

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Determining the Relative Price after Trade (8 of 8)
• Relative demand of cheese is the quantity of cheese demanded in all
countries relative to the quantity of wine demanded in all countries.
• As the price of cheese relative to the price of wine rises, consumers in all
countries will tend to purchase less cheese and more wine so that the relative
quantity demanded of cheese falls.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 3.3 World Relative Supply and Demand
The RD and RD’
curves show that the
demand for cheese
relative to wine is a
decreasing function
of the price of
cheese relative to
that of wine, while
the RS curve shows
that the supply of
cheese relative to
wine is an
increasing function
of the same relative
price.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Gains from Trade (1 of 2)
• Gains from trade come from specializing in the type of production which uses
resources most efficiently, and using the income generated from that
production to buy the goods and services that countries desire.
– “Using resources most efficiently” means producing a good in which a
country has a comparative advantage.
– Domestic workers earn a higher income from cheese production
because the relative price of cheese increases with trade.
– Foreign workers earn a higher income from wine production
because the relative price of cheese decreases with trade and the
relative price of wine increases with trade.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Gains from Trade (2 of 2)
• Think of trade as an indirect method of production that converts cheese
into wine or vice versa.
– Without trade, a country has to allocate resources to produce all of the
goods that it wants to consume.
– With trade, a country can specialize its production and exchange for the
mix of goods that it wants to consume.
• Consumption possibilities expand beyond the production possibility
frontier when trade is allowed.
• With trade, consumption in each country is expanded because world
production is expanded when each country specializes in producing the good
in which it has a comparative advantage.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Figure 3.4 Trade Expands Consumption Possibilities

International trade allows Home and Foreign to consume anywhere within the blue-
colored lines, which lie outside the countries’ production frontiers (black-colored
lines). Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Do Wages Reflect Productivity?
• Do relative wages reflect relative productivities of the two countries?
• Evidence shows that low wages are associated with low productivity.
• Other evidence shows that wages rise as productivity rises.
• →Wages do not converge with international trade (as relative prices do).
They reflect productivity.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Productivity and Wages
A country’s
wage rate is
roughly
proportional to
the country’s
productivity

Source: International
Monetary Fund and
The Conference
Board.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Misconceptions about Comparative Advantage (1 of 3)
1. Free trade is beneficial only if a country is more productive than foreign
countries.
– But even an unproductive country benefits from free trade by avoiding
the high costs for goods that it would otherwise have to produce
domestically.
– The benefits of free trade do not depend on absolute advantage,
rather they depend on comparative advantage: specializing in
industries that use resources most efficiently.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Misconceptions about Comparative Advantage (2 of 3)
2. Free trade with countries that pay low wages hurts high wage countries.
– While trade may reduce wages for some workers, thereby affecting the
distribution of income within a country, trade benefits consumers and
other workers.
▪ Consumers benefit because they can purchase goods more cheaply.
▪ Producers/workers benefit by earning a higher income in the
industries that use resources more efficiently, allowing them to earn
higher prices and wages.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Misconceptions about Comparative Advantage (3 of 3)
3. Free trade exploits less productive countries whose workers make low
wages.
– While labor standards in some countries are less than exemplary
compared to Western standards, they are so with or without trade.
– Are high wages and safe labor practices alternatives to trade? Deeper
poverty and exploitation may result without export production.

– Top 10 Reasons to Oppose the World Trade Organization? Criticism, yes

… misinformation, no!
– https://www.wto.org/english/thewto_e/minist_e/min99_e/english/misinf_e/10tide_e.htm

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Transportation Costs and Non-traded Goods
• The Ricardian model predicts that countries completely specialize in
production.
• But this rarely happens for three main reasons:
More than one factor of production reduces the tendency of specialization
(Chapters 4-5).
Protectionism (Chapters 9–12).
Transportation costs reduce or prevent trade, which may cause each
country to produce the same good or service.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Economics: Theory and Policy

Chapter 4
Specific Factors and
Income Distribution
Preview
• Introduction
• The Specific Factors Model
• International Trade in the Specific Factors Model
• Income Distribution and the Gains from Trade

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Introduction
• If trade is so good for the economy, why is there such opposition?
• Two main reasons why international trade has strong effects on the
distribution of income within a country:
– Resources cannot move immediately or costlessly from one industry to
another.
– Industries differ in the factors of production they demand.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Specific Factors Model (1 of 4)
• The specific factors model allows trade to affect income distribution.
• Assumptions of the model:
– Two goods, cloth and food.
– Three factors of production: labor (L), capital (K) and land (T, terrain).
– Perfect competition prevails in all markets.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Specific Factors Model (2 of 4)
– Cloth produced using capital and labor (but not land).
– Food produced using land and labor (but not capital).

– Labor is a mobile factor that can move between sectors.

– Land and capital are both specific factors used only in the production of
one good.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Specific Factors Model (3 of 4)
• How much of each good does the economy produce?
• The production function for cloth gives the quantity of cloth that can
be produced given any input of capital and labor:

QC = QC ( K , LC )
– QC is the output of cloth
– K is the capital stock
– LC is the labor force employed in cloth

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Specific Factors Model (4 of 4)
• The production function for food gives the quantity of food that can
be produced given any input of land and labor:

QF = QF (T , LF )

– QF is the output of food

– T is the supply of land
– LF is the labor force employed in food

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Production Possibilities (1 of 5)
• How does the economy’s mix of output change as labor is shifted from one
sector to the other?
• When labor moves from food to cloth, food production falls while output of cloth
rises.
• Figure 4.1 illustrates the production function for cloth.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 4.1 The Production Function for Cloth

The more labor employed in the production of cloth, the larger the output. As a result of
diminishing returns, however, each successive person-hour increases output by less
than the previous one; this is shown by the fact that the curve relating labor input to
output gets flatter at higher levels of employment.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Production Possibilities (2 of 5)
• The shape of the production function reflects the law of diminishing marginal
returns.
– Adding one worker to the production process (without increasing the
amount of capital) means that each worker has less capital to work with.
– Therefore, each additional unit of labor adds less output than the last.
• Figure 4.2 shows the marginal product of labor, which is the increase in
output that corresponds to an extra unit of labor.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 4.2 The Marginal Product of Labor

The marginal product of labor in the cloth sector, equal to the slope of the production
function shown in Figure 4.1, is lower the more labor the sector employs.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Production Possibilities (3 of 5)
• For the economy as a whole the total labor employed in cloth and food must
equal the total labor supply:

LC + LF = L
• Use these equations to derive the production possibilities frontier of the
economy.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Production Possibilities (4 of 5)
• Use a four-quadrant diagram to construct production possibilities frontier in
Figure 4.3.
– Lower left quadrant indicates the allocation of labor.
– Lower right quadrant shows the production function for cloth from Figure
4.1.
– Upper left quadrant shows the corresponding production function for food.
– Upper right quadrant indicates the combinations of cloth and food that can
be produced.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 4.3 The Production Possibility Frontier in the
Specific Factors Model
PP in the upper-
right quadrant
shows the
economy’s
production
possibilities for
given supplies of
land, labor, and
capital. Due to
diminishing
returns, PP is a
bowed-out
(concave) curve
instead of a
straight line.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Production Possibilities (5 of 5)
• Why is the production possibilities frontier curved?
– Diminishing returns to labor in each sector cause the opportunity cost to
rise when an economy produces more of a good.
– Opportunity cost of cloth in terms of food is the slope of the production
possibilities frontier – the slope becomes steeper as an economy
produces more cloth.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Prices, Wages, and Labor Allocation (1 of 10)
• How much labor is employed in each sector?
– Need to look at supply and demand in the labor market.
• Demand for labor:
– In each sector, employers will maximize profits by demanding labor up to
the point where the value produced by an additional hour equals the
marginal cost of employing a worker for that hour.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Prices, Wages, and Labor Allocation (2 of 10)
• The demand curve for labor in the cloth sector:
MPLC  PC = W
– The wage equals the value of the marginal product of labor in
manufacturing.

• The demand curve for labor in the food sector:

MPLF  PF = W
– The wage equals the value of the marginal product of labor in food.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Prices, Wages, and Labor Allocation (3 of 10)
• Figure 4.4 represents labor demand in the two sectors.
• The demand for labor in the cloth sector is MPLC from Figure 4.2 multiplied by
PC
• The demand for labor in the food sector is measured from the right.
• The horizontal axis represents the total labor supply L.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Prices, Wages, and Labor Allocation (4 of 10)
• The two sectors must pay the same wage because labor can move between
sectors.
• If the wage were higher in the cloth sector, workers would move from making
food to making cloth until the wages become equal.
• Where the labor demand curves intersect gives the equilibrium wage and
allocation of labor between the two sectors.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 4.4 The Allocation of Labor
Labor is allocated
so that the value of
its marginal
product (P × MPL)
is the same in the
cloth and food
sectors.
In equilibrium, the
wage rate is equal
to the value of
labor’s marginal
product.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Prices, Wages, and Labor Allocation (5 of 10)
• At the production point, the production possibility frontier must be tangent to
a line whose slope is (minus) the price of cloth divided by that of food.
• Relationship between relative prices and output:

MPLC  PC = W MPLF  PF = W

MPLF PC
− =−
MPLC PF

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 4.5 Production in the Specific Factors Model
The economy produces
at the point on its
production possibility
frontier (PP) where the
(minus) slope of that
frontier equals the
relative price of cloth.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Prices, Wages, and Labor Allocation (6 of 10)
• What happens to the allocation of labor and the distribution of income when the
prices of food and cloth change?
• Two cases:
− An equal proportional change in prices
− A change in relative prices

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Prices, Wages, and Labor Allocation (7 of 10)
• When both prices change in the same proportion, no real changes occur.
– The wage rate (w) rises in the same proportion as the prices, so real wages
(i.e., the ratios of the wage rate to the prices of goods) are unaffected.
– The real incomes of capital owners and landowners also remain the same.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 4.6 An Equal-Proportional Increase in the Prices
of Cloth and Food

The labor demand curves in cloth and food both shift up in

proportion to the rise in PC from PC1 to PC 2 and the rise in PF
from PF 1 to PF 2 . The wage rate rises in the same proportion,
from W 1 to W 2 , but the allocation of labor between the two
sectors does not change.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Prices, Wages, and Labor Allocation (8 of 10)
• When only PC rises, labor shifts from the food sector to the cloth sector and the
output of cloth rises while that of food falls.
• The wage rate (w) does not rise as much as PC since cloth employment
increases and thus the marginal product of labor in that sector falls.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 4.7 A Rise in the Price of Cloth

The cloth labor demand curve rises in proportion to the 7 percent increase in PC, but the
wage rate rises less than proportionately. Labor moves from the food sector to the cloth
sector.
Output of cloth rises; output of food falls. Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Figure 4.8 The Response of Output to a Change in the
Relative Price of Cloth

The economy always produces at the point on its production possibility

frontier (PP) where the slope of PP equals (minus) the relative price of
cloth. Thus, an increase in PC  PF causes production to move down and
to the right along the production possibility frontier corresponding to
higher output of cloth and lower output of food.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Figure 4.9 Determination of Relative Prices
In the specific factors
model, a higher relative
price of cloth will lead to
an increase in the output
of cloth relative to that of
food. Thus, the relative
supply curve RS is upward
sloping.
Equilibrium relative
quantities and prices are
determined by the
intersection of RS with the
relative demand curve RD.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Prices, Wages, and Labor Allocation (9 of 10)
• Relative Prices and the Distribution of Income
– Suppose that PC increases by 10%. Then, the wage would rise by less than
10%.
• What is the economic effect of this price increase on the incomes of the
following three groups?
– Workers, owners of capital, and owners of land.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Prices, Wages, and Labor Allocation (10 of 10)
• Owners of capital are definitely better off (cloth is produced by labor and
capital).
• Landowners are definitely worse off (food is produced by labor and land).
• Workers: cannot say whether workers are better or worse off:
– Depends on the relative importance of cloth and food in workers’
consumption.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Trade in the Specific Factors Model (1 of 3)
• Trade and Relative Prices
– The relative price of cloth prior to trade is determined by the intersection of
the economy’s relative supply of cloth and its relative demand.
– Free trade relative price of cloth is determined by the intersection of world
relative supply of cloth and world relative demand.
– Opening up to trade increases the relative price of cloth in an
economy whose relative supply of cloth is larger than for the world as
a whole.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 4.10 Trade and Relative Prices

The figure shows the relative supply curve for the specific factors economy along with the world
relative supply curve. The differences between the two relative supply curves can be due to
either technology or resource differences across countries. There are no differences in relative
demand across countries. Opening up to trade induces an increase in the relative price from
( PC  PF ) to ( PC  PF ) .
1 2
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
International Trade in the Specific Factors Model (2 of 3)
• Gains from trade
– Without trade, the economy’s output of a good must equal its consumption.
– International trade allows the mix of cloth and food consumed to differ from
the mix produced.
– The country cannot spend more than it earns:

PC DC + PF DF = PCQC + PFQF

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Trade in the Specific Factors Model (3 of 3)
• The economy as a whole gains from trade.
– It imports an amount of food equal to the relative price of cloth times the
amount of cloth exported:
 PC 
DF − QF =    (QC − DC )
 PF 
– It is able to afford amounts of cloth and food that the country is not able to
produce itself.
– The budget constraint with trade lies above the production
possibilities frontier in Figure 4.11.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 4.11 Budget Constraint for a Trading Economy and
Gains from Trade
Point 2 represents the economy’s
production. The economy can
choose its consumption point
along its budget constraint (a line
that passes through point 2 and
has a slope equal to minus the
relative price of cloth). Before
trade, the economy must consume
what it produces, such as point 1
on the production possibility
frontier (PP). The portion of the
budget constraint in the colored
region consists of feasible post-
trade consumption choices, with
consumption of both goods higher
than at pre-trade point 1.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Income Distribution and Trade Politics (1 of 2)
• International trade shifts the relative price of cloth to food, so factor prices
change.
• Trade benefits the factor that is specific to the export sector of each
country, but hurts the factor that is specific to the import-competing
sectors.
• Trade has ambiguous effects on mobile factors.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Income Distribution and Trade Politics (2 of 2)
• Trade benefits a country by expanding choices.
– Possible to redistribute income so that everyone gains from trade. Those
who gain from trade could compensate those who lose and still be better
off themselves.
– Redistribution hard to implement in practice.
– Governments usually provide a “safety net” of income support to cushion
the losses to groups hurt by trade (or other changes).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Economics: Theory and Policy

Chapter 5
Resources and Trade:
The Heckscher-Ohlin
Model
Preview
• Production possibilities
• Changing the mix of inputs
• Relationships among factor prices and goods prices, and resources and
output
• Trade in the Heckscher-Ohlin model
• Factor price equalization
• Trade and income distribution

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Introduction
• The Heckscher-Ohlin theory argues that trade occurs due to differences in
labor, labor skills, physical capital, capital, or other factors of production
across countries.
– Countries have different relative abundance of factors of production.
– Production processes use factors of production with different relative
intensity.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Two-Factor Heckscher-Ohlin Model
1. Two countries: home and foreign.
2. Two goods: cloth and food.
3. Two factors of production: labor and capital.
4. The mix of labor and capital varies across goods.
5. The supply of labor and capital in each country is constant and varies across
countries.
6. In the long run, both labor and capital can move across sectors, equalizing
their returns (wage and rental rate) across sectors.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Production Possibilities (1 of 4)
• With more than one factor of production, the opportunity cost in production is
no longer constant and the PPF is no longer a straight line. Why?
• Economy must produce subject to both constraints – i.e., it must have
enough capital and labor.
• Without factor substitution, the production possibilities frontier is the interior of
the two factor constraints.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 5.1 The Production Possibility Frontier without
Factor Substitution
If capital cannot be
substituted for labor or
vice versa, the
production possibility
frontier in the factor-
proportions model would
be defined by two
resource constraints:
The economy can’t use
more than the available
supply of labor or capital.
So the production
possibility frontier is
defined by the red line in
this figure.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Production Possibilities (2 of 4)
• If producers can substitute one input for another in the production
process, then the PPF is curved.
– Opportunity cost of cloth increases as producers make more cloth.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 5.2 The Production Possibility
Frontier with Factor Substitution

If capital can be substituted for labor and vice versa, the production possibility frontier
no longer has a kink. But it remains true that the opportunity cost of cloth in terms of
food rises as the economy’s production mix shifts toward cloth and away from food.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Production Possibilities (3 of 4)
• What does the country produce?
• The economy produces at the point that maximizes the value of
production, V.
• An isovalue line is a line representing a constant value of production, V:

V = PCQC + PF QF

– where PC and PF are the prices of cloth and food.

– slope of isovalue line is − PC
PF

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 5.3 Prices and Production

The economy produces at the point that maximizes the value of production
given the prices it faces; this is the point on the highest possible isovalue line. At that
point, the opportunity cost of cloth in terms of food is equal to the relative price of cloth,
PC > PF. Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Production Possibilities (4 of 4)
• Given the relative price of cloth, the economy produces at the point Q that
touches the highest possible isovalue line.
• At that point, the relative price of cloth equals the slope of the PPF, which
equals the opportunity cost of producing cloth.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Choosing the Mix of Inputs (1 of 2)
• Producers may choose different amounts of factors of production used to
make cloth or food.
• Their choice depends on the wage, w, paid to labor and the rental rate, r,
paid when renting capital.
• As the wage w increases relative to the rental rate r, producers use less
labor and more capital in the production of both food and cloth.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 5.4 Input Possibilities in Food Production
A farmer can produce a
calorie of food with less
capital if he or she uses
more labor, and vice
versa.
→ Isoquant

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Choosing the Mix of Inputs (2 of 2)
• Assume that at any given factor prices, cloth production uses more labor
relative to capital than food production uses:

aLC aLF LC LF
 or 
aKC aKF KC K F

• Production of cloth is relatively labor intensive, while production of food

is relatively land intensive.
• Relative factor demand curve for cloth CC lies outside that for food FF.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 5.5 Factor Prices and Input Choices
At any given wage-rental
ratio, cloth production uses
a higher labor-capital ratio;
when this is the case, we
say that cloth production
is labor-intensive and
that food production is
capital-intensive.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Factor Prices and Goods Prices (1 of 3)
• In competitive markets, the price of a good should equal its cost of
production, which depends on the factor prices.
• How changes in the wage and rent affect the cost of producing a good
depends on the mix of factors used.
– An increase in the rental rate of capital should affect the price of food
more than the price of cloth since food is the capital intensive industry.
𝑤 𝑃𝐶
• → Changes in are tied to changes in .
𝑟 𝑃 𝐹

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 5.6 Factor Prices and Goods Prices
Because cloth production
is labor-intensive while
food production is capital-
intensive, the higher the
relative cost of labor, the
higher must be the
relative price of the labor-
intensive good.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Factor Prices and Goods Prices (2 of 3)
• Stolper-Samuelson theorem:
If the relative price of a good increases, then the real wage or rental rate of
the factor used intensively in the production of that good increases, while
the real wage or rental rate of the other factor decreases.
→ Any change in the relative price of goods alters the distribution of
income.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 5.7 From Goods Prices to Input Choices
Fig. 5.6
Fig. 5.5
turned to the
left by 90°

If the relative price of cloth rises, the wage-rental ratio must rise. This will cause the
labor-capital ratio used in the production of both goods to drop.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Factor Prices and Goods Prices (3 of 3)
PC
• An increase in the relative price of cloth, , is
PF
predicted to
w
– raise income of workers relative to that of capital owners, .
r
– raise the ratio of capital to labor services, K ,
L
used in both industries.
– raise the real income (purchasing power) of workers and lower
the real income of capital owners.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Resources and Output (1 of 3)
• How do levels of output change when the economy’s resources change?
• Rybczynski theorem:
If you hold output prices constant as the amount of a factor of production
increases, then the supply of the good that uses this factor intensively
increases and the supply of the other good decreases.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Resources and Output (2 of 3)
• Assume an economy’s labor force grows, which implies that its
ratio of labor to capital L/K increases.

→ Expansion of production possibilities is biased toward cloth.

→ At a given relative price of cloth, the ratio of labor to capital used in both
sectors remains constant.
→ To employ the additional workers, the economy expands production of
the relatively labor-intensive good, cloth, and contracts production of the
relatively capital-intensive good, food.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 5.8 Resources and Production Possibilities
An increase in the supply
of labor shifts the
economy’s production
possibility frontier outward
disproportionately in the
direction of cloth
production.
At an unchanged relative
price of cloth, food
production declines.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Resources and Output (3 of 3)
• An economy with a high ratio of labor to capital produces a high output of
cloth relative to food.
• Suppose that Home is relatively abundant in labor and Foreign in capital:

L L*

K K*
– Likewise, Home is relatively scarce in capital and Foreign in labor.
• Home will be relatively efficient at producing cloth because cloth is relatively
labor intensive.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Trade in the Heckscher-Ohlin Model (1 of 5)
• The countries are assumed to have the same technology and the same
tastes.
– With the same technology, each economy has a comparative advantage
in producing the good that relatively intensively uses the factors of
production in which the country is relatively well endowed.
– With the same tastes, the two countries will consume cloth to food in the
same ratio when faced with the same relative price of cloth under free
trade.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Trade in the Heckscher-Ohlin Model (2 of 5)
• Since cloth is relatively labor intensive, at each relative price of cloth to food,
Home will produce a higher ratio of cloth to food than Foreign.
→ Home will have a larger relative supply of cloth to food than Foreign.
→ Home’s relative supply curve lies to the right of Foreign’s.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 5.9 Trade Leads to a Convergence of Relative
Prices
In the absence of trade,
Home’s equilibrium would
be at point 1, where
domestic relative supply
RS intersects the relative
demand curve RD.
Similarly, Foreign’s
equilibrium would be at
point 3. Trade leads to a
world relative price that
lies between the pre-
trade prices, such as at
point 2.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Trade in the Heckscher-Ohlin Model (3 of 5)
• Like the Ricardian model, the Heckscher-Ohlin model predicts a
convergence of relative prices with trade.
• With trade, the relative price of cloth rises in the relatively labor abundant
(home) country and falls in the relatively labor scarce (foreign) country.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Trade in the Heckscher-Ohlin Model (4 of 5)
• Relative prices and the pattern of trade: In Home, the rise in the relative
price of cloth leads to a rise in the relative production of cloth and a fall in
relative consumption of cloth.
– Home becomes an exporter of cloth and an importer of food.
• The decline in the relative price of cloth in Foreign leads it to become an
importer of cloth and an exporter of food.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Trade in the Heckscher-Ohlin Model (5 of 5)
• Heckscher-Ohlin theorem:
The country that is abundant in a factor exports the good whose
production is intensive in that factor.
• This result generalizes to a correlation:
– Countries tend to export goods whose production is intensive in
factors with which the countries are abundantly endowed.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Trade and the Distribution of Income
• Changes in relative prices can affect the earnings of labor and capital.
– A rise in the price of cloth raises the purchasing power of labor in terms of
both goods (while lowering the purchasing power of capital in terms of
both goods).
– A rise in the price of food has the reverse effect.
• Thus, international trade can affect the distribution of income, even in the long
run:
– Owners of a country’s abundant factors gain from trade, but owners
of a country’s scarce factors lose.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Economics: Theory and Policy

Chapter 6
The Standard
Trade Model
Preview
• Relative supply and relative demand
• The terms of trade and welfare

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Introduction
• Standard trade model is a general model that includes Ricardian, specific
factors, and Heckscher-Ohlin models as special cases.
– Two goods, food (F) and cloth (C).
– Each country’s PPF is a smooth curve.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Production Possibilities and Relative Supply (1 of 2)
PC
• What a country produces depends on the relative price of cloth to food .
PF

• An economy chooses its production of cloth QC and food QF to maximize

the value of its output V = P Q +P Q ,
C C F F

given the prices of cloth and food.

 PC 
– The slope of an isovalue line equals −  .
 PF 

– Produce at point where PPF/TT is tangent to isovalue line.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 6.1 Relative Prices Determine the Economy’s
Output
An economy whose
production possibility
frontier is TT will
produce at Q, which is
on the highest possible
isovalue line.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Production Possibilities and Relative Supply (2 of 2)
• Relative prices and relative supply (Fig. 6.2):
PC
– An increase in the price of cloth relative to food
PF
makes the isovalue line steeper.
2
– Production shifts from point Q to point Q .
1

QC
– Supply of cloth relative to food rises.
QF
– Relative supply of cloth to food increases with the relative price of cloth
to food.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 6.2 How an Increase in the Relative Price of
Cloth Affects Relative Supply

In panel (a), the isovalue lines become steeper when the relative price of cloth rises. As a result, the
economy produces more cloth and less food. Panel (b) shows the relative supply curve associated
with the production possibilities frontier TT. The rise in the relative price of cloth leads to an increase
in the relative production of cloth.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Relative Prices and Demand (1 of 6)
• The value of the economy’s consumption must equal the value of the
economy’s production.

PC DC + PF DF = PCQC + PF QF = V

• Assume that the economy’s consumption decisions may be represented as if

they were based on the tastes of a single representative consumer.
• An indifference curve represents combinations of cloth and food that leave
the consumer equally well off (indifferent).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Relative Prices and Demand (2 of 6)
• Indifference curves
– are downward sloping — if you have less cloth, then you must have more
food to be equally satisfied.
– that lie farther from the origin make consumers more satisfied — they prefer
having more of both goods.
– become flatter when they move to the right — with more cloth and less
food, an extra yard of cloth becomes less valuable in terms of how many
calories of food you are willing to give up for it.
– must not cross.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Relative Prices and Demand (3 of 6)
• Consumption choice is based on preferences and relative price of goods (Fig.
6.3):
– Consume at point D where the isovalue line is tangent to the indifference
curve.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Relative Prices and Demand (4 of 6)
• Relative prices and relative demand (Fig. 6.3)
PC
– An increase in the relative price of cloth causes
PF
2
consumption choice to shift from point D1 to point D

DC
– Demand for cloth relative to food falls.
DF

– Relative demand for cloth to food falls as the relative price of cloth to food
rises.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 6.3 Production, Consumption, and Trade in the
Standard Model
The economy produces at
point Q, where the production
possibility frontier is tangent to
the highest possible isovalue
line. It consumes at point D,
where that isovalue line is
tangent to the highest possible
indifference curve. The
economy produces more cloth
than it consumes and therefore
exports cloth; correspondingly, it
consumes more food than it
produces and therefore imports
food.

No full specialization.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Relative Prices and Demand (5 of 6)
• An economy that exports cloth is better off when the price of cloth rises relative
to the price of food (Fig. 6.4):
– the isovalue line becomes steeper and a higher indifference curve can be
reached.
• A higher relative price of cloth means that more calories of food can be
imported for every yard of cloth exported.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Relative Prices and Demand (6 of 6)
• If the economy cannot trade (Fig. 6.4):
– The relative price of cloth to food is determined by the intersection of
relative demand and relative supply for that country.
– Consume and produce at point D 3
where the indifference curve is tangent to the
production possibilities frontier.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 6.4 Effects of a Rise in the Relative Price of
Cloth and Gains from Trade

In panel (a), the slope of the isovalue lines is equal to minus the relative price of cloth. As a result, when that
relative price rises, all isovalue lines become steeper. Production shifts from Q1 to Q2 and consumption shifts
from D1 to D2. If the economy cannot trade, then it produces and consumes at point D3. Panel (b) shows the
effects of the rise in the relative price of cloth on relative production (move from 1 to 2) and relative demand
(move from 1 to 2). If the economy cannot trade, then it consumes and produces at point 3.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
The Welfare Effects of Changes in the Terms of Trade
• The terms of trade refers to the price of exports relative to the price of
imports.
– When a country exports cloth and the relative
price of cloth increases, the terms of trade rise.
• Because a higher relative price for exports means that the country can afford
to buy more imports, an increase in the terms of trade increases a country’s
welfare.
• A decline in the terms of trade decreases a country’s welfare.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Determining Relative Prices
• To determine the price of cloth relative to the price food, use relative supply
and relative demand.
– World supply of cloth relative to food at each relative price.
– World demand for cloth relative to food at each relative price.
– World quantities are the sum of quantities from the two countries in the
world:

(Q C + QC  ) and
(D
C + DC  ).
(Q F + QF 
) (D
F + DF  )

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 6.6a Equilibrium Relative Price with Trade and
Associated Trade Flows

ToT

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 6.6b Equilibrium Relative Price with Trade and
Associated Trade Flows

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Effects of Economic Growth (1 of 4)
• Is economic growth in China good for the standard of living in the U.S.?
• Is growth in a country more or less valuable when it is integrated in the world
economy?
• The standard trade model gives us answers to these questions.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Effects of Economic Growth (2 of 4)
• Growth is usually biased: it occurs in one sector more than others, causing
relative supply to change.
– Rapid growth has occurred in U.S. computer / software industries but
relatively little growth has occurred in U.S. textile industries.
– In the Ricardian model, technological progress in one sector causes biased
growth.
– In the Heckscher-Ohlin model, an increase in one factor of production
causes biased growth.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 6.7 Biased Growth (1 of 2)

Growth is biased when it shifts production possibilities out more toward one good than toward
another. In case (a), growth is biased toward cloth, while in case (b), growth is biased toward food.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
 Figure 6.7 Biased Growth (2 of 2)

The associated shifts in the relative supply curve are shown in panel (c): shift to the right when
growth is biased toward cloth, and shift to the left when growth is biased toward food.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
The Effects of Economic Growth (3 of 4)
• Biased growth and the resulting change in relative supply causes a
change in the terms of trade.
– Biased growth in the cloth industry (in either the home or foreign country)
will lower the price of cloth relative to the price of food and lower the
terms of trade for cloth exporters.
– Biased growth in the food industry (in either the home or foreign country)
will raise the price of cloth relative to the price of food and raise the
terms of trade for cloth exporters.
– Suppose that the home country exports cloth and
imports food.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 6.8 Growth and World Relative Supply

Growth biased toward cloth shifts the RS curve for the world to the right (a), while growth
biased toward food shifts it to the left (b). Copyright © 2018 Pearson Education, Ltd. All rights reserved.
The Effects of Economic Growth (4 of 4)
• Export-biased growth is growth that expands a country’s production
possibilities disproportionately in that country’s export sector.
– Export-biased growth reduces a country’s terms of trade, reducing its
welfare and increasing the welfare of foreign countries.
• Import-biased growth is growth that expands a country’s production
possibilities disproportionately in that country’s import sector.
– Import-biased growth increases a country’s terms of trade, increasing
its welfare and decreasing the welfare of foreign countries.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Economics: Theory and Policy

Chapter 7
External Economies of Scale
and the International
Location of Production
Preview
• Types of economies of scale
• Economies of scale and market structure
• The theory of external economies
• External economies and international trade
• Dynamic increasing returns

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Introduction (1 of 2)
• The models of comparative advantage thus far assumed constant returns to
scale:
– When inputs to an industry increase at a certain rate, output increases at
the same rate.
– If inputs were doubled, output would double as well.
• But there may be increasing returns to scale or economies of scale:
– This means that when inputs to an industry increase at a certain rate,
output increases at a faster rate.
– A larger scale is more efficient: the cost per unit of output falls as a firm or
industry increases output.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Introduction (2 of 2)
• Mutually beneficial trade can arise as a result of economies of scale.
• International trade permits each country to produce a limited range of goods
without sacrificing variety in consumption (trade as “indirect production”).
• With trade, a country can take advantage of economies of scale to produce
more efficiently.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Economies of Scale and Market Structure (1 of 2)
• Economies of scale could mean either that larger firms or a larger industry
would be more efficient.
• External economies of scale occur when cost per unit of output depends on
the size of the industry.
• Internal economies of scale occur when the cost per unit of output depends
on the size of a firm.
– Imperfect competition.
– Market power (amazon, facebook, Alphabet,…).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Economies of Scale and Market Structure (2 of 2)
• Both external and internal economies of scale are important causes of
international trade.
• They have different implications for the structure of industries:
– An industry where economies of scale are purely external will typically
consist of many small firms and be perfectly competitive.
– Internal economies of scale result when large firms have a cost
advantage over small firms, causing the industry to become imperfectly
competitive.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Theory of External Economies (1 of 5)
• Many modern examples of industries that seem to be powerful external
economies:
– In the United States,
the semiconductor industry is concentrated in Silicon Valley,
investment banking in New York, and the entertainment industry in
Hollywood.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Theory of External Economies (2 of 5)
– In developing countries such as China, external economies are pervasive
in manufacturing.
▪ One town in China produces most of the world’s underwear, another
nearly all cigarette lighters.
– External economies played a key role in India’s emergence as a major
exporter of information services.
▪ Indian information services companies are still clustered in Bangalore.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Theory of External Economies (3 of 5)
• For a variety of reasons, concentrating production of an industry in one
or a few locations can reduce the industry’s costs, even if the individual
firms in the industry remain small.
• External economies may exist for a few reasons:

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Theory of External Economies (4 of 5)
1. Specialized equipment or services may be needed for the industry, but are
only supplied by other firms if the industry is large and concentrated.
– For example, Silicon Valley has a large concentration of silicon chip
companies, which are serviced by companies that make special machines
for manufacturing silicon chips.
– These machines are cheaper and more easily available there than
elsewhere.
2. Labor pooling: a large and concentrated industry may attract a pool of
workers, reducing employee search and hiring costs for each firm.
3. Knowledge spillovers: workers from different firms may more easily share
ideas that benefit each firm when a large and concentrated industry exists.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
The Theory of External Economies (5 of 5)
• Represent external economies simply by assuming that the larger the
industry, the lower the industry’s costs.
• There is a forward-falling supply curve: the larger the industry’s output,
the lower the price at which firms are willing to sell.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 7.1 External Economies and Market
Equilibrium
When there are external
economies of scale, the
average cost of producing a
good falls as the quantity
produced rises. Given
competition among many
producers, the downward-
sloping average cost curve
AC can be interpreted as
a forward-falling supply
curve. As in ordinary
supply-and-demand
analysis, market equilibrium
is at point 1, where the
supply curve intersects the
demand curve, D. The
equilibrium level of output is
Q1, the equilibrium price P1.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
External Economies and International Trade (1 of 10)
• Prior to international trade, equilibrium prices and output for each country
would be at the point where the domestic supply curve intersects the
domestic demand curve.
• Suppose Chinese button prices in the absence of trade would be lower than
U.S. button prices.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 7.2 External Economies Before Trade

In the absence of trade, the price of buttons in China, PCHINA, is lower than the price of
buttons in the United States, PUS. Copyright © 2018 Pearson Education, Ltd. All rights reserved.
External Economies and International Trade (2 of 10)
• What will happen when the countries open up the potential for trade in
buttons?
• The Chinese button industry will expand, while the U.S. button industry will
contract.
• This process feeds on itself: As the Chinese industry’s output rises, its costs
will fall further; as the U.S. industry’s output falls, its costs will rise.
• In the end, all button production will be in China.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

External Economies and International Trade (3 of 10)
• How does this concentration of production affect prices?
• Chinese button prices were lower than U.S. button prices before trade.
• Because China’s supply curve is forward-falling, increased production as a
result of trade leads to a button price that is lower than the price before trade.
• Trade leads to prices that are lower than the prices in either country
before trade!

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

External Economies and International Trade (4 of 10)
• Very different from the implications of models without increasing returns.
• In the standard trade model relative prices converge as a result of trade.
• With external economies, the effect of trade is to reduce prices
everywhere.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 7.3 Trade and Prices
When trade is opened,
China ends up producing
buttons for the world
market, which consists
both of its own domestic
market and of the U.S.
market. Output rises
from Q1 to Q2, leading to
a fall in the price of
buttons from P1 to P2,
which is lower than the
price of buttons in either
country before trade.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

External Economies and International Trade (5 of 10)
• What might cause one country to have an initial advantage from having a
lower price?
• One possibility is comparative advantage due to underlying differences in
technology and resources.
• If external economies exist, however, the pattern of trade could be due to
historical accidents:
– Countries that start as large producers in certain industries tend to remain
large producers even if another country could potentially produce more
cheaply.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

External Economies and International Trade (6 of 10)
• A tufted blanket, crafted as a wedding gift by a 19th-century teenager, gave
rise to the cluster of carpet manufacturers around Dalton, Georgia.
• Silicon Valley may owe its existence to two Stanford graduates, Bill Hewlett
and Dave Packard, who started a business in a garage there.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

External Economies and International Trade (7 of 10)
• Assume that the Vietnamese cost curve lies below the Chinese curve
because Vietnamese wages are lower than Chinese wages.
• At any given level of production, Vietnam could manufacture buttons more
cheaply than China.
• One might hope that this would always imply that Vietnam will in fact supply
the world market.
• But this need not always be the case if China has enough of a head start.
• → No guarantee that the right country will produce a good that is
subject to external economies.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 7.4 The Importance of Established Advantage
The average cost curve for
Vietnam, ACVIETNAM, lies below
the average cost curve for
China, ACCHINA. Thus Vietnam
could potentially supply the world
market more cheaply than
China. If the Chinese industry
gets established first, however,
it may be able to sell buttons at
the price P1, which is below the
cost C0 that an individual
Vietnamese firm would face if it
began production on its own. So
a pattern of specialization
established by historical
accident may persist even
when new producers could
potentially have lower costs.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
External Economies and International Trade (8 of 10)
• Trade based on external economies has an ambiguous effect on national
welfare.
– There will be gains to the world economy by concentrating production of
industries with external economies.
– It’s possible that a country is worse off with trade than it would have
been without trade: a country may be better off if it produces everything
for its domestic market rather than pay for imports.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

External Economies and International Trade (9 of 10)
• Imagine that Thailand could make watches more cheaply, but Switzerland
got there first.
• The price of watches could be lower in Thailand with no trade.
• Trade could make Thailand worse off, creating an incentive to protect its
potential watch industry from foreign competition.
→ Import-substituting Industrialization (chapter 11).
• What if Thailand reverts to autarky?

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

External Economies and International Trade (10 of 10)
• Note that it’s still to the benefit of the world economy to take advantage of the
gains from concentrating industries.
• Each country wanting to reap the benefits of housing an industry with
economies of scale creates trade conflicts.
• Overall, it’s better for the world that each industry with external economies be
concentrated somewhere.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 7.5 External Economies and Losses from Trade
When there are external
economies, trade can
potentially leave a country
worse off than it would be in
the absence of trade. In this
example, Thailand imports
watches from Switzerland,
which is able to supply the
world market (DWORLD) at a
price (P1) low enough to block
entry by Thai producers, who
must initially produce the
watches at cost C0. Yet if
Thailand were to block all
trade in watches, it would be
able to supply its domestic
market (DTHAI) at the lower
price, P2.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Dynamic Increasing Returns (1 of 3)
• So far, we have considered cases where external economies depend on the
amount of current output at a point in time.
• But external economies may also depend on the amount of cumulative
output over time.
• Dynamic increasing returns to scale exist if average costs fall as
cumulative output over time rises.
– Dynamic increasing returns to scale imply dynamic external economies of
scale.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Dynamic Increasing Returns (2 of 3)
• Dynamic increasing returns to scale could arise if the cost of production
depends on the accumulation of knowledge and experience, which depend
on the production process over time.
• A graphical representation of dynamic increasing returns to scale is called a
learning curve.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 7.6 The Learning Curve
The learning curve shows
that unit cost is lower the
greater the cumulative
output of a country’s
industry to date. A country
that has extensive
experience in an industry
(L) may have a lower unit
cost than a country with
little or no experience, even
if that second country’s
learning curve (L*) is lower
— for example, because of
lower wages.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Dynamic Increasing Returns (3 of 3)
• Like external economies of scale at a point in time, dynamic increasing
returns to scale can lock in an initial advantage or a head start in an
industry.
• Can also be used to justify protectionism.
– Temporary protection of industries enables them to gain experience:
infant industry argument.
– But temporary is often for a long time, and it is hard to identify when
external economies of scale really exist.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Economics: Theory and Policy

Chapter 9
The instruments
of Trade Policy
Preview
• Partial equilibrium analysis of tariffs in a single industry: supply, demand, and
trade
• Costs and benefits of tariffs
• Export subsidies
• Import quotas
• Voluntary export restraints
• Local content requirements

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Types of Tariffs
• A tariff is a tax levied when a good is imported.
• A specific tariff is levied as a fixed charge for each unit of imported goods.
– For example, $3 per barrel of oil.

• An ad valorem tariff is levied as a fraction of the value of imported goods.

– For example, 25% tariff on the value of imported trucks.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Supply, Demand, and Trade in a Single Industry (1 of 4)
• Consider how a tariff affects a single market, say that of wheat.
• Suppose that in the absence of trade the price of wheat is higher in Home than
it is in Foreign.
• With trade, wheat will be shipped from Foreign to Home until the price
difference is eliminated.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Supply, Demand, and Trade in a Single Industry (2 of 4)
• An import demand curve is the difference between the quantity that Home
consumers demand minus the quantity that Home producers supply, at each
price.
• The Home import demand curve
MD = D − S
intercepts the price axis at PA and is downward sloping:
– As price increases, the quantity of imports demanded declines.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 9.1 Deriving Home’s Import Demand Curve

As the price of the good increases, Home consumers demand less, while Home
producers supply more, so that the demand for imports declines.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Supply, Demand, and Trade in a Single Industry (3 of 4)
• An export supply curve is the difference between the quantity that Foreign
producers supply minus the quantity that Foreign consumers demand, at each
price.

• The Foreign export supply curve

XS  = S  − D

intersects the price axis at PA and is upward sloping:
– As price increases, the quantity of exports supplied rises.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 9.2 Deriving Foreign’s Export Supply Curve

As the price of the good rises, Foreign producers supply more while Foreign consumers
demand less, so that the supply available for export rises.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Supply, Demand, and Trade in a Single Industry (4 of 4)
• In equilibrium,
import demand = export supply,
home demand − home supply = foreign supply − foreign demand,
home demand + foreign demand = home supply + foreign supply,
world demand = world supply.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 9.3 World Equilibrium

The equilibrium world price is where Home import demand (MD curve) equals Foreign
export supply (XS curve). Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Effects of a Tariff (1 of 4)
• A tariff acts like a transportation cost, making sellers unwilling to ship goods
unless the Home price exceeds the Foreign price by the amount of the tariff:


PT − t = PT

• A tariff makes the price rise in the Home market and fall in the Foreign market.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 9.4 Effects of a Tariff

A tariff raises the price in Home while lowering the price in Foreign. The volume traded
thus declines. Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Effects of a Tariff (2 of 4)
• Because the price in the Home market rises from PW under free trade to PT
with the tariff,
– Home producers supply more and Home consumers demand less, so
– the quantity of imports falls from QW under free trade to QT with the tariff.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Effects of a Tariff (3 of 4)
• Because the price in the Foreign market falls from PW under free trade to PT 
with the tariff,
– Foreign producers supply less, and Foreign consumers demand more, so
– the quantity of exports falls from QW to QT .

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Effects of a Tariff (4 of 4)
• The quantity of Home imports demanded equals the quantity of Foreign exports
supplied when

PT − PT  = t

• The increase in the price in Home can be less than the amount of the tariff.
– Part of the effect of the tariff causes the Foreign export price to decline.
– But this effect is sometimes very small.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Effects of a Tariff in a Small Country
• When a country is “small,” it has no effect on the foreign (world) price because
its demand is an insignificant part of world demand for the good.
– The foreign price does not fall, but remains at Pw .
– The price in the home market rises by the full amount of the tariff,
to PT = Pw + t .

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 9.5 A Tariff in a Small Country
When a country is small, a
tariff it imposes cannot lower
the foreign price of the good
it imports. As a result, the
price of the import rises from
PW to PW + t and the quantity
of imports demanded falls
from D1 − S1 to D2 − S2.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Costs and Benefits of Tariffs
• A tariff raises the price of a good in the importing country, so it hurts consumers
and benefits producers there.
• In addition, the government gains tariff revenue.
• How to measure these costs and benefits?
• Use the concepts of consumer surplus and producer surplus.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Consumer and Producer Surplus (1 of 2)
• Consumer surplus measures the amount that consumers gain from
purchases by computing the difference in the price actually paid from the
maximum price they would be willing to pay for each unit consumed.
– When price increases, the quantity demanded decreases as well as the
consumer surplus.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 9.7 Geometry of Consumer Surplus

Consumer surplus is equal to the area under the demand curve and above the price.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Consumer and Producer Surplus (2 of 2)
• Producer surplus measures the amount that producers gain from sales by
computing the difference in the price received from the minimum price at which
they would be willing to sell.
– When price increases, the quantity supplied increases as well as the
producer surplus.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 9.8 Geometry of Producer Surplus

Producer surplus is equal to the area above the supply curve and below the price.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Measuring the Costs and Benefits of Tariffs (1 of 3)
• A tariff raises the price in the importing country:
– consumer surplus decreases (consumers worse off)
– producer surplus increases (producers better off).
– the government collects tariff revenue equal to the tariff rate times the
quantity of imports with the tariff.

( )
t QT = PT − PT  ( D2 − S2 )

• Change in welfare due to the tariff is e − (b + d).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 9.9 Costs and Benefits of a Tariff for the
Importing Country

The costs and benefits to different groups can be represented as sums of the five areas
a, b, c, d, and e. Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Measuring the Costs and Benefits of Tariffs (2 of 3)
• For a “large” country, whose imports and exports affect world prices, the
welfare effect of a tariff is ambiguous.
• The triangles b and d represent the efficiency loss.
– The tariff distorts production and consumption decisions: producers
produce too much and consumers consume too little.
• The rectangle e represents the terms of trade gain.
– The tariff lowers the Foreign price, allowing Home to buy its imports
cheaper.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Measuring the Costs and Benefits of Tariffs (3 of 3)
• Part of government revenue (rectangle e) represents the terms of trade gain,
and part (rectangle c) represents some of the loss in consumer surplus.
– The government gains at the expense of consumers and foreigners.
• If the terms of trade gain exceed the efficiency loss, then national welfare will
increase under a tariff, at the expense of foreign countries.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 9.10 Net Welfare Effects of a Tariff
The colored triangles
represent efficiency
losses, while the rectangle
represents a terms of
trade gain.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Export Subsidy (1 of 3)
• An export subsidy can also be specific or ad valorem:
– A specific subsidy is a payment per unit exported.
– An ad valorem subsidy is a payment as a proportion of the value exported.
• An export subsidy raises the price in the exporting country, decreasing its
consumer surplus (consumers worse off) and increasing its producer surplus
(producers better off).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Export Subsidy (2 of 3)
• Also, government revenue falls due to paying S X S  for the export subsidy.

• An export subsidy lowers the price paid in importing countries

PS  = PS − S.

• In contrast to a tariff, an export subsidy worsens the terms of trade by

lowering the price of exports in world markets.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 9.11 Effects of an Export Subsidy
An export
subsidy raises
prices in the
exporting country
while lowering
them in the
importing country.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Export Subsidy (3 of 3)
• An export subsidy damages national welfare.
• The triangles b and d represent the efficiency loss.
– The export subsidy distorts production and consumption decisions:
producers produce too much and consumers consume too little compared
to the market outcome.
• The area b + c + d + f + g represents the cost of the subsidy paid by the
government.
– The terms of trade decrease, because the price of exports falls.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Import Quota
• An import quota is a restriction on the quantity of a good that may be
imported.
• This restriction is usually enforced by issuing licenses or quota rights.
• A binding import quota will push up the price of the import because the
quantity demanded will exceed the quantity supplied by Home producers and
from imports.
• When a quota instead of a tariff is used to restrict imports, the government
receives no revenue.
– Instead, the revenue from selling imports at high prices goes to quota
license holders.
– These extra revenues are called quota rents.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Voluntary Export Restraint
• A voluntary export restraint works like an import quota, except that the quota
is imposed by the exporting country rather than the importing country.
• These restraints are usually requested by the importing country.
• The profits or rents from this policy are earned by foreign governments or
foreign producers.
– Foreigners sell a restricted quantity at an increased price.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

A Voluntary Export Restraint in Practice (1 of 2)
• In 1979, sharp oil price increases caused the U.S. market to shift abruptly
toward smaller cars.
• Japanese producers moved in to fill the increased demand faster than U.S.
auto companies could come out with smaller, more fuel-efficient models.
• As the Japanese market share soared and U.S. output fell, strong political
forces in the United States demanded protection.
• Rather than act unilaterally and risk creating a trade war, the U.S. government
asked the Japanese government to limit its exports.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

A Voluntary Export Restraint in Practice (2 of 2)
• The Japanese, fearing unilateral U.S. protectionist measures if they did not
do so, agreed to limit their sales.
– The first agreement, in 1981, limited Japanese exports to the United
States to 1.68 million automobiles.
– A revision raised that total to 1.85 million in 1984.
– In 1985, the agreement was allowed to lapse.
• The price of Japanese cars in the United States rose, with the rent captured
by Japanese firms.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Local Content Requirement (1 of 2)
• A local content requirement is a regulation that requires a specified
fraction of a final good to be produced domestically.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Local Content Requirement (2 of 2)
• From the viewpoint of domestic producers of inputs, a local content
requirement provides protection in the same way that an import quota would.
• Local content requirement provides neither government revenue (as a tariff
would) nor quota rents.
• Instead, the difference between the prices of home goods and imports is
averaged into the price of the final good and is passed on to consumers.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Other Trade Policies
• Export credit subsidies
– A subsidized loan to exporters
– U.S. Export-Import Bank subsidizes loans to U.S. exporters.
• Government procurement
– Government agencies are obligated to purchase from home suppliers, even when they
charge higher prices
(or have inferior quality) compared to foreign suppliers.
• Bureaucratic regulations (red tape)
– Safety, health, quality, or customs regulations can act as a form of protection and trade
restriction.
• Decoupling from China, “reshoring”, “friendshoring” of supply chains.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Table 9.1 Effects of Alternative Trade Policies

Voluntary Export
Policy Tariff Export Subsidy Import Quota Restraint
Producer Increases Increases Increases Increases
surplus

Consumer Falls Falls Falls Falls

surplus

Government Increases Falls (government No change (rents to No change (rents to

revenue spending rises) license holders) foreigners)

Overall national Ambiguous (falls Falls Ambiguous (falls for Falls

welfare for small small country)
country)

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Economics: Theory and Policy

Chapter 10
The Political Economy
of Trade Policy
Preview
• The cases for free trade
• The cases against free trade
• Political models of trade policy
• International negotiations of trade policy and the World Trade Organization

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

http://www.bbc.com/news/business-38209407

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
 Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Source: https://www.imf.org/en/Publications/fandd/issues/2023/06/the-costs-of-geoeconomic-fragmentation-bolhuis-chen-kett
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
The Cases for Free Trade (1 of 4)
• The first case for free trade is the argument that producers and consumers
allocate resources most efficiently when governments do not distort market
prices through trade policy.
– National welfare of a small country is highest with free trade.
– With restricted trade, consumers pay higher prices and consume too little
while firms produce too much.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 10.1 The Efficiency Case for Free Trade

A trade restriction, such as a tariff, leads to production and consumption distortions.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.
The Cases for Free Trade (2 of 4)
• However, because tariff rates are already low for most countries, the estimated
benefits of moving to free trade are only a small fraction of national income for
most countries.
– For the world as a whole, protection costs less than 1 percent of GDP.
– The gains from free trade are somewhat smaller for advanced economies
such as the United States and Europe and somewhat larger for poorer
developing countries.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Cases for Free Trade (3 of 4)
• Free trade allows firms or industry to take advantage of economies of scale.
– Protected markets limit gains from external economies of scale.
• Free trade provides competition and opportunities for innovation (dynamic
benefits).
– By providing entrepreneurs with an incentive to seek new ways to export or
compete with imports, free trade offers more opportunities for learning and
innovation.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Cases for Free Trade (4 of 4)
• Free trade avoids the loss of resources through rent seeking.
• The political argument for free trade says that free trade is the best
feasible political policy, even though there may be better policies in
principle.
– Any policy that deviates from free trade would be quickly manipulated by
political groups, leading to decreased national welfare.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Cases against Free Trade (1 of 6)
• For a “large” country, a tariff lowers the price of imports in world markets and
generates a terms of trade gain.
– This benefit may exceed the efficiency losses caused by distortions in
production and consumption.
• A small tariff will lead to an increase in national welfare for a large country.
– But at some tariff rate, the national welfare will begin to decrease as the
economic efficiency loss exceeds the terms of trade gain.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 10.2 The Optimum Tariff
For a large country
there is an optimum
tariff to at which the
marginal gain from
improved terms of
trade just equals
the marginal
efficiency loss from
production and
consumption
distortion.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Cases against Free Trade (2 of 6)
• A tariff rate that completely prohibits imports leaves a country worse off, but
tariff rate tO may exist that maximizes national welfare: an optimum tariff.
• For some large countries like the U.S., an import tariff and/or export tax could
improve national welfare at the expense of other countries.
• But this argument ignores the likelihood that other countries may retaliate
against large countries by enacting their own trade restrictions.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Cases against Free Trade (3 of 6)
• An export tax (a negative export subsidy) that completely prohibits exports
leaves a country worse off, but an export tax rate may exist that maximizes
national welfare through the terms of trade.
– An export subsidy lowers the terms of trade for a large country; an export
tax raises the terms of trade for a large country.
– → An export tax may raise the price of exports in the world market,
increasing the terms of trade.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Cases against Free Trade (4 of 6)
• A second argument against free trade is that domestic market failures may
exist that cause free trade to be a suboptimal policy.
– The economic efficiency loss calculations using consumer and producer
surplus assume that markets function well.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Cases against Free Trade (5 of 6)
• Types of market failures include
– Persistently high underemployment of workers
▪ surpluses that are not eliminated in the market for labor because wages
do not adjust.
– Persistently high underutilization of structures, equipment, and other forms
of capital
▪ surpluses that are not eliminated in the market for capital because
prices do not adjust.
– Property rights not well defined or well enforced

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Cases against Free Trade (6 of 6)
• Types of market failures include
– Technological benefits for society discovered through private production,
but from which private firms cannot fully profit (no patents).
– Environmental costs for society caused by private production, but for
which private firms do not fully pay (e.g., EU Carbon border adjustment
mechanism).
– Sellers that are not well informed about the (opportunity) cost of
production or buyers that are not well informed about value from
consumption.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Which Industries Are Protected?
• Agriculture: In the U.S., Europe, and Japan, farmers make up a small
fraction of the electorate but receive generous subsidies and trade protection.
– Examples: European Union’s Common Agricultural Policy, Japan’s 778%
tariff on imported rice, America’s sugar quota.
• Clothing: textiles (fabrication of cloth) and apparel (assembly of cloth into
clothing).
• Semiconductor chip production?

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Negotiations of Trade Policy (1 of 3)
• After rising sharply at the beginning of the 1930s, the average U.S. tariff rate
has decreased substantially from the mid-1930s to 1998.
• Since 1944, much of the reduction in tariffs and other trade restrictions has
come about through international negotiations.
– The General Agreement of Tariffs and Trade was begun in 1947 as a
provisional international agreement and was replaced by a more formal
international institution called the World Trade Organization in 1995.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Negotiations of Trade Policy (2 of 3)
• Multilateral negotiations help avoid a trade war between countries, where
each country enacts trade restrictions.
• A trade war could result if each country has an incentive to adopt
protection, regardless of what other countries do. A dominant strategy
can result in a prisoner’s dilemma.
– All countries could enact trade restrictions, even if it is in the interest of
all countries to have free trade.
– Countries need an agreement that prevents a trade war or eliminates the
protection from one.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Table 10.3 The Problem of Trade Warfare – Analysis
with game theory

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Negotiations of Trade Policy (3 of 3)
• In this example, each country acting individually would be better off with
protection (20 > 10), but both would be better off if both chose free trade than
if both choose protection (10 > −5).
• If Japan and the U.S. can establish a binding agreement to maintain free
trade, both can avoid the temptation of protection and both can be made
better off.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.
International Trade Agreements: A Brief History
• In 1930, the United States passed a remarkably irresponsible tariff law, the
Smoot-Hawley Act.
– Tariff rates rose steeply and U.S. trade fell sharply.
• Initial attempts to reduce tariff rates were undertaken through bilateral trade
negotiations:
– U.S. offered to lower tariffs on some imports if another country would
lower its tariffs on some U.S. exports.
• Bilateral negotiations, however, do not take full advantage of international
coordination.
– Benefits can “spill over” to countries that have not made any concessions.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

World Trade Organization (1 of 6)
• In 1947, a group of 23 countries began trade negotiations under a
provisional set of rules that became known as the General Agreement on
Tariffs and Trade, or GATT.
• In 1995, the World Trade Organization, or WTO, was established as a
formal organization for implementing multilateral trade negotiations (and
policing them).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

World Trade Organization (2 of 6)
• WTO negotiations address trade restrictions in at least 3 ways:
1. Reducing tariff rates through multilateral negotiations.
2. Binding tariff rates: a tariff is “bound” by having the imposing country agree
not to raise it in the future.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

World Trade Organization (3 of 6)
3. Eliminating nontariff barriers: quotas and export subsidies are changed
to tariffs because the costs of tariff protection are more apparent and easier
to negotiate.
– Subsidies for agricultural exports are an exception.
– Exceptions are also allowed for “market disruptions” caused by a surge
in imports.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

World Trade Organization (4 of 6)
• The World Trade Organization is based on a number of agreements:
– General Agreement on Tariffs and Trade (GATT): covers trade in
goods.
– General Agreement on Tariffs and Services (GATS): covers trade in
services (ex., insurance, consulting, legal services, banking).
– Agreement on Trade-Related Aspects of Intellectual Property (TRIP):
covers international property rights (ex., patents and copyrights).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

World Trade Organization (5 of 6)
– The dispute settlement procedure: a formal procedure where countries
in a trade dispute can bring their case to a panel of WTO experts to rule
upon.
▪ The panel decides whether member counties are breaking their
agreements.
▪ A country that refuses to adhere to the panel’s decision may be
punished by the WTO allowing other countries to impose trade
restrictions on its exports.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

World Trade Organization (6 of 6)
• In 2001, a new round of negotiations was started in Doha, Qatar, but these
negotiations never produced an agreement.
– Most of the remaining forms of protection are in agriculture, textiles, and
clothing—industries that are politically well organized.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Preferential Trading Agreements (1 of 4)
• Preferential trading agreements are trade agreements between countries in
which they lower tariffs for each other but not for the rest of the world.
• Under the WTO, such discriminatory trade policies are generally not allowed.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Preferential Trading Agreements (2 of 4)
• There are two types of preferential trading agreements in which tariff rates
are set at or near zero:
1. A free trade area: an agreement that allows free trade among members,
but each member can have its own trade policy towards non-member
countries.
– An example is the North America Free Trade Agreement (NAFTA) and its
successor USMCA.
2. A customs union: an agreement that allows free trade among members
and requires a common external trade policy towards non-member
countries.
– An example is the European Union
(in addition, the EU is also a common market). Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Preferential Trading Agreements (3 of 4)
• Are preferential trading agreements necessarily good for national welfare?
• No, it is possible that national welfare decreases under a preferential trading
agreement.
• How? Rather than gaining tariff revenue from inexpensive imports from
world markets, a country may import expensive products from member
countries but not gain any tariff revenue.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Preferential Trading Agreements (4 of 4)
• Preferential trading agreements increase national welfare when new trade is
created, but not when existing trade from the outside world is diverted to trade
with member countries.
• Trade creation
– occurs when high-cost domestic production is replaced by low-cost
imports from other members.
• Trade diversion
– occurs when low-cost imports from nonmembers are diverted to high-cost
imports from member nations.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Economics: Theory and Policy

Chapter 11
Trade Policy in
Developing Countries
Import-Substituting Industrialization (1 of 2)
• Import-substituting industrialization was a trade policy adopted by many low-
and middle-income countries before the 1980s.
• The policy aimed to encourage domestic industries by limiting
competing imports.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Import-Substituting Industrialization (2 of 2)
• The principal justification of this policy was/is the infant industry argument:
– Countries may have a potential comparative advantage in some
industries, but these industries cannot initially compete with well-
established industries in other countries.
– To allow these industries to establish themselves, governments should
temporarily support them until they have grown strong enough to compete
internationally.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Problems with the Infant Industry Argument
• It may be wasteful to support industries now that will have a comparative
advantage in the future.
• Even with protection, infant industries may never “grow up” or become
competitive.
• There is no justification for government intervention unless there is a market
failure that prevents the private sector from investing in the infant industry.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Economics: Theory and Policy

Chapter 14
Exchange Rates and the
Foreign Exchange Market:
An Asset Approach

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Preview
• The basics of exchange rates
• Exchange rates and the prices of goods
• The foreign exchange markets
• The demand of currency and other assets
• A model of foreign exchange markets

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Definitions of Exchange Rates
• Price of one currency expressed in terms of another currency.
• Exchange rates are quoted as
foreign currency per unit of domestic currency or
domestic currency per unit of foreign currency.
• Exchange rates allow us to denominate the cost or price of a good or service
in a common currency.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Depreciation and Appreciation
• Depreciation is a decrease in the value of a currency relative to another currency.
– A depreciated currency is less valuable and therefore can be exchanged for a
smaller amount of foreign currency.
– A depreciated currency lowers the price of exports relative to the price of
imports.
• Appreciation is an increase in the value of a currency relative to another currency.
– An appreciated currency is more valuable and therefore can be exchanged for
a larger amount of foreign currency.
– An appreciated currency raises the price of exports relative to the price of
imports.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

 https://markets.ft.com/data/currencies/tearsheet/summary?s=EURUSD

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Foreign Exchange Markets (1 of 2)
The participants:
• Commercial banks and other depository institutions: transactions involve
buying/selling of deposits in different currencies for investment purposes.
• Non-bank financial institutions (mutual funds, hedge funds, securities firms,
insurance companies, pension funds) may buy/sell foreign assets for
investment.
• Central banks: conduct official international
reserves transactions.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Foreign Exchange Markets (2 of 2)
• Computer and telecommunications technology transmit information rapidly and
have integrated markets.
• The integration of financial markets implies that there can be no significant
differences in exchange rates across locations.
– Arbitrage: buy at low price and sell at higher price for a profit.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Demand of Currency Deposits (1 of 8)
• What influences the demand of deposits denominated in domestic or foreign
currency?
• Factors that influence the return on assets determine the demand of those
assets.
• Rate of return: the percentage change in value that an asset offers during a
time period (usually one year).
– The annual return for $100 savings deposit with an interest rate of 2% is $100 × 1.02 =
$102, so that the rate of return = 2%.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Demand of Currency Deposits (2 of 8)
• Real rate of return: inflation-adjusted rate of return, which represents
the additional amount of goods & services that can be purchased with
earnings from the asset.
– The real rate of return for the above savings deposit when inflation is
1.5% is 2% − 1.5% = 0.5%.
• If prices are fixed (price level does not change; inflation rate is 0%) →
nominal rate of return = real rate of return.
• Because trading of deposits in different currencies occurs on a daily basis,
we often assume that prices do not change from day to day.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Demand of Currency Deposits (3 of 8)
• Risk of holding assets also influences decisions about whether to buy them.
• Liquidity of an asset, or ease of using the asset to buy goods and services,
also influences the willingness to buy assets.
• We assume that risk and liquidity of currency
deposits in foreign exchange markets are essentially the same, regardless of
their currency denomination.
– Risk and liquidity are only of secondary importance when deciding to buy
or sell currency deposits.
Is this a sensible assumption? https://markets.ft.com/data/bonds/government-bonds-
spreads

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Demand of Currency Deposits (4 of 8)
• → focus on rate of return on currency deposits.

• To compare the rate of return on a deposit in domestic currency with one in

foreign currency, consider
– the interest rate for the foreign currency deposit
– the expected rate of appreciation or depreciation of the foreign
currency relative to the domestic currency.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Demand of Currency Deposits (5 of 8)
• Suppose the interest rate on a dollar deposit is 2%.
• Suppose the interest rate on a euro deposit is 4%.
• Does a euro deposit yield a higher expected rate
of return?
– Suppose today the exchange rate is $1/€1, and the expected rate one year
in the future is $0.97/€1.
– $100 can be exchanged today for €100.
– These €100 will yield €104 after one year.
– These €104 are expected to be worth $0.97/€1 × €104 = $100.88 in one
year.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Demand of Currency Deposits (6 of 8)
• The rate of return in terms of dollars from investing in euro deposits is
0.88%.
• The rate of return is simply the interest rate, 2%.
• The euro deposit has a lower expected rate of return: thus, all investors
should be willing to hold dollar deposits and none should be willing to hold
euro deposits.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Demand of Currency Deposits (7 of 8)
$0.97 − $1
• Note that the expected rate of appreciation of the euro was = −0.03 = −3%.
$1

• We simplify the analysis by saying that the dollar rate of return on euro
deposits approximately equals
– the interest rate on euro deposits
– plus the expected rate of appreciation of euro deposits

– 4% + −3% = 1% ≈ 0.88%
E e $ / € − E$ / €
– R€ +
E$ / €

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Demand of Currency Deposits (8 of 8)
• The difference in the rate of return on dollar deposits and euro
deposits is

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Model of Foreign Exchange Markets (1 of 5)
• Construct model of foreign exchange markets using to determine market
equilibrium by comparing:
– the rate of return on dollar denominated deposits.
– and the rate of return on foreign currency denominated deposits.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Model of Foreign Exchange Markets (2 of 5)
• Model is in equilibrium when deposits of all currencies offer the same
expected rate of return: interest parity.
– Interest parity implies that deposits in all currencies are equally desirable
assets.
– Interest parity implies that arbitrage in the foreign exchange market is not
possible.
E e $ / € − E$ / €
• Interest parity says: R$ = R€ +
E$ / €

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Model of Foreign Exchange Markets (3 of 5)
• Why should the interest parity condition hold?
– Suppose it did not. Suppose
E e $ / € − E$ / €
R$  R€ +
E$ / €

– Then no investor would want to hold euro deposits, driving down the
demand and price of euros.
– Then all investors would want to hold dollar deposits, driving up the
demand and price of dollars.
– The dollar would appreciate until equality was achieved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Model of Foreign Exchange Markets (4 of 5)
• How do changes in the current exchange rate affect the expected rate of return
of foreign currency deposits?
• Depreciation of the domestic currency today lowers the expected rate of return
on foreign currency deposits.
– When the domestic currency depreciates, the initial cost of investing in foreign currency
deposits increases, thereby lowering the expected rate of return of foreign currency
deposits.

• Appreciation of the domestic currency today raises the expected return of

deposits on foreign currency deposits.
– When the domestic currency appreciates, the initial cost of investing in foreign currency
deposits decreases, thereby lowering the expected rate of return of foreign currency
deposits.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Figure 14.3 The Relation between the Current Dollar/Euro
Exchange Rate and the Expected Dollar Return on Euro
Deposits
An appreciation of the dollar
against the euro raises the
expected return on euro
deposits, measured in terms
of dollars.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 14.4 Determination of the Equilibrium Dollar/Euro
Exchange Rate
Equilibrium in the
foreign exchange
market is at point 1,
where the expected
dollar returns on dollar
and euro deposits are
equal.
Interest parity

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Model of Foreign Exchange Markets (5 of 5)
• The effects of changing interest rates:
– an increase in the interest rate paid on deposits denominated in a particular
currency will increase the rate of return on those deposits.
– This leads to an appreciation of the currency.
▪ Higher interest rates on dollar-denominated assets cause the dollar to appreciate.
▪ Higher interest rates on euro-denominated assets cause the dollar to depreciate.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 14.5 Effect of a Rise in the Dollar Interest Rate
A rise in the interest rate
offered by dollar deposits
causes the dollar to
appreciate from point 1 to
point 2.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 14.6 Effect of a Rise in the Euro Interest Rate
A rise in the interest rate
paid by euro deposits
causes the dollar to
depreciate from point 1
to point 2.)

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Effect of an Expected Appreciation of the Euro
• If people expect the euro to appreciate in the future, then:
– The expected rate of return on euros increases.
– An expected appreciation of a currency leads to an actual appreciation (a
self-fulfilling prophecy).
– An expected depreciation of a currency leads to an actual depreciation (a
self-fulfilling prophecy).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Economics: Theory and Policy

Chapter 15
Money, Interest Rates,
and Exchange Rates
Preview
• Control of the supply of money
• The willingness to hold monetary assets
• A model of real monetary assets and
interest rates
• A model of real monetary assets, interest rates, and exchange rates
• Long-run effects of changes in money on prices, interest rates, and exchange
rates

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Money Supply
• The central bank substantially controls the quantity of money that circulates
in an economy, the money supply.
– In the U.S., the central banking system is the Federal Reserve System.
▪ The Federal Reserve System directly regulates the amount of
currency in circulation.
▪ It indirectly influences the amount of checking deposits, debit card
accounts, and other monetary assets.
– In Europe: “Eurosystem”, European Central Bank (ECB) plus national
Central Banks of countries participating in the Euro.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Money Demand
• Money demand represents the amount of monetary assets that people are
willing to hold (instead of illiquid assets).
– What influences willingness to hold monetary assets?

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

What Influences Demand of Money
for Individuals and Institutions?
1. Interest rates / expected rates of return on monetary assets relative to the
expected rates of returns on non-monetary assets.
2. Risk: the risk of holding monetary assets principally comes from
unexpected inflation, which reduces the purchasing power of money.
– But many other assets have this risk too, so this risk is not very important in defining the
demand of monetary assets versus nonmonetary assets.
3. Liquidity: A need for greater liquidity occurs when the price of transactions
increases or the quantity of goods bought in transactions increases.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

What Influences Aggregate Demand of Money? (1 of 2)
1. Interest rates/expected rates of return: monetary assets pay little or no
interest, so the interest rate on non-monetary assets like bonds, loans, and
deposits is the opportunity cost of holding monetary assets.
– A higher interest rate means a higher opportunity cost of holding
monetary assets → lower demand of money.
2. Prices: the prices of goods and services bought in transactions will
influence the willingness to hold money to conduct those transactions.
– A higher level of average prices means a greater need for liquidity to
buy the same amount of goods and services → higher demand of
money.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

What Influences Aggregate Demand of Money? (2 of 2)
3. Income: greater income implies more goods and services can be bought, so
that more money is needed to conduct transactions.
– A higher real national income (GNP) means more goods and services are
being produced and bought in transactions, increasing the need for liquidity
→ higher demand of money.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

A Model of Aggregate Money Demand
The aggregate demand of money can be expressed as:

M d = P  L ( R,Y ) or
where:
P is the price level
Y is real national income
R is a measure of interest rates on nonmonetary assets
L(R,Y) is the aggregate demand of real monetary assets
• Aggregate demand of real monetary assets is a function of national income
and interest rates.
Md
= L ( R,Y )
P
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Figure 15.1 Aggregate Real Money Demand and the
Interest Rate
The downward-sloping real
money demand schedule
shows that for a given real
income level Y, real money
demand rises as the
interest rate falls.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 15.2 Effect on the Aggregate Real Money
Demand Schedule of a Rise in Real Income
An increase in real
income from Y1 to Y2
raises the demand for
real money balances
at every level of the
interest rate and
causes the whole
demand schedule to
shift upward.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

A Model of the Money Market
• When no shortages (excess demand) or surpluses (excess supply) of
monetary assets exist, the model achieves an equilibrium:
Ms = Md

• Alternatively, when the quantity of real monetary assets supplied matches

the quantity of real monetary assets demanded, the model achieves an
equilibrium:
Ms
= L ( R,Y )
P

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 15.3 Determination of the Equilibrium Interest
Rate

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 15.4 Effect of an Increase in the Money Supply
on the Interest Rate

For a given price level, P, and real income level, Y, an increase in the money supply from M1 to M2
reduces the interest rate from R1 (point 1) to R2 (point 2).
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Figure 15.5 Effect on the Interest Rate of a Rise in Real
Income

MS
Given the real money supply,
P
( )
= Q1 , a rise in real income from Y1 to Y2
raises the interest rate from R1 (point 1) to R2 (point 2). Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Figure 15.6 Simultaneous Equilibrium in the U.S.
Money Market and the Foreign Exchange Market
Both asset markets are in
equilibrium at the interest
rate R1 and exchange
Interest parity rate E1; at these values,
money supply equals
money demand (point 1)
and the interest parity
condition holds (point 1’).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 15.7 Money Market/Exchange Rate Linkages
Monetary policy actions by
the Fed affect the U.S.
interest rate, changing the
dollar/euro exchange rate
that clears the foreign
exchange market. The
ECB can affect the
exchange rate by changing
the European money
supply and interest rate.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 15.8 Effect on the Dollar/Euro Exchange Rate and
Dollar Interest Rate of an Increase in the U.S. Money
Supply
Given PUS and YUS when
the money supply rises from
M1 to M2 the dollar interest
rate declines (as money
market equilibrium is
reestablished at point 2)
and the dollar depreciates
against the euro (as foreign
exchange market
equilibrium is reestablished
at point 2’).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Changes in the Domestic Money Supply
• An increase in a country’s money supply causes interest rates to fall, rates
of return on domestic currency deposits to fall, and the domestic currency to
depreciate.
• A decrease in a country’s money supply causes interest rates to rise, rates
of return on domestic currency deposits to rise, and the domestic currency to
appreciate.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Changes in the Foreign Money Supply
• How would a change in the supply of euros affect the U.S. money market and
foreign exchange markets? (Fig. 15.9)
• An increase in the supply of euros causes a depreciation of the euro (an
appreciation of the dollar).
– The increase in the supply of euros reduces interest rates in the EU,
reducing the expected rate of return on euro deposits.
– This reduction in the expected rate of return on euro deposits causes the
euro to depreciate.
– We predict no change in the U.S. money market due to the change in
the supply of euros.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 15.9 Effect of an Increase in the European
Money Supply on the Dollar/Euro Exchange Rate
By lowering the dollar
return on euro deposits
(shown as a leftward shift
in the expected euro return
curve), an increase in
Europe’s money supply
causes the dollar to
appreciate against the
euro. Equilibrium in the
foreign exchange market
shifts from point 1’ to point
2’ but equilibrium in the
U.S. money market
remains at point 1.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Long Run and Short Run (1 of 3)
• In the short run, prices do not have sufficient time to adjust to market
conditions.
– The analysis heretofore has been a short-run analysis.
• In the long run, prices of factors of production and of output have sufficient
time to adjust to market conditions.
– Wages adjust to the demand and supply of labor.
– Real output and income are determined by the amount of workers and
other factors of production not by the quantity of money supplied.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Long Run and Short Run (2 of 3)
• In the long run, the quantity of money supplied is predicted not to influence
the amount of output, (real) interest rates, and the aggregate demand of real
monetary assets L(R,Y).
• However, the quantity of money supplied is predicted to make the level of
average prices adjust proportionally in the long run.
MS
– The equilibrium condition = L ( R,Y )
P
shows that P is predicted to adjust proportionally when Ms adjusts,
because L(R,Y) does not change.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Long Run and Short Run (3 of 3)
• In the long run, there is a direct relationship between the inflation rate and
changes in the money supply.

M S = P  L ( R,Y )
MS
P =
L ( R,Y )
P M S L
=
≈ S
−
P M L

– The inflation rate is predicted to approximately equal the growth rate in

money supply minus the growth rate in money demand.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Money, Prices, and Exchange Rates in the Long Run
• A permanent increase
in a country’s money
supply causes
inflation.
• A permanent increase
in a country’s money
supply also causes a
long-run depreciation
of its currency
(→ next chapter).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Economics: Theory and Policy

Chapter 16
Price Levels and
the Exchange Rate
in the Long Run
Preview
• Law of one price
• Purchasing power parity
• Long-run model of exchange rates: monetary approach
• Relationship between interest rates and inflation: Fisher effect
• Shortcomings of purchasing power parity
• Long-run model of exchange rates: real exchange rate approach
• Real interest rates

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Behavior of Exchange Rates
• What models can predict how exchange rates behave?
– Long run means a sufficient amount of time for prices of all goods and
services to adjust to market conditions so that their markets and the money
market are in equilibrium.
– Because prices are allowed to change, they will influence interest rates
and exchange rates in the long-run models.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Law of One Price (1 of 2)
• The law of one price states that the same good in different competitive
markets must sell for the same price, when transportation costs and barriers
between those markets are not important.
– Why? Suppose the price of pizza at one restaurant is $20, while the price of
the same pizza at an identical restaurant across the street is $40.
– What do you predict will happen? Many people will buy the $20 pizza, few
will buy the $40 one.
– People would have an incentive to adjust their behavior and prices would
tend to adjust until one price is achieved across markets (across
restaurants).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Law of One Price (2 of 2)
• Consider a pizza restaurant in Seattle and one across the border in
Vancouver.
• The law of one price says that the price of the same pizza (using a common
currency to measure the price) in the two cities must be the same if markets
are competitive and transportation costs and barriers between markets are
not important.

P pizza US = EUS$/C$ × P pizza Canada

P pizza US = price of pizza in Seattle

P pizza Canada = price of pizza in Vancouver
EUS$/C$ = U. S. dollar/Canadiandollarexchangerate

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Purchasing Power Parity (1 of 3)
• Purchasing power parity is the application of the law of one price across
countries for all goods and services, or for representative groups (“baskets”)
of goods and services.

PUS = EUS$/C$ × PCanada

PUS = level of average prices in the U. S.

PCanada = level of average prices in Canada
EUS$/C$ = U. S. dollar/Canadiandollarexchangerate

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Purchasing Power Parity (2 of 3)
• Purchasing power parity (PPP) implies that the exchange rate is determined
by levels of average prices

PUS
E US$ =
C$
PCanada

– Predicts that people in all countries have the same purchasing power with
their currencies.
– Price levels are only determinants of exchange rate.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Purchasing Power Parity (3 of 3)
• Purchasing power parity (PPP) comes in 2 forms:
• Absolute PPP: purchasing power parity that has already been discussed.
Exchange rates equal the level of relative average prices across countries.

PUS
E$ / € =
PEU
• Relative PPP: changes in exchange rates equal approximately changes
in price level (inflation) between two periods:
(E$ / €,t − E$ / €, t −1 )
=  US,t −  EU,t
E$ / €, t −1

where  t = inflation rate from perid

periodt −t-1 to tt
1 to
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Monetary Approach to Exchange Rates (1 of 5)
• Monetary approach to the exchange rate: uses monetary factors to
predict how exchange rates adjust in the long run, based on the absolute
version of PPP.
– It predicts that levels of average prices across countries adjust so that
the quantity of real monetary assets supplied will equal the quantity of
real monetary assets demanded:

M S US
PUS =
L ( R$ ,YUS )
PUS
E$ / € =
PEU M S EU
PEU =
L ( R€ ,YEU )
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Monetary Approach to Exchange Rates (2 of 5)
• To the degree that PPP holds and to the degree that prices adjust to equate
the quantity of real monetary assets supplied with the quantity of real
monetary assets demanded, we have the following prediction:
– The exchange rate is determined in the long run by price levels
which are determined by the relative supply and demand of real
monetary assets in money markets across countries.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Monetary Approach to Exchange Rates (3 of 5)
Predictions about changes in
1. Money supply: a permanent rise in the domestic money supply
– causes a proportional increase in the domestic price level,
– thus causing a proportional depreciation in the domestic currency (through
PPP).
– This is same prediction as long-run model without PPP.
2. Interest rates: a rise in domestic interest rates
– lowers the demand of real monetary assets,
– and is associated with a rise in domestic prices,
– thus causing a proportional depreciation of the domestic currency (through
PPP).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Monetary Approach to Exchange Rates (4 of 5)
3. Output level: a rise in the domestic level of production and income (output)
– raises domestic demand of real monetary assets,
– and is associated with a decreasing level of average domestic prices (for a fixed
quantity of money supplied),
– thus causing a proportional appreciation of the domestic currency (through
PPP).
• All 3 changes affect money supply or money demand, and cause prices to adjust so
that the quantity of real monetary assets supplied matches the quantity of real
monetary assets demanded, and cause exchange rates to adjust according to PPP.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Monetary Approach to Exchange Rates (5 of 5)
• A change in the money supply results in a change in the level of average prices.
• A change in the growth rate of the money supply results in a change in the growth
rate of prices (inflation).
– A constant growth rate in the money supply results in a persistent growth rate in
prices (persistent inflation) at the same constant rate, when other factors are
constant.
– Inflation does not affect the productive capacity of the economy and real
income from production in the long run (“neutrality of money”).
– Inflation, however, does affect nominal interest rates. How?

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Fisher Effect (1 of 2)
• The Fisher effect (named after Irving Fisher,
1867-1947) describes the relationship between
nominal interest rates and inflation.
– Derive the Fisher effect from the interest parity condition:

R$ − R€ =
( E e
$/ € − E$ / € )
E$ / €

– If financial markets expect relative PPP to hold, then expected exchange rate
changes will equal expected inflation between countries:

R$ − R€ =
( E e
$/ € − E$ / € ) = e
−  eEU
US
E$ / €

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Fisher Effect (2 of 2)
– Therefore, R$ − R€ =  eUS −  eEU

– The Fisher effect: a rise in the domestic inflation rate causes an equal rise
in the interest rate on deposits of domestic currency in the long run, when
other factors remain constant.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Shortcomings of PPP (1 of 5)
• There is little empirical support for absolute purchasing power parity.
– The prices of identical commodity baskets, when converted to a single
currency, differ substantially across countries.
• Relative PPP is more consistent with data, but it also performs poorly to predict
exchange rates.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Shortcomings of PPP (2 of 5)
Reasons why PPP may not be accurate: the law of one price may not hold
because of
• Trade barriers and nontradable products
• Imperfect competition
• Differences in measures of average prices for baskets of goods and
services

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Shortcomings of PPP (3 of 5)
• Trade barriers and nontradable products
– Transport costs and governmental trade restrictions make trade expensive
and in some cases create nontradable goods or services.
– Services are often not tradable: services are generally offered within a
limited geographic region (for example, haircuts).
– The greater the transport costs, the greater the range over which the
exchange rate can deviate from its PPP value.
– → One price need not hold in two markets.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Shortcomings of PPP (4 of 5)
• Imperfect competition may result in price discrimination: “pricing to market.”
– A firm sells the same product for different prices in different markets to
maximize profits, based on expectations about what consumers are
willing to pay.
– → One price need not hold in two markets.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Shortcomings of PPP (5 of 5)
• Differences in the measure of average prices for goods and services
– levels of average prices differ across countries because of differences in
how representative groups (“baskets”) of goods and services are
measured.
– Because measures of groups of goods and services are different, the
measure of their average prices need not be the same.
– → One price need not hold in two markets.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Law of One Price for Hamburgers?

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Big Mac Index as Indicator for implicit real exchange
rates

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Source: The Economist, https://www.economist.com/big-mac-index
The Real Exchange Rate Approach to Exchange Rates
(1 of 2)

• Because of the shortcomings of PPP, economists have tried to generalize the

monetary approach to PPP to make a better theory.
• The real exchange rate is the rate of exchange for goods and services across
countries.
– For example, it is the dollar price of a European basket of goods and services
relative to the dollar price of an American basket of goods and services:

qUS =
( E $/ €  PEU )
EU
PUS

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The Real Exchange Rate Approach to Exchange Rates
(2 of 2)

qUS =
( E
$/ €  PEU )
EU
PUS

– A real appreciation of the value of U.S. products means a rise in a dollar’s

purchasing power of EU products relative to a dollar’s purchasing power
of U.S. products.
▪ This implies that U.S. goods become more expensive and more
valuable relative to EU goods.
▪ This implies that the value of U.S. goods relative to value of EU goods
rises.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Economics: Theory and Policy

Chapter 18
Fixed Exchange Rates
and Foreign Exchange
Intervention
Preview
• Balance sheets of central banks
• Intervention in the foreign exchange markets and the money supply
• How the central bank fixes the exchange rate
• Monetary and fiscal policies under fixed exchange rates
• Financial market crises and capital flight
• Types of fixed exchange rates: reserve currency and gold standard systems

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Introduction
• Many countries try to fix or “peg” their exchange rate to a currency or group
of currencies by intervening in the foreign exchange markets.
• Many with a flexible or “floating” exchange rate in fact practice a managed
floating exchange rate.
– The central bank “manages” the exchange rate from time to time by
buying and selling currency and assets, especially in periods of
exchange rate volatility.
• How do central banks intervene in the foreign exchange markets?

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Central Bank Intervention and the Money Supply
• To study the effects of central bank intervention in the foreign exchange
markets, first construct a simplified balance sheet for the central bank.
– This records the assets and liabilities of a central bank.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Central Bank’s Balance Sheet (1 of 2)
• Assets
– Foreign government bonds (official international reserves)
– Gold (official international reserves)
– Domestic government bonds
– Loans to domestic banks
• Liabilities
– Deposits of domestic banks
– Currency in circulation

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Central Bank’s Balance Sheet (2 of 2)
• Assets = Liabilities + Net Worth
– If we assume that net worth is constant, then
▪ An increase in assets leads to an equal increase in liabilities.
▪ A decrease in assets leads to an equal decrease in liabilities.
• Changes in the central bank's balance sheet lead to changes in currency in
circulation or changes in deposits of banks, which lead to changes in the
money supply.
– If their deposits at the central bank increase, banks are usually able to use
these additional funds to lend to customers, so amount of money in
circulation increases.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Assets, Liabilities, and the Money Supply (1 of 2)
• A purchase of any asset by the central bank will be paid for with currency from
the central bank,
– causing the supply of money in circulation to increase.
– The transaction leads to equal increases of assets and liabilities.
• When the central bank buys domestic bonds or foreign bonds, the domestic
money supply increases.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Assets, Liabilities, and the Money Supply (2 of 2)
• A sale of any asset by the central bank will be paid for with currency to the
central bank,
– causing the supply of money in circulation to shrink.
– The transaction leads to equal decreases of assets
and liabilities.
• When the central bank sells domestic bonds or foreign bonds, the domestic
money supply decreases.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Foreign Exchange Markets
• Central banks trade foreign government bonds in the foreign exchange
markets.
– Foreign currency deposits and foreign government bonds are often
substitutes: both are fairly liquid assets denominated in foreign currency.
– Quantities of both foreign currency deposits and foreign government
bonds that are bought and sold influence the exchange rate.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Sterilization
• Because buying and selling of foreign bonds in the foreign exchange markets
affects the domestic money supply, a central bank may want to offset this
effect.
• This offsetting effect is called sterilization.
• If the central bank sells foreign bonds in the foreign exchange markets, it can
buy domestic government bonds in bond markets—hoping to leave the amount
of money in circulation unchanged.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Table 18.1 Effects of a $100 Foreign Exchange
Intervention: Summary
Effect on Effect on Central Effect on Central
Domestic Central
Domestic Money Bank’s Domestic Bank’s Foreign
Bank’s Action
Supply Assets Assets
Nonsterilized foreign +$100 0 +$100
exchange purchase

Sterilized foreign 0 −$100 +$100

exchange purchase

Nonsterilized foreign −$100 0 −$100

exchange sale

Sterilized foreign 0 +$100 −$100

exchange sale

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Fixed Exchange Rates (1 of 4)
• To fix the exchange rate, a central bank influences the quantities supplied
and demanded of currency by trading domestic and foreign assets, so that
the exchange rate (the price of foreign currency in terms of domestic
currency) stays constant.
• Foreign exchange markets are in equilibrium when

R=R 
+
( Ee −E )
E

• When the exchange rate is fixed at some level E 0 and the market expects it
to stay fixed at that level, then
R = R
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Fixed Exchange Rates (2 of 4)
• To fix the exchange rate, the central bank must trade foreign and domestic
assets in the foreign exchange market until R = R  .

• Alternatively, we can say that it adjusts the quantity of monetary assets in the
money market until the domestic interest rate equals the foreign interest
rate, given the level of average prices and real output:

MS
P
(
= L R  ,Y )

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Fixed Exchange Rates (3 of 4)
0
• Suppose that the central bank has fixed the exchange rate at E but the level
of output rises, raising the demand of real monetary assets.
• This is predicted to put upward pressure on interest rates and the value of the
domestic currency.
• How should the central bank respond if it wants to fix exchange rates?

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Fixed Exchange Rates (4 of 4)
• The central bank should buy foreign assets in the foreign exchange markets,
– thereby increasing the domestic money supply,
– thereby reducing interest rates in the short run.
– Alternatively, by demanding (buying) assets denominated in foreign
currency and by supplying (selling) domestic currency, the price/value of
foreign currency is increased and the price/value of domestic currency is
decreased.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 18.1 Asset Market Equilibrium with a Fixed
0
Exchange Rate, E
To hold the exchange rate
fixed at E 0 when output
rises from Y 1 to Y 2, the
central bank must purchase
foreign assets and thereby
raise the money supply from
M 1 to M 2.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Monetary Policy and Fixed Exchange Rates
• When the central bank buys and sells foreign assets to keep the exchange
rate fixed and to maintain domestic interest rates equal to foreign interest
rates, it is not able to adjust domestic interest rates to attain other
goals.
– In particular, monetary policy is ineffective in influencing output and
employment.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Fiscal Policy and Fixed Exchange Rates in the Short
Run
• Temporary changes in fiscal policy are more effective in influencing output and
employment in the short run:
– The rise in aggregate demand and output due to expansionary fiscal policy
raises demand for real monetary assets, putting upward pressure on
interest rates and on the value of the domestic currency.
– To prevent an appreciation of the domestic currency, the central bank must
buy foreign assets, thereby increasing the money supply and decreasing
interest rates.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Devaluation and Revaluation
• Depreciation and appreciation refer to changes in the value of a currency due
to market changes.
• Devaluation and revaluation refer to changes in a fixed exchange rate caused
by the central bank.
– With devaluation, a unit of domestic currency is made less valuable, so that
more units must be exchanged for 1 unit of foreign currency.
– With revaluation, a unit of domestic currency is made more valuable, so
that fewer units need to be exchanged for 1 unit of foreign currency.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Devaluation
• For devaluation to occur, the central bank buys foreign assets, so that
domestic monetary assets increase and domestic interest rates fall, causing
a fall in the rate return on domestic currency deposits.
– Domestic products become less expensive relative to foreign products,
so aggregate demand and output increase.
– Official international reserve assets (foreign bonds) increase.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Financial Crises and Capital Flight (1 of 6)
• When a central bank does not have enough official international reserve assets
to maintain a fixed exchange rate, a balance of payments crisis results.
– To sustain a fixed exchange rate, the central bank must have enough
foreign assets to sell in order to satisfy the demand of them at the fixed
exchange rate.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Financial Crises and Capital Flight (2 of 6)
• Investors may expect that the domestic currency will be devalued, causing
them to want foreign assets instead of domestic assets, whose value is
expected to fall soon.
1. This expectation or fear only makes the balance of payments crisis worse:
– Investors rush to change their domestic assets into foreign assets,
depleting the stock of official international reserve assets more quickly.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Financial Crises and Capital Flight (3 of 6)
2. As a result, financial capital is quickly moved from domestic assets to
foreign assets: capital flight.
– The domestic economy has a shortage of financial capital for investment and
has low aggregate demand.
3. To avoid this outcome, domestic assets must offer high interest rates to
entice investors to hold them.
– The central bank can push interest rates higher by reducing the money supply
(by selling foreign and domestic assets).
4. As a result, the domestic economy may face high interest rates, a reduced
money supply, low aggregate demand, low output, and low employment.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Financial Crises and Capital Flight (4 of 6)
• Expectations of a balance of payments crisis only worsen the crisis and hasten
devaluation.
– What causes expectations to change?
▪ Expectations about the central bank’s ability and willingness to maintain the
fixed exchange rate.
▪ Expectations about the economy: shrinking demand of domestic products
relative to foreign products means that the domestic currency should become
less valuable.
• In fact, expectations of devaluation can cause a devaluation: a self-fulfilling
crisis.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Financial Crises and Capital Flight (5 of 6)
• What happens if the central bank runs out of official international reserve
assets (foreign assets)?
• It must devalue the domestic currency.
– This will allow the central bank to replenish its foreign assets by buying
them back at a devalued rate,
– increasing the money supply,
– reducing interest rates,
– reducing the value of domestic products,
– increasing aggregate demand, output, and employment over time.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Financial Crises and Capital Flight (6 of 6)
• In a balance of payments crisis,
– the central bank may buy domestic bonds and sell domestic currency (to
increase the money supply) to prevent high interest rates, but this only
depreciates the domestic currency more.
– the central bank generally cannot satisfy the goals of low domestic interest
rates (relative to foreign interest rates) and fixed exchange rates
simultaneously.

https://www.ft.com/content/737b5d1a-64d0-4e2d-8ca1-e7bcd4ff4487

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Interest Rate Differentials (1 of 3)
• For many countries, the expected rates of return are not the same:

RR 
+
( E e
−E ). Why?
E
• Default risk:
The risk that the country's borrowers will default on their loan repayments.
Lenders therefore require a higher interest rate to compensate for this risk.
• Exchange rate risk:
If there is a risk that a country's currency will depreciate or be devalued, then
domestic borrowers must pay a higher interest rate to compensate foreign
lenders.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Interest Rate Differentials (2 of 3)
• Because of these risks, domestic assets and foreign assets are not treated
the same.
– Previously, we assumed that foreign and domestic currency deposits
were perfect substitutes: deposits everywhere were treated as the
same type of investment, because risk and liquidity of the assets were
assumed to be the same.
– In general, foreign and domestic assets may differ in the amount of risk
that they carry: they may be imperfect substitutes.
– Investors consider these risks, as well as rates of return on the assets,
when deciding whether to invest.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Interest Rate Differentials (3 of 3)
• A difference in the risk of domestic and foreign assets is one reason why
expected rates of return are not equal across countries:

R =R 
+
( E e
−E )+
E
where  is called a risk premium, an additional amount
needed to compensate investors for investing in risky domestic assets.

• The risk could be caused by default risk or exchange rate risk.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Spread between Italian and German 10 year
government bonds

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

https://www.tradingview.com/symbols/TVC-BTPBUND/
Types of Fixed Exchange Rate Systems
1. Reserve currency system: one currency acts as official international
reserves.
– The U.S. dollar was the currency that acted as official international reserves
from under the fixed exchange rate system from 1944 to 1973.
– All countries except the U.S. held U.S. dollars as the means to make official
international payments.
2. Gold standard: gold acts as official international reserves that all countries
use to make official international payments.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

International Economics: Theory and Policy

Chapter 21
Optimum Currency Areas
and the Euro
Preview
• The European Monetary System
• Policies of the EU and the EMS
• Theory of optimal currency areas
• Is the EU an optimal currency area?
• Other considerations of an economic and monetary union

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

What Is the EMS?
• The European Monetary System was originally a system of fixed
exchange rates implemented in 1979 through an exchange rate
mechanism (ERM).
• The EMS has since developed into an economic and monetary union
(EMU), a more extensive system of coordinated economic and monetary
policies.
– The EMS has replaced the exchange rate mechanism for most
members with a common currency under the economic and monetary
union.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Membership of the Economic and Monetary Union
• To be part of the economic and monetary union, EMS members must
− adhere to the exchange rate mechanism: exchange rates were fixed in
specified bands around a target exchange rate.
− follow restrained fiscal and monetary policies as determined by Council
of the EU and the European Central Bank.
− replace the national currency with the euro, whose circulation is
determined by the European System of Central Banks.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

 Copyright © 2018 Pearson Education, Ltd. All rights reserved.
http://www.ecb.int/euro/intro/html/map.en.html
 Copyright © 2018 Pearson Education, Ltd. All rights reserved.
http://www.ecb.int/euro/intro/html/map.en.html
Why the Euro (EMU)?
EU members adopted the euro for 4 main reasons:
• Unified market: the belief that greater market integration and economic growth
would occur.
• Political stability: the belief that a common currency would make political
interests more uniform.
• The belief that German influence under the EMS would be moderated under a
European System of Central Banks.
• Elimination of the possibility of devaluations/ revaluations: with free flows of
financial assets, capital flight and speculation could occur in an EMS with separate
currencies, but it would be more difficult for them to occur in an EMS with a single
currency.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Policies of the EU and EMS (1 of 3)
• The Single European Act of 1986 recommended that many barriers to trade,
financial asset flows, and immigration be removed by December 1992.
• The Maastricht Treaty, proposed in 1991, required the 3 provisions to transform
the EMS into an economic and monetary union.
– It also required standardizing regulations and centralizing foreign and defense
policies among EU countries.
– Some EU/EMS members have not ratified all of the clauses.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Policies of the EU and EMS (2 of 3)
• The Maastricht Treaty requires that members that want to enter the economic
and monetary union
1. attain exchange rate stability defined by the ERM before adopting the euro.
2. attain price stability: a maximum inflation rate of
1.5% above the average of the three lowest national inflation rates among EU
members.
3. maintain a restrictive fiscal policy:
– a maximum ratio of government deficit to GDP of 3%.
– a maximum ratio of government debt to GDP of 60%.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Policies of the EU and EMS (3 of 3)
• The Maastricht Treaty requires that members that want to remain in the
economic and monetary union
1. maintain a restrictive fiscal policy:
– a maximum ratio of government deficit to GDP of 3%.
– a maximum ratio of government debt to GDP of 60%.
– Financial penalties are imposed on countries with “excessive” deficits or
debt.
• The Stability and Growth Pact, negotiated in 1997, also allows for financial
penalties on countries with “excessive” deficits or debt.
– Not worth the paper it is written on….

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Theory of
Optimum Currency Areas (1 of 10)
• The theory of optimum currency areas argues that the optimal area for a
system of fixed exchange rates, or a common currency such as the Euro, is
one that is highly economically integrated.
– Economic integration means free flows of
• goods and services (trade)
• financial capital (assets) and physical capital
• workers/labor (immigration and emigration)
• The theory was developed by Robert Mundell, a Canadian economist, in
1961. He was awarded Nobel Memorial Prize in 1999 for his work in
optimum currency areas.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Theory of Optimum Currency Areas (2 of 10)
• Fixed exchange rates have costs and benefits for countries deciding
whether to adhere to them.
• Benefits of fixed exchange rates are that
they avoid the uncertainty and international transaction costs that floating
exchange rates involve.
• The gain that would occur if a country joined a fixed exchange rate system is
called the monetary efficiency gain.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Theory of Optimum Currency Areas (3 of 10)
• The monetary efficiency gain of joining a fixed exchange rate system depends on
the amount of economic integration.
• Joining fixed exchange rate system would be beneficial for a country if
− trade is extensive between it and member countries, because transaction costs
would be greatly reduced.
− financial assets flow freely between it and member countries, because the
uncertainty about rates of return would be greatly reduced.
− people migrate freely between it and member countries, because the
uncertainty about the purchasing power of wages would be greatly reduced.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Theory of Optimum Currency Areas (4 of 10)
• In general, as the degree of economic integration increases, the monetary
efficiency gain increases (GG schedule on following figure).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 21.3 The GG Schedule
The upward-sloping GG
schedule shows that a
country’s monetary
efficiency gain from
joining a fixed exchange
rate area rises as the
country’s economic
integration with the area
rises.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Theory of Optimum Currency Areas (5 of 10)
When considering the monetary efficiency gain,
• we have assumed that the members of the fixed exchange rate system
would maintain stable prices.
– But when variable inflation exists among member countries, then joining
the system would not reduce uncertainty (as much).
• we have assumed that a new member would be fully committed to a fixed
exchange rate system.
– But if a new member is likely to leave the fixed exchange rate system,
then joining the system would not reduce uncertainty (as much).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Theory of Optimum Currency Areas (6 of 10)
• Economic integration also allows prices to converge between members of a
fixed exchange rate system and a potential member.
– The law of one price is expected to hold better when markets are
integrated.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Theory of Optimum Currency Areas (7 of 10)
• Costs of fixed exchange rates are that they require the loss of monetary
policy for stabilizing output and employment, and the loss of automatic
adjustment of exchange rates to changes in aggregate demand.
• Define this loss that would occur if a country joined a fixed exchange rate
system as the economic stability loss.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Theory of Optimum Currency Areas (8 of 10)
• The economic stability loss of joining a fixed exchange rate system also
depends on the amount of economic integration.
• After joining a fixed exchange rate system, if the new member faces a fall in
aggregate demand:
− Relative prices will tend to fall, which will lead other members to increase
aggregate demand greatly if economic integration is extensive, so that the
economic loss is not as great.
− Financial assets or labor will migrate to areas with higher returns or
wages if economic integration is extensive, so that the economic loss is
not as great.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Theory of Optimum Currency Areas (9 of 10)
− The loss of the automatic adjustment of flexible exchange rates is not
as great if goods and services markets are integrated. Why?
• Consider what would have happened if the country did not join the fixed
exchange rate system:
– the automatic adjustment would have caused a depreciation of the
domestic currency and an appreciation of foreign currencies, which would
have caused an increase in many prices for domestic consumers when
goods and services markets are integrated.
– In general, as the degree of economic integration increases, the
economic stability loss decreases (Fig. 21.4).

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 21.4 The LL Schedule
The downward-sloping
LL schedule shows that
a country’s economic
stability loss from
joining a fixed exchange
rate area falls as the
country’s economic
integration with the area
rises.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Theory of Optimum Currency Areas (10 of 10)
• At some critical point measuring the degree of integration, the monetary
efficiency gain will exceed the economic stability loss for a member considering
whether to join a fixed exchange rate system.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 21.5 Deciding When to Peg the Exchange Rate
The intersection of GG and LL
at point 1 determines a critical
level of economic integration,
1, between a fixed exchange
rate area and a country
considering whether to join. At
any level of integration above
1, the decision to join yields
positive net economic benefits
to the joining country.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Is the EU an Optimum Currency Area? (1 of 4)
• If the EU/EMS/economic and monetary union can be expected to benefit
members, we expect that its members have a high degree of economic
integration:
– large trade volumes as a fraction of GDP
– a large amount of foreign financial investment
and foreign direct investment relative to total investment
– a large amount of migration across borders as a fraction of total labor
force

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Figure 21.7 Unemployment Rates in Selected EU
Countries

Widely divergent unemployment rates moved closer together after the euro’s launch in 1999 but since the
late 2000s have moved sharply apart.
Source: International Monetary Fund, World Economic Outlook database, April 2016. Numbers for 2016
are IMF forecasts. Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Is the EU an Optimum Currency Area? (2 of 4)
• Deviations from the law of one price also occur in many EU markets.
– If EU markets were greatly integrated, then the (currency-adjusted)
prices of goods and services should be nearly the same across markets.
– The price of the same BMW car varies 29.5% between British and Dutch
markets.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Is the EU an Optimum Currency Area? (3 of 4)
• Regional migration is not extensive in the EU.
• Europe has many languages and cultures, which hinder migration and labor
mobility.
• Unions and regulations also impede labor movements between industries
and countries.
• Differences of U.S. unemployment rates across regions are smaller and less
persistent than differences of national unemployment rates in the EU,
indicating a lack of EU labor mobility.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Is the EU an Optimum Currency Area? (4 of 4)
• There is evidence that financial assets were able to move more freely within
the EU after 1992 and 1999.
• But capital mobility without labor mobility can make the economic stability loss
greater.
– After a reduction of aggregate demand in a particular EU country, financial
assets could be easily transferred elsewhere while labor is stuck.
– The loss of financial assets could further reduce production and
employment.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Other Considerations for an EMU (1 of 3)
• The structure of the economies in the EU’s economic and monetary union is
important for determining how members respond to aggregate demand shocks.
– The economies of EU members are similar in the sense that there is a
high volume of intra-industry trade relative to the total volume.
– They are different in the sense that Northern European countries have
high levels of physical capital per worker and more skilled labor,
compared with Southern European countries.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Other Considerations for an EMU (2 of 3)
– How an EU member responds to aggregate demand shocks may depend
on how the structure of its economy compares to that of fellow EU
members.
– For example, the effects on an EU member of a reduction in aggregate
demand caused by a reduction in demand in the software industry will
depend on whether the EU member has a large number of workers skilled
in programming relative to fellow EU members.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Other Considerations for an EMU (3 of 3)
• The amount of transfers among the EU members may also affect how EU
economies respond to aggregate demand shocks.
– Fiscal payments between countries in the EU’s federal system, or fiscal
federalism, may help offset the economic stability loss from joining an
economic and monetary union.
– But relative to interregional transfers in the U.S., little fiscal federalism
occurs among EU members.
– Will the European Commission’s €750bn budget increase make a
difference?

Copyright © 2018 Pearson Education, Ltd. All rights reserved.