2 Preface

A MODERN BOOK FOR

A MODERN AUDIENCE
Feenstra and Taylor’s text incorporates
fresh perspectives, current topics, and
4 The Eurozone in Crisis, 2008–2013 up-to-date empirical research. It expands
For almost 10 years, Eurozone policy making focused on two main macroeconomicthe study of international economics to
goals: the ECB’s monetary policy credibility and inflation target, seen as a broad
success given low and stable inflation outcomes; and the Eurozone governments’encompass the latest theories and world
fiscal responsibility, seen as a failure given the general disregard for the SGP rules.events.
However, policy makers (like their counterparts all over the world) failed to spot key
macroeconomic and financial developments that were to plunge the Eurozone into
crisis in 2008 and beyond.
Boom and Bust: Causes and Consequences of an Asymmetrical Crisis With
a fanatical devotion to inflation targeting, the ECB (and its constituent central banks)
paid insufficient attention to what was historically a primary responsibility of central
banks, namely, financial stability. Within some parts of the Eurozone (as elsewhere)
borrowers in the private sector were engaged in a credit-fueled boom. In other parts The chapter on the euro covers
of the Eurozone, savers and banks funneled ever more loans toward those borrow-
ers. The creditors were core Northern European countries like Germany and the
the dramatic developments
Netherlands; the debtors were fast-growing peripheral nations such as Greece, Ireland, since 2010, including the Greek
Portugal, and Spain (so called because they are located geographically on the periph-
ery of Europe).
debt restructuring; assistance
In Greece, much of the borrowing was by a fiscally irresponsible government that programs in Spain, Ireland and
was later found to be falsifying its accounts. In the other peripheral nations, how-
ever, the flow of loans funded rapid investment and consumption surges, including a Portugal; and the Cyprus bank-
residential construction boom that in places (e.g., Dublin and Barcelona) rivaled the
property bubble in parts of the United States. In Ireland and Spain, even as this boom
ing crisis.
took place, the governments had maintained a fiscal position close to balance, or even
surplus; the asymmetric boom helped them at that time. The trouble was to come
when the boom gave way to a severe asymmetric bust.

page 843 FIGURE 7-14

Trade surplus 140

(US$ billion)
120
100
United States
80
United Kingdom
60
40
20
India
0
–20
1970 1975 1980 1985 1990 1995 2000 2005 2010

Trade Surplus in Business Services This figure United Kingdom, its chief competitor, up until about
shows the combined trade surplus in computer and 2000. Since then the surpluses of the United Kingdom
information services, insurance, and financial services and of the United States have been similar. India’s

THEORY TESTED AND REFINED

for the United States, the United Kingdom, and India surplus began growing around 2000 and is based
from 1970 to 2010. The U.S. surplus in these categories entirely on its exports of computer and information
of services has been growing since about 1985, with an services.
Feenstra and Taylor’s text covers many occasional dip, and exceeded the trade surplus of the Source: World Bank World Development Indicators.

empirical studies that prove or refute ex-

isting theories, revealing important new
3 The Politics and Future of Offshoring
lessons about the determinants of trade, Offshoring is controversial and is often the topic of political debate. In
factor flows, exchange rates, and crises. February 2004 the first quote at the beginning of this chapter appeared in the
Economic Report of the President. The writer of that sentence, Harvard economist
N. Gregory Mankiw, who was chairman of the Council of Economic Advisors,
page 222
 MODERN TOPICS
In March 2012, the United States, the European Union, and Japan filed another
WTO case against China charging that it applied unfair export restrictions on its rare
Feenstra and Taylor’s text shows why trade
earth minerals, as well as tungsten and molybdenum. The first step in such a case is and capital flows have been liberalized
for the parties involved (the United States, Europe, and Japan on one side; China and allowed to grow. The text focuses
on the other) to see whether the charges can be resolved through consultations at
the WTO. Those consultations failed to satisfy either side, and in September 2012, more attention on emerging markets and
the case went to a dispute settlement panel at the WTO. The Chinese government developing countries—regions that now
appealed to Article XX of the GATT, which allows for an exception to GATT rules carry substantial weight in the global
in cases “relating to the conservation of exhaustible natural resources.” But the WTO
ruled against China, who is expected to appeal. economy.
Regardless of the ultimate outcome of that case, it appears that China has already
changed its policies on rare earth minerals. By the end of 2012, China realized that
its policy of export quotas for rare earth minerals was not having the desired effect
of maintaining high world prices. It therefore shifted away from a strict reliance on
export quotas, and introduced subsidies to help producers who were losing money.
These new policies are described in Headlines: China Signals Support for Rare
Earths. The new subsidy policy might also lead to objections from the United States,
the European Union, and Japan. But as we have seen earlier in this chapter, it is more
difficult for the WTO to control subsidies (which are commonly used in agriculture)
than to control export quotas.
A final feature of international trade in rare earth minerals is important to rec-
ognize: the mining and processing of these minerals poses an environmental risk,
because rare earth minerals are frequently found with radioactive ores like tho-
rium or uranium. Processing these minerals therefore leads to low-grade radioactive
waste as a by-product. That aspect of rare earth minerals leads to protests against
the establishment of new mines. The Lynas Corporation mine
in Australia, mentioned in the Headlines article, processes the
minerals obtained there in Malaysia. That processing facility was
targeted by protesters in Malaysia, led by a retired math teacher
named Tan Bun Teet. Although Mr. Tan and the other protestors
did not succeed in preventing the processing facility from being
opened, they did delay it and also put pressure on the company to
TIM WIMBORNE/Reuters/Corbis

ensure that the radioactive waste would be exported from Malaysia,

in accordance with that country’s laws. But where will this waste
go? This environmental dilemma arises because of the exploding
worldwide demand for high-tech products (including your own
cell phone), whose manufacturing involves environmental risks.
This case illustrates the potential interaction between international Protesters from the Save
Malaysia Stop Lynas group
trade and the environment, a topic we examine in more detail in demonstrating outside a
the next chapter. ■ hotel in Sydney, Australia.

7 High-Technology Export Subsidies

We turn now to consider high-technology final products. This sector of an economy
also receives substantial assistance from government, with examples including subsi-
dies to the aircraft industries in both the United States and Europe. In the United
States, subsidies take the form of low-interest loans provided by the Export-Import

page 351
 APPLICATION
China and the Multifibre Arrangement APPLICATIONS
One of the founding principles of GATT was that countries should not use quotas
to restrict imports (see Article XI of Side Bar: Key Provisions of the GATT). The Applications illuminate real-world
Multifibre Arrangement (MFA), organized under the auspices of the GATT in 1974, policies, events, and empirical evidence.
was a major exception to that principle and allowed the industrial countries to restrict
imports of textile and apparel products from the developing countries. Importing
countries could join the MFA and arrange quotas bilaterally (i.e., after negotiating
with exporters) or unilaterally (on their own). In practice, the import quotas estab-
lished under the MFA were very detailed and specified the amount of each textile
and apparel product that each developing country could sell to countries including
Canada, Europe, and the United States.
Although the amount of the quotas was occasionally revised upward, it did not keep
page 269

HEADLINES
HEADLINES
Headlines boxes offer insights into the global
Economic Crisis in Iceland economy from international media sources.
International macroeconomics can often seem like a dry and abstract
subject, but it must be remembered that societies and individuals can be
profoundly shaken by the issues we will study. This article was written
just after the start of the severe economic crisis that engulfed Iceland in
In a small, close-knit country of just
2008, following the collapse of its exchange rate, a financial crisis, and a
317,000 people, where everyone knows
government fiscal crisis. Real output per person shrank the
everyone, by more than
stigma of 10%,
accepting a
and unemployment rose from 1% to 9%. Fivehand-out
years later a recovery
is hard to livewas justand of
down
beginning to take shape. the dozens of people waiting outside
the food bank in the snow on a dreary
Reykjavik—The crisis that brought down small, formerly fishing-based economy “The 550 families we welcome here
March afternoon, Iris is the only one
page 417
cult for me to come

HALLDOR KOLBEINS/AFP/Getty Images

here in the beginning. But now I try
not to care so much anymore,” said the
weary-looking 41-year-old, who lost her
job in a pharmacy last summer, as she

The contrast is brutal with the os-

tentatious wealth that was on display
across the island just two years ago, as Protesters outside the Icelandic parliament in Reykjavik demand that the government do more
ooded the to improve conditions for the recently poor.
Continued on next page

Available now:
International Economics
International Trade
International Macroeconomics
Essentials of International Economics
For more information, go to www.worthpublishers.com/economics
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third edition

international
economics
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third edition

international
economics
ROBERT C. FEENSTRA ALAN M. TAYLOR
University of California, Davis University of California, Davis

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About the Authors

Bud Harmon
Robert C. Feenstra and Alan M. Taylor research associates of the National Bureau of Economic
are Professors of Economics at the University of Research, where Feenstra directs the International
California, Davis. They each began their studies Trade and Investment research program. They have
abroad: Feenstra received his B.A. in 1977 from both published graduate level books in international
the University of British Columbia, Canada, and economics: Offshoring in the Global Economy and Product
Taylor received his B.A. in 1987 from King’s College, Variety and the Gains from Trade (MIT Press, 2010),
Cambridge, U.K. They trained as professional econo- by Robert C. Feenstra, and Global Capital Markets:
mists in the United States, where Feenstra earned his Integration, Crisis and Growth (Cambridge University
Ph.D. in economics from the Massachusetts Institute Press, 2004), by Maurice Obstfeld and Alan M. Taylor.
of Technology in 1981 and Taylor earned his Ph.D. in Feenstra received the Bernhard Harms Prize from
economics from Harvard University in 1992. Feenstra the Institute for World Economics, Kiel, Germany,
has been teaching international trade at the under- in 2006, and delivered the Ohlin Lectures at the
graduate and graduate levels at UC Davis since 1986, Stockholm School of Economics in 2008. Taylor was
where he holds the C. Bryan Cameron Distinguished awarded a Guggenheim Fellowship in 2004 and was
Chair in International Economics. Taylor teaches awarded a Houblon-Norman/George Fellowship by
international macroeconomics, growth, and economic the Bank of England in 2009–10.
history at UC Davis, where he also holds appoint- Feenstra lives in Davis, California, with his wife,
ments as Director of the Center for the Evolution of Gail, and has two grown children: Heather, who is
the Global Economy and Professor of Finance in the a genetics counselor; and Evan, who is a musician
Graduate School of Management. and entrepreneur. Taylor also lives in Davis, with his
Both Feenstra and Taylor are active in research and wife, Claire, and has two young children, Olivia and
policy discussions in international economics. They are Sebastian.

v
To our parents
Brief Contents
PART 1 Introduction to International Trade PART 5 Introduction to International
Chapter 1 Trade in the Global Economy 1 Macroeconomics
Chapter 12 The Global Macroeconomy 411
PART 2 Patterns of International Trade
Chapter 2 Trade and Technology: The Ricardian PART 6 Exchange Rates
Model 27 Chapter 13 Introduction to Exchange Rates and
Chapter 3 Gains and Losses from Trade in the the Foreign Exchange Market 435
Specific-Factors Model 59 Chapter 14 Exchange Rates I: The Monetary
Chapter 4 Trade and Resources: The Approach in the Long Run 473
Heckscher-Ohlin Model 87 Chapter 15 Exchange Rates II: The Asset
Chapter 5 Movement of Labor and Capital Approach in the Short Run 521
between Countries 123
PART 7 The Balance of Payments
PART 3 New Explanations for International Chapter 16 National and International Accounts:
Trade Income, Wealth, and the Balance of
Payments 567
Chapter 6 Increasing Returns to Scale and
Monopolistic Competition 165 Chapter 17 Balance of Payments I: The Gains
from Financial Globalization 609
Chapter 7 Offshoring of Goods and
Services 197 Chapter 18 Balance of Payments II: Output,
Exchange Rates, and Macroeconomic
PART 4 International Trade Policies Policies in the Short Run 663
Chapter 8 Import Tariffs and Quotas Under
PART 8 Applications and Policy Issues
Perfect Competition 233
Chapter 19 Fixed Versus Floating: International
Chapter 9 Import Tariffs and Quotas Under
Monetary Experience 715
Imperfect Competition 279
Chapter 20 Exchange Rate Crises: How Pegs
Chapter 10 Export Subsidies in Agriculture and
Work and How They Break 757
High-Technology Industries 327
Chapter 21 The Euro 811
Chapter 11 International Agreements: Trade,
Labor, and the Environment 367 Chapter 22 Topics in International
Macroeconomics 859
Index I-1

vii
Contents

Preface xxvi

PART 1 CHAPTER 1 Trade in the Global Economy 1

Introduction to 1 International Trade 3
International Trade The Basics of World Trade 3
HEADLINES Sum of iPhone Parts: Trade Distortion 5
APPLICATION Is Trade Today Different from the Past? 5
Map of World Trade 7
Trade Compared with GDP 11
Barriers to Trade 12
“First Golden Age” of Trade 12
“Second Golden Age” of Trade 14
HEADLINES A Sea Change in Shipping 50 Years Ago 15

2 Migration and Foreign Direct Investment 16

Map of Migration 16
Map of Foreign Direct Investment 19

3 Conclusions 23
Key Points, Key Terms, and Problems

CHAPTER 2 Trade and Technology: The Ricardian Model 27

PART 2
1 Reasons for Trade 29
Patterns of
Proximity 29
International Trade
Resources 30
Absolute Advantage 30
SIDE BAR Can Comparative Advantage Be Created? The Case
of “Icewine” 31
Comparative Advantage 32
SIDE BAR David Ricardo and Mercantilism 32

2 Ricardian Model 33
The Home Country 33
The Foreign Country 37

viii
 CONTENTS ix

APPLICATION Comparative Advantage in Apparel, Textiles, and

Wheat 38

3 Determining the Pattern of International Trade 40

International Trade Equilibrium 41
APPLICATION Labor Productivity and Wages 46

4 Solving for International Prices 47

Home Export Supply Curve 47
International Trade Equilibrium 51
APPLICATION The Terms of Trade for Primary Commodities 52

5 Conclusions 53
Key Points, Key Terms, and Problems

CHAPTER 3 Gains and Losses from Trade in the Specific-Factors

Model 59
1 Specific-Factors Model 61
The Home Country 61
The Foreign Country 64
Overall Gains from Trade 64
APPLICATION How Large Are the Gains from Trade? 65

2 Earnings of Labor 66
Determination of Wages 66
Change in Relative Price of Manufactures 68
APPLICATION Manufacturing and Services in the United States:
Employment and Wages across Sectors 71
APPLICATION Trade Adjustment Assistance Programs: Financing the
Adjustment Costs of Trade 73

3 Earnings of Capital and Land 74

Determining the Payments to Capital and Land 74
HEADLINES Services Workers Are Now Eligible for Trade
Adjustment Assistance 75
Numerical Example 77
What It All Means 80
APPLICATION Prices in Agriculture 80

4 Conclusions 82
HEADLINES Rise in Coffee Prices—Great for Farmers,
Tough on Co-ops 83
Key Points, Key Terms, and Problems
x CONTENTS

CHAPTER 4 Trade and Resources: The Heckscher-Ohlin

Model 87
1 Heckscher-Ohlin Model 88
Assumptions of the Heckscher-Ohlin Model 89
APPLICATION Are Factor Intensities the Same Across Countries? 91
No-Trade Equilibrium 92
Free-Trade Equilibrium 94

2 Testing the Heckscher-Ohlin Model 98

Leontief’s Paradox 99
Factor Endowments in 2010 100
Differing Productivities across Countries 102
HEADLINES China Drawing High-Tech Research from
U.S. 105
Leontief’s Paradox Once Again 107

3 Effects of Trade on Factor Prices 110

Effect of Trade on the Wage and Rental of Home 110
Determination of the Real Wage and Real Rental 113
Changes in the Real Wage and Rental: A Numerical Example 115
APPLICATION Opinions toward Free Trade 117

4 Conclusions 119
Key Points, Key Terms, and Problems

CHAPTER 5 Movement of Labor and Capital Between

Countries 123
1 Movement of Labor between Countries: Migration 125
Effects of Immigration in the Short Run: Specific-Factors
Model 125
APPLICATION Immigration to the New World 128
APPLICATION Immigration to the United States and Europe
Today 129
HEADLINES Call for Return of Border Controls in Europe 130
HEADLINES The Economic Windfall of Immigration
Reform 131
Other Effects of Immigration in the Short Run 133
Effects of Immigration in the Long Run 134
Rybczynski Theorem 139
Factor Price Insensitivity Theorem 140
APPLICATION The Effects of the Mariel Boat Lift on Industry
Output in Miami 140
APPLICATION Immigration and U.S. Wages, 1990–2006 142
 CONTENTS xi

2 Movement of Capital between Countries: Foreign Direct

Investment 144
Greenfield Investment 145
FDI in the Short Run: Specific-Factors Model 145
FDI in the Long Run 147
APPLICATION The Effect of FDI on Rentals and Wages in
Singapore 149

3 Gains from Labor and Capital Flows 151

HEADLINES The Myth of Asia’s Miracle 151
Gains from Immigration 152
SIDE BAR Immigrants and Their Remittances 155
APPLICATION Gains from Migration 156
Gains from Foreign Direct Investment 159

4 Conclusions 160
Key Points, Key Terms, and Problems

CHAPTER 6 Increasing Returns to Scale and Monopolistic PART 3

Competition 165 New Explanations
1 Basics of Imperfect Competition 168 for International
Monopoly Equilibrium 168 Trade
Demand with Duopoly 169

2 Trade Under Monopolistic Competition 170

Equilibrium without Trade 172
Equilibrium with Free Trade 174

3 The North American Free Trade Agreement 178

Gains and Adjustment Costs for Canada Under NAFTA 178
HEADLINES The Long and the Short of the Canada-U.S. Free
Trade Agreement 179
Gains and Adjustment Costs for Mexico Under NAFTA 179
HEADLINES NAFTA Turns 15, Bravo! 180
HEADLINES Nearly 20 Years After NAFTA, First Mexican Truck
Arrives In U.S. Interior 181
Gains and Adjustment Costs for the United States Under NAFTA 184

4 Intra-Industry Trade and the Gravity Equation 187

Index of Intra-Industry Trade 188
The Gravity Equation 189
APPLICATION The Gravity Equation for Canada and the United
States 190

5 Conclusions 193
Key Points, Key Terms, and Problems
xii CONTENTS

CHAPTER 7 Offshoring of Goods and Services 197

SIDE BAR ”Foreign Outsourcing” Versus “Offshoring” 199

1 A Model of Offshoring 200

Value Chain of Activities 200
Changing the Costs of Trade 203
APPLICATION Change in Relative Wages Across Countries 205
Change in Relative Wages in the United States 206
Change in Relative Wages in Mexico 211

2 The Gains from Offshoring 212

Simplified Offshoring Model 213
Production in the Absence of Offshoring 213
Terms of Trade 216
APPLICATION U.S. Terms of Trade and Service Exports 219

3 The Politics and Future of Offshoring 222

HEADLINES How to Destroy American Jobs 224
HEADLINES Caterpillar Joins “Onshoring” Trend 225
The Future of U.S. Comparative Advantage 225

4 Conclusions 226
Key Points, Key Terms, and Problems

PART 4 CHAPTER 8 Import Tariffs and Quotas Under Perfect

International Trade Competition 233
Policies 1 A Brief History of the World Trade Organization 235

2 The Gains from Trade 236

Consumer and Producer Surplus 236
SIDE BAR Key Provisions of the GATT 237
Home Welfare 239
Home Import Demand Curve 241

3 Import Tariffs for a Small Country 242

Free Trade for a Small Country 242
Effect of the Tariff 242
Why and How Are Tariffs Applied? 246
SIDE BAR Safeguard Tariffs 247
APPLICATION U.S. Tariffs on Steel and Tires 248

4 Import Tariffs for a Large Country 256

Foreign Export Supply 256
Effect of the Tariff 257
 CONTENTS xiii

APPLICATION U.S. Tariffs on Steel Once Again 261

5 Import Quotas 263

Import Quota in a Small Country 263
HEADLINES Banana Wars 265
HEADLINES Sugar Could Sweeten U.S. Australia Trans-Pacific
Trade Talks 266
APPLICATION China and the Multifibre Arrangement 269

6 Conclusions 272
Key Points, Key Terms, and Problems

CHAPTER 9 Import Tariffs and Quotas Under Imperfect

Competition 279
1 Tariffs and Quotas with Home Monopoly 281
No-Trade Equilibrium 282
Free-Trade Equilibrium 283
Effect of a Home Tariff 284
Effect of a Home Quota 286
APPLICATION U.S. Imports of Japanese Automobiles 288

2 Tariffs with Foreign Monopoly 291

Foreign Monopoly 291
APPLICATION Import Tariffs on Japanese Trucks 293
HEADLINES The Chickens Have Come Home to Roost 295

3 Dumping 296
Numerical Example of Dumping 298

4 Policy Response to Dumping 298

Antidumping Duties 299
APPLICATION United States Imports of Solar Panels from
China 299
APPLICATION Antidumping Duties Versus Safeguard Tariffs 302

5 Infant Industry Protection 304

Free-Trade Equilibrium 306
Tariff Equilibrium 306
APPLICATION Examples of Infant Industry Protection 308
Government Policies in the Solar Panel Industry 308
U.S. Tariff on Heavyweight Motorcycles 310
HEADLINES Solar Flares 310
Computers in Brazil 314
Protecting the Automobile Industry in China 316
xiv CONTENTS

HEADLINES Milestone for China Car Output 316

HEADLINES Shanghai Tie-Up Drives Profits for GM 318

6 Conclusions 320
Key Points, Key Terms, and Problems

CHAPTER 10 Export Subsidies in Agriculture and High-

Technology Industries 327
1 WTO Goals on Agricultural Export Subsidies 329
Agricultural Export Subsidies 329
Other Matters from the Hong Kong WTO Meeting 330

2 Export Subsidies in a Small Home Country 331

Impact of an Export Subsidy 332

3 Export Subsidies in a Large Home Country 334

Effect of the Subsidy 334
APPLICATION Who Gains and Who Loses? 336
HEADLINES G8 Shifts Focus from Food Aid to
Farming 339
HEADLINES Hunger and Food Security Back on Political
Agenda 340

4 Production Subsidies 340

Effect of a Production Subsidy in a Small Home Country 341
Effect of the Production Subsidy in a Large Home Country 343

5 Export Tariffs 343

Impact of an Export Tariff in a Small Country 344
Impact of an Export Tariff in a Large Country 345

6 Export Quotas 347

APPLICATION Chinese Export Policies in Mineral Products 349

7 High-Technology Export Subsidies 351

HEADLINES China Signals Support for Rare Earths 352
“Strategic” Use of High-Tech Export Subsidies 352
Effect of a Subsidy to Airbus 355
Subsidy with Cost Advantage for Boeing 357
APPLICATION Subsidies to Commercial Aircraft 358

8 Conclusions 361
HEADLINES EU Seeks $12 billion from US over Boeing
Aid 362
Key Points, Key Terms, and Problems
 CONTENTS xv

CHAPTER 11 International Agreements: Trade, Labor,

and the Environment 367
1 International Trade Agreements 370
The Logic of Multilateral Trade Agreements 370
Regional Trade Agreements 373
Trade Creation and Trade Diversion 375
Numerical Example of Trade Creation and Diversion 375
HEADLINES China-ASEAN Treaty Threatens Indian
Exporters 376
Trade Diversion in a Graph 377
APPLICATION Trade Creation and Diversion for Canada 380

2 International Agreements on Labor Issues 380

Labor Side Agreement Under NAFTA 381
Other Labor Agreements 382
HEADLINES Wal-Mart Orders Chinese Suppliers to Lift
Standards 384
HEADLINES American Tariffs, Bangladeshi Deaths 386
HEADLINES U.S. Suspends Bangladesh’s Preferential Trade
Status 387

3 International Agreements on the Environment 388

Environmental Issues in the GATT and WTO 388
Does Trade Help or Harm the Environment? 391
Examples of the Environmental Impact of Trade 394
The Tragedy of the Commons 396
International Agreements on Pollution 400
APPLICATION The Kyoto Protocol and the Copenhagen Accord 402

4 Conclusions 404
HEADLINES Dismal Outcome at Copenhagen Fiasco 405
Key Points, Key Terms, and Problems

CHAPTER 12 The Global Macroeconomy 411 PART 5

1 Foreign Exchange: Currencies and Crises 412 Introduction to
How Exchange Rates Behave 413
International
Why Exchange Rates Matter 414
Macroeconomics
When Exchange Rates Misbehave 415
Summary and Plan of Study 416
HEADLINES Economic Crisis in Iceland 417

2 Globalization of Finance: Debts and Deficits 418

Deficits and Surpluses: The Balance of Payments 418
Debtors and Creditors: External Wealth 421
xvi CONTENTS

Darlings and Deadbeats: Defaults and Other Risks 422

Summary and Plan of Study 423

3 Government and Institutions: Policies and Performance 424

Integration and Capital Controls: The Regulation of International
Finance 424
Independence and Monetary Policy: The Choice of Exchange Rate
Regimes 426
Institutions and Economic Performance: The Quality of Governance 427
Summary and Plan of Study 429
HEADLINES The Wealth of Nations 429

4 Conclusions 431
Key Points, Key Terms, and Problems

PART 6 CHAPTER 13 Introduction to Exchange Rates and the Foreign

Exchange Rates Exchange Market 435
1 Exchange Rate Essentials 436
Defining the Exchange Rate 436
Appreciations and Depreciations 438
Multilateral Exchange Rates 440
Example: Using Exchange Rates to Compare Prices in a Common
Currency 441

2 Exchange Rates in Practice 443

Exchange Rate Regimes: Fixed Versus Floating 443
APPLICATION Recent Exchange Rate Experiences 444

3 The Market for Foreign Exchange 449

The Spot Contract 449
Transaction Costs 450
Derivatives 450
APPLICATION Foreign Exchange Derivatives 451
Private Actors 452
Government Actions 452

4 Arbitrage and Spot Exchange Rates 453

Arbitrage with Two Currencies 454
Arbitrage with Three Currencies 455
Cross Rates and Vehicle Currencies 456

5 Arbitrage and Interest Rates 457

Riskless Arbitrage: Covered Interest Parity 457
APPLICATION Evidence on Covered Interest Parity 459
Risky Arbitrage: Uncovered Interest Parity 460
 CONTENTS xvii

SIDE BAR Assets and Their Attributes 461

APPLICATION Evidence on Uncovered Interest Parity 463
Uncovered Interest Parity: A Useful Approximation 464
Summary 466

6 Conclusions 466
Key Points, Key Terms, and Problems

CHAPTER 14 Exchange Rates I: The Monetary Approach in

the Long Run 473
1 Exchange Rates and Prices in the Long Run: Purchasing Power
Parity and Goods Market Equilibrium 474
The Law of One Price 475
Purchasing Power Parity 476
The Real Exchange Rate 477
Absolute PPP and the Real Exchange Rate 477
Absolute PPP, Prices, and the Nominal Exchange Rate 478
Relative PPP, Inflation, and Exchange Rate Depreciation 478
Summary 480
APPLICATION Evidence for PPP in the Long Run and
Short Run 480
How Slow Is Convergence to PPP? 481
What Explains Deviations from PPP? 482
SIDE BAR Forecasting When the Real Exchange Rate Is
Undervalued or Overvalued 483
HEADLINES The Big Mac Index 484

2 Money, Prices, and Exchange Rates in the Long Run: Money

Market Equilibrium in a Simple Model 486
What Is Money? 486
The Measurement of Money 486
The Supply of Money 487
The Demand for Money: A Simple Model 488
Equilibrium in the Money Market 489
A Simple Monetary Model of Prices 489
A Simple Monetary Model of the Exchange Rate 490
Money Growth, Inflation, and Depreciation 491

3 The Monetary Approach: Implications and Evidence 492

Exchange Rate Forecasts Using the Simple Model 492
APPLICATION Evidence for the Monetary Approach 495
APPLICATION Hyperinflations 496
SIDE BAR Currency Reform 497
xviii CONTENTS

4 Money, Interest Rates, and Prices in the Long Run:

A General Model 499
HEADLINES The First Hyperinflation of the Twenty-First
Century 500
The Demand for Money: The General Model 500
Long-Run Equilibrium in the Money Market 501
Inflation and Interest Rates in the Long Run 502
The Fisher Effect 503
Real Interest Parity 504
APPLICATION Evidence on the Fisher Effect 505
The Fundamental Equation Under the General Model 506
Exchange Rate Forecasts Using the General Model 507

5 Monetary Regimes and Exchange Rate Regimes 509

The Long Run: The Nominal Anchor 510
APPLICATION Nominal Anchors in Theory and Practice 512

6 Conclusions 514
Key Points, Key Terms, and Problems

CHAPTER 15 Exchange Rates II: The Asset Approach in the

Short Run 521
1 Exchange Rates and Interest Rates in the Short Run:
UIP and FX Market Equilibrium 522
Risky Arbitrage 522
Equilibrium in the FX Market: An Example 524
Adjustment to Forex Market Equilibrium 525
Changes in Domestic and Foreign Returns and FX Market Equilibrium 526
Summary 528

2 Interest Rates in the Short Run: Money Market Equilibrium 528

Money Market Equilibrium in the Short Run: How Nominal Interest Rates
Are Determined 528
Money Market Equilibrium in the Short Run: Graphical Solution 530
Adjustment to Money Market Equilibrium in the Short Run 530
Another Building Block: Short-Run Money Market Equilibrium 531
Changes in Money Supply and the Nominal Interest Rate 531
APPLICATION Can Central Banks Always Control the Interest Rate?
A Lesson from the Crisis of 2008–2009 533
Changes in Real Income and the Nominal Interest Rate 534
The Monetary Model: The Short Run Versus the Long Run 534

3 The Asset Approach: Applications and Evidence 535

The Asset Approach to Exchange Rates: Graphical Solution 535
 CONTENTS xix

Short-Run Policy Analysis 537

APPLICATION The Rise and Fall of the Dollar, 1999–2004 540

4 A Complete Theory: Unifying the Monetary and

Asset Approaches 541
Long-Run Policy Analysis 542
SIDE BAR Confessions of a Foreign Exchange Trader 544
Overshooting 548
SIDE BAR Overshooting in Practice 550

5 Fixed Exchange Rates and the Trilemma 551

What Is a Fixed Exchange Rate Regime? 551
Pegging Sacrifices Monetary Policy Autonomy in the Short Run:
Example 551
Pegging Sacrifices Monetary Policy Autonomy in the Long Run:
Example 553
The Trilemma 554
SIDE BAR Intermediate Regimes 556
APPLICATION The Trilemma in Europe 557

6 Conclusions 558
APPLICATION News and the Foreign Exchange Market in
Wartime 558
Key Points, Key Terms, and Problems

CHAPTER 16 National and International Accounts: Income, PART 7

Wealth, and the Balance of Payments 567 The Balance of
1 Measuring Macroeconomic Activity: An Overview 568
Payments
The Flow of Payments in a Closed Economy: Introducing the National
Income and Product Accounts 568
The Flow of Payments in an Open Economy: Incorporating the Balance of
Payments Accounts 570

2 Income, Product, and Expenditure 573

Three Approaches to Measuring Economic Activity 573
From GNE to GDP: Accounting for Trade in Goods and Services 573
From GDP to GNI: Accounting for Trade in Factor Services 574
APPLICATION Celtic Tiger or Tortoise? 575
From GNI to GNDI: Accounting for Transfers of Income 577
What the National Economic Aggregates Tell Us 578
HEADLINES Are Rich Countries “Stingy” with Foreign
Aid? 579
Understanding the Data for the National Economic Aggregates 580
What the Current Account Tells Us 582
xx CONTENTS

APPLICATION Global Imbalances 583

3 The Balance of Payments 588

Accounting for Asset Transactions: The Financial Account 588
Accounting for Asset Transactions: The Capital Account 588
Accounting for Home and Foreign Assets 589
How the Balance of Payments Accounts Work: A Macroeconomic
View 590
How the Balance of Payments Accounts Work: A Microeconomic
View 591
SIDE BAR The Double-Entry Principle in the Balance of
Payments 592
Understanding the Data for the Balance of Payments Account 593
What the Balance of Payments Account Tells Us 595

4 External Wealth 596

The Level of External Wealth 597
Changes in External Wealth 597
Understanding the Data on External Wealth 599
What External Wealth Tells Us 601

5 Conclusions 601
SIDE BAR Beware of Greeks Bearing Statistics 601
Key Points, Key Terms, and Problems

Appendix to Chapter 16 607

CHAPTER 17 Balance of Payments I: The Gains from Financial

Globalization 609
1 The Limits on How Much a Country Can Borrow: The Long-Run
Budget Constraint 611
How The Long-Run Budget Constraint Is Determined 612
The Budget Constraint in a Two-Period Example 613
A Long-Run Example: The Perpetual Loan 615
Implications of the LRBC for Gross National Expenditure and Gross
Domestic Product 616
Summary 617
APPLICATION The Favorable Situation of the United States 617
APPLICATION The Difficult Situation of the Emerging Markets 620

2 Gains from Consumption Smoothing 622

The Basic Model 623
Consumption Smoothing: A Numerical Example and Generalization 623
Summary: Save for a Rainy Day 627
 CONTENTS xxi

SIDE BAR Wars and the Current Account 627

APPLICATION Consumption Volatility and Financial Openness 628
APPLICATION Precautionary Saving, Reserves, and Sovereign Wealth
Funds 629

3 Gains from Efficient Investment 630

The Basic Model 630
HEADLINES Copper-Bottomed Insurance 631
Efficient Investment: A Numerical Example and Generalization 632
Summary: Make Hay While the Sun Shines 635
APPLICATION Delinking Saving from Investment 635
Can Poor Countries Gain from Financial Globalization? 637
APPLICATION A Versus k 641
SIDE BAR What Does the World Bank Do? 645
HEADLINES A Brief History of Foreign Aid 645

4 Gains from Diversification of Risk 646

Diversification: A Numerical Example and Generalization 647
APPLICATION The Home Bias Puzzle 652
Summary: Don’t Put All Your Eggs in One Basket 654

5 Conclusions 655
Key Points, Key Terms, and Problems

Appendix to Chapter 17 661

CHAPTER 18 Balance of Payments II: Output, Exchange Rates,

and Macroeconomic Policies in the Short Run 663
1 Demand in the Open Economy 664
Preliminaries and Assumptions 664
Consumption 665
Investment 666
The Government 666
The Trade Balance 667
HEADLINES Oh! What a Lovely Currency War 669
HEADLINES The Curry Trade 670
APPLICATION The Trade Balance and the Real Exchange Rate 671
SIDE BAR Barriers to Expenditure Switching: Pass-Through and
the J Curve 673
Exogenous Changes in Demand 675

2 Goods Market Equilibrium: The Keynesian Cross 676

Supply and Demand 676
xxii CONTENTS

Determinants of Demand 677

Factors That Shift the Demand Curve 677
Summary 679

3 Goods and Forex Market Equilibria: Deriving the IS Curve 680

Equilibrium in Two Markets 680
Forex Market Recap 680
Deriving the IS Curve 682
Factors That Shift the IS Curve 683
Summing Up the IS Curve 685

4 Money Market Equilibrium: Deriving the LM Curve 686

Money Market Recap 686
Deriving the LM Curve 686
Factors That Shift the LM Curve 687
Summing Up the LM Curve 688

5 The Short-Run IS-LM-FX Model of an Open Economy 689

Macroeconomic Policies in the Short Run 689
Monetary Policy Under Floating Exchange Rates 691
Monetary Policy Under Fixed Exchange Rates 692
Fiscal Policy Under Floating Exchange Rates 693
Fiscal Policy Under Fixed Exchange Rates 694
Summary 696

6 Stabilization Policy 697

APPLICATION The Right Time for Austerity? 697
Problems in Policy Design and Implementation 699
APPLICATION Poland Is Not Latvia 700
APPLICATION Macroeconomic Policies in the Liquidity Trap 702

7 Conclusions 706
Key Points, Key Terms, and Problems

Appendix 1 to Chapter 18 711

Appendix 2 to Chapter 18 713

PART 8 CHAPTER 19 Fixed Versus Floating: International Monetary

Applications and Experience 715
Policy Issues
1 Exchange Rate Regime Choice: Key Issues 717
APPLICATION Britain and Europe: The Big Issues 717
Key Factors in Exchange Rate Regime Choice: Integration and
Similarity 722
Economic Integration and the Gains in Efficiency 722
 CONTENTS xxiii

Economic Similarity and the Costs of Asymmetric Shocks 723

Simple Criteria for a Fixed Exchange Rate 724
APPLICATION Do Fixed Exchange Rates Promote Trade? 725
APPLICATION Do Fixed Exchange Rates Diminish Monetary
Autonomy and Stability? 727

2 Other Benefits of Fixing 730

Fiscal Discipline, Seigniorage, and Inflation 730
SIDE BAR The Inflation Tax 731
Liability Dollarization, National Wealth, and Contractionary
Depreciations 733
Summary 739

3 Fixed Exchange Rate Systems 740

Cooperative and Noncooperative Adjustments to Interest Rates 740
Cooperative and Noncooperative Adjustments to Exchange Rates 743
APPLICATION The Gold Standard 745

4 International Monetary Experience 747

The Rise and Fall of the Gold Standard 747
Bretton Woods to the Present 750

5 Conclusions 753
Key Points, Key Terms, and Problems

CHAPTER 20 Exchange Rate Crises: How Pegs Work and How

They Break 757
1 Facts About Exchange Rate Crises 758
What Is an Exchange Rate Crisis? 758
How Costly Are Exchange Rate Crises? 758
SIDE BAR The Political Costs of Crises 761
Summary 762

2 How Pegs Work: The Mechanics of a Fixed Exchange Rate 764

Preliminaries and Assumptions 764
The Central Bank Balance Sheet 765
Fixing, Floating, and the Role of Reserves 766
How Reserves Adjust to Maintain the Peg 767
Graphical Analysis of the Central Bank Balance Sheet 767
Defending the Peg I: Changes in the Level of Money Demand 769
APPLICATION Risk Premiums in Advanced and Emerging
Markets 772
APPLICATION The Argentine Convertibility Plan Before the Tequila
Crisis 775
Defending the Peg II: Changes in the Composition of Money Supply 777
xxiv CONTENTS

APPLICATION The Argentine Convertibility Plan After the Tequila

Crisis 782
The Central Bank Balance Sheet and the Financial System 784
SIDE BAR The Great Reserve Accumulation in Emerging
Markets 786
Summary 788

3 How Pegs Break I: Inconsistent Fiscal Policies 789

The Basic Problem: Fiscal Dominance 789
A Simple Model 789
APPLICATION The Peruvian Crisis of 1986 792
Summary 796

4 How Pegs Break II: Contingent Monetary Policies 797

The Basic Problem: Contingent Commitment 797
A Simple Model 798
APPLICATION The Man Who Broke the Bank of England 803
Summary 804

5 Conclusions 804
Can We Prevent Crises? 804
Key Points, Key Terms, and Problems

CHAPTER 21 The Euro 811

1 The Economics of the Euro 814
The Theory of Optimum Currency Areas 814
Simple Optimum Currency Area Criteria 815
What’s the Difference Between a Fix and a Currency Union? 816
Other Optimum Currency Area Criteria 817
APPLICATION Optimum Currency Areas: Europe Versus the United
States 819
Are the OCA Criteria Self-Fulfilling? 822
Summary 824
HEADLINES Currency Unions and Trade 825

2 The History and Politics of the Euro 826

A Brief History of Europe 826
Summary 832

3 Eurozone Tensions in Tranquil Times, 1999–2007 833

The European Central Bank 834
The Rules of the Club 838
Sticking to the Rules 842

4 The Eurozone in Crisis, 2008–2013 843

 CONTENTS xxv

5 Conclusions: Assessing the Euro 851

HEADLINES A Bad Marriage? 852
Key Points, Key Terms, and Problems

CHAPTER 22 Topics in International Macroeconomics 859

1 Exchange Rates in the Long Run: Deviations from Purchasing
Power Parity 860
Limits to Arbitrage 860
APPLICATION It’s Not Just the Burgers That Are Cheap 863
Nontraded Goods and the Balassa-Samuelson Model 865
Overvaluations, Undervaluations, and the Productivity Growth: Forecasting
Implications for Real and Nominal Exchange Rates 867
APPLICATION Real Exchange Rates in Emerging Markets 869
Conclusion 871

2 Exchange Rates in the Short Run: Deviations from Uncovered

Interest Parity 871
APPLICATION The Carry Trade 871
APPLICATION Peso Problems 874
HEADLINES Mrs. Watanabe’s Hedge Fund 875
The Efficient Markets Hypothesis 878
Limits to Arbitrage 880
Conclusion 884

3 Debt and Default 884

A Few Peculiar Facts About Sovereign Debt 885
A Model of Default, Part One: The Probability of Default 886
APPLICATION Is There Profit in Lending to Developing
Countries? 891
A Model of Default, Part Two: Loan Supply and Demand 893
APPLICATION The Costs of Default 896
Conclusion 899
APPLICATION The Argentina Crisis of 2001–2002 900

4 The Global Macroeconomy and the 2007–2013 Crisis 903

Backdrop to the Crisis 903
HEADLINES Is the IMF “Pathetic”? 904
Panic and the Great Recession 910
Conclusion: Lessons for Macroeconomics 921
Key Points, Key Terms, and Problems

Index I-1