International Economics 3rd Salvatore

SCHAUM’S OUTLINE OF THEORY AND PROBLEMS of INTERNATIONAL ECONOMICS ecunne LJUBO JURCIC Third Edition DOMINICK SALVATORE, Ph. D. Professor of Economies Fordham University SCHAUM’S OUTLINE SERIES McGRAW-HILL, INC. New York St. Louis San Francisco Auckland Bogoté Caracos Hamburg Lisbon London Madrid Mexico Mitin Montreal New Delhi Paris San Juan Sa0 Paulo Singopare Sydney Tokyo TorontoDOMINICK SALVATORE received his Ph.D. in 1971 and is currently Professor of Economics at Fordham University in New York. He is the author of the textbooks international Econontics, 3rd Ed. (1990), Microeconomic Theory, 2nd Ed. (1991), and Managerial Economics (1989). He has also writen Schaum's Outlines in Microeconomic Theory, Managerial Economics and Statistics and Econometrics, and couulhored Principles of Economics and Development Economics. His research has been published in numerous leading scholarly journals and presented at national and international conferences. ‘Schaum's Outiae of Theény and Problems of INTERNATIONAL ECONOMICS, ‘Copyright © 1990, 1984, 1974 by MsGraw Hl, Ine_ All ight reserved. Printed inthe United States of America. Hucept as permite under the Copyright Act of 1976, no pat ofthis publication my be feprduced or dizuioued ia any form or By tay means, of stored in data base or teticval sytem, without che prior writin permission of the publisher. 345678910 11 1213 14 15 16 17 18 19 20 SHP SHP 921 ISBN 0-07-054538-3 Sponsorag Editor, John Alisno Production Supervise, Janelle Travers iting Supervisors, Meg Tobin, Metreen Walker Cover design by Amy E. Becker Library of Congress Cataloging-in-Publicatlon Data ‘Salvator, Dominick ‘Schaum's ovine of theory and problems of intemalinal 1 Dominik Salvator, —- 3rd ed. 'p-_em,—ISchpum’s ouloe series) ISBN 007-054538-3, 1, Interatenal economic reulons~Oulines, silibi, te 2 Inercational economic relaons—Problems, exercises, et 5. Tie. I Tie: Theory and problems of intemational HIII1.524 1900 78160 337-de20 7Preface Incernational Economics deals with the theory and practice of international trade and finance. International economics hes great relevance in today's world, but it can get extemely complicated and confusing. ‘The purpose of this book is to present in a clear and systematic way the theoretical and practical core of modem intemational economics. While primarily intended 2s a supplement to all current international economics textbooks, the statements of theory and principles are sufficiently complete to enable its Use as an independent text as well. Each chapter begins with a clear statement of theory, principles or background information, fully illustrated with examples. This is followed by a set of multiple-choice review questions with answers. Subsequently, mumerous theoretical, numerical and practical problems are presented with their detailed, step-by-step solutions. These solved ‘problems serve to illustrate and amplify the theory, to bring into sharp focus those fine points without which the student continually feels on unsafe ground and to provide the application and the reinforcement so vital to effective leaning. There are also sample midterm and final examination questions, with answers ‘The topics are arranged. in the order in which they are usually covered in international economics courses and texts, As far as content, this book contains more material than is usually covered in most one-semester undergraduate courses ia intemational economics, the level of presentation is somewhat more rigorous and many important practical real- ‘world problems are'also analyzed, Thus, while directed primarily at undergraduates, this book can also provide a very useful source of study, review and reference for graduate students at the M.A. and M.B.A. levels as well as for business people. There is no prerequisite for its study othir than a prior course in or some knowledge of elementary economics. ‘The methodology of this book and much ofits content has been tested in international economics classes at Fordham University. The students were enthusiastic and made many valuable suggestions for improvements. To all of them, 1 am deeply grateful. 1 would like to express my gratitude to the entite Schaum staff of McGraw-Hill for their assistance. ‘nd especially John Carleo, John Aliano, and Meg Tobin. This is the THIRD EDITION of a book that has enjoyed gratifying market success and was translated into Spanish, French, Portuguese, Arabic, and Indonesian. All of the features that made the first and second editions successful were retained. Besides a thorough updating, the third edition includes important new theoretical developments and applications. These are the rise of the new protectionism, strategic trade policy, the formation of trading blocks, the U.S. as a debtor nation, exchange rate dynamics, integration of intemational capital markets and trade negotiations and reforms. Many other changes and additions were also made in response to the aumerous helpful comments that ¥ received from the many professors and students who used the first and second editions. One such change is the presentation ofthe partial equilibrium analysis of tari before the general equilibrium analysis. In preparing this third edition, I greatly benefited from comments from Professors John Piderit, Edward Dowling, Williem Hogan, Patrick O'Sullivan, Reza Barazesh, Francis Colella, Clive Daniel, Nick Gianaris, Thomas Hatcher, Darryl McLeod, George Mungia, Anita Pesmantier, Henry Schwelbengerg, Michael Szenberg and Eden S.H. Yu. ‘Alan Anderson and Emily Tuseneza, my graduate assistants, also provided much help-PREFACE, Other volumes in the same series authored or coauthored by the same author arc: Microeconomic Theory, 3rd ed. (1991), Managerial Economics (1989), Statistics and Econometrics (1982), Principles of Economics (1980) and Development Economics (1977). DOMINICK SALVATOREContents Fx ripais LJUSO JURCIC Chapter J INTRODUCTION .. 1.1. Tesemation! Ezanoniesané Ezoromie Tory 1.2 The Subject Mater of ltematonsl Economies... 1 1 1 1.3 The Mereanitist View on Trade 1 14 Adam Smith: Absolute Advaninge «.. we 2 1.5 David Ricardo; Compartve Adverage : . 3 1.6 Bvaluaton of Ricedo's Law of Comparaive Adventage 3 Chapter 2 THE PURE THEORY OF INTERNATIONAL TRADE: SUPPLY 2.1 Comparative Advantage and Opportunity Coss : 2.2. The Predueton Possibilies Curve: Constant Cass ccceectecnees 16 2.3. The Basis for Trade and the sles from Trade under Constant Cole sss csseeseevesviee 2.4 The Production Possibitiies Curve: Ineresing COS oo. sessceeevesceeesesecetecsescesences 2.5. The Basis for Trade andthe Gains from Trade under Increasing Costs 9 2.6 The Determinants of Comparative Advanage .... srneeeeeesees soe Grossagy - 2» Review Questions .. 20 ‘Solved Problems s-cssescsscsseescessees 2 Chapter 3 THE PURE THEORY OF INTERNATIONAL TRADE: DEMAND AND SUPPLY . ” 3.4 Community Indifference Curves cece secueenies x 3.2 The Basis for Trade and the Gains from Trude Rested - 3” 3.3. The Offer Curve of One Nation » 34 The Ofer Curve of he Other Nation . . 0 3.5. Offer Curves and the Egulbcam Relaive Commodity rice with Tage “0 3.6 Tre Terms of Tae of « Nation 4 Glossy eee a Review Questions « 4a Solved Problems 2 Chapter 4 THE HECKSCHER-OHLIN THEORY AND EXTENSIONS .......... 56 41 The Hedkscher-Ohlia Theary ------ 56 42. Empirical Tests and Fectorinensity Reversal... 56 43. Trnde Based on Diferentnted Products. ” 4.4 Trade Based on Heonomies of Seale... ”45° Trude Based on Technological Gaps and Prodoct Cyeles 8 AB Troneponition Cagis... cece ences - 58 Glossary... 8 Review Questions 2 Solved Problems . & Chapter 5 DYNAMIC FACTORS IN INTERNATIONAL TRADE: GROWTH AND DEVELOPMENT 5 Dynamle Pastors... 5.2. Growin Factor Supplies rough Time 53 Technical Progress. - . 54 cha ia Paco Spps an Telly nd Trade a 5.5. Change In Testes and Trade «+. 22+---- 5.6 Dynamic Factor, Trade and Development Ghossry Review Questions... Solved Proems «... Bane sesesss Chapter 6 TRADE RESTRICTIONS: TARIFFS AND OTHER, COMMERCIAL POLICIES ....... 6.1. Resticions onthe Fow of Seaton Trade... 6.2. Faria Eaulibium Ansys of Tait 6.3 Nominal versus Elective Twi Rae. 64 Gener! Bauiirium Anayss of Tuite. 6.5 Some Arguments foe ‘Trade Protection «4... 66 * a a 28 9 pce 96 7” Midterm Rxamination ........- .17 Chapter 7 THE FOREIGN EXCHANGE MARKETS. 7A. Definiion and Fonction: 7.2 The Foreign Exchange Rates 7.3 The Equilibrium Foreign Exchange Rate TA Med 18 : 7.6 Covered Interest Artizage 1.7. xchange Rete Dynamics 7.8 The Ewrocurescy Markets. Grosaey oa mm a a‘CONTENTS Review Questions - Solved Problems - poeeeeee cece 126 Chapter & ‘THE BALANCE OF PAYMENTS 2.1. Balance of aymems Accounting 2. The Curent Account 8.3. The Capit Account 5A The Official Reserve Account. 85 Double-Entry Bookkeeping 86 Siasical Diserepaney 18.7 Measuring the Deficit of be Surplus, of OfelalIneevestion Glossary wae Review Questions sees... . an cece 12 Solved ProbemS os. ccossereseeseseesserssieteevieesessaevieesenaserasessenses Ml Chapter 9 ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC .. 15+ 9.1 Types of Adjustment... 9.2. Price Adjustment Mechanism under a Fesible Exchange Rate System 9.3. Price Adjustment Mechanism under the Gold Standiré 944 The Income Adjustment Mechanism ....--sessesetssrshevsveesseets - 15 9.5 Synthesis of Automatic Price end Income Adjusients under Fesible Exchange Rates ..........+ 156: 9.6 Syuibess of Automatic Adjustments under the Gold-Exchange Standard Giossary Review Questions s+... Solved Problems... 34 Chapter 10 ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS _ 120 10.1 Beonomie Objectives of Nations 10.2 Incemnal Balance with Expenditire-Changing Policies 10.3 keemal Balance wit Expenciure-Switching Policies 104 toemal and Exar ahace wih Expendine-Canigand-Swchig Poles... 10.5. Teertsl and Extemal Balance with Fiscal and Monetary Policies 10.8 The Policy Mix for lnemal and External Balance 10.7. Direct Controls ... Glossary Review Questions Solved Problems... Chapter 1 ‘THE MONETARY APPROACH TO THE BALANCE OF PAYMENTS AND FLEXIBLE VERSUS FIXED EXCHANGE RATES .... ILL The Moetry Approach under Fixed Htchange Rates pete 11.2 Policy Implications of the Monetary Approtch under Fined Exchange Rates.11.3. The Monetary Approach under Foxble Exchange Rates 205, 11.4 Types of Exchange Rate Systems. 20s 11.5. The Case for Fleible Bxcheoge Rates 205 116 The Case for Fixed Bachange Rees 306 Glossary 206 Review Questions... 20 Salved Problems 208 Chapter 12 | THE INTERNATIONAL MONETARY SYSTEM: PAST AND PRESENT .......... cove eee e eee M6 12.1 The Classical Gold Slandaré Petiod 2.2. . 218 ‘The Inverwar Period 26 ‘The Breion Woods System oo... cesar cseceenise . 26 12.4 Operstion and Evolsion ofthe Breton Woods System . “ a7 12.5 The U.S, Balance of Payments Problem... 27 126. The Collapse of the Breton Woods Stem coset eeceeeeeee - 218 12.0. The Present International Monetary System a 28 Glossary. ceeestieses 29 Review Questions Solved Problems Final Bramitiation .......-.--- ce INDEX .--.-- cece tee teeter sete e teeta e ee eeeee BBSHi Chapter 1 Introduction 1.1 INTERNATIONAL ECONOMICS AND ECONOMIC THEORY International economics deals with the economic relations among nations. ‘The resulting interdependence is very important lo the economic well-being of most nations of the world and is on the increase (see Example », ‘The economic relations among nations differ from the economic relations among the various parts of a nation (see Example 2). This gives rise to different problems, requiring somewhat different tools of analysis, ‘and justifies Intemational Economics as a distinct and separate branch of “applied” economics. EXAMPLE 1, Most nations of the world export some goods, services and fattrs of production in exchange for imports ‘which could ony be supplied relatively tess efcienly at home, or not tal! (as for example, coffe inthe U.S., petroleum in Germany, cars in Kenys), Thus, a great deal ofthe economic well-being of most nations rests crucially on international interdependence. Inecrdependence has grawn during the past decedes as indicated by the fact that world trade has grown faster than world output. EXAMPLE 2. When a U.S. frm wants to export a piece of machinery to Germany, it faces certain restriction (such 4 tariff) imposed by Germany. It must also overcame differences in languoge, customs and laws. In addition, the fix may receive payment in the foreign currency which may change in value in celation to the dollar. No such barriers are involved when the U.S. fim sels its machinery domestically. In order to antlyzs the different problems arising from international as opposed to interregional relations, we must modiy, adapt, extend and integrate the microeconomic and macroeconomic tools appropriate forthe analysis of purely domestic problems. 1,2. THE SUBJECT MATTER OF INTERNATIONAL ECONOMICS | oo Intemational economies deals with (W) The Pure Theory of Trade. This examines the basis for trade and the gains from trade. (2) The Theory of Commercial Policy. This studies the reasons for and the results of obstructions to the free flow of trade. @) The Balance of Payments. This examines 4 nation’s total payments to and total receipts from the rest of the world. These involve the exchange of one currency for athers. (4) Adjustments in the Balance of Payments. This deals with the mechanism of adjustment o balance Of payments disequilibria under different international monetary systems. Topics 1 and 2 represent the microeconomic aspects of international economics and are covered in the firs half of the book. Topics 3 and 4 are the mocraeconcmic aspects and are covered in the second part of the book, 1.3. THE MERCANTILIST VIEW ON TRADE. ‘The economic philosophy known 2s mercantitism (popular from the sixteenth to the middle of the eighteenth ‘century in such countries as Britain, Spain, France and the Netherlands) maintained thet the most important ‘way for a nation to become rich and powerful was to export more than it imparted. ‘The difference would be2 INTRODUCTION [cHaP. 1 settled by an inflow of precious metals—-mostly gold. The more gold 2 nation had, the richer and more powerful i was. Thus miercaitilists advocated thatthe government should stimulate exports and restrict imports. Since not all nations could have ati export surplus simultaneously and the amount of gold in existence was fixed at any one time, a nation could only gain at the expense of the other nations (see Problem 1.6). 1.4 ADAM SMITH: ABSOLUTE ADVANTAGE In 1776, Adam Smith published his famous book, The Wealth of Nations, in which he attacked the mercaniilist view on trade and advocated instead fice trade as the best policy for the nations of the world, Smith argued hat with free wade, each nation could specialize in the production of those commodities in which it hed an absolute advantage (or could produce more efficiently than other nations) and import those commodities in ‘which it had an absolute disadvantage (or could produce less efficiently). This international specialization of factors in production would result in an increase in world output which would be shared by the trading nations. ‘Thus a mation need not gain at the expense of other nations—all nations could gain simultaneously. EXAMPLE 3, Table 1.1 shows thet the U.S. has an absolute advantage over the U.K. in the production of west and ‘the ULK. has an absolute advantage in the production of cloth. If the U.S. specialized in the production of wheat and the U.K. in the production of clot, the combined output of wheat and cloth of the U.S, and the U.K, would be greater, and ‘both the U.S. and the U.K. would share in this inerease Uhrough (voluntary) exchange (seo Problems 1.7 and 1.8). Table 1.1 ‘Wheat (bushelstabor-hour) Cloth (yards/tsbor-hour) ‘Smith's theory of absolute advantage is obviously correct, but it does not go very far—it explains only small portion of international trade. It remained for Ritards, writing some 40 years tater, to explain the bulk of world trade with his law of comparative advantage. 1.§ DAVID RICARDO: COMPARATIVE ADVANTAGE Ricardo slated that even if a nation had an absolute disadvantage in the production of both commodities with respect to the other nation, mutually advantageous trade could still take place. The less efficient nation should speci in the production of and export of the commodity in whict absolute disadvantage is less. This is the commodity in which the nation has comparative advantage. On the other hand, the nation should ‘import the commodity in which its absolute disadvantage is greater. This is the area of its comparative disadvantage. This is known as the Law of Comparative Advantage—one of the most famous and still unchallenged laws of economics B he EXAMPLE 4. Table 1.2 shows thatthe U.K, has an absolue disadvantage with respect to the U.S. inthe production ‘Of both wheat and cloth. However, its disadvantage is less in cloth than in wheat. Thus the U.K? has a comparative advantage with respect (o the U.S. In Yloth and « comparative disedvantage in wheat. For the U.S" the opposite is ruc. ‘That is, the U.S*has an absolute sdvantege over the U.K in both commodities, but this advantage is greater in wheat (G1) than in cloth 3:2). Thus the U.SPhas a comparative advantage over the U.K Fin whet and a comparative disadvantage ince Mamalyaheages ce ol epi US, extant) force (i aK, % EXAMPLES. "With reference to Table 1.2, we see thai the U.S. could exchange 6W for with the U.K., he U.S, ‘would gain 3C (since the U.S. cam only exchange 6W for 3C domestically. To produce OW itself, the U.K. would requireCHAP, 1) INTRODUCTION 3 6 hours of labor (see ‘Table 1.2). Instead, the U.K. cam use the 6 labor-hours to produce 12C (see Table 1.2), exchange 6 of these 12C for 6W from the U.S., and end up with 6C more for itself. Thus by exchanging OW for 6C, the U.S. would gain 3C und the U.K. 6C. ‘There are many other ratios of exchange of W for C (besides 6W for 6C) that would bee advantageous to both nations (see Problem 1.13(c)]. The rete at which exchange actually takes place determines hot the gains from trade are shared by the two nations, What that rate itself will be depends also on demand conditions in ‘each nation, ‘These will be discussed ia Chapter 3 Tea f B us. | UK Wheat (bushelsfsborhous) | 6 1 Cloth (yardstabor-hour) | 3 2 1.6 EVALUATION OF RICARDO’S LAW OF COMPARATIVE ADVANTAGE Ricardo based his reasoning on a number of simplifying assumptions (see Problem 1-18). One of these is the so-alled labor theory of value, which says that the value of price of a commodity is equal to or can be inferred from the amount of labor time going into the production of the commodity. Today we reject the labor theory of value (sce Problem 1.21). In so doing, we must also reject Ricardo’s explanation of comparative advantage, but we need not reject the law of comparative advantage itself. The law of comparative advantage is valid and can be explained in terms of opportunity casts. This is done in Chapter 2. Glossary Interdependence The economic relationships among nations. Pure theory of trade The theory dealing with the basis for and the gains from tade. Basts for trade The forces (absolute advantage for Smith and comparative advantage for Ricardo} that sive rise to intemational trade. Gains from trade The increase in each nation's consumption resulting from specialization in production. and trede, Theory of commercial policy A theory dealing with che reasons for and the results of obstructions to the free flow of trade. Balance of paymants The measure of a nation’s total reccipts from and total payments to the rest of the world. Adjustment /n the balance of payments The mechanisms for correcting balance-of-payments disequi- ii : Microeconomic Having to do with individual economic units, such as a particular nation and tke relative tice of a single commodity. Macroeconomic Having to do with the whole or the aggregate of an economy, such as the total receipts and payments of a nation and the general price index, tc4 INTRODUCTION (CHAP. 1 Absolute advantage’ The greater efficiency that one nation may have over another in the producticn af 2 commodity. According to Adam Smith, this is the basis for trade. Law of comparative advantage This law governing trade states that even if a nation has an absolute disadvantage of is less efficient thaa another nation in the production of commodites, there is stil a bosis for mutually beneficial trade if the less efficiem vation specializes in the production of, and exports, the commodity of its smallest absolute disadvantage (comparative advantage) and exchanges part of its ourput for the other commodities. Labor theory of value theory purporting that the value or price of a commodity is equal to or can be inferred from the amount of labor time going into the production of the commodity. Review Questions \ 1. For which of the following groups of products docs the U.S. rely exciusvely on imports? (a) Petroleum, cea, natural g28, wood: (6) coffe, te, cocoa, tin; (c) eopper, aluminum, iron, steel; Cd) computes, typewriters, spas, cas, ‘Ans. (0) Coffe, tx and coest can only be produced eflciendly in a ropa! climate act presen in the U.S., and the U.S. has no deposits of tn, 12. One similarity berween international and intzrregional trade is thet in gener both must overcome (a) tiffs, (© differences in language, (€) distance or space, (4) diflerences in eurencies and monetary systems. Ans. (c) See Example 2. {, @ Inte sty ofinerational economies we ws he els of) iroeonomic tear nly, (2) macroeconomic + Leary only, (¢) neither miiema nor macro theory, (d) both micro and macro theory, but we afso extend, adapt and integrate chem. dns) Sec Example Yi With which of he floming ois does intemal economics dl? (a) ‘The pe fear of wed, (4) te 7 theory of commercial poticy, (c) the balance of payments, (4) adjustment to diseqilbria in the balance of eayments, (e) al of the above Ans. («) See Section L2 SS (B) Te which of ue following would the merci have objected? (4) Free inde, (6) stimulating exports, () resicting imports, (4) accumulation of gold by their nation. ‘Ans, (a) Soe Seetion 1.3. TSA 6. we can best undertt Sins viens on tae if me rp hom as &reston (a) the a of comparative vantage, (B) the mercantilst view on unde, (c) Ricardo's views oo trade, (d) all of the above ‘Ans. (b) Smith objected tothe restrictions op trade advocated by the mereantlists on the grounds that these would lilt specialization in production, the vokme of trade end the benefits that nations receive from rade. *S: @)seyon arc tistndcoteor tang toa, Ghean, tinne, tee Ani, (c) See Example 3. SAL @) THe commosity in which a nan has the leas absolute disadvantage represents its ia of (a) comparative disadwantoge, (4) comparative advantage, (c) absolute advantage, (d) cannot say without additional information. ‘Ans. (b) See Section 1.5.CHAP. 1} INTRODUCTION 5 A % 9. With ference to Table 1.2 in Example 4, we ca ay tht the U.S, hus a compaative vantage vgs the UK. i the proucon of wht because one aborhou ine UE. is (a) wie as praucne in tan in, (B) wee /o ts proteine in Khana Cy (0) 15 nes moe prdette Wot Stier mee pods ne CL ub (d) 6 timed more probe in W but ony 1.3 tines more frodveve in € than i the U.K. ‘AB (ay See Brame 4. Noe tt chats bt comes, bls Ht saci by He to answe his use 1D, Wit fee Tae 1.2 an xem a5 ic ach fe flowing semen crest) The rate at which W Exchanges for in production in the UES. is 2:1. (6) The rate at which W’exchanges for Clin production inthe U.K. is 1:2, (e) Th rate a which W exchanges for Cin wade between the U.S. and ake U.K. is, (@) Allof the above, * 1 a 8 ‘Ans, (d) See Table 1.2 and Examples 4 and 5. fh y 11, Wi foes o Beagle 5, ne wih pf te towing snes aes. () Te US. pin 3 by ans cemrss emma momen one, Oe gs pee re ne etc eerie ere ee al QRieeiee ‘Ans, (d) See Example 5 and Table 1.2. @ ‘Ricardo's law of comparative advantage is based on (a) the opportunity cost theory, (B) the Isbor theory of JV value, (c) the law of diminishing retaras, (4) all ofthe above ‘Ans, (b) See Section 1.6, Solved Problems INTERNATIONAL ECONOMICS AS A SUBJECT LX (a) What does international economics deal with? (b) Why do we study it? (¢) How can we justify international economics as a special branch of economics? (@) Intemational economics deals with the economic relations and interdependence among nations, These ‘nflvence (and are in turn influenced by) the politcal, social, cultwat and military relations emon ations. (We study interactions economics primarily in order to analyze the effet of te international flow of goods, services and factors of production on the welfere of domestic consumers. (Remember, consumption is the «nd of economic stvity. Praduction and exchange arc only the means o that end.) We also wish to examine ‘or forecast now aational policies directed at reguling these interotional Nows affect domestic welfare. ‘As ladividwals and voters, we need to study intermationsl economics in order to be able to form intelligent ‘opinions on these matters. (© We can justify international economics #8 a special branch of economics on grounds that international economic relations differ from interregional economic relaions and requise somewha different tools oF analysis from those used to analyze the domestic economy. Intemational economics has been 2 speciel branch of economics for almost two centuries and owes its development to some of the world’s most distinguished economist, including Smith, Ricardo, Mill, Marshall, Keyacs, Samuelson and many others. 1.2 (4) How do international economic relations differ from interregional economic relations? (b) In ‘what way are they similar? How do both differ from the rest of economics? (@) Nations impose restrictions on the ee intemational Now af goods, services and factors, Differences in Innguage, customs and laws also hamper thes intemstiond flows, Lo adton,intemational flows may shes -6 INTRODUCTION * [CHAP. 1 involve receipts and payments in different currencies which may change in value in relation to one another ‘through time, This is 10 be contrasted withthe interregional flow of goods, services and factors which face ‘no such restrictions as tariffs and are conducted in terms of the sane currency, usually in the same language ‘and onder basically the same set of customs and laws. (©) Both intentional and interregional economic relations involve the overcoming of space or distance. Indeed, ‘they both arise from the problems created by distance. This distinguishes them from the rest of economies, ‘which abstracts from space and treats the economy usa single point in space in which production, exchange and consumption take place. 1,3 (@) How can we measure the degree of economic interdependence of a nation sith the rest of the wv world? (6) Why docs the U.S. rely much less on international trade than any other noncommunist developed nation? (¢) What would happen to its standard of living if the U.S. withdrew completely from international trade? (@ A rough measur ofthe degree of esonamic interdependence ofa nation withthe rest of the word is given by the value of is imports as a percentage of its GNP. For small devoloped nations such as Belgium, the _— .-.Nethetlands, Switzerland, Denmark and Sweden, the figure ranges from 30 to 6%. For large developed nations such as Germany, England, Francs and Maly, the figure ranges from 20 to 30%. Por the U.S., the Sigure is about 96, © Tae US. isu nation of continental size with immense natural and human resources. As such it cam produce with elatve effeieney most of te products it needs. Contrasted (0 this i the poston of small ation Tike Switzerland which can only specialize in the production of and export of a small range of commodities, and impons all the others, In genera, and as the figures in part (a) indicate, the larger the nation, the srmale its economic interdependence With the rest ofthe werld, (©) Even though the U.S. roles only toa relatively small extent on foreign trade, 2 significant part ofits high standard of iving depends on it For one thing, there tre certain commodities such as coffee, tea, cocoa, Scotch, cognac, etc. that the U.S. cannot produce at all. In addition, the U.S. has no deposits of cenain minerals such as Ga and tungsten, which ace important for industrial production. Much mote important ‘quantzaively 1o its economic well-being ace the many commodities which the U.S. could produce do- ‘mestically but only at relavely higher costs than the imported commodities. These account for most of the {ins from trade, However, the U.S. could probably survive without dati consequences from withdtawing {fom world ude. The same cannot be said of any othr developed nation with the exespion of Russia, (ln ‘addition to being a huge nation, Rusia has, until recently actively pursued a policy of slfsuceney for poll and military rexsons.) 1.4 (a) What is the purpose of theory? (6) What are some of the simplifying assumptions madc by international economic theorists? (c) What do they seek to accomplish? © Toe purpose of mneory—not just economic theory but theory in general—is to predict and expltin. That is, ‘theory abstracts fom the details of an event and focuses on onc or two relationships deemed most important in onder to predict and explain the event () Internationa) economists wsually essume a two-nation, two-commodity and two-fector world. They further ‘assume thet there is perfect competition, that factors are perfectly mobile interegionally but perfectly immobite intentionally, that there are originally no obstvctions to the free intemadional flow of goods ¥ ‘and services and that transportation costs are ze70, They offen make additional sssumptions. ‘These as- sumpuions may seem unduly restrictive, but it can be proved that mest ofthe conclisions reached on the basis of such simplified models can be extended to a muli-nation, multiproduct and multi-fctor workt— toaotld where perfect competiion is unusual, where facors are not perfectly mobile interegionlly while there is some intemational mobility, where netions impose restrictions on trade and where transportation costs are not 20. (©) Using these simplifying assumptions, intorcetions! economists seek (1) fo predict and explain the composition ‘and volume of the itemetional Sows af goods and services, (2) o assess their impect ou domestic welfare and (3) to predict how national polices affect these flows and, trough them, domestic welfare.CHAP. 1] INTRODUCTION 7 15 (a) Why are the pure theory of international trade and the theory of commercial policy referred to as the microeconomic aspects of intemational economics? (b) Why arc the study of the balance of payments and of the process of adjustment to disequilibria in the balance of payinents referred t0 9s the macroeconomic aspects of intemational economics? (@) ‘The pice theory of trade examines the basis far and the gains ftom trade. The theory of commercial policy studies the reasons for and the ests of obstructions tothe fre flow of trade, Since these topics are geierally discusted by vesting each nation as a single unit and by dealing with individual (relative) commodity and {factor eosts and prices, we ure in the realm of microeconomic analysis. (®) In the real world, nations aommally exchange many goods, services and factors with other nations. The balance of payments summarizes the sora! receipts and payments resulting from all of these international Uuansactions and, as such, itis a mzerceconomis concept. In addition, trade and dhe required adjustment to disequilibria inthe balance of payments that may result from Wade affect the aggregate level of output an income and the general price index of the trading nations. These are also macroeconomic concepts, Note that this book starts on an abstract and theoretical level and then becomes more applied in nature and more policy oriented, This is because we must understand the problem in order ¢o propose appropriate policies for its solution. Je the second part of the book, some integration of ube microeconomic and mucreeconomic tools of analysis will also be necessary. PRE-RICARDO VIEWS ON TRADE 16 ua (2) How does the mercantilist concept of national wealth differ from fodkiy's view? (b) Why did mercantilism advocate the accumulation of gold? (c) How do the mercantiliss’ views on trade differ from those of Adam Smith? (@) According to the mercantilsts, the wealth of a nation was measured by the stock of precious metals— particule) gla ais possessed, Tody, we measure tutors wealth by the total tock of human and aural escarces tit se in protection, The get erations wellh the gett Row of rood and Eervices ta can be made avalele to each person, an the higher te rane of living in hat ain. (@)Mereanitism advocated the acurleton of god because got was eprded asthe real welt the ain. ‘Ata more sphisited level of tnalge, tee vere mare tana aso, Wid god, monarch could cauip the esc, buy the spies td ai temas at hay needed to console power and acquie Celeste, More god meant mor gol coins in culation a eater snes ae. Ince accu fold, the ualon had to eocurge sexperts an Teste impor, thus simulalig mln ouput an olor “t (6) The mercantlatsadvouted sic coatls onde by fe goverment, they tied to show thatthe Lik of nations were basieally in confit, and they PEEP Et nomic naionalism, In & somembat more ceined tnd disguised way, some ot hese views are ill alive and even tving today in a sort of neometcanism On the other hand, Adar Sth (nd ke lsialecooomivs) advected fee rodeos te be polcy for the nations of the world. Only few exceptions to this policy of free trade. were to be allowed. One of these ws the prceton of indus iporant for national deface. (a) With reference to Tabie 1.3, indicate in what commodity the U.S. and the U.K. have an absolute advantage. (6) How much would the U.S, and the U.K. gain if 6W were exchanged for 3C? (c) What if 6W were exchanged for 6C? Table 1.3 Us. | UK. Wheat (oushelslabor-hour) | 6 i Cloth (yanierabor-tour) 318 INTRODUCTION (chap. (@) The U.S. is more efficient than or has an absolute advantage over the U.K. in the production of wheat, ‘while the U.K. has an absolute advantage over the U.S. in the production of cloth. (@) Ime DS, exchanged 6W for 3C with the U.K., the U.S. would gain 2C or would save 2 labor-hours (Gince the U.S, can only exchange 6W for 1C domestically). The 6W which the U.K. receives from the USS. is equivalent to or would have required 6 Iabor-HOurs to produce in the U.K. These same 6 taborhours can produce 18C in the ULK. (See the table), By exchanging 3C (which require only 1 Isbor-hour to produce) for 6W, the U.K. thus gains 15C or saves 5 labor-honrs. : (Ifthe U.S. exchanged 6W for 6C with the U.K., he U.S. would gain SC or would save 5 Tabarshours. ‘Since 6W is equivalent (o 18C in the U.K., and the U.K. need only give up 6C for 6W, the U.K. gains 12C or saves 4 Isbor-hours. (a) How did Adam Smith explain his contention that al! nations engaged io ade can benefit from trade? (b) Why do nations usually impose restrictions on the free flow of trade? (a) Smith explained that if each nation specialized in (or produced more than it wanted to consume domestically of the commodity ia which it was more ecient, and exchanged this excess for ine cawumodty in which i was less efficient, the output ofall commodities enlesing trade would increase. Tis increase would be shared by all nations tut voluntarily engaged in wade. Thus, the guins from trade would arse from Specialization in production and trade. This i simply an extension tothe jntematonal sexing of the gains fiom specialization or division of labor (and exchange) that Saith showed to occur within the nation economy. These gins would be maximized when the government interfered as litle as possible with He persion of the domestic exocomy (llsserfeie) and with international tats (Gee wade) @) Since Smith believed that fre’tade generally leads to maximum world welfare, it may seem paradoxical that nations invariably impose some resiétions on the free flow of goods, Services and factors. Trade tesrictions re invariably reinalized ip terms of national welfare, In reality, they are usually edvocated by and imposed to protect dose industries chat would be hur by impors. Thus, trade resictions geacaly benef few ac the expense of many (bo wil have to pay higher prices for domestically produced produc). COMPARATIVE ADVANTAGE Ww From Table 1.4, indicate (a) whether the U.S. tas ‘un absolute advantage or disadvantage in wheat and cloth, (b) the commodity in which the U.S. and the U.K. kave a comparative advantage, and {c) the gaius to the U.S, and the U.K. if they exchange 6W for 6C. 4 ‘Table 1.4 vs, [UK v ‘Wheat (bustels/labor-hour) 6 1 “4 [ eo (yardvabor hour) 4] 3 {@) The US. has an absolute advantage over the U.K. in the production of both commodities. Trade under these cineumstances cannot be based on absolute advantage. (®) The absolute advantage which the U.S. has over the U.K. is greater in wheat (6:1) than in cloth (43). ‘Thus, the U.S. has a comparntive advantage over the U.K. in wheat and a comparative disadvantage in cloth. Note that once itis established thet the U.S. has a comparative advantage in wheat it must always follow (by definition) tat te U.S. has a comparative disadvantage and the U.K.» comparative advantage in cloth, This i always so ina Wo-nation, two-commodity world.CHAP, 1) INTRODUCTION 9 A (©) Ihe U.S. exchanges 6W for 6C with the U.K., the U.S. guins 2C or saves 172 tbar-hour (since the U. carol ecg for 4G domenty) The LK wow hve aid 6 hows 1 rte 6 iAsolf, Instead, the U.R. usesTthese 6 labor-hours to produce 18C. By then exchanging 6 of these 18C for 6W with the U.S., the U.K. gains (or saves 4 labor-heurs. 1.10 (a) Ifa lawyer cams $100 per hour at practicing law but can also type faster than her secretary who receives $10 per hour, does it pay for the lawyor to fire het secreiary and do her own typing? (B) The reasoning you employed in answering pan (a) is an example of what principle? (a) If the lawyer can be fully occupied {For all the hours she wants to work) at practicing law, t would not pay for her 10 do her own typing. Far ecch hour of typing that she does, she would save $20 (since she can type twice as fast as for Secretary who reveives $10 por hour). However, in order to type for one hour, the nwyer would have to give up practicing law by one hour and thus forgo eaming $100. The lawyer would then lose $80 for each hour that she switches from the practice of law to typing. ()_ ‘This isan application of the law of compartive advantage to everyday life. The lawyer has an absolve advantage over her secretary in both typing (wice) and the practice of law. However, her absolute avaeage is (infinitely) greater in the practice of taw than in typing since the secretary cannot practice law. Thus it pays for the lawyer Co specialize (i.e, use all of her time) inthe practice of law and leave the typing to hor secretary. The secretary also gains by not having to look for another job and possibly earning less. (Note that if the tawyer did aot have a sufcient numberof clients to be fully occupied at practicing law, then she may truly save or earn S10 per hour by doing her own typing). 1.11 With respect to each part of Table 1.5, indicate in which commodity the U.S. has an absolute and comparative advantage with respect to the U.K. and which commodity the U.S. should export to England. Wheat (bushelsabor hous) Cloth (yards/abor-hour) (@) Te U.S. has an absolute advantage over the U.K. in the production of both commodities. However, since this advantage is grester in wheat (4:2) than in cloth (3:2) the U.S, has a compwative advantage in wheat snd & comparative disadvantage in cloth with respect to the U.K. Thus, the U.S, should specialize dn tke Production of and export wheat in exchenge for English cloth (©) Tae U.S. hasan absolute advantage in wheat buts equally productive as the U.K. in cloth, Thus, the U.S. has comparative advantage and should export witeat tothe U.K, in exchange for English cloth (©) Ths U.S. hs an absofute advantage over the U.K. in the production of both commodities. But now this advantage isthe same in wheat (4:2) as in cloth (2:1). That is, the U.S. is exactly rwice as efficient in the roduction ofboth wheat and eloh. In his cbse we cannot speak of comparative advantage or disadvantage ‘and there can be no mutually advanwogeous trade. For example, in order forthe U.S. to gain from trade it would have to get more then 2C for 4W (Since the U.S. can exchange 4W for 2C domestically). But the U.K. is not willing (0 give up more thin 2C for 4W from the U.S. since the U.K. can produce 4W domestically by giving up only 2C. This leads to a slight modifiation to the statement of the law of comparative advantage to read: Buen if a notion es an absolute disedvantage in the production of both commodities with respect to ke other nation, mutally sdvantageous trade is still possible, wnless the bsolute disadvantage is exacily the same or inthe same proportion for the two commodities.% SI 10 INTRODUCTION ICHAP. 1 ia With reference to Table 1.6 (the same as"Table 1.2 in Example 4), indicate what happens if (a) 6W ./ are exchange for 9C, (b) 6W are exchanged for 3C of (c) 6W are exchanged for 12C. Ties eB UK US. HY Wheat @ustetstaborhow) | 6 [1 [Gan geastetoctoun | 3 [2 fu (a) ithe U.S. exchanges OW for 9C withthe U.K., te U.S. gains 6C or saves 2 labor hours. Inthe U.K ‘6W is equivalnt (0 (or requires as many hours to produce as) 12C. Since the U.K. only gives up 9C for ‘6W, the U.K. gains 3C or saves 1 1/2 Inborhours. Note that while in Example 5, W exchanged for Cal 2 ratio of 1:1, hare the rato of exchange is 1:1 1/2. In ether case, Boch nations gan fom wads (te guns, Uowover, ae shared differen; see Example 5). (Tite U.S. exchanges GW for 3C with the U-K., the U.S. gains noting (since in the U.S. 6W and. 3C both requice | Tabor-hou to produce). Ths, all ofthe gains fom tage [9C; see Review Question 11] acerve to the U-K. In tis cas, the U.S. is iferent and may aot be willing to tnde. 9 Ir the U.S. exchanges GW for 12C with the U-K., the U.S. recives all of the guns from made (C). The U.K. dus gains (and ses) nothing (snes inthe U-K., GW end 12C both requis: 6 labor-hours to produc). In tis case, the U.K. is inifferem and may aot be willing wo wade. ft x y LAS Withrleence © Table 1.6, (a) woul he USS. be willing to exchange 6W for less than sci the BK? Why? (b) Would the U:R. be willing to exchange more than 12C for 6W? Why? (©) What quanities of § for 6 represent he limits within which mutually advantagdous wade between the U.S. and the U.K can take place? (Inthe U.S., | Tebor-hour can produce either 6W or 3C. Thus the U.S. would not be willing to exchaage GW for fess than 3C. @) The UK. would not be willing to exchange more than 12C (which requires more than 6 taborhous to produce) for 6W (which requires only 6 Iebor-hours to produce in the U.K.) (©) Im onder for both the U.S. and the U.K. 0 gain from trade, 6W must exchange for more than 3C (fot the US. to gan) but less than 12C (forthe UK. to gain), or 3C < GW < 12C. The difference between 12C and 3C (ie.. 9C) represents the total gain from specialization in production and trade. The closer the ratio. ‘of exchange sues 1o 6W for 12C, the greater the proportion ofthe tal guns rom trade going to tke US. (On the other hand, the closer the ratio of exchange serles to GW for 3C, the greater the proportion of the total gains from wade going o the UX. Exacily what the ratio of exchange will be (within the possible limits) depends also on demand conditions in each nation. This will be examined in Chapter 3. Also note ‘hatin this problem (and chapter, al! of the gains from trade are expressed in cloth. We could have expressed tho total ‘gains from wade entirely in whedt or partly in wheat and panty in cloth (See Chapter 2). Finally, Jf a given ratio of exchange, more than 6W is trated, the combined gains from trade ofboth mations and ‘of each nation separately would be proportionately greater. This és also shown in Chapter 2. 1.14 If Inbor is the only factor of production and is homogeneous (i.e., all of one type), as Sqrith and Ricardo assumed, (a) express the cost in terms of labor content of producing what and clolh in the U.S. and in the U.K, implied by Table 1.6, (8) express the cos or price of wheat (Pi) in terms of labor content relative to the cost or price of cloth (PY) for the U.S. and for the U.K. in the absence of trade and (c) express Pe relative to Py for both the U.S. and the U.K. in the absence of made. < (@) From Table 1.6, we see that I labor-hour produces, 6W in the U.S. Therefore, IW is produced with 16 ofCHAP. 1] INTRODUCTION u 115 116 | Iabor-hour. This is recorded in the top left-hand comer of Table 1.7. The other figures in the table are similarly obtained from Table 1.6. ‘Table 1.7 vs. | UK —— Costin labor-hours to produce 1W | 1/6 IL Cost in Iabor-hours to produce IC | WS | ud «4 (nthe absence of wade, the U.S. can preduce IW with half the labor-houre required to produce IC (W/6 is 112 of 1/3). his means tha in he ULS.. the cost or price of producing 1W of Py (expressed notin dollars but in labor content is half the cost or price of producing IC or Pc (aso expressed in labor content). That is, Pu = Pc2 of PlBe = 1/2 Jn te U.S. in the sence of te, This reads: Py relative to Peis 12, ‘which is what we Were STREET find. Turing to the U.K. we find that inthe absence of trade, the U.K. requires twice 3¢ much labor time 1 produce JW than IC (See Table 1.7), Thus, in the absence of trade, Py = 2c oF PadPc = in the U.K. Is tis difference in relative commodity prices between the U.S. and the U.K. in'the abseace of wade tat isthe basis for mutually advantageous trade. (©) Perelative to Py can be ewinen as PPy, PciPy is the inverse oF reciprocal of PylPe. Since Pyle U2 in he U.S. in the absence of tade (see pat (6), PolPw = 2 im the U.S. For the U.K., we found in art (6) that PyéPc = 2 inthe absence of trade, Therefore, PciPw = 1/2 in the U.K: Hence, the UK. has 2 comparative cos! or price advanage over the U.S. in loth while the U.S, has the comparative advantage in sheet. With respect to Problem 1.14, (a) express the limits for mutually advantageous trade in terms of PulPe and PolPw. (b) If PcfPw is stabilized at | with trade, how ean you show the gains from trade for the U.S.and the U.K.? (© In Problem 1.14(b). we sav that inthe absence of trade, Py/Pe = V/2In the U.S. and 2 in the U.K. Thus, the limis for mutually advantageous trade are in < Pathe <2 he Pap et {In Problem 1.14(¢), we saw that in the absence of tade, PoP the limits for mutually advantageous trade are Was habe <2 No Pape oe Both mulls indicate that the U.S. has a comparative cot! or price advantage over the U.K. in wheat and the U.K, hes the comparative advantage in cloth. ©) I PdPy = 1 with wade, the U.S. gains by being able to import cloth from the U.K. ata smaller relative Drie than the U.S, could provide cloth for itself [since PPw = 2 In the U.S. in the absence of trade; see Problem 1.i4(e)). Put differently, this means thatthe U.S. can import 1C by giving up only IW, while to produce cloth domestealy, it would have to give up 2W for 1C [See Review Question 10(a)]. Siace with ltode, PoiPw = 1, PaiPc = 1also, Inthe U.K. in the absence af trade, Py/Pc = 2 {see Problem 1.14(b)]. Thus, the U.K. also gains from trade because i oports wheat tthe relative price of L, while to produce 1C domestically, it would have 10 pay the relative price of 2[.e., it would have to give up 2C for 1W domestically; see Review Question 108). = in the U.S. and 1/2 in the U.K. Thus Given Table 1.8 (the same as Table 1.5), (a) express the cost of producing wheat and cloth in the US. and in the U.K. in ferms of labor content. (6) Find Po/Py for both the U.S. and the U.K, in the absence of trade. (c) Express the limits for mutually advantageous trade in terms of Po/Py. What does this result indicate?2 INTRODUCTION (CHAP. 1 Tobe 18 us. Waea buselstaborou) | 4 | 2 Cth (yardvabor hou) aft @ ‘Table 1.9 SEW bw us. [UK Cost in Taborhours ro produce IW | 4 | 12 Cost in abor-hours io produce IC | 42 | 1 (6) For the U.S, in the absence of wade, ze Pw For the U.K. in the absence of trade, PolPy = 11(172) = 2. (© 2< PdPy <2, This means that the price of cloth relative to the price of wheat is the same in both the U.S. and the U.K. in the ebsence of trade. Thus, there is no comparative cost or price advantage or disadvantage, and no mutually advantageous trade is possible. ka 1.17 With reference to Table 1.6 and assuming that the wage rate per labor-hour is $6 in the U.S. and £1.8 in the U.K. (the symbol £ stands for pound, the currency of England), (a) express Py and Pe if Ss the U.S. in terms of dollars and in the U.K. in terms of pounds, in the absence of trade. (b) Which commodity wit! the U.S. import and expor ifthe exchange rate between the dollar and the pound is $3 per pound (.e., £1 = $3)? (c) What if £1 = $0.50? (d) What if £1 = $27 If i = $17 (e) When will trade be balanced between the U.S. and the U.K.? @) Since | labor-hour receives $6 in the U.S. and produces 6W, Py ~ SI. Similarly, Pe = $2 in the U.S. In he UK., Py = £1,8 and Pe ~ £09. (@) WEL ~ 83, Py ~ £1,8 = $5.40 and Pe = £0.9 = $2.70 inthe UK. inthe absence of unde. Sin Pw and Pe (in dollars) ae lower in the U.S. than in the U.K., the U.S. will eport both commodities to the U.K. Ir these are the only commodties traded, trade wil Be unbelanced in favor of the U.S. Thi is, te exchange rate between the dollar and the pound isso high tat England's comparative advantage docs not show. (6) II = $0.50, Py = £1.8 = $0.90 and Pe = £0.90 = $0.45 in the U.K. in the absence of trade. The - $1, (6) £1 = $2, and (¢) £1 = $0.50, ‘Table 1.10 Price in the U.S, $ | Price in he U.K. £4 INTRODUCTION {cuap. 1 (2) Inecder to answer this (and the other questions), we must fist express the price of all commodities in terms ‘of the same currency and then compare the prices in the two nations. For example, the dollar price of the ‘commodities in we U.K. when £1 = $1, are Commodity ajaic|ples Datlar Price inthe UK. 1 7 Poe ta lt {In this case, the U.S. will export commodities A and B 10 the U.K, and impor D and E. (©) ICEL = $2, the dollar prices in the U.K. aro Commodity alal{civle Dollar Price inthe UK. | as tts tz ta | 2 In this case, the U.S. will export commodities A, B and C to the U.K. and import commodity B. (© HEL = $0.50, wo have Commodicy alpliciole Dollar Price in the UK. 14.5013.501 3 | 2 loso [Now the U.S. will export only commodity A to the U.K. and import all the others. This analysis can be extended to many more commodities and to more than two natiens. ie (a) What does the labor theory of value state? (b) Why must we reject it? 122 (@) The labor theory of value states thatthe value or price of a commodity is equal t or can be infeed from the amount of labor time going into the production of the commodity. This implies that (I) either bor is the only factor of production or tat labor i used in the some fixed proportion in the production ‘of all commodities, and (2) labor is homogeneous (.., of only oue type). Based on cece assumption Problem 1.14 we were able say that since only 1/6 of a Inbor-hour is required to produce 1 unit of ‘wheat while 1/3 of a lbor-bour is required to produce | unit of cloth in the U.S, in the absence of trade, then Pye = PZ in the US. (Gy The tabor theory of value must be rejected because (1) labor is neither the only factor of production ror is it used in the same fixed proportioa ia the production of all commodities (some, such es steel, use much less labor ger unit of eapital than others, such as textes; in addition, some substitution of labor for capital {in production is usually possible); (2 labor is obviously not al of ene type (zme, such as doctors, embody rruch more skill, are much more productive and receive much higher wages than mest others). For there reasons, the Inbor theory of value must be rejected. The modern teary of value overcomes these shortcomings and can be used to explain comperaive advantage. This is done in Chapler 2 with the induction of the ‘opportunity cost theory and the production pssibiliies curve, Figure I-1 shows the result of an empirical test of the Ricardian trade model. The scales are Jogorithmic (Go that equal distances refer to equal percentage changes). The vertical axis measures the ratio of the productivity of U.S. labor to U.K. Jabor. The horizontal axis measures the ratio of U.S. exports to sn. stele | 7 4 4CHAP. INTRODUCTION 15 Tiedery *Civcss Sire fag vee | Fig. 1-1 soumc: G. D. A, MacDoga “Bish and American Expos: A Sly Suggested by he Theor of Compuntive Gus Event Jon evens 1959.3, UX. exports to the rest of the world in 20 industries. Does the figure tend to support or reject the. Ricerdian ude model? Why? ‘The figure supports the Ricardian trade model. That is, the higher the productivity of U.S. labor in relation 10 UK, labor, the higher is the ratio of U.S. to U.K. exports. Thus, production costs other than labor costs, ‘demand considerations und so on, did not break the link between relative labor producuviies and export shares,Chapter 2 The Pure Theory of International Trade: Supply 2.1 COMPARATIVE ADVANTAGE AND OPPORTUNITY COSTS. In Section 1.6, we saw that Ricardo based his law of comparative ndvantage on the labor theory of vaiue, which is unacceptable. However, the law. can be explained in terms of the opportunity cost theory. This Says that the cost of a Gériuiodity ig the aiautt of a second commodity that must be given ‘Up Tarde to release just enough factors of prodlugtion of resources to be able to produce one additional unit of the first commodity. Note that here labor ‘he only fasior of production nor is it assumed that the cost ot price of a commodity can be inferred fom Ww oe «© 0 wo wim wo Fig. 24 2.6 THE DETERMINANTS OF COMPARATIVE ADVANTAGE, ‘The difference in pretrade relative commodity prices (comparative advantage) between the two nations is based on a difference in factor endowments, technology, or tastes between the two nations. A difference in alles20 ‘THE PURE THEORY OF INTERNATIONAL TRADE: SUPPLY (CHAP. 2 ‘| idowments or technology Ieads to a difference in the shape and location of each nation's production ties curve (seo Fig. 2-3), which, unless neutralized by difference in tastes, will load to different telative commodity prices and mutually beneficial tradc (see Fig. 2-4). However, even if two nations have | xactly the same factor endowments and technology (and thus identical production possibilities curves), @ : difference in tastes can be the basis for mutually beneficial trade (see Probtem 2.21). Glossary Opportunity cost theory This thcory states that the cost of one commodity is the amount of another commodity that must be given up in order to release just enough factors of production or resources to enable the production of one addtional unit of the first commodity. 4 Production possibiiities curve A curve that shows the various altemative combinations of the two commodities that a nation can produce by fully utilizing all ofits factors of production with the best echnology available to that particular nation. This eurve is also known as the transformation curve or the production frontier. Marginal rate of transformation (MRT) ‘The amount of one commodity that a nation must give up in forder to get one more unit of the secoud commodity. This is another name for the opportunity cast of & commodity. ‘Constant opportunity costs The equal amounts of one commodity that a nation must give up in order to release just enough resources to produce each additional unit of another commodity. 4 Relative commodity price The ratio of the prices or costs of two commodities. Autarky The absence of trade; economic isolation, Consumption frontier The various altemative combinations of the two commodities that a nation can sonsume, Increasing opportunity costs The increasing amounts of onc commodity thet a nation must give up in ‘order to release just enough resources to proxuce eacti additional unit of another commodity. Complete specialization The production of only one commodity in a nation with trade. incomplete specialization The continued production, even with trade, of both commodities in both nations. NN Review Questions 0) @ tre opyocuniy co ary sms tat (hr te yr of con) te pice root Cammy ca einer am aia eos" [e) abs bamogenae ans fe sore ‘ans. (2) See Seton 2.1. 2) with respect to a production possible curve, we can sny tht (a) a point side or below it implies thatthe 9 economy is either not wlizig ful all fl esoues or nol wing the test techaology avalabe toi (6) a plat fn it volves he fil employment of te economy's rescues and the use of the Beat technology avalible, Ce) 8CHAP. 2) ‘THE PURE THEORY OF INTERNATIONAL TRADE: SUPPLY 21 point above it cannot be reached with the resources and technotogy presealy available to the nation, (d) all of the above. ‘Ans, (d) See Section 2.2. Gs seit poco psi cre las © (octet, ining ene, eng costs, (4) any of the above. Ans. (a) See Example 2. x 44 eta messed tng he orzo ai an wit along he vera ai, habit lope fa tight ine production possiblides curve gives (a) the MRTow, (0) the PoPy, (e) both the MRTew and the PeiPy, (@) neither the MRTey nor the Pela wy Ans, (c) See Example 2. Ly A y 5. If a the absence of wade, the intemal equilibrium Pe/PY is lower in the U.K. than in the U.S,, then (a) the U.K. has a comparative advantage in cldth with respect to the U.S% (6) the U.K. has a comparative disadvantage in wheat, (c} the U.S. has a comparative advantage in wheat, (d) the U.S. bas a comparative disadvantage in cloth, (e) alll of the above, ‘Ans, (@) See Examples 3 and 5. 6. The production frontier for the U.K. in Fig. 2-2 is given by the stright line through points (a) A and 2 in the absence of tmde, and E and B with wade; (b) A and B with wade, and E and B without wade; (c) E and B with and without trade; (4) A and 8 with and without rade, ‘Ans. (d) See Example 3. Note thet the U.K. could bave produced at point B even without trade, but the U.K, did ‘ot want fo consume at point B (i.e., 120C and OW) without trade. tte nation gins from trade its consumption pont is (a) on its production possiblities frontier, (8 inside ts prodeton posible: frome, e) above fs production possiblities foner, (2) any of he shove. ‘Ans. (€) See Examples 3 and 5. {)) Increasing opportunity costs fo produce more and more units of a commodity is given by a production possibillties ceurve that js. (a) concave tothe origin, (9) convex tothe origin, (e) a stright lie, (d) any of the above... ‘Ans. (a) See Fig. 23. 9. with ets measured slong th orzo xis and feat slong tin versal ans the absolute slope af # easave production possiblities curve gives (a) the MRTew, (6) the internal equiibrium Pe/Py in isolation, (c) both the MRToe and the internal equilibrium Po/Py, (d) nother the MRTey nor the internal equilibrium Pc/Py. Ans. (a) See Section 2.4. 10, wit ola measured along the hozotl exis nd let log the vena ars, «movement down te production possibilities curve results in (a) a decrease in MRTow, (b) an increase in METey, (c) an increase in MRT we, a) any of the above, ay ‘Ans, (b) See Example 4, & (4: |, Winn trade, specialization in production is Ukely to be (a) complete with increasing costs and incomplete with constant costs, (b) complete with constant costs and incomplete with increasing costs, (c) complete with constant ‘and inereasing casts, (4) incomplete with both constant and increasing costs. ‘Ans, (b) Compare production points B and B' in Fig, 2-2 with those in Fig. 2-4. AA difference in relative commodity prices berween two nations ean be based upon a difference in (a) factor endowments, (6) technology, (c) asies, (4) all of the above. ‘Ans. (d) See Section 2.6. a2 ‘THE PURE THEORY OF INTERNATIONAL TRADE: SUPPLY [cHap. 2 Solved Problems COMPARATIVE ADVANTAGE AND OPPORTUNITY COSTS 21 (a) Compare the explanation of the law of comparative advantage given by Ricardo with that based ‘on the opportunity cost theory. (6) Identify the three main groups of factors of production and some ‘of the major subgroups. (e) Name some of the most important products in which the U.S. has 3 comparative cost or price advantage and some in which the U.S. has a comparative disedvantage. (@ Ricardo's explanation ofthe law of comparative advantage is based on the labor theory of value. This theory folds that labor isthe only fgcor of production (or that Isbor is used in the same fixed proportion in the production of all commodities), i assumes that labor is homogeneous (i.e... of only one type) and concludes tht the cost or price of a commodity is equal to (or ean be inferred from) its Inbor content Since labor is assumed io be homogeneous within each nation but nonhomogeneous (i, of diferent productivities) in iffereat nations, we have constant costs of production within a nation but comparative advaniage and dlisadvontage between nations. We roject tis explanation of the law of comparative advantage because it is based on the unacceptable labor theory of value. The opportunity cost theory, which is acceprable, recognizes that various nonhomogensous factors of production are usually combined in different proportions {o produce various products and also ellows for increasing (opportunity) costs in producing more ef each product. The law of comparative advantage can then be explained in terms of diffeent opportunity costs ‘or relative commodity prices in afferent nations. (©) The three main groups of factors of production, economic resourees or inputs are: labor capital and and. Each group can be broken down into many subgroups. For exemple, labor inctades vasklled,sémisklled, skilled and enteepreneurial. Capital may be liquid (such 2s money) and nontguid (such as machinery, factories tc.) Land might be subdivided oto agricultural, mineral-bearng, industrial and residential arcas. ‘Moreover, each of these subgroups can be furker subdivided ito ramerous more detailed types, each ‘commanding a specifi price, having a particular productivity in each ofits possible uses, and a specific shoct-ron and long-run demand and supply elasticity. It should be evident that there are muny nonhoma- ‘geneous factors rater than one or a few homogeneous nes. (© The U.S. has a comparative advantage in and exports: products with high technotogical content (Such as Aircrafts, computers and electronics), construction and mining machinery and equipment; some chersicals. and pharmaceuticals, ad sevoral agricultural commodities (such as soy beans, grins, tobacco ané cotton). ‘On the otherhand. the U.S. has a comparative disadvantage in and imports many labor-intensive commodities such as lentils, shoes, bicycles, motorcycles, sewing machines and also some types of machinery, small cars and ships. To be noted is thet comparative advantage and disadvantage i not setled once and fo al for a nation but changes over time. For example, the U.S. lost the comparative advantage that it once had in tentites and leather goods and, more recently, in stel and automobiles. In this connestion, itis often ssid that de U.S. has a comparative advanlage in rescafch and innovation but that it loss it to other nations fs products become standardized and other nations Jeam how to mansfacture them through imitation. THE BASIS FOR TRADE AND THE GAINS FROM TRADE UNDER CONSTANT COSTS 2.2 Table 2.2 gives the maximum amount of wheat or cloth that the U.K. and U.S. could produce if they Fully utilized all of the factors of production at their disposal with the best technology available to them. Table 2.2 ‘Wheat Go millions of bushelsiyeas) | 50 | 120 Cloth (in millions of yards/yeat) 150 | 40CHAP. 21 ‘THE PURE THEORY OF INTERNATIONAL TRADE: SUPPLY 23 Tf, in addition, we are told thatthe (opportunity) cost of producing wheat and cloth is always constant in ack nation, (a) draw the production possibilities curves of the U.K. and the U.S., (b) indicate some of the combinations of wheat and cloth that each nation cam produce and (c) specify the consumption choices open to wach nation in dhe absence of ide. (@) See Fig. 2-5. o & 8 © w mw meow we © Fig. 25 () Table 2.3 gives some of the aleruative combinations of wheat and cloth thet the U.K. and the U.S. ean produce (all figures ar in millions of wits per year). ble 2 U.K. us. wilejwlie so | o| 20} © 4 | 30 | 9 | 20 3 | «| @ | 50 2 | 9 | 30 | wo | 20} 0 | #0 o | 150 Points inside ox below the production possibilities curves of Fig, 2-5 are also possible but inefficient. Points above the curves carzat be reached with the present supplies of factors of production and technology availabe. (©) _In the absence of ude, each nation can only choose to consume from among the alternative combinations ‘of wheat and cloth tat it ean produce. When this isthe case, @ nation's production possiblities curve or frontier also represcns its consumption frontier. Which one ofthe many alternative combinations of wheat ‘and cloth the nation will atutlly produce and consume depenes on tases or demand conditions inthe nation (Gee Section 3.1). 2.3. (a) With reference to Fig. 2-5, find MRT yw for the U.K. and the U.S. Does MRTew vary as we move along each nation's production possibilities curve? Why? (b) Under what conditions will a nation24 \) 24 28 ‘THE PURE THEORY OF INTERNATIONAL TRADE: SUPPLY ICHAP. 2 face constant costs, constant MRT oF a straight-line production possibilities curve? (c) Find Pe/Piy and Py/Pc for the U.K. and the U.S. from Fig. 2-5. What is the relationship between Po/Py and MRTow in each nation? (@) The MRTcy measures by how much the nation must reduce its output of wheal in order to release just enough factors of production to produce exactly one more unit of cloth. MIRTeq is given by the (absolute) slope of the production possibilities or transformation curve. Thus for the U.K., MRTew = 50/150 = 1/3. Forthe U.S., MRTew ~ 120/80 = 3/2. Since each production possibilities or transformation curve of Fig. 2-5 isa straight linc, its slope or MRTew cemains the same throughout the entire iength of the curve. Thus, we have a case of constant (opportunity) costs. () A nation will be facing constant costs only if (1) te factors of production are perfect substiutes for each other or are used in the same fixed proportions in the production of both commoditios and (2) all units of each factor of production are homogeneous or of the same quality. Then, as a nation transfers resources {rom the production of wheat to the production of cloth, the nation will not have to use resources which bbocome less and less suited for the production of clouh. As a result, che nation will have to give up exactly the sarne amount of wheat for each additional unit of cloth produced—regardless of how far the process ha already proceeded. The same is tue if the nation wants 1o produce more wheat. Thus, the cost of each additional unit of the commodity produced in terms of the other is always the same, and we havea case of constant costs. This is seldom, if ever, true in the real world. The constant cost case is discussed frst because it provides a good model from which to develop more sophisticated and realistic models. (©) As long as each nation produces something of both commodities, Pe/Pw in each nation is given by the (absolute) slope of its (strlght-ine) production possiblities curve or transformation curve. PyiPe is then the reciprocal or inverse of PeiPy. Thus, for tie U.K., Poly = SO'LSO = U3 and PyiPc = 3. For the US., PoPy = 12080 = 3/2 and Pe = 25. PolPy = MRTey in each nation and remains constant. ‘Thus, under constant coss, the intemal equilibrium P/P in each aati is determined exclusively by the supply conditions in the nation. With reference tp Problems 2.2 and 2.3, (a) indicate in which commodity the U.K. and the U.S. have acomparative advantage, (b) What are the limits within which mutually advantageous exchange ‘can take place between the U.K. and the U.S.? (c) If PciPy is stabilized at 1 with trade, explain why the U.K. and the U.S. gain. (d) How is this problem different from Problem 1.97 (a) Since Po'Py is lower in the U.K. (1/3) than in the U.S. (3/2) [see Problem 2.3(a)], the U.K. has a comparative advantage over the U.S. in cloth and the U.S. bas a comparative sdvantage in wheat (©) The limis for mutally advanageous wade ar: 15 < PoPy < 32 (©) PoP is stabilized at 1 with wade, the U.K. gains because it can get each unit of wheat it wants fo consume by giving up only 1 unit of cloth through ted, wile it wauld have to give up 3 units of elt domestically (ie, without te). The U.S. also gains because it can get cach unit of cloth it wants 0 consume by giving up only 1W through trade rater than 1SW in the absence of trade. Not that in his use the U.K. gains more than the U.S. fm tude. () In Problem 1.9 te explanation of te law of comparative advanage was based on the labor theory of valu, wile here is based onthe opportunity cost theory. Note that both here and in Problem 1.9, PP ~ 1 forthe ULK. and 37 forthe US. in the absence of trade Starting with Fig, 2-5 and assuming that the U.K. produces 60C and 30W and the U.S, 40C and 60W in the absence of trade, show the point of production and consumption for each mation with trade, if ‘each nation specializes completely in the production of the commodity of its comparative advantage and then trade 50 units of it for 50 units of the commodity of its comparative disadvantage. In Fig. 26, We U.K. produces and consuines at point A inthe sbscoce of trade, while the U.S. isa point A’, Since the U.K. hes a comparative advantage in cloth and the U.S. in wheat, with complete specialization in production, the U.K. will be at point B snd the U.S. at point B’. Since the U.K. exchanges SOC for SOW with the U.S., the U.K. will move to point Ein consumption andthe U.S. to point. Thus both the U.K. and the USS. gain from specialization and te.CHAP. 2) ‘THE PURE THEORY OF INTERNATIONAL TRADE: SUPPLY 25 26 24 ‘An alternative to Fig. 2-6 1 ilustrate the gains from trade under constant costs is obtained by rotsting by 180° the U.S. production possibiltes carve and superimposing iten the U.K. production possibilities curve in such a way that points B and B' coincide. (a) Draw sucha figure and shade the atea showing, the total gains from trade. (B) What does line BE'in your figure show? (a) See Fig. 2-7. » WT UK. Fig. 27 (©) Line BE (the same as B°E") shows iow the total gains from trade are divided betwoen the two nations. With reference to Figs. 2-6 and 2-7, (a) indicate the quantity of wheat and clath produced in the U.K., in the U.S. and in total before and after specialization in production, and the change in the production of cach commodity in esch nation und in total. (b) Indicate the quantity of wheat and loth consumed in the U.K., in the’ U.S. and in total before and after trade, and the gain in the consumption of each commodity in each nation and in total.dF» 28 ‘THE PURE THEORY OF INTERNATIONAL TRADE: SUPPLY CHAP. 2 @ Table 2.4 PRODUCTION Before ‘After ‘Specialization Specialization Change . w. c Ww c w c ox | 30 a o | 1% | -30 | +90 us. | © «o | 120 o | +60 | -40 ‘oa | 90 ro | 120 | 150 | +30 | +50 UK. os. Total With reference to Problem 2.7, (a) explain how the combined output of the U.K. and the U.S. for both wheat and cloth can increase without any inerease in the quantity of the factors of production available to either the U.S. or the U.K. (b) Why didn’t the U.K. and the U.S. want to specialize in produetion in the absence of trade? (c) What is the effect of trade on the relationship between production and consumption in each nation? (d) What is the ratio of exchange of cloth for wheat between the U.K. and the U.S.? (e) Why is this the equilibrium ratio of exchange? (f) What would hhappen if the exchange ratio was above or below the equilibrium one? (@) The combined output of the U.K. and the US. for both wheat and cloth increased because each nation specialized in the production of the commodity of is comparative advantage, Note that this involves Production on different point but on the same production possibilities curve, The production possibilities ‘curve af each nation remains unchanged because the quantity of factors of production (and technology) ‘were assumed to remain constant in each nation. (@) ‘The ULK. and the U.S, did not went to take advamtege of specialization in production in the absence of trade because the U.K. did not want to consume only cloth and the U.S. did not want {0 consume only wheat, Only when the possibility of trade is open will this specialization in production be desireble and advantageous . (©) Trade causes an imbalance between the nation’s production and consumption, That is, with trade each nation usually ends Up consuming a greater range of products than it produces. (@) Since 50C are exchanged for SOW, the rato of exchange or Pc/Pw = 1. Note that at this ratio of exchange, the U.K. gains more than the U.S. from trade [see Problem 2.7(2)]. (e) This is the equilibrium ratio of exchange because at Pe/P = 1. the quantity of cloth imports demanded by the U.S. exactly equals the quantity of cloth exports supplied by the U.K. and the queniy of whest imports demanded by the U.K. exactly equals the quantity of wheat expors supplied by the US. D) ACPolPe > 1, the quantity of cloth impons demanded by the U.S. flr short of the quantity of cloth ‘exports supplied by the U.K. and there will be a pressure on Pc/Py ofall toward the equllbxium value of 1. At PofPy < 1, the quaatity of cloth imports demanded by the U.S, exceeds the quantity of cloth exports supplied by the U.K. and there wil be a pressure on FolPy to rise toward the equilibrium level. The same thing could be expressed in teams of wheat, as follows. At Py/Po > 1, the quantity of wheat importsCHAP. 2) ‘THE PURE THEORY OF INTERNATIONAL TRADE: SUPPLY 2 29 demanded by the U.K. falls short of the quantity of wheat exports supplied by the U.S. and so there witl be m pressure on PyiP¢ 10 rise 10 1. At PyiPe < I, the exact opposite occurs, Draw a figure and explain what happens if, starting from points A and A’ in Fig. 2-1, the U.K. and. the U.S. specialize completely in the production of the commodity of their respective comparative. advantage and then exchange 80C for 40W with each other. In Fig. 2-8, the U.K. moves from point to point B in production while the U.S, moves from A’ to B (so far this is exactly te same as in Example 3). Since 80C are exchanged for 40W, the equilibrium PeiPw or terms of trade = 1/2, which is the same as the pretrade Pc/P in the U.K. Thus the U.K. gains nothing from trade (indeed, in this ease, point E coincides with point A so thatthe U.K. consumes oxacily the same combination of 40C and 4OW with teade as without trade; see Fig. 2-8), The U.S. moves from point B’ in production to point in consumption and captures all of the geins from trade of 40C and 40W [compare point &” to the no-tmde production and consumption point A’ in Fig. 2-8; see also Problem 1.12(c)}, If, after specializing completely in production, the U.K. exchanged a ¢ifferent quantity of cloth for wheat at the equilibrium Pc/Py of 1/2, the U.K. ‘would end up consuming at a different point on its production possibililes curve, but once again it will gain nothlag from trade (inthe sense thatthe U.K. could have produced and consumed that combination of wheat and loth without cade). w woo rote tt 2.10 (a) Draw a figure and explain what happens if, starting from points A and A" in Fig. 2-1, 30C are exchanged for 60W. (b) What generalization can you reach with regard to specialization in production and the distribution of the gains from trade between the two nations by looking at Example 3 and Problems 2.9 and 2.10¢a)? (@ ta Fig. 29, the U.K. moves from point A to point B in production while the U.S. moves fram A’ w 8. [Note that in wis case, the U.K. specializes completely in the production of cloth (point 8) but the U.S. ‘oes not specialize completely inthe production of wheat (i.e, at point B’, the U.S. continues to produce some cloth). This occurs because the U.K. is too small a natioa fo provide all of the cloth demanded by ium Pc/Py of 2 (resulting when 30C are exchanged for 60W; see Fig, 2-9) Since the equilibrium Po/Py is the same as te pretrde PefPy inthe U.S., tie U.S. gains nothing fom trade (is corsumpsion point with trade, E’, coincides wth its pretrade consumption point, A’. The U-K. thus capaues all ofthe gains from trade of SOC and 20W [see Fig. 29; se also Problem 1.12(5) (@) With constant cost, if the equlibrium relative commodity price with trade is benwees the pretrade relative8 ‘THE PURE THEORY OF INTERNATIONAL TRADE: SUPPLY [cHAP. 2 Etetare PEE we ee Fig. 29 commodity pics in each nation, then each notion specializes completely in production and ezch gains from teade (See Example 3 and Problem 25. Ifthe equiibrium price with trade isthe same as the pretade pice {in one ofthe nations, that nation may or may not specialize completely in production (compare Fig. 2-8 ‘with Fig, 29) and the nation gains nothing from trade. Its trade partner. on the other hand, will elvays specialize completely in production (see Figs. 2-8 and 2-6) and wil capte all ofthe gains from nude ‘Tyo most likly ofthe two cases enone ofthe nations gains nothing is that discussed in Problem 2.10(@), ‘where a very smull nan (ceriainly not the U.K.) might wade atthe prevade prices in a large nation, specialize compltoly in production and capture all ofthe guns from trade. Ths is sonvetimes refered to 45 “the imponaace of being unimportant.” The lage nation then will not be completely specialized in production and gains nothing from trade. 2.41 Starting at points A and A’ in Fig. 2-1, suppose that the U.K. and the U.S. specialize in production and then exchange 60C for wheat at the equilibrium Po/Py of 4/3, (a) How much wheat is traded? (&) Will specialization in production be complete in each nation? Why? (c) Draw a figure showing the pretrade point of production and consumption in each ration, the point of production with spe- Ciolizetion, and the new consumption point with trade, (d) Which nation gains more from trade? Compare the distribution of the gains in this problem with that in Example 3. (@) In ower forthe equilibrium PcPy 10 be 43 when 6OC are waded, these 6OC must exchange for BOW (so fiat IC = 11 3W and PoP = 1 U3 or 43), (©Since the equilibrium PefPw wit trade (43) les between he premade Fo/Py inthe U.K. (12) and in the USS. (2), eich nation will specialize completely in the production of the commodity of its comparative scivaatge (See Problem 2.10(6)]. Specifically, since the U.K. rast always give up only 1/2W to produce IC end ean always exchange each IC for I L/3W withthe U.S. itpays forthe U.K, to specialize completely in the production of cloth. The U.S. alzo (and forthe analogous reason) will want to specialize completely in the production of wheat. (©) TaFig. 2-10, the pretade point of production and consumption forthe U.K. is A and for the U.S. is A’. With trade, the U.K, will produce st poi B and the U.S. at pont BY (9 fa this is identical to Example 2). From point B, the U.K. exchanges 60C for 8OW with the U.S. and reaches point B, The U.S. goes from point B10 E" (te Fig. 2-10) (@) In Fig. 2:10, the U.K. consumes 20C and 40W more st point E then at point A. At point", the U.S. ‘consumes only 20C more than at point A'. Thus the U.K. gains more than the U.S. from trade. This result is ode contrased to tha in Example 2, where the equilibrium Pe/Py of | wilh ade, each nation gains cexacily the same (20C and 200%; see Fig, 2-2 from ide.cHaP. 2] ‘THE PURE THEORY OF INTERNATIONAL TRADE: SUPPLY 9 Fig. 210 2.12 [fone of the values in Table 2.1 were changed as indicated in Table 2.6 and we retained our assumption of constant (opportunity) costs in each nation, would mutually advantageous trade still be possible between the U.K, and the U.S.2 Why? Table 2.6 ux. | Us. Wheat (in millions of bushelsiyear) | 60 | 160 Cloth (in millions of yardsyea) 30} 8 ‘Since the (sieight-line) production possibilities curves in Fig. 2-11 have identical (absolute) slopes (= MRTew = pretrade PP y of 1/2), we cannot speak of comparative advantage or disadvantage between the two nations and no mutually advantageous trade is possible [see Problem 1.11(c)}.30 ‘THE PURE THEORY OF INTERNATIONAL TRADE: SUPPLY ICHAP. 2 ‘THE BASIS FOR TRADE AND THE GAINS FROM TRADE UNDER INCREASING COSTS 213 Table 2.7 gives five allemative combinations of wheat and cloth (in millions of units/year) thet the U.K, and the U.S. can produce by fully utilizing al of the factors of production at their disposal with the best technology available to them. (a) Sketch the production possibilities curve for the U.K. and the U.S. What is MRTow in the U.K. if it produces 60C and SOW? 130C and 20W? What is MRTow in the U.S, if it produces 80C and 20W? 40C and 90W? (6) Why is the production possibilities curve of the U.K. different from that of the U.S.? ‘Table 2.7 UK, US. wilelwtfe sz | of im] o so | w| 9 | 40 3s | uo | | 6 2 | 0 | 2 | 8 o |] of & (a) Figure 2-12 gives te production possibilities curves ofthe U.K. and the U.S. Points below and inside each ‘productin possibilities curve art also possible but jaeficient, Points above each curve cannot be reached. ‘with the present supplies of factors of production and technology evailable to each nation, At point A, MRTow = the (absolute) slope of the curve = 1/6 in the U.K. (see Fig. 2-12). ALB, MRTow = 1. For the U.S., MRTew © 6 at point A" and MRTew = £ at point B’. (8) The production possibilities curve for the U.K. is different from that of the U.S, beeause the U.K. has different Fator endowments and may be using = diffezent technology than the U.S. fa general, the production possibilities curves of different nations are different. When the supply of factors of production and technology change through (ime, the production possibilities cunws shift. The type and extent of the shift depend on the type and extent of the changes cccurring. These are discussed in Chapler 5. w oft & mom iw woe C Fig. 212 2.14 (a) Redraw Fig. 2-3 and show on it tha starting at point A, the U.K. must give up more and more wheat for each additional bstch of 20C that it wants to produce. Also show that starting at point A’, the U.S. must give up more and more cloth for each additional batch of 20W that it wants to produce. (b) What does the answer to part (a) imply for the MRTew for a movement down the Moe i:CHAP. 2] ‘THE PURE THEORY OF INTERNATIONAL TRADE: SUPPLY 31 production possibilities curve of the U.K.? For the MRTwe for a movement up the production possibilities curve of the U.S.? (c) Explain the reason for the shape of the production possibilities curves of the U.K. and the U.S. (See Fig. 2.13. ( MRTow (reads: the marginal rat of transformation of cloth for wheat) is given by the (absolute) stope of the production possibilities or transformation curve, It measures how much a nation must reduce its output ‘of wheat in order to release just enough factors of production to produce cach additional unit of cloth. Thus. the U.K. moves from point A to point 2 in production, MRTcw increases, indicating that the U.K. faces increasing opportunity costs to produce each additional unit of cloth (see Fig. 2-13). On the other hand, MRT qe (fads: the marginal rate of transformation of wheat for cloth) is given by the inverse or reciprocal (of the [aheolue) slope of the production possbilides or transformation curve, It measures how much a ration must reduce its output of clerk in order to release just enough factors of production to produce each additional unit of wheat, Thus, as the U.S. moves from poiat a’ to B’ in production, MRTwc inereases, indicating that the U.S. faces increasing opporurity costs to produce exch adihional unit of wheat (see Fig. 2-13). Note that MRTye would also increase forthe U.K. if the U.K. wanted to produce more wheat and MRTew would also increase for the U.S. ifthe U.S, wanted to produce more cloth (©The production possibilities cures for the U.K. and the U.S. in Fig. 2-13 are concave 10 the origin, dus showing increasing (opportunity) costs. This is the usual case, Increasing costs result i (1) factors of production are only partial (rather than perfect) subsitutes for eachother ard (2) exch commodity is produced ‘ith diferent facter combinations or intensities. Then, as 2 nation transfers resources from the production ‘of one commodity to the production of another, the nation will have to use factors that er tess and less suitable tothe production of the second commmodity. AS a result the nation will have to give up more and more of the first commodity to produce cach additionel unit of the second commodity. Thus, we have increasing opportunity costs and production possibilities curves that are coneave to the origi. 2.15 With reference to Fig. 2-3, answer the following questions for the U.S.: (a) What change'in the production of cloth and wheat is indicated by a movement ftom point A’ to point B’? (b) What is, MRTow at point A"? AUB"? (c) What is MRTwe et A’? ALB"? (d) What does the change in MRT we {in moving from point A’ to point B* mean for the U.S.? What is this change in MRTwe due to? (© Atpoint 4’, the U.S. produces 80C and SOW (see Fig. 2-3). At point 3", the U.S. produces 40 and 130W, ‘Thus, a roovement from A’ to BY indicates « change of production inthe U.S. of ~40C and + 80W. (8) At point A’, MRToy = 4 (the absolute slope of Uie U.S. production possibilities curve at point A’; see32 216 ‘THE PURE THEORY OF INTERNATIONAL TRADE: SUPPLY ICHAP. 2 Fig. 2-3). At point B", MRTey = 1. A movement fom A’ to A" then results in a reduction in MRTew from 4 t0 1 (© MRT ye is the recipracal or inverse of MRTey’ [S02 Problem 2.14(8)). Thus at point A’, MIRTwe = 1/4 in ts U.S. At point 8°, MRTrc = 1, A movement from A" to 8" then results in an increase in MRT wc from Wath, (0 The increase in MRTye from 1/4 to | in going from A’ to B" indicates that in order to produce more wheat, the U.S, Incors increasing (opportunity) costs in terms of eloth, This oreurs because rhe production possibilities curve is concave to the origin. Starting with Fig, 2-12 and assuming that in the absence of trade. che internal equilibrium Po/Pyy = [V6 in the U.K. and 6 in the U.S., show (a) the point of produetion and consumption for each nation in the absence of trade, (4) the point of production and consumption for each nation with trade if the ‘equilibrium Po/Py with trade is f and SOC are waded. (@) Inthe absence of trade, the U.K. will produce at point A where its MRT cy = PefPw = V6 (S00 Fig. 2 12). The U.K, will also consume at point 4, singe inthe absence of trade a nation can only consume what it produces. In the absence of wade, te U.S. will produce st point A’ where its MRTow = Pol = 6 Point A’ then also represents the no‘rade consumption point for the U.S. : (b) Since in the absence of trade, the internal equilibrium Pe/Py in the U.K. is different (lower) than in the ULS., mutually advantageous trade is possible, Al the equilibrium Po/Py = 1 with trado, the U.K. moves from point A (o point 2 in production. By then exchanging SOC for SOW with the U.S: the U.K. ends up ‘consuming at point E, which is superior to A (the no-tade consumption point; see Fig. 2-14). With trade, de U.S. moves from 4" to Bin production, exchanges SOW for SOC and ends up at E’ (which is superior (0A. Note that with increasing costs, specialization in production is incomplete 2.47 From Fig, 2-14, (a) explain why it does not pay for the U.K, to continue to specialize in the production of cloth past point A. (b) Construct a table similar to Table 2.4 in Problem 2.7(a). (c) Construct a table similar to Table 2,5 in Problem 2.7(6). (2) Past point B in Fig. 2-14, MRTey in the UK. is higher than PeéPy in trade, and so it does not pay forthe UGK, to continue to specialize in the production of cloth. Another way of saying this is that past point B, MRTcin the U.K. is smaller than Py/P¢ in trade, and 30 it pays for the U.K. to continue to produce some ofits wheat (.e., with increasing costs, specialization in production is incomplete).CHAP. 2) ‘THE PURR THEORY OF INTERNATIONAL TRADE: SUPPLY 3 w Table 2.8 PRODUCTION. Before After Specialization Specialization ‘Change Ww c w c w c ux. | 50 0 2 | wo | -30 | +70 vs. | 20 50 90 ao | +10 | -40 ‘out | 70 wo | no | 1 | +40 | 430 © Tobie 2.9 (CONSUMPTION Before Trade ‘After Trade Gains Ww c Ww. c Ww c unats ux | 0 o 70 80 20 0 WuBo Jurcie us. | 2 fo EF 0 20 16 Tow | 70 wo | no | 10 | +0 | +30 [Note that in this euse, as opposed to Example 5, the gains from trade are not shared equally by the two nations 2.18 (a) What determines the intemal equilibrium Pe!Py in each nation in the absence of trade? (6) Starting with Fig. 2-12, explain what happens if the U.K. is in internal equilibrium in production and consumption at point B in the absence of trade, while the U.S. is in internal equilibrium in production and consumption at point B'. (c) What if the U.K. is in internal equilibrium in production and consumption to the right of & while the U.S. position is to the left of B”? (@) The infernal equilivium P/Py in each nation in the absonce of rade is determined by both the supply conditions in the nation (es sosumarized by its production possiblities curve) and the tastes or demand conditions in the nation (which determine at which point on its production posi ussed in dealt in Chapter 3, All we nee to add hore is thet the slope curve at the point where the nation is in equilibriom in production of the nation’s production possi «and consumption gives the intemal equilibrium Pe/Pw in the nation. I is this pretrade, intemal equilibrium PoiPur in each nation that determines the pattern of specialization in production and i trade, (@) tastes or demand conditions are such that the U.K. is in internal equilibrium in production and consumption at point B in the absence of trade, white the U.S. is at point B’, the pretrade MRTew = Po/Pw = 1 in bolh the U.K. and the U.S. (See Fig. 2-12), ard 50 no mutually advantageous trade is possible. (2) It in the absence of wade, the U.K. isin intemal equilibrium in production and consumption o the right of B on its production posites curve while the U.S. isto the leR of B", MRTcw and PolPy (as given by the absolute slope of the producuon possibilities curve) would be greater in the U.K. than inthe U.S. (Gee Fig. 2-12). By opening trade, the U.K. would then have to specelize in the production of and export ‘wheat in exchange for Armerican cloth, while thc U.S. would have to speciaize in and export cloth in exchange for English wheat. Thus, in this case, the peter of specialization and trade would be Une exact opposite of that in Problem 2.16,[CHAP. 2 Fig. 215 2.19 With reference to Fig. 2-15, assume that nation A (sith production possibilities curve AA) isin internal ‘equilibrium in production and consumption at poiat C in isolation, while nation B (with production possibilities curve BB) is in imernal equilibrium at point W in isolation. (a) Explain how with trade ‘each nation ends up consuming at point {. (b) Explain how the equilibrium Px/Py and the equilibrium quantities traded are determined. (c) How long will this equilibrium condition persist? (@) At point C, the internal equilibrium P/Py in nation A is smaller than in nation B at point N. Thus, A. specializes in X and moves along AA in x downward direction ati it reaches point F, while B specializes in ¥ unt it reaches R. AUF and R (and with free trade and no transportation costs), Py/Py isthe seme in both nations (and is given by line FAR in Fig. 2-15). Thea, A exports FG of X in exchange for GEf imports of ¥ and reaches point H (See “rude triangle” FGH in Fig. 2-15). B exports RT of ¥ for TH imports of X + abd also reaches point H (see “iade tiongle” RTH), Thus with tade, A and B bath consume at point H, and H > Cand H >. (®) The equilitum P.iP and the equilibrium quantities of X and ¥ traded are determined simultaneously by the foross of demand and supply in nations A and B, Only atthe equilibrium Py (given by line FAR in Fig. 2-15) will the quantity of X exporied by A (FG) equal the quantity of X imported by B (TH), and the quantity of Y exported by B (RT) equal the quantity of Y imported by A (GH). At PxlPr > FHR, A ‘wants fo export more of X than B wants fo import and Py(Py falls toward FAIR. At PxiPy 2. Note that B's exports of Y (CH) equal A's impors of ¥ (GE), and A's expors of K (CG) equal B's imports of X (HEF). (#) IC the two notions also had identical tases, they Would produce and consume at the same point on their respective production possibilities eurves in isolation. Thus, Py/P, would be the same in both nations and there would be no besis for mutually advantageous trade, (© With constant costs, there would be no basis for trade between A and B if each had identical production possibilities curves but difercat tastes. This is so because the pretrade PyiPy would be the same in both nations reganiless of tastes (.., reganless ofthe preirade production and consumption point in each nrion). Pow ew wim x cee eos awe em x Fig. 216 Fig, 2417 ate nena eA ee36 ‘THE PURE THEORY OF INTERNATIONAL TRADE: SUPPLY (CHAP. 2 2.22 Suppose that (I) a nation has the production possibilities curve of Fig. 2-16, (2) the nation is in internal ‘equilibrium at point 4 in isolation and (3) Py/P on the work! market is 1 and is not affected when this nation specializes in production and trades. (a) Draw a figure showing whit happens if this nation exports 30X. If it exports SOX. (6) Dots this nation gain in either case from wade? Why (c) ‘Under what condition will this nation nor affect world prices by trading? (@) In Fig. 2-17, the nation moves ftom point A to point C in production. If it exchanges SOX for 30Y, it ends up consuming at point & [the same asin Problem 2.21(a)]. IF exchanges SOX for SOY, itende up consuming at point W. (0) Poinc Eis cleanly superior (o point A since E involves both more X and more ¥ dun A. Poin W. however, ‘would involve more of ¥ bu less of X than at A. Unless the nation does in fact ge to point NW wih wade and dees 50 voluntarily, We cannot say unequivocally whether W > A. To answer this question, we need ‘community indifference eurves (se Sections 3.1 and 3.2). (© Anation may not affect worl pice by trading if the nation is Very small In thet event, the nation rectives allof te guns rom wade. This is refered to4s ce imporiance of being unimportant [se Problem 2.10(8)).Chapter 3 The Pure Theory of International Trade: Demand and Supply 3.1. COMMUNITY INDIFFERENCE CURVES So far, we have dealt with the supply conditions in each nation, almost to the complete neglect of the demand side, In this chapter, we expand our model to include explicitly the tastes or demand preferences of each nation, These are introduced by community indifference curves, ‘A community indifference curve shows the various combinations of two commodities which yield equal satisfaction to the community or nation. Higher curves refer to more satisfaction, lower ones to less. Community indifference curves are negatively sloped, they are couvex to the origin and, in otder to be useful, they must, not cross, The (absolute) slope of a community indiferente curve at any point gives the i rate of {ubsitton (MRS) the amount ofa commodity which te nation swiling fo give upto obiain one anal ‘THE Of The OlGcr commodity (and still remain on the same indifference curve). EXAMPLE 1. Figure 3-1 gives thee indifference curves from the indifference map of the U.K. and the U.S. Ta terms of satisfaction, N= A J >A for the U.K., and E* > J*.> A" forthe U.S, (©) The fac ha the indifference curves of the U.K. in Fig. 3-6 differ in shape and location from these of the plies that the U.K, and the U.S. ave eifferent tastes or demand preferences for wheat and cloth. ‘the U.K. and the U.S. had identical tastes would their indifference map and indifference curves be identical, . (4) Community indifference cures, together with the aation's production potsibilitis curve, are aeeded to determine the interal equilibrium point in production and consumption and the equilibrium relative eom-32 33 ‘THE PURE THEORY OF INTERNATIONAL TRADE. ICHAP. 3 smedlty price in the nation inthe absence of wade (axzarky). Community indifference curves ar also needed to determine the nation’s point of consumption with iad. (©) Community indifference curves are negatively sloped, they are convex tothe ovigit end, to be useful, they ‘ust not eross (see Section 3.1 and Fig. 3-6). (a) Why are community inditference curves negatively sloped? (b) Find the average MRS cw between consecutive points on indifference curves If and IV for the U.K. and the U.S. in Fig. 3-6. (c) Find MRScw at points 4, J and E and A", J" and £' on the community indifference curves in Fig. 3-6. ‘What happens to MRScw 28 we move down community indifference curve? (d) Why are community indifference curves convex to the ofigin? (a) Since we are dealing with economic (i.e, scarce) goods, ifthe nation consumes more of ane good, it must ‘consume less of the other to remain atthe same level of satisfaction (.e., on the same indifference curve). ‘Therefore, community indifference curves must be negatively stoped. () The average MRScw between any two points n'a community indifference curve is given by —AWIAC. Table 3.2 (©) MitScw at any point on a community indiferonce curve is given by the (absolute) stope of the (agent to the) curve at that point. AS we mave dawn 8 community indifference curve, its (ebsolute)stope or MBScwr declines (see Fig. 36) Table 3.3 $$ UK Us. Indifference Indifference Point | Curve | MRScy | Poi [ Cure | MRScy Curve _} MR’ A i 6 a a 6 t m wa a a 32 Ez Vv 1 B Vv 1 (2) Asa nation moves down an indifference curve, itis willing ta give up less and less ofits wheat in order to oblain each addtional unit of cicth (Le., MRScw declines). This is so because the fess Wheat and the ‘more cloth a nation has (ie., the lower point on the inference curve), the more valuable i each remaining un of wheat and theless valuable is etch additional unit of cloth torhe aation. A declining MRScy resulls jn community indifference curves that aze convex tothe origin. (a) Why must community indifference curves noteross in order to be useful? (4) Why cen community indifference curves cross when we open up trade or incresse the volume of trade? (c) How éan we ‘overcome the problema raised by the possibility of intersecting community indifference curves?CHAP. 3) ‘THE PURE THEORY OF INTERNATIONAL TRADE, 4s (@ When wo community indifference curves cross, one of them is above the other Gmplying a higher level of satisfaction) at one side ofthe point of intersection, and below the other (implying a lower level of satisfction) on the other side ofthe point of intersection, Thus, we cannar say unequivocally which of the two community indifference curves refers 10 a greater level of Satisfaction. ©) White en individual's indifference curves, by definition, cannot cross, community indifference curves may cross, This is because the indifference map of a nation refers to a pastcular income distibution within the nation, Fora diferent income distribution, we have a different community indifference map, whose indifference curves may cross those of the previows indifference map. This is precisely what happens between two trad situations. That is, when we open up Gade oF expand its volume, domestic producers of the importable commodity are hurt while pendacers of the exportable commodity benefit, Thus, the income distribution of the nation changes, and we get & new and diferent community indiforence map with Indifference curves that may cross those of the previous community indifference map. In that caSe, we ‘canna ase them to detersie if the opening or the expansion of trade increased the nation’s welfare. GC) One way we cen overcome the problem raised by intersecting community indifference curves is by the so- ‘called compensation principle. This says that if those who gain from wade can compensate the losers entitely for thei losses and sill have something of the gsin left over, and if atthe same time, the losers are not willing to bribe the giners into forgoing trade, then trade is beneficial co the nation—whether compensation actually occurs or not. While the compensation principle isnot sufficient to overcome all of the conesptiat difficulties inherent in the use of community indifference curves, the concept of such carves isa neat device that continues 10 be used (albeit cautiously) in unde theory. ‘THE BASIS FOR TRADE AND THE GAINS FROM TRADE RESTATED 34 Using the production possibilities curve of Fig. 2-12 and the community indifference curves of Fig. 3-6, determine (a) the equilibrium point of production and consumption in the U.K. and in the U.S. in autarky, and (5) the equilibrium Pc/Pw in the U.K. and in the U.S. in autarky. (c) What conditions hold at the autarky equilibrium point? (d) What do points of intersection of a community indifference curve with the nation's production possibilities curve indicate? (@) In dhe absence of tade, the UK. is in equilitrium at point A and the U.S. at A’, where the production possibilities curve of cach nation is tangent to its community indifference curve II—the highest each nation ccan reach in eutarky (See Fig. 3-7). Since community indifference curves are convex to the origin and are dra as nonintersecting, the equilibrium point i unique (i.e. , here is only one such tangency or equilibrium plat). Also, the fact that community indiffewace maps are dense (j.e., they are made up of an infinite ‘number of indifference curves) always ensures the existence of an equilibrium point46 35 36 ‘THE PURE THEORY OF INTERNATIONAL TRADE ICAP. 3 (©) The autarky equtitrium PolPy = Py = M6 in the U.K. and Pyr = 6 in the U.S. (see Fig, 3-7). These ‘are given by the (absolute) slope of the tangent 10 the production possibilities curve and community ference curve It at points A and A, respectively. Thus, the nation’s supply conditions (as sanvmarized by its production possbiies frontier) and demand preferences (as summarized by its indifference map) rogether detersine the equilibrium rolative commodity price inthe nation in autacky. (6) At point A, the U.K. is i equilibrium both in production (because MRTey = Px) and in consumption ecause MRScy = Pq). This, at point A, MRTow = Px = MRSow = U6 in he U.K. (ote Fi 3-7) ‘Atpoint A’, MRTey = Py = MBSoy ='6 inthe U.S, (4) Points of inteection of a community indifference curve with the nation’s produstion possbites curve are attainable but do not maximize the nation’s satistcton, For example, at point N in Fig. 3-7, MIScw > MRTow. This means thal the U.K. is willing to give up more wheat in consumption than it needs to give up in production to obtsin one more unit of cloth. Thus, it pays forthe U.K. to produce (and constime) ‘more cloth and less ‘wheat. As it does this, the U.K. moves down its production possbilies frontier and reaches higher and higher indifference curves ntl pict A on indifference curve Il—the highest te U. ‘can reach with its production constraint. The exact opposite iste atthe oer intersection point (i... point Gin Fig 2-7. Points on higher indifference curves are beyond the present production capacity of ihe U.K. With reference to Fig. 3-7, (a) indicate in which commodity the U.K. and the U.S. have a com- ‘parative advantage. () On what is the difference in P, and Pa: based? (c) What would happen if Community indifference curve I was tangent (o the production possibilities curve at point & in the U.K. and at point B' in the U.S.? (4) If the tangeney point was to the right of B in the U.K. and 10 the left of B" in the U.S.? (@) Since in isoinion, Pq < Par (See Fig. 3-7), the U.K. has @ comparative price advantage over tho U.S. in cloth and the U.S. in wheat. fe follows that with trade between the two mations, the U.K. should specialize in cloth and import whcat wiile the WS. specializes in wheat and imports cloth () ‘The indifference in Py and Py’ is based on botk the difference in supply conditions and demand conditions in the U.K. and the U.S. From the supply side (e., from the skape ofthe production possibilities curve), * -we see that the U.K. has a production bias in favor of cloth and the U.S. in Savor of wheat (see Fig. 3-7). From the demand side (.¢., ftom the shape and location of the community indifference curves). we 5e© thatthe U.K. has a consumption bts in favor of wheat and the U.S. in favor of cloth. More specifically, the U.K. can supply a large quantity of cloth in relatian to its small taste or demand for cloth, while it can supply a small quantity of wheat in relation to its tase for wheat. Thus, bh supply and demand condivons in the U.K, reinforce cach other in making the pretrade equiibriom Po/Py low in the U.K, The exact ‘opposite is true in the U.S., thus making the pretrade equilibrium Pc!Py higher in the U.S. (© When the tangency point is at B in the U.K. and at Bin the U.S., the equilibrium Pc/Py = 1 in utarky -in both nations (ee Fig. 3-7) and no mutually advantageous trade is possible between them. This occurs ‘only if the English derand for its own loth in isolation isso strong that (o produce that large quantly of cloth, the U.K. incurs the relatively high MRTow PefPw (see point B in Fig. 3-7). At the same time, the U.S. consumption bias in favor of whest is so high the neutralizes its production bias in favor ‘of wheat and gives a PolPy = MRTev = 1. (4) If the tangency point is tthe right of B in the UK. and to the left of B' in the US., the equilibrium PofPw > 1 in the UK, and Po/Py < 1 in the U.S. in auusky. In this ease, demand considerations wikia cach nation overwhelm supply considerations and fea to a trade patter which fs the reverse ofthe more usual ease discussed in part (6). Stasting at the axterky points A and A’ in Fig. 3-7, draw a figure showing the points of production ‘and consumption for the U.K. and the U.S., if trade takes place at Po/Pw = 1. Is tis the equilibrium price with trade? Why? How much does each nation gain from trade? At PoP = 1 with wide, the U.K. moves from point & to point B in production, exchanges 50C for SOW with the U.S. and ends up at point E on its indifference curve TY (thus gaining 20C and 20W; see Fig. 3-8). This is the highest level of satisfaction that the U.K. ean reach with trade at PoiPw = 1, since MRTew at B= MRSow tt E = Pe/Py = Py = 1.CHAP. 3) ‘THE PURE THEORY OF INTERNATIONAL TRADE a7 37 ° woe he we eC” Fig. 3 On the other hand, the U.S. moves from A’ w Bin production, exchanges SOW for SOC withthe U.K. and reaches £” on its indifference curve IV (ths guining 10C and 20W). This isthe highest indifference curve the U.S, can reach with trade al PoP = 1, since MIRTow at B" = MRSey aE’ = PoPy = Py = 1. Since the quantiles taded are in equim, Poy = Pq = Far = 1 i te equilibrium price with trde. Note that, ‘while in Problem 2.16(b) we had tobe tld that SOC and SOW were traded, we can now determine that volume of trade at P/Py = with the aid of community indifference curves, (a) Add the hypothetical community indifference curves for nation 1 and nation 2 to Fig. 2-16 so that ‘we get the results reached in Problem 2.21(a). (&) What conditions are now determined but hed to be assumed or given in Problem 2:21(a)? (2) In Fig. 3.9, indifference curves I and Il refer to nation 1, and I" and i" to nation 2. In autarky, nation 1 is in equilibrium at point A, where MRTrr = MRSxy ~ Pa = 1/4 and nation 2 at point 8, where MRT = MRSqy = Px = 4. With trade, nation 1 moves from A to C in production, exchanges 30X & uRRis WuBO JuRcie48 38 ‘THE PURE THEORY OF INTERNATIONAL TRADE (CHAP. 3 {or 30Y with nition 2 and reaches point & on indifference curve Il. Nation 2 moves from B to Cin production, exchanges 30Y for 30X with nation | and reaches point F on indifference curve II’, Thus, at equilibrium in production and consumption with vade, MRTyy = MRSqr = Po = | in both nations. The swo nations ‘will beable to reach higher indifference curves then Tl and I” only asthe supply oftheir factors of production rises and technology improves through time. This model ise eeverse ofthe more usual case, where nations ce more ot les identical tastes but different Factor endawments or pratuction possibilities curves, Ifthe indifference map of each nation were also the same in Fig. 39, then their eutarky points of groduetion and ‘consumption would coincide, Py/Py would be the same ip each nation, and no mutually advantageous trade ‘would be possible between them, () With the introduction of community indifference curves for vations 1 and 2, we can now determine the autacky equilibrium of production and consumption in each gation. We can also determine exactly what quantities of X and Y are traded at Py'Py = 1, Both af these conditions had to be assumed or given in Problem 2.21(a). Note, however, hal in order for this trade model :o be complete, we still must show how ‘he equilibrium PB, = 1 with trade is determined, Draw a set of indifference curves for the nation in Problem 2.22 and Fig, 2-17 showing that A is the autarky equilibrium point, 4 << E, and & is the equilitsiura point of consumption with wade. 4a Fig. 3:10, the nation is in equilibrium in autarkcy at point A, wire its indifference curve I is tage its prodvetion possibilites curve. Thus, Ue autarky PylPy = Py = 1/4 inthe nation. Since we are told in Problem, 2.22 that Puy — Py = 1 nthe world market and is act affected when this ation specializes in the production ‘of X and trades, the nation moves to point C in production (where ts MTs, = Py = 1), exchanges 30X for BOY. and reaches point E on lis indifference curve TI (Se Fig. 3-10). At point E, the nation's MRSry = Py 1, and indifference curve I is the hight the nation can reach, The nation could rach point N by exchanging ‘50K for SOY. Point 4 (on community indifference curve If) is superior te point A (on I) but inferior to point ECHAP. 3] ‘THE PURE THEORY OF INTERNATIONAL TRADE. “0 39 (on I). At point W, MRSyy > Pw and the nation would be consuming too much of Y and too lite of X to be in equilibrium in consumption with trade (reread the soltion to Problem 2.22). The fac thatthe rest of the world passively willing to wade any quantity of ¥ in exchange for X at Pw = 1 with this aalion has an important implication fr the shape of the world's offer curte from this nation’s pont of view (see Problem 3.16). For the nation of Problem 3.8, show the breakdown of the total gains from trade into the gains from exchange alone and the gains from specialization in production. {In Fig. 3-11, the change in consumption from point A {on inference curve I) (0 paint 7 (on indifference ccorve I") measures the gai ftom exchange alone if the nation, for whatever reason, cannot move to point Cin ‘Production but continues to produce at point A even with trade, The change in consumption fram point Fto point E (on indifference curve HU} measures the guns from specialization in production,50 ‘THE PURE THEORY OF INTERNATIONAL TRADE (CHAP. 3 3.10 Add hypothetical community indifference curves for the U.K. and the U.S. to Fig. 2-2, so that we fet the results reached in Example 3 of Chapter 2 ‘The commentary for Fig. 3-12 isthe same as in Example 3 in Chapter 2, except for the fat that by adding ‘community indifference curves for the U.K. and the U.S. to Fig. 2-2, we can wow determine rater than assume ‘the autarky equilibrium point of production and consumpuioa for each nation and the equilibria point of con- sumpiion with tade [see also Problem 2.21(c)] Still to be assurned, however, is the equilibrium Py/Py = 1 at ‘which unde takes place. OFFER CURVES AND THE EQUILIBRIUM RELATIVE COMMODITY PRICE WITH TRADE 3.11 Starting atthe autarky equilibrium point A forthe U.K. in Fig. 3-7 and using the community indifference curves of the U.K. in Fig. 3-6, derive the offer curve of the U.K. Jo Panet A of Fig. 3-13, che U.K. stats at the autarky equilibrium point A, as in Fig. 3-7. If inde takes place at Py = PolPw — I, the U.K. moves to point 8 in production, exchanges SOC for SOW with the USS. and reaches point £ (so far tis is enaedy as in Fig. 3-8 in Problem 3.6). Trade triangle BFE in Pane] A of Fig. 3-13 comesponds to trade triangle OFE in Panel B and we get point F on the U.K.'s offer curve. At PoPw = Po = 12 (see Panel A of Fig. 3-13) the U.K. would move instead to point G in production, exchange 40C for 20W with the U.S. and reach point J on its indifference curve Il. Note that Po is less favor able to the U-X. than Pp and so the U.K. gains less from trace (ie., J < é). Trade triangle GH in Panel A ‘corresponds to wiangle Of7 in Pare! B, and we get point J as another point on the U.K." offer curve. By staning with other PiPy at which trade could tke place, we would oblain in a similar manner other points on the U.K.'s offer curve, By joining the origin with these poims, we generale the U.K,'s offer curve shown in Panel B. Note that Pa, Po and Pa in Panel B of Fig. 3-13 refer to the same PoPw 25 Pa, PB and Pa in panel A, since they refer to the seme absolate slope. 3.12 With reference to the U.K.'s offer curve in Panel B of Fig. 3-13, answer the following questions. (a) What does the offer curve show? () In what way can the offer curve be regarded as @ demand curve? How is this different from the usual demand curve of microeconomic theory? (©) In what way can the offer curve be regarded as a supply curve? How is this different from the usual supply curve of microeconomic theory? (d) Why must the U.K. receive 2 higher Po/Py to be induced to export more cloth? (e) How much cloth is the U.K. willing to export at B,? (@) The U.K.'s offer curve shows bow much wheat imports the U.K. requires 10 be willing to export various ‘quantities of its cloth (The UK's offer curve can be regarded (in sense) a a demand curve, in that it shows the quantity of wheat imports demanded by the U.K. at various total expenditures in cerms of eoth. This is diferent (rom the usual demand curve of microeconomic theory, which shows the quantity demanded of a commodity st various per unt prices in terms of money. (©) The U.K.'s offer curve could also be regarded (in a sonse) es supply curve, in that it shows the quantity of cloth exports supplied by the U.K. at vatious fra! expenditures in temis of wheat. This is different from the usual supply curve of microeconomic theory, which shows the quantity supplied of x commodity at sarious per unit prices in terms of maney. (@) The UK. must receive a higher Po/Py to be indoced to export more cloth because to produce more cloth {or expor, the U.K. incurs increasing opportunity costs in cloth production, Also, asthe U.K. exports more cfeth, the U.K. receives more wheat. But the more wheat the U.K. consumes, the lower the exira (oF rmarginel) satisfaction it receives from each additional unit of (imported) wheat, Thus, Po/Pw mist rise because (1) it costs more to produce each additiona uni of cloth for export and (2) each additional unit oF ‘wheat received in exchange results in less extra satisfaction. (©) At Pe (the autrky equilibrium Po/Pw in the U.K.., see Panels A and B of Fig. 3-13), the U.K. is willing to export sbout 15C (see Pane! B). That is, for this small quantity of cloth exports, the U.K.'s offer curve coincides with P, : 3.13 Starting atthe autarky equilibrium point A’ forthe U.S. in Fig. 3-7 and using the community indifference curves of the U.S. in Fig. 3-6, derive the offer curve of the U.S.‘CHAP. 3} ‘THE PURE THEORY OF INTERNATIONAL TRADE, st52 31d 3.5 ‘THE PURE THEORY OF INTERNATIONAL TRADE. (CHAP. 3 In Panol A of Fig, 3-14, the U.S. stars at the amterky equilibrium point A’. as in Fig. 3-7. If trade tikes place at Far = Poe = 1, the U.S. moves to B' in production, exchanges SOW for SOC with the U.K. and reaches point £’ (es in Fig. 3-8). Trade triangle B'F'E” in Pancl A of Fig. 3-14 coresponds 10 trade wiangle OF in Panel B, and we get pot on the U.S. offer curve, Using another PoP (in the range: 16 < PolPy < 6, a1 which trade can take place berween the U.S. and the U.K}, say PelPy = Por = 372, wwe sei wade triangle G'H'Y" in Panel A which comesponds to trade tangle OH'J" in Panel B, and we get point Fon the U.S. offer curve. By joining the origin with such points as J” and E', we get the U.S, offer cunte Of Ponel B. This shows how much cloth imports the U.S, fequires to expor. various quantities of wheat. In a sense, the U.S. offer curve can be regarded as the U.S. demand curve for cloth and also asthe U.S. supply eurve of wheat. Nowe that in order fo induce the U.S. to export more wheat, Pc/Py mins fll (Le., PydPe Mus ise), but the U.S. is willing to export about SW at Pa” (se Panel A of Fig. 3-14). Using the offer curve of the U.K. in Panel B of Fig. 3-13 and the offer curve of the U.S. in Panel B of Fig. 3-14, determine (a) the equilibrium P./Py at which trade takes place between thent and (4) the terms of trade of the two nations. (@) In Fig, 3.15, the offer curves imerscct at point E (which coincides with point £°, giving eqiibiom PoiPy = Py = Pay = 1. Pa i the equlrium relative commodity price bectse at Pay the SOW of imports demanded by the U.K, exacly matches the SOW of exports stpplieé by the U.S, and the 50C of imports demanded by the U.S. exec matches the SOC af exports supplied bythe U.K. (6) The terms of trade of the U.K. = Px/Py = PoP = 1. The terms of trade of the U.S. = Px/Pyq = PylPe = 1 also in this case. If a nation oxports and imports more than one commodity, then Px and Py refer fo price index numbers of expods and imports, respectively. These lerms of trad are sometimes refered fo asthe net barter tems of trade or 38 the commodity terms of trade to distinguish them from ‘ter terms of mada tobe diseosed in Problems 5.23 and 5.24 in connection with rade and devzlopmen “The tem of trade of nations anf the volume of trade change troogh tine as their offer curves shit due to changes in factor endowments, techaology and tases (se Chapt 5). Starting from Fig. 3-15, (a) extend the Pg price line and the U.S. offer curve so that they cross at ‘60W from 160C; also extend the Po’ price line and the U.K. offer curve so that Uhey cross at 120W and 60C. () With reference to the figure in part (a), explain in terms of the quantities of cloth waded, why Po and Po are not the equilibrium Pe/Py. How is Py reached? (c) Do the same thing as in past (6) in terms of whear traded, Fig. 3-15, @) See Fig. 3-16, @)_ALPo, the 49C expors supplied by the U.K. (poiat J in Fig. 3-16) falls far short of the 160C importsCHAP. 3) ‘THE PURE THEORY OF INTERNATIONAL TRADE 53 3.16 demanded by the U.S. (point R in Fig. 3-16). This excest demand teads (o drive PciPy up from Po- As this occur, the U.K, moves up its offer curve and supplies more cloth (or export while the U.S. moves down its offer curve and demands less cloth imports. This continues until, at Pp, the desired quanttos of cloth exports and imports ar equalized (see points E and" in Fig. 3-16), At Po the 20C impos demanded by the U.S. (point J" falls short of the 6OC exports supplied by the U.K. (point R'). This excess supply causes Pe/Pw to fell from Po', AS this occurs, the U.S. moves up its offer curve and demands more ctoth imports white the U.K moves down its offer curve and supplies less cloth for export. This continues unit Pp, where the desired quantities of cloth impor and exports are the same, (© AtPo, the LSW imports demanded by the U.K. (point J) fills short of the 6OW exports supplicd by the US. {point R). This causes PeiPw to rise—which means that Pw/Pe falls. AS this occur, the U.K. moves pits offer curve and demands more wheat imports, while the U.S. moves down is offer curve and supplies less wheat for export. This continues unl Pp, where the desired quantities of wheat imports and exports are the same, At Po', the U.S. is willing to export 40W (point) but the U.K, wents 10 import 120W (point R’). This excess demand causes Py/Pe 10 1st rom Porto Pa, where the desired quantities of whesk imports and exports are equil. Thus, Py isthe unique equilibrium PyéPc in the sense that only at Py does the market clear itself (a) Using offer curves, show that nation 2—a “very small” nation—mey trade at the autarky PolPw = P; prevailing in nation 1—a “very large” nation. (2) Under what condition would a nation’s commodity price would trade take place if the partner's offer curve took the usual shape? (c) What ‘would happen if both nations operate under constant conditions throughout? (@, tn Fig. 3-17, notion 2 is so small tha it offer curve crosses the straight-line segment of the lerge watoa's (Le., nation'1) offer curve. Thus, whe equilibrium volume of tae Pp, there will ban excess supply of exports of commodity X and this will drive PulPy down 10 Br. At Pay < Py ete wil be an excess demard for imports of X and this wil drive Pky up to Ps Figure 3-19 refers to partie equtiium analysis, while Figs. 3-5 and 3-15 refer to general equilibria analysis. Speciielly, Fig. 3-19 examines only the market for commodity X, while Figs. 3-5 and 3-15 exomine simultancotsly the market for commodities X and Y. Thus, Fig. 3-19 provides only a partial analysis or approxirnaton tothe general equllbrivm analysis showa in Figs. 3-5 ané 2-19.Chapter 4 The Heckscher-Ohlin Theory and Extensions 4.1 THE HECKSCHER-OHLIN THEORY ‘We have seen in Section 2.6 that comparative advantage and trade are based on a difference in factor endowments, technology or tastes between nations. The Heckscher-Giitin (H-O) theory focuses on the difference in relative factor endowments and factor prices between nations as the most important determinants ‘of trade (on the assumption of equal or similar technology and tastes). The H-O thearem postulates that each ration will export te commodity intensive in its relacvely abundant and cheap factor and import the commodity intensive in its selatively scarce and expensive factor. The factor-price equalization theorem (actually, & corollary of the H-O theorem) postulates that trade will Iead to the elimination or reduction in the pretrade difference in relative and absolute factor prices between nations. EXAMPLE 1. Figure 4-1 shows the production possiblities curves of he U.K. andthe U.S, onthe same set of axes. Tech- nology is assumed be the same in both nations. Production is skewed towardthe cloth ais in the U.K. becauseclothis labor (Lyintensive and the U.K. hasarelstivedbundance of labor, Prodyctionis skewed toward the whestaxisin he U.S. because “na is capital (K}-intnsive andthe U.S. has relative abundance of capital. The same indiference map refers to both na- sions because ofthe assumption of equal ate or demand preferences. Inthe abscner of ade (efi panelof Fig, 4-1), the U.K. produces and consumes a point ons indiference cure Lith PoP = Pp, whiletheU.S. ise" onl with Py. Widkrade (Gightpanc of Fig. 4-1), the U.K. producosat point (Le. itspecilizas inthe production of ttt and consumes at point Eon indifference curve M; while he U.S. produces at! and consumesat” onllat Pgs = Py. AstheUK. specializes inctth (he ‘intensive commodity) and produces less wheat (the intensive commodiy), ts demand for and price of labor ime ihe wage ‘te rites whileit demand for and price of capital (he interest ras) falls. Tae exact opposite occurs inthe US. with he wage rat falling ad the interstate sing. This continues wail relative and absolute factor pices are cquatied in te two nations {unde highly restrictive assumptions; se Problems. 3(6)] SEE Pe + +o oT He co q ot. bet Fig. 41 4.2, EMPIRICAL TESTS AND FACTOR-INTENSITY REVERSAL ‘The first empirical test of the H-O theory was conducted by Leontief in 1951 using U.S. data for 1947. Leontief found that U.S. import substitutes were about 30 perceat more K-intensive than U.S. exports. Since 56CHAP. 4] ‘THE HECKSCHER-OHLIN THEORY AND EXTENSIONS 7 the U.S. was the most X-abundant nation, this result was the opposite of what the H-O theory predicted and became known as the Leantief paradox. While subsequent refinements of the test seem to have resolved the paradox (see Problems 4.5 and 4.6), mote recent empirical studies found only partial support for the H-O theory. Another possible reason for Leontiel's results is fuctor-intensity reversal (FIR). This refers to the situation where a commodity is the L-intensive comntodity in the L-abuidant nation and the K-intensive commodity in the K-abundant nation. This would lead to the rejection of the H-O theory. Empirical tests indicate that FIR is aot very prevalent in the real world. EXAMPLE 2. Ifcloth isthe L-inensive commodity in the U.K. (the Z-abundant and L-cheap nation) and the K-intensive commodity inthe U.S. (the K-abundant and K-cheap nation), we have FIR. Nove that we would expect cloth and wheat be more Z-intensive in the U.K. thaa in the U.S. because the ratio of wage of labor to interest an capital (wir) is lower inthe U.K,; bul to have FIR, cloth woulé have to be the L-intensive commodity inthe U.K. ard the K-intensive commodity in the U.S. With FIR, the 1-0 theorem would fall because it would predict that the U.K. should export cloth (the intensive commodity in the U.K.) because the U.K. is the Z-abundant nation, and the U.S, should also export cloth {he K-intensive commodity inthe U.S.) because the U.S. is the K-abundant sation. As the U.K, and the U.S. cannot export the same (homogeneous) commodity to each other, the U.S. may end up exporting whet, Since wheat is the in the U.S., the demand for L and w (wage of tabor) would rise in both the U.K, and the U.S... and so w roay move apart rather than closer in the two nations. Thus, the facior-price equalization theorem would also not hold, FIR results when factor substnuion is much greater in the groduction of one commodity (say, cloth) than ia the outer (see Problem 4.9). 4.3. TRADE BASED ON DIFFERENTIATED PRODUCTS ‘Although the Heckscher-Ohlin theory is retained, there is a substantial portion of international trade that the basic H-O model does not explain, Some of this is intra-indusiry trade or trade in differentiated products. Differentiated products refer to similar, but not identical, products (such as automobiles, typowriters and cigarettes) produced by the same industry or broad product group in various nations. Intra-industry trade arises ‘as producers, cates to “majority” tales within their nation, leaving “minority” tastes to be satisfied by import, Related to this is the sharp inerease in international trade in product parts and components as multinational corporations produce parts and assemble them in different nations in order to minimize production costs EXAMPLE 3. The U.S. both imports and exports automobiles, typewritors, cigarettes, chemicals and many other Indistal products. Anoher example isthe European Common Marke. The formation of the European Common Market Jed sume in he volume of tade among momber nations, but most ofthe inereat involved the exchsoge of ifereaited produce, For example, German sstomobiles appeal to te majoriy of ear buyers in Germany, ut ah important minority ‘mn Germany sll prefers French, Taian or Brish cae, Trade in pts and components arises when, for example, German tnd Japanese camera manofactres ship pars 10 be assembed ia Singapore to lake advantage of mich cheaper isbor ther 4.4 ‘TRADE BASED ON ECONOMIES OF SCALE Even if two nations are identical in every respect (so that the H-O model would predict no trade), there is till a basis for mutually beneficial trade based on economies of seale, Economies of scale refer tothe production situation where output grows proportionately more than the increase in the use of inputs or factors of production. EXAMPLE 4, If de two nations are idendcal in every respect (Le., in factor endowments, techaology and tastes), relative commodity prices would be the same in two nations in isolation and no trade would be possible according tothe HO model, However, if both commodities face economies of seale in production, each nation coulé specialize in the production of one of the wo commodities ‘and, by exchanging some ofits output for the output ofthe other raton, each {higher evel of satisfaction (consumption) tan in isolation. The gains with trade arise from the increase inthe tot output of both corto resuling from economics of scale (see Problem 411)58 ‘THE HECKSCHER-OHLIN THEORY AND EXTENSIONS IcHAP. 4 4,8 TRADE BASED ON TECHNOLOGICAL GAPS AND PRODUCT CYCLES ‘According to the technological gap model, great deal of the exports of industrial nations are based on the introduction of new products and new production processes. These give the nation a temporary monopoly until other nations copy the technology and undersell the nation that intoduced the newer technology. In the meantime, the technological leader may have introduced still newer products and new production processes. 4 generalization and extension of the technotogical gap mode! is Vernon's product cycle model. According {o this model, the introduction of a new product usually requires highly skilled labor in the production process. ‘As the product matures and acquires mass acceptance, its production becomes standardized, requiring only ‘unskilled labor. The comparative advantage then shifts from the nation chat introduced the product to the natin with the cheaper labor. A great deal of the exports of the U.S. (often the technological leader) involve the continuous introduction of new products. EXAMPLE S. immediately after World War i, the U.S. dominated the world market for redios based on vacuum tubes developed in the U.S, A few years iater, Jagen copied the technology and undersold the U.S. becaus of lower wages in Japan, ‘The U.S, recapcured the technological leadership and market wit the development of transistors. But again, in a few years, Japan copied the technology and undersold the U.S. The U.S. then introduced the printed circuit and reacquired its ability to suocessully compete with Japan. Tt remains to be seen if Japan can quickly copy this new ‘echnology and ance agsin take the market avay from the U.S. or whether both nations wil be displaced by still cheaper producers in Korea, Taiwan or Singapore, 4.6 TRANSPORTATION COSTS So far we have abstracted from transporation costs (i.e., we have implicitly assumed that they were zero). ‘Their inclusion modifies our trade mode! slightly, as follows. A commodity will be traded only ifthe pretrade price difference between the two nations exceeds the cost of transporting it between them. In addition, when trade is in equilibrium, the price of the traded commodity ia the importing nation exceeds the price'of the same commodity in the exporting nation by the cost of transportation (sce Problems 4.14 to 4.16), Glossary Heckscher-Ohlin (H-O} theory A theory that is based on the f1- theorem and the factor-price equalization ‘theorem. Factor endowments The availebility of such factors of production and resources as labor and capital Factor prices The wage of labor (w) and the interest rate on capital (r) to hire or use a unit of labor and capital, respectively. Heckscher-Ohlin (H-0) theorem ‘This theorem postulates thet each nation will export the coramodity intensive in its relatively abundant and cheap factor and import the commodity intensive in its relatively scarce ‘and expensive factor. Factor-price equalization theorem This theorem postulates that ade leads to the equalization of relative and absolute factor prices between nations (under highly restrictive assumptions). Import substitutes Commodities (such as cars) produced at home and imported because of incomplete specialization. Leontief paradox The empirical results obtained by Leontief that showed U.S. import substitutes in 1947 4o be about 30% more X-intensive than U.S. exports, Since the U.S. was the most X-abundant nation, this result was the opposite of what the H-O theory predicted. Factory-intensity reversal (FIR) ‘The situetion where a commodity is the L-intensive commodity in the L-abundant nation and the K-intensive commodity in the X-abundant nation. If prevalent, it would lead to the rejection of the H-O theory.CHAP. 4} ‘THE HECKSCHER-OHLIN THEORY AND EXTENSIONS 39 Labor-intenslve commodlty The commodity that requires a higher ratio of Inbor t0 capital (L/K), oF lower K/L, in production. L-abundant nation The nation with the higher ratio of total labor to total capital (L/K) and lower ratio of wages to interest rate (wir), or higher ri. Capitalntensive commodity The commodity that requires @ higher ratio of capital to labor (KIL), or lower L/K in production. K-abundant natlon The nation with the higher ratio of total capital to total labor (K/L) available and tower ratio of interest to wages (ri), or higher wir. Factor substitution The possibility of reducing the amount of one factor by increasing the amount of another factor to produce a unit of a commodity. Intra-Industry trade International trade in differentisted products of the same industry oF broad product group. Differentiated products Similar, but not identical, products (Such as cass, typewriters and cigarettes) produced by the same industry or broad product group. Economles of scale The production situation where output grows proportionately more than the increase in the use of inpuls or factors of production. Technological gap mode! “This mode\ postuizes tha a grea deal ofthe expons of industrial nations are ‘based on the introduction of new products and new production processes. Product cycle mode! This generalization and extension of the technological gup atodel postulates that the comparative advantage in introducing new products lies in the high-technology nations but shifts to cheap- labor nations once the product acquires mass acceptance. The premise underlying this mode! is that highly tally required to produce a new product; but upon mass acceptance and standardization of the product, production can be carried out by unskilled labor, and hence the comparative advantage shifts 10 cheap-laboc rations. Review Questions For Heckscher and Oblin, the most important cause of the diference in relative commodity prices and trade between tations is a dilfereace in’ (a) facior endowments, (6) technology, (c) tastes, (d) demand conditions ‘Ans. (a) See Section 4.1. The H-O theory postolstes that as a result of trade, the difference in factor prices between nations (a) dimin- fishes, (6) inereases, (c) remains unchanged, (d) any of the ebove are possible, ‘Ans. (a) See Section 4.1 “The Leonfel paradox refers tothe esuitthat US, (o) exports ure more K-inteasive han U.S, imports, (b)enpors ‘a more K-intensivethaa U.S. impor substitutes, (e) mpons are more K-inteasive than U.S. exports, (a) impor substitutes are mote K-iatensive than U.S. exports. ‘Ans. (d) See Section 4.2, 4. Factor intensity reversal refers tothe stution where (a) both commodities re more L-intensive in one naion than inthe other nation, (6) one commodity isthe Z-intensive commodity in one nation snd the K-intensive commodity0 ‘THE HECKSCHER-OHLIN THEORY AND EXTENSIONS (CHAP. 4 in the other nation, (c) the same commodity is more L-inensive in one nation than in the other nation, (4) any of the above, ‘Ans. (6) See Example 2. XY GB) woes ope artes novesined by he Hesse On wale mode? (0) newindsty nde, (Hee based on economies of sae, "(ete Dated on nation gps an prodst cee, Cd ala he above, Ans. (d) See Sections 4.3 10 4.5. , wi yak! 6. Trade in diferensted roduts refers oa) inerindasty trade, (4) intandy tad, (c) trade bated on ccooomis of sae, (0 wade Based on ition gaps and prod ees. ‘Ans. (b) See Section 4.3. 7 Trae in diferentes products rests fom domestic producer catering [0 (a) majorly tastes in the nation, (6) majority tastes abroad, (c) minority tastes in the nation, (4) any of the above. Xe pt onan SS (6) Economics of scale is a term that refers tothe production situetion where the growth of output in elation to the increase im the use its is (a) greater, (b) less, (c) equal, (d) any of the above, ‘Ans. (a) See Section 4.4. The technological gap mode! represents an cxtesion ofthe H-O modet becavse the H-O model (a) didnot consider technology, (2) viewed technology statically (.c.. alone point inte), (c) viewed techuotogy dynamically. cover time), (a) any of the above. ‘Ans. (b) Compare Section 4.5 with Section 4.1. ]) Accoring to tne proreceyle tate model_ (0) when ane pot is inrodoe, it usaly egies highly stile Jabor to produce; (4) after the product acguses mass acceptance and is standardized, ican be produced with unshlle labor, (¢) comparative advaniage Sifts to cheap-labor nations alter the produc is standardized; (4) all ‘of the above. Ans. (d) See Section 45. nations, then trade in al good is (a) possible, (b) impossible, (c} reversed, (d) cannot say. Ans. (b) See Section 4.6. [stew ‘Which of the following siatements is not true with respect to transportation costs? (a) The price of the tnaded ‘commodity in the importing nation exceeds the price of the came commodity in the experting nation by the cost of transportation, (4) Some commodities are not traded because of transportation costs. (c) Consideration of trans~ oration costs invalidates the H-O theory. (d) Transportation cost is not what distinguishes international from interregional trade. ‘Ans. (¢) See Section 4.6 and Problem 1.2(0). BNY oy 1 te cost of transporting a good between tonal exceed the pezade dfertoe for good betwee he two Solved Problems ‘THE HECKSCHER-OHLIN THEORY 4.1 (a) Identify the conditions that may give rise to trade between two nations. (b) What are some of the assumptions on which the Heckscher-Ohlin theory of trade is based? (c) What does this theory say about the pettcm of trade and effect of trade on factor prices?CHAP. 4] ‘THE HECKSCHER-OHLIN THEORY AND EXTENSIONS 6. 42 43 (@ Trade can be based on a difference in factor endowments, technology or tastes between two nations. A ifleence ether in factor endowments or technology resuks in a diferent production possibilities curve for each nation, which, unless neutralized by a difference in uses {sce Problem 2.18(6)), leads oa difference in relative commodity price and mutuelly beneficial trace (see Problem 2.16). Iftwo nations face increasing costs and have identical production possibilities curves but different tastes, there will also be a difference in relative commodity prices ané the basis for mutually beneficial ade betwesn the two nations (sec Problem 2.21), The difference in relative commodity rice is then translated into a difference in absolute commodity pices berween the two netions, which isthe immediate eause of trace (see Problem 1.20) (The Heckscher-Ohlin theory (sometimes referred to a5 the madam theory-—as oppesed to classical theory — of international made) assumes thet nations have the same tastes, use the same techaclogy, face constant relums fo scale (.., 8 given perceniage increas i ll inputs increases ouput by the same percentage) bul differ widely in factor endowments, I also says that inte fae of identical tastes or demand conditions, this dffernce in facor endowments wil result in a differeace in relative factor peves between nations, ference in relave commodity prices and trade (see Example 1). Thos, inthe Heckscher-Ohlin theory, Wve international difference in supply condions alone determines the pattem of trade, To be noted is thatthe two nations need nat be identical in other respecs in order for interaaional trade to be based primarily on the difference in ther factor endowments (306 Section 3.2 and Fig. 3-2). (© The Heckscher-Ohlin theorem postulates that each nation will export the commodity intensive inits relatively ‘bundant and cheap factor and import the commodity intensive in its relarvely scarce and expensive factor. AAS an important corollary, i€ adds thet under highly restrictive assumptions (see Problem 2.33(c)]. wade ‘will completely eliminate the pretrace relative and absolute differences in tho price of homogeneous factors ‘mong nitions. Under less restrictive and more usual conditions, however, trade will reduce, but not climinate, the pretrade differeces in relative and absoluie factor prices among nations (see Problem 4.3). In any event, the Heckscher-Ohlin theory does sey something very wseful on how trade affects factor prices and the distribution of income in egch nation. Classical economists were practically silent on this point Suppose that (1) the capital-labor ratio (Le.. KIL) to produce unit of wheat is greater than the K/L, fo produce | unit of cloth (i.c., wheat is K-intensive relative to cloth) in both the U.S. and the U.K.. (Q) the ratio of total capital to total labor available in the U.S. is greater than in the U.K.; (3) the laste for wheat and cloth is the same in both nations; (4) each nation faces increasing costs of production; and (5) the same technology is available to both nations. (a) Indicate how the U.S. production Possibilities curve would differ from that ofthe U.K. (6) In which nation isthe price of capital (i.e., the interest rate, r) relative to the price of labor time (i.c., the wage rate, w) lower? Why? (c) Which nation in isolation will have the lower equilibrium Pu/P P, by the cost of transporting OH units of elit from the U.K. fo the U.S, This equals FG of wheat. Viewed in terms of wheat, vee can say that the U.S. exports FA of wheat ai PylPe = Py while the U.K. imports GH of wheat atthe higher PudP of P PyiPeof Py > PuiPe Of Py by the cost of transporting GH of wheat from the U.S. tothe U.K. This equals FG of wheat. Tho introduction of transportation costs also reduces tne volume of wade (see Fig. 4) Needless to say, the genetal equilibrium approach which measures transportation costs in terms ofthe amount of 4 commodity is very awkward. A better and simpler method is by the paral equlibviwa approcch discusses in. Problem 4.15.Chapter 5 Dynamic Factors in International Trade: Growth and Development 5.1 DYNAMIC FACTORS So far, we have assumed that each nation has given and unchanging factor endowments and technology (hence a given production possibilities curve) and given and unchanging tastes (hence a given community indifference map). On this premise, we examined the basis and the gains from trade, However, over time, a nation’s factor endowments change and its technology may improve. These changes cause its production possibilities carve to shift. Similarly, a nation’s tastes may change and result in a different indifference map. All of these changes affect the terms of trade and the volume of trade. How much these arc allered depends on the actual type and degree of the changes occurring. 5.2. GROWTH IN FACTOR SUPPLIES THROUGH TIME. If techrology, remains the same but the factors of production available to a nation increase, the nation’s ‘production possibilities curve shifts outward, This shifts uniform or symmetrical (so that the new production ‘possibilities curve has the same shape as the old one) if labor and capital grow in the same proportion. This is called balanced growih. If only the nation’s supply of labor increases or if its supply of labor increases Proportionately more than its supply of capital, then the nation's production possibilities curve shifts more along the axis measuring the L-intensive commodity than along the axis measuring the K-intensive commodity. ‘The opposite shift occurs if only the nation’s supply of capital increases or if its supply of capital increases proportionately miore than its supply of labor. According to the Rybczynski theorem, at constant relative commodity prices, the growth of only one factor leads to the absolute expansion in the output of the commodity using the growing factor intensively and to the absolute reduction in the output of the commodity using the nongrowing factor intensively. EXAMPLE 1. If only the supply of labor increases inthe U.K., or ifthe supply of labor increases proportionately mere ‘han the supply of capital and its techoology remains the same, then the UL.K."s production possibilies curve or ans- {ormation curve in Fig. 2-3 might shift cuward from TT to T’T” as shown in Fig, $1. Note tht the shit is greater slong the horizontal axis, which measures cloth (the L-infensive commodity) than along the vertical axis, which mescaes whaat (the K-intensive commodity). The shift along the cloth ani in Fig, $-1 is exaggerated for pedagogical reasons. Even if the supply of labor alone increases in the U.K., the U.K. production possibilities curve will nevertheless shift slightly upward since labor is also used in the production of wheat (ihe X-intesive comsnodity). However, sccording to the Rybozynski theorem, the output of cloth would rise while de ouput of wheat would fill in the U.K. at constant P/Pw, Fr the effect of other types of factor changes on the production possbiides curve of the U.K. and the U.S. and for ‘graphical iusiations and an intuitive proof of the Rybezyaski theorem, soe Problems 5.5 to 5.8. 5.3. TECHNICAL PROGRESS ‘Technical progress increases the productivity of a nation’s factors of production and has the same generel effect on the nation's production possibilities curve as an increase in the supply of its factors. There are at least three types of technical progres70 DYNAMIC FACTORS IN INTERNATIONAL TRADE [cHaP. 5 Fig. 5 (1) K-saving technical progress throughout the economy increases the productivity of labor proportionately more than that of capital. As a result, L is substituted for K in production at constant wir, and K/L falls in the production of both commodities. This means that a given output can now be produced with fewer units of Z. and K but also with lower K/L (higher Z/K). K-saving technical ‘progress is equivalent to a proportionately greater increase in the supply of labor than of capital (with unchanged technology), For example, X-saving technical progress in the U.K. equally appli cable ta cloth and wheat production might cause an outward shift in the U.x. production possibilities, curve from TT to T'T’ in Fig. 5-1. Note that technical progress is defined at constant wir, and constant returns to scale are assumed in production. (2) Lesaving technical progress ‘s exacly the apposite of K-saving technical progress (see Figs. 5-4 and 5-7). @) Neutral technical progress increases the productivity of L and K by the same proportion and results in a uniform or symmetrical outward shift in the nation’s production possibilities curve (see Figs. 5-5 and 5-8). 5.4 CHANGE IN FACTOR SUPPLIES AND TECHNOLOGY, AND TRADE ‘When there is an increase in @ nation’s supply of factors of production and/or technical progress, the nation’s production possibilities curve shifts outward. With unchanged tastes, this causes a change in the terms of trade, the volume of trade and in the distribution of the gains from trade between the two nations. The actual result depends on the type and degree of the changes occurring. EXAMPLE 2, In Pancl A of Fig, 5-2, we see that before any change in factor endowments and/or technology. the U.K. produces at point 8 on TT, exports 6OC for 6OW, and consumes at point & on TH (as in Fig 3-2). This gives point E on the UCK. offer curve in Pane! B (as in Fig. 3-3). With unchanged tases and at she same terms of trade of Pr but after TTT shied to T'T’, the U.K. would like to produce at point Mon T'T’, export 150C for LSOW. and consume at point U on VIL. This gives point U on offer curve U.K." in Panel B. f nothing changed in the U.S. (So that the U.S. offer curve in Panel 6 of Fig. 5-2 is the stan as that in Fig. 2-4), we sce that at Ps the U.K. would like to export more ofits Me awe we moe Coot aw Fig, 5:14DYNAMIC FACTORS IN INTERNATIONAL TRADE IcHaP. 5 5.13 Starting wilh (he U.S. free-trade position in Fig. 3-2, (a) draw a figure and explain what happens 5X8 if TT shifts to T’T’ for the U.S. as shown in Fig. 5-8, and if, as income rises, the U.S, continues t0 consume wheat and cloth in the same proportion. (b) How would the result in part (a) differ if the USS. decided to consunie 110C at Pp, after ts TT curve shifted to'T’T’? (c) What if the U.S, decided (2) AU Py and with T°T’ in Panel A of Fig. 5-15, the U.S. would lke to produce st point 8" on TT’ and consume at point £ by exchanging about 72W for 2C. This gives point" on offer curve U.S." in Panel B. Since at Pa, the U.S, wants to wade more shan the U-K. i willing to trade (See Pare B), the U.S. tems of te deteriorate from IP to UP. Pes given by the new equilibriure point /*, where the unchanged U.K. offer curve crosses offer curve U.S." (ee Pane! B). Thus, the U.S. would cad vp producing along TT to the sight of B", where Py’ is tangeat to T'T’ (oot shown in Pancl A) and exchange about 71W for 61C (see point F* in Panel B) so as to consume befow pain. along the ray from the origin through points FE and E* (22 Panel A). "eee it ve a oe bw om » a a me we Rig. 515 (0) Whe U.S. decided to consume 110C (and 100W; see point V in Panel A). at Fo, the U-S. would produce st point B* in Panel A and would exchange GOW for 60C, the same as before TT shifted to TT" (because EV is parallel w B'B” and so B'E = B°V). In his case, the U.S. offer curve would remain unchanged « the result ofits neutral technical progress or proportional increase in its supply of labor and capital. Thus, the terms of trade, the volume of trade and the gains from rade would remein completely unchanged after this type of growth in the U.S, This is possible but unusual. Ifthe U.S., on the other herd, decided ¢o consume less then L10C and more than 100W at Ps (ic, to the lefe of point V oa Py in Pane! A), the U.S. would want to trade less than 6OW for 6OC and its terms of trade would improve, The rest is qualitatively identical to Z-saving technical progress in the U.S. Note that if te U.S. consumed less than 100C (and mote than 110W) along Pa in Panel A, it would mean that cloth is awinferior good forthe U.S. since the U.S. would be consuming less cloth than at point E (je, before growth occurred and real income rose inthe U.S.). © (a) How do Problems 5.9 to 5.13 bring forth the general equilibrium character of our trade model? (b) How can we analyze the effect of more than one change in the conditions of production occurring simultaneously in one or both nations?Ex tine LWUBO WuRee CHAP. 5) DYNAMIC FACTORS IN INTERNATIONAL TRADE. 83 $5 (@) The gencral equilibrium character of our basic trae model is brought forth bythe fat that we taced the effect of change in the condition of production in one nation onthe (erms of unde, the volume of trade, ‘the Tove of consumption and the distibuton of tie gains between the WWo nations. (®) Soar, we have used comparative statics to trace the effect ofa single change inthe conditions of production ina single nation. However, it should be obvious that we can extend ths type of analysis fo examine the effect of more then one change occuring simultaneously in one or both nations. For example, if changes in both factor endowments end technology escur in one or boih aains, we can find thie net effet on cach nation’s production possibilities and offer curves. The point where these new offer curves czoss will -deversine the sax terms of ade and equlhrim volume ef tade, We could theo gp back 10 each nation’s production possiblities curve ( find its new equilibrium point of production and consumption. (a) Discuss what would happen if at the same time that there is E-saving technical progress in the U.K. that shifts the U.K. offer curve to U.K." in Panel B of Fig. 5-11 the supply of capital or the supply of labor also increases in the U.K. (while nothing changes in the U.S.). (b) Draw a figure and explain what happens iat the same time that there is L-saving technical progress in the U.K. that shifts the U.K. offer curve t0 U.K," in Panel B of Fig. 5-11, K-saving technical progress also occurs in the ULS. that shifts the U.S. offer curve fo U.S.’ in Panel B of Fig. $-12. (2) fin addition tothe L-sving tecnica! progres, the supply of capital aso increases inthe U.K., the U.K. ‘offer curve would shift othe let (past offer curve U.K") and intersect the unchanged U.S. offer curve 0 ‘he left of J” in Panel B of Fig. 5-I1. Thus, tho new U.K. terms of trade will be better tran Por and the ‘volume of trade even less than that indicated by point J. Therefore, L-saving technical progress end the simultaneous increase in the supply of eapoa! in the U.K. operate in the same direction and reinforce each other. On the other hand, an increase in the supply of Inbor in the U.K. operates in the opposite direction as the L-seving technical progress. Thus, the U.K, offer curve would move back to the right from offer curve U.K.", How far back depends on how much the supply of labor iccreses in the U-K. In cther ease, once the new equilibrium terms of trade ae established, we can determine on the new U.K. production possibilities curve its new equilibrium point of production, and, with the use of the nation’s indifferenes zap, Its new cqulibitzn point oF consumption. (H) In Fig, 5-16, offer eure U.K." crosses offer curve U.S.’ at point Z. Thus, the new terms of trade remain at Py for the U.K. and at Py for the US. while he volume of trade dwindles to 15C for 1SW (rom OW for 60C at point E, before the technical progres in tho U.K. and the U.S.). From Panel A of Fig ‘5-11, we can then see that in the U-K., the new production point is ton T’T" while the new consumpsion polat is at Z on 1V. From Panel A of Fig. 5-12, we see that the U.S. aow produces at N' at T°T” and ‘onsumes at on TV. Note that these Mbinsed iomovations in the U.K. and in abe OS. reduce the U.K. ‘comparative advantage in cloth and the U.S. comparative advactage in wheat, and if they continue to occur, they could conceivably reverse the patem of trade between the two countries, OF cour, Ue same thing ‘would evestually happen if, dheough time, the U.K. supply of capital continued to grow proponicnately ‘more than its supply of labor, while the opposite occured in the U.S. Other simultaneous changes in the ‘onctions of preduction in both nations could be sinitaly analyzed CHANGE IN TASTES AND TRADE 5.16 (a) Explain how a shift in tastes fromm wheat to cloth in the ULK. affects the U.K.'s indifference map. (b) From Fig. 5-3, draw a figure showing the points of production and consumption in the U.K. before the change in tastes deseribed in part (a), and afer. (@) Te wheat is measured along the vertical axis and cloth along the horizontal axis, a shift in tastes from wheat {o cloth in the U.K. will cause the community indifference curves of the U.K. t0 shift down and (0 the right and become steeper. They shift down and to thé right because at each level of real income and unchanged Pe/Pw, the U.K. demands a smaller quantity of wheat and a larger quantity of clah than before, ‘They become steeper (.c., MRScw rites in the U.K.; see Section 3.1) because cloth is now worth more in terms of wheat than before to the U.K. If on the other hand, the U.K, tastes shifted from cloth to wheat, the U.K, incifference curves would shift up and to the left and become falter. In any event, when tastes84 DYNAMIC FACTORS IN INTERNATIONAL TRADE (CHAP. 5 Big. 5-17 change, «nation's indiference curves change shape and cross te original inference curves of he ration (Ge, thot referring othe conditions befor the change nase) This makes welfare comparton imposible (@) in Fig, 517, the UK. produces at pont B, exchanges 60C for GOW, and consumes at pont on I (es in Fig. 3.2) before the chang of ass. This is how point Ein Fig, 5.3 was derived. Sings the U.K. tastes ‘shifted from wheat to cloth, the U.K. demands a smaller quantity of wheat and a larger quantity of clath than tee at unchanged income and PlPy. This wil enuse Fey (ve, tke WK ers of tae tose, thot modern the decline f the quay of when and the increase Inte quality of lth demanded by the UK. pe ine pedod. From Fig. 5:2, we know Ga Yi the new and higher U.K. rms of tee and that the UK. exchanges 20C for 4OW atP. Thus, the U.K. musi be producing st plnt Gand consuming 2 pont in Fig, 517. ALP, a now common inference curve, whichis boo othe ight and Seper than HL, mast be tangeat to Pr. Sine Wand I are pat of to afferent U.K. indifrence maps {Aree (o before the change in astx inthe U.K., and Mtoe) ve cannot ceteris the effect of the change in sts on the welfare ofthe UK. (ie, wheter J” 2). Nowe tha since the U.K. texhnology an supply of factors emsined unchanged, the UK. production posibies carve has oot changed. 5.17 Starting with the original U.K, and U.S. offer curves that eros at point £ in Fig. 5-3, draw a figure and explain what happens if the U-K, tastes shift from cloth to wheal, while there is no change in supply or demand conditions in the U.S. y . bw oe a a We We wie ie we OoCHAP. 5) DYNAMIC FACTORS IN INTERNATIONAL TRADE 85 IE the U.K. tases shit from etoth to wheat (ther things being equal), offer curve U.K. in Fig 53 shits down or rotates clockwise, say to offer curve U.K.* in Fig. $-18. This happens because the U.K. now wants ‘wheat more intensely and is willing to offer more ofits cloth than before foreach quanty of wheat imponed or, equivalenly, the U.K. requires less wheat imports foreach quanly of cloth exported than before. This causes the volume of trade to rise and the U.K, terms of tre to fall. In Fig. 5-18, the volume of trade rises from 60C for 6OW to 140 for 70W, and the U.K, terms of trade decline from Py to Pc. However, we cannot determine ‘whether or not the U.K. is beter off now than before (i.e., whether RB E) Point i in Fig. 5-18 isto be contrasted with point R in Pane! B of Fig. 5-2, which was also reached by the ULK. exchanging 140C for 70W, but which resulted from a change in the conditions of production inthe U.K. ‘with unchanged tastes. Since lasts were unchanged in Fig, 5-2, we were ablo to determine that R > E. Note, however, thar the assumption of unchanged tastes in the U.K. in te fae of significant changes in is production Conditions is unrealistic. We made that assumption in Example 2 in order o isolate the effect of only one change, before moving on to the more complicated cases of muliple changes, 5.18 Starting with Ue original U.K. and U.S. offer curves crossing at point E in Fig, 5-3, draw a figure and explain what haypens (1) if the U.S. tastes for cloth decline and/or tastes for wheat increase, while there is no change in the U.K. and (2) if the U.S. tastes change in the opposite direction. If U.S. tases for cloth detine alo tastes for wheat increase (ther ings being equal), the US, offer carve in Fig. 5-3 shits down or routs clackwite, say to offer cure U.S." in Fig. S19. This is because the U.S. now waats clot les intensely end i wiliagto offer les fis wheat than before foreach quantity of eloth imported or, equivatently, for each vant of whest exported, the U.S. now requires more cloth. With offer curve U.S." in Fig. 5-19, the volume of ade declines fram GOW for 60C to 20W for AOC (eee point J) end the ULS. terms of tide improve from I/Py = 1 to /Pq = 2, but we cannot tell whether J 5 E for the U.S. If the opposite changes occur in U.S, tases, the U.S. offer carve rotates inthe opposite diesion. Hit moves to offer cave U.S.* in Fig. 5-19, the volume of trade ies to 1éDW for 7OC (ve point H) and the U.S. terms of trade decline 1 1Pa = V2, but once aptin, we cannot say wheter Hf B & forthe U.S 5.19 (a) Draw a figure and show what happens if, because of a change in tastes, offer curve U.K. shifts to offer curve U.K.* (as in Panel B of Fig. 5-2), while offer curve U.S. shifts to offer curve U.S.* (as in Fig. 5-19). (b) What would happen if at the same time that tastes change in the U.K. and the ULS., the conditions of production also change in both netions? Treperr © . os tm me ae uae ee on « = em me we mo Fig. 6:19 Rig. $205.20 DYNAMIC FACTORS IN INTERNATIONAL TRADE ICHAP. 5 (e) In Fig, 5-20, we see that with offer curves U.K.* and U.S.*, 150C are exchanged for 1SOW between the UK, and the U.S. at Pe/Pw = Po = 1, Other simultaneous changes In tastes in te U.K. and jn the U.S. can be similarly examined. (®) I tastes, factor endowments and technology change at the same time and in both nations, anything ean ‘happen (even the pattern of trade can be reversed) and ur comparative statistics approach would become, ‘very complicated, if not impossible. (a) Draw a figure and explain what would happen if because of changes in tastes, offer curve U.K. of Fig. 5-19 shifted to offer curve U.K.’ of Fig. 5-3, or to offer curve U.K.* of Fig. 5-20, and the ULS. offer curve was a straight-line ray from the origin with a slope of I and remained unchanged. () What general rule can you deduce from Example 3 and Problems 5.16 to 5.20(a) as to the effect of changes in the nation’s tastes on the votume of trade, on the nation’s terms of trade and on its welfare? (a) A straight-line U.S. offer curve asin Fig, 5.21 would mean thatthe U.S. is willing to expoct any quantity ff wheat at PyiPtc = PolPy = 1 (ie. the U.S. offer curve is infinitely clastic). Thus, with offer curve U.K., England exchanges 6OC for 6OW with the U.S. at Po/Pu = 1 (soe poim F in Fig. 5-21). With offer ‘curve U.K.", England trades 15C for 15W at Pc/Py ~ 1 (see pia), and with offer curve U.K,*, England ‘wades 150-C for 1SOW also al PciPw = 1 (see point U). The terms of Wade would also remain unchanged. {for both nations (but the volume af trade would change) ifthe offer curve of a very small nation shifted in ‘auch @ way a6 {0 continue to intersect the straight-line segment of an olberwise bending offer curve of a very large nation (the reader is teft lo skeich this out for him- or herself, stating with « figure such as Fig. 317). Fig. 5.21 (®) If a nation shifts from its imporable 1 its exportable commodity, the volume of wade declines and the nation’s terms of trade improve—anless the offer curve of its trade partner is infinitely clastic (see Figs. 5.3, 5-21 and 5-19), With the opposite changes inthe nation’s tases, the results are the reverse (sce Figs. 5-18, $-19 and 5-21). In either case, however, we cannot determine Whether the nation is bewer off after the change in tastes than before (see Problem 5.16 and Fig. 5-17 DYNAMIC FACTORS, TRADE AND DEVELOPMENT 5.21 (a) Explain why LDCs in general feel thal traditional trade theory is irrelevant as a guide to development. (6) How would you counter such a charge?CHAP. 5] DYNAMIC FACTORS IN INTERNATIONAL TRADE 87 5.22 5.23 (@) LDCs attack traditional trade theory as completely static. More specifically, they Fel that taditonal trade ‘theory might be useful to determine a nation’s comparative advantage and pattem of tage under existing conditions, Bul development involves changing, not adjusting to existing conditions, and for ths, a truly ddynomie theaey is equised, For example, with the present distribution of factor endowments and technology between LDCs and DCs, toitional trade theory prescribes that LDCs should continue to specialize inthe rodection of and export raw materials, fuel, miners and food 10 DCs in exchange for manufactured products. LDCs feel tht though this trade pattem may maximize their welfre in the short ron, it would continue o relegue them to subordinate position vs-ivis DCs and would prevent them ftom reaping the dynamic benefits of industry and from maximizing their welfare and development in the long run. (8) ts te that waitional trad thoory is stati jn mature. However, it can readily be extended to Incorporate changes in factor endowments, technology and tstes by the technique of comparative statics, as shown in this chapter. What this means is tht a nation’s comparative advantage and trade patiem are nat determined ‘once and forall, but must be recomputed asthe wnderlying conditions change or are anteipated to change. ‘Thus, LDCs are not necessarily relegated by vaditional ade theory vo be exporters of primary commodities and importers of manufctured goods. If capitst zccumulation, the scquisiton of skills and vchnology proceed faster in some LDCs than in ether nations their comparative advantage will eventually skifi away from primary products (0 simple manufactured goods fst and then to more sophisticated ones, This process «aay be occuring today in Brazil and in many other LDCs, Thus, comparative statics ean cery us a long, ‘way toward incorporating dynamic changes in the economy into traditional trade theory. However it must tbe recognized thet this is still far short of « truly dynamic trade theory. State briefly the problems which LDCs face in their trade relations with DCs and the ways in which they seek to overcome these problems. {A} “Though the empirical evidence available gives conflicting resute, LIC belive that in general (end except for petcoleumexporiag LDCS), they face declining terms of trade. They have thus banded together to demand higher prices for tbeir traditional exports. (@) LDCs complain that their export prices and export receipts Auctane ta9 widely, and that dis hinders their ‘development plans. Eropiical evidence seems 10 support ther fist contention, but thexe are conflicting results as to the second. In any evenl, LDCs advocate so-called international commodity agreements 10 sabilize their export prices and receipts. These are in general very expensive to operate and often uaman- ageatle, There ae oaly afew of them presently in operation. (3) Since LDCs’ demas (or manufactured imports increases faster than their eamings from primary exports, LLDCS feet the need 10 industiaize. Most LDCs belleve that the autural way to begin their process of industalzation is heough import-subsutution, ()_DCsin general give a great deal of protection (see Cheplcr 6) to their relatively simple E-intensive industries such as textes, shoes, bicycles, cic. These are the industies in which many LDCs already have ot can soon be expected to achieve a comparative advaniage, ‘Therefore, LDCs advocate that DCS impor these ‘commas from them on a preferential basis. (5) LDCs believe hat he international monetary system was created by DCs primarily to reflect and serve DCS" seeds. Araong the reforms that LDCs are asking is the distribution of new international monetary reserves {to LDCS so that they can spend them on development (see Seeton {2.7) ‘Most of these demands, including the demand for increased foreign sid (which in recent years has stagnated), are pat of LDCS" cal fr a New fntemational Economic Order (NIEO). A nation’s commodity or net barier terms of wade, N = (Py/Pyq)100, where Py. is an‘index of export prices, Py¢ is an index of impor prices, and we multiply by 100 in order to express N as & percentage. IF we take 1990 as the base year (N = 100) and we find that by the end of 1991 a nation’s Py has fallen by 5% (lo 95) white its-Pyq has risen by 10% (10 110), (a) determine by how much N changes for this nation during 1991. (b) IF during 1991, this nation’s export volume index increased by 20% (from 100 to 120), determine by how much this nation’s capacity to import chenged during 1991. + (2), Since = (Pa/P,)100 = (95/110)100 = 86.36, this nation’s terms of trade declined about 14% during 1991,5.24 5.25 DYNAMIC FACTORS IN INTERNATIONAL TRADE (CHAP. 5 (6) Aan cect igen (ee PP tie hae Qe er Spe ln 12a, = oxaonian = 3.68 imeem ng 9), sn’ cy ie ty 3408 cer 1980 oe ag Pipers ray npr ra ee yl pon oes o rel Dae ance A nation’s single factoral terms of trade, S = (Px/Px) *Zxy whore Zy is an export productivity index. If during 1991, the productivity of the ation in Problem 5.23 rose by 30% (from 100 to 130) in its export sector, (a) determine how much $ changed for this nation during 1991. (6) Which of the different terms of trade defined here and in Problem 5.23 do you think is most significant for a LDC? (a) Since 5-2-2 = oxsqus9 = 2 jn 1991, the nation gets 12.27% more imports per unit of factors of production embodied into its exports than in 1990, ‘Thus, Uke nation is better off, even if it shares the benefit of the productivity increase in its ‘export sector with its trade partner, This concept of single factoral terms of trade could be extended to Aefine the nation's double factoral terms of trade, D = N/(ZxfZs). where Zqy is an import productivity Index. Thus, D measures how many units of domestic factors embodied jn this nation’s exports exchange. Der unit of foreign factors embodied into this nation’s imports. (©) Of the four differnt terms of wade defined (Le., N, 1, $, D), D is the most cumbersome and difficult to ‘measure. In addition, it does not seem very relevant and so itis rarely, included here for the sake of completeness), The niost relevant, especially for LDCs, are S and f, but itis 1 that is used most often because itis the simplest 10 calculate. Indeed, N is often referred fo simply as tbe “terms of trade. However, as we have seen in Problems 5.23 ang 5.24(a), 1 cam deteriorate at the sume time as f and $ are improving. This situation is normally interpreted as being beneficial of the LDC. Obviously, the mast favorable situation for a LDC occurs when W, F, S and D all improve. (a) Explain how intemational trade operated as an “engine of growth” for the “regions of recent settlement” (such as the U.S., Canada, Argentina, Uruguay, Austrlia, New Zealand and South Arica) in the 19th century. (6) Explain from the supply point of view and (c) from the demand point of view, why internetional trade is not an engine of growth for today's LDCs. (a) Inthe 19% century, workers with various skills and capital moved in great waves from the highly populated areas of Europe io the mostly empty and naturalresouree-rch lands in the “new world.” This, together ‘with avery epily rowing demand for food and raw mesial, particularly from industrializing bu resaurce- poor England, resulted in rapid and sustained expor-ied growth in the economies ofthese new tends. Thus, international trade was truly an engine of growth in these new lands in the 19th century (B) Today's LDCS believe that this experince is no) applicable t0 them in che 20% ceatory. Or the supply sida, they cite the fact thet today's LDCs are in general overpopulated and resource poor (except for some petroleum-exporting LDCS) and so even ifthe demand fr food and raw materials were growing very rapidly, they would be unable to expard their outputs of these products greally and thus experience significant exported growth, (€) More importantly, LDCs feet that the world demand for food and some raw materials is not growing as rapidly today as it grew for the regions of recent setlaent in the 19th century and as required for expor- led growth. Thoy give several reasons (or this: the income lasichy of demand in DCs for many of the food exports of LDCS is quite low, agricultural protectionism in most DCs; te center of world prodvetion shifted to some extent from resource-poor Europe to the U.S. and Russi both of which are of continental - sie and rch in patra resources; the development of synthetic raw materials such as syietic rubber; new {echnological breakthroughs which increased the amount of output per unit of raw roaterial input (Such as tinepited cans, microcireuts, et.) a more rapid inerease in the output of services than commedites iCHAP. 5] DYNAMIC FACTORS IN INTERNATIONAL TRADE 89 5.26 5.27 DCs. For these reasons, today's LDCs believe (and to & large extent, justifiably so) that they cannot rely ‘on their exports of traditional products to grow and develop rapidly. Draw @ figure and explain how a LDC can be worse off with free trade after growth than before growth, ‘The LDC in Figs $-22 produces and consumes at point A on TT and 1 in autarky and before growth, With free rade and terms of trade of Pq, the nation produces at point B on TT and consumes at point E en Ul. The movement from A to E represents the LDC's gains from trade before growth, With export-biased grow, the LDC produces at point F on TT’ and eonsirees at point G on Ul, Since G < E, ute LDC is worse off with free twade after growth than before. This is refered to as immiserizing grawoh. limiserizing grove occurs only rarely, when as a result of X-biased growth in tae LDC, the terms of trade of the LDC deteriorate so much that the LDC ‘exports more than the eatire benefit of ts growth (compare Fig. 5.22 with Fig. 5-2, where R > E and we did ‘not have immiserizing growth). ° T ¥ c Fig, 5.22 ‘ration of multinational corporations (MNCS). These are firms that own, control or manage production facilities in several countries. With regard to MNCs, explain (a) the reason for thcit existence, (b) some of the alleged problems that they create for the home country and (c) some of the alleged problems that they create for the host country, {@) The basio reason for the existence of MINCs is the competitive advantage that they have over other forms of economic organization based on economies of seale in production, financing, research and development (R&D), and in gathering market information, resulting from a global network of production and distribution, Today, MNCs sccount for over 20% of world output, and the trade between the pacent finns and thoit foreign affilistes accounts for more than 254% of world trae in manufactured goods. (®) The most controversial of the alleged harmful effects of MNCs on the home nation is te toss of domestic {obs resulting from forvign direct investments. However, it must be pointed out that the home nation may have lost some of these jobs anyway to foreign competitors. A related problem stems from the expon of ‘advanced technology. Countering this harmful effect, however, is the tendency of MNCS to concentrate their R & D in the home nation. Finally, easy accessibility of MNCs to the intemational capital market reduces the effectiveness of domestic monetary policy. (©) Host countries have even more secious complaints against MNCs. First isthe alleged domination by the MNCS of the hosts" economy. The largest MNCs have yearly sales greater than the GNP of all but 2 hand of nations. Its furher alleged that MNCs absorb local savings and local enteeprencural talent, use exces- sively X-intensive production techniques inappropriate for developing nations and do not trin focal labor. Most of these complaints are to some extent true especially for host LDCs and have led these nations to regulote foreign direct investments inorder to mitigate te barmfel effects and increase the possible benefits.90 DYNAMIC FACTORS IN INTERNATIONAL TRADE, (CHAP. 5 5.28 (a) In'what way can the economic decision to migrate (o other nations be regarded as an investment in human capital? (b) Wheat are the effects of international labor migration on the nation of immigration? (c) What are its effects on the nation of emigration? (a) The ccosomic decision o migeate can be regarded as an investment in human capital because, just as any other investment, it involves a cost (tansporation, job search and 80 on) and confers certain economic ‘benefits (the higher earings over the remaining working life ofthe migrant beter education opportunities for the migrants children and so on). (b) Migration generally increases the output of the nation of immigration While it prevents real wages from being as high as they would have been in he absence of immigration. For this resson, immigration 1s severally oppose by organized labor. Since migrants are usually young workers, the age siucture of the sation of immigration improves, Ce) Migraion reduces output and increases real wages in the nation of emigration (unless the migrants were tmnemployed ar act part of the labor foree in the nation of emigration). To the extent that emigrants arc young workers, the age structure ofthe nation of emigration worsens. Since the 1950s and 1860s, concern ias increased about the great number of scienists, technicians, doctors, nurses and other highly silted personnel migrating from LDCs to DCs and from Europe to the U.S, This is refered to a8 the brain drain. ‘The problem arses because the nation of emigration incurs the cost of taining these workers but the benefits acerve to the nation of inmnigration. This is of particular concer to LDCS, which have a great need for skilled people.Chapter 6 Trade Restrictions: Tariffs and Other Commercial Pol 6.1 RESTRICTIONS ON THE FLOW OF INTERNATIONAL TRADE ‘So far we have established that free trade is beter than autarky for each nation. However, a nation can try to increase its welfare at the expense of other nations by restricting trade. Trade restrctioas are classified as tariff and ontariff. The ad valorem import tariff has received the most attention. This is expressed as a percentage of the value of the imported commodity and is usually imposed to limit the volume of imports. ‘An import quota is a direct quantitative restriction on the importation of a commodity and has many of the effects of an import tariff (See Problem 6.9). Tariffs have generally declined since World War Ul and are now ‘only about 6% on manufactured goods [see Problem 6.21(c)]. Since the mid-1970s, however, the number ‘and importance of nontariff restrictions on trade of new protectionism in the form of voluntary export restraints, technical, administrative, and other regulations have incrcased significantly (see Problem 6.3). Trade in agricultural commodities is also subject 10 many direct quantitative, restrictions and other nontariff trade barriers. 6.2, PARTIAL EQUILIBRIUM ANALYSIS OF TARIFFS ‘The effects of a tariff can be studied with partial equilibrium analysis when the industry and the nation are ‘scball. Partial equilibrium analysis of a tariff shows: (1) that a tariff usually results in a higher domestic price for the importable commodity, lower domestic consumption, higher domestic production and thus smaller imports of the commodity; (2} the revenues collected by the government; (3) the redistribution of income from consumers (who must pay a higher price for the commodity) to producers (who receive the higher price) and from the nation's abundant factor(s) of production, which produce exportables, to the nation's soarce factors, which produce import-competing products; (4) the inefficiencies, called protection costs, resulting from the tariff. Aig. 61 EXAMPLE 1, Assume that in Fig.6-1 De stands forthe U.S. demand for loth and Sc forthe U.S. supply of cloth (the imporble commodity of ti US.) and that te cloth industy and the U.S. ae stall. At the free-trade price of cloth of SU, the U.S, demands 70 units of cloth (FB), of which 1O units reproduced domestcelly (FG) and the semaindet aL92. ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES [CHAP. 6 ‘of 60 units (GB) is imported. ‘The horizontal dashed line Se represents the infinitely elastic free-trade foreign supply of cloth tothe U.S. If he U.S. imposes a 100% ad valorem cif on the importation of cloth, then Pe = 32 (01) inthe USS. At Pe = $2, he US, demands 50€ (JH), of which 20 units (14) are produced domestically and 30 (42) are imported. Th horzonal dashed line Sey rpresents the eew tart inelusve foreign supply curve af cloth tothe US, “Tous. the consunption effect equals ~20C (BR), the production effect equals + 10C (GN), impors decline by 300 (BR + GN} and the government collects $30 in revenue (NHEFR). The consumers” surplus (massved by the sea under the demand curve and above the going pice forthe commodity) is $122.50 (he area of viangle ABF) unde fee trade nd $62.50 (he area of tangle AH) with that uf. OF the S60 reduction in consumers” surplus ($122.50 — 362.50 = area of FJHA), $30 (MER) is collected by the government as tai revenue, $15 (PIMG) is redisubuted to producers in te form of rent (se Problem 6.7), and te cemnining $15 (GMN + BHR) represents the protection cost to the economy (see Problem 6.2), 6.3 NOMINAL VERSUS EFFECTIVE TARIFF RATE So far, we have discussed the ad valorem or nominal tariff on imports. When the demestic import-competing industry uses imported inputs subject to a different nominal tariff rate than that on the final commodity, then the nominal tariff rate differs from the effective protective rate. The latter measures the actual rate of protection thatthe nominal trif rate actually provides to the import-competing industry. The rare of effective protection is the larff on value added and is measured by the Following formula: ' t ai fe where f = the rate of effective protection = the nominal tariff rate on the fina! commodity, @ = the ratio of the value of the imported input to the value of the final commodity i = the nominal tariff race on the imported input EXAMPLE 2, If1 = 100%, = 0.5 and i = 0% (.e., the imported input is allowed in duty fre, then 100% = 0 05 ‘That is, since the imported input represents 50% of the value of the final commodity, a nominal tariff of 100% computed ‘on the value of the final commodity represents a 200% tariff on the valve added of the import-competing industry and ‘gives a measure of the actual or effective rate of tariff protection provided to domestic producers. If had instead equalled 10%, f would have been 20%. The average valucs of | and fon manufactured imports in the world today are about 6% and 9% respectively. = 200% 6.4 GENERAL EQUILIBRIUM ANALYSIS OF TARIFFS ‘Tariff in a Small Nation ‘The imposition of an import tariff by a small mation has the following generat equilibrium results: (1) prices on the world market remain unchanged; (2) the domestic price of the importable commodity rises by the full amount of the tariff for individual producers and consumers inthe small nation; (3) domestic production of the importable commodity rises, while domestic consumption and imports fall in the small nation; (4 the price of the impostabte commodity for the small nation as « whole remains unchanged since the small nation itself collects the tariff; (5) the welfare of the small nation declines; and (6) the real income of the nation’s searce factor increases (this is called the Stolpe-Samuelson theorem). EXAMPLE 3. At the free-trde Pc/Py, = Py = 1 00 the world market, the U.S, (now assumed to be a smal cation) produces at point # and consumes a point E in Fig, 6-2 (asin the right panel of Fig. 3-2, bat omitting for simplicity theCHAP. 6] ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES 2 Fig. 624 ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES ICHAP. 6 primes attached tothe Ioters). Ifthe U.S imposes 100% ad veforem taf on its cloth impos, Pc/Py remains unchanged al the free-trade price of Py = I on the warld market because the U.S. is now assumed 10 be # small nation, How ever, for individual producers and consumers in the U.S., PfPy = 2 (acu ies by the full amount ofthe tsi). At PelPy = Bq = 2, te US. produces a point G and exports 30W (GH) for 30C (HI, of which LSC (HU) goes dzetly 0 USS. consumers and the remaining 1C (1's collected as a aif (in kind) by the U.S. govemment, For the U.S, ‘sa whole, PoP = Pe = I since the U.S, ielf eolleets the wrff. The U.S. consumption point with the tai (pint 1) is givan tthe intersection ofthe two dashed lines and is inferior to the U.S. fee-rade consumption point (pint). Howeter, the el income of labor (the scarce fctor in the U.S.) sses (or an intuve proof see Problem 6.16). ‘Tariff in a Large Nation ‘The imposition of « tariff by a large nation improves its terms of trade, reduces the volume of trade and may improve the nation’s welfare. However, since the improvement in the nation’s position comes at the expense Of its trade partner, the trade partner is likely to retaliate and, in the end, both nations usvally lose. These effects are best analyzed with offer curves (sce Example 4). ‘The Stolper-Samuelson theorem also holds for large nations in the vast majority of the cases. EXAMPLE 4, Assume that both tho U.S. and the ULK. are now large nations and affect world prices. Under free trade, ‘offer curves U.S. and U.K. in Fig, 6-3 cross at point F giving the equilibrium PIPy = Py = 1, at which 60C are ‘exchanged for 60W. If the U.S. now imposes a 100% import tariff on cloth, offer curve U.S. rotates down to offer curve U.S", which is at all points twice as distant from the wheat axis a offer curve US. This happens because with a 100% tariff on cloth imports, te U.S. now wants 100% more, o¢ twice as much, cloth as before for each quantity of wheat ‘exported. With offer curve U.S.', the terms of trade of the U.S. improve to PyiPc = Per = Sfé = 1.25, but the ‘volume of trade declines to 40W for SOC. Ifthe postive effect on the U.S.'s welfere resulting from the better terms of ‘rade overwhelms the negative effect from the reduced volume of trade, the U.S."s welfare will also be greater, Starting from the free-trade postion, as the U.S. imposes higher tariffs the U.S."s welfare will increase up to poict (the optimut tariff) and dectine thereafter. However, since the improved pesition of the U.S. comes at the expense of the U.K., the U.K. is likely to relliatc. If the U.K. imposed a 100% impor tariff on wheat, the offer curve of the U.K. would rotate up and cross offer curve U.S.” at point £*, Then both nations sould be worse off than under free trade (see Problem 6.21). The other effects of the aff are more easily analyzed with partial equilibrium analysis. 6.5 SOME ARGUMENTS FOR TRADE PROTECTION ‘Trade protection is sometimes advocated to: (1) Protect dosiestic labor against cheap foreign labor. (2) Make the price of the imported good equal to the price of the domestically produced good (the “scientific tariff") so as to enable domestic producers to compete with foreign rivals. (G)_ Reduce: domestic unemployshent (by producing at home some of the goods previously imported). (4) Cure a deficit in the nation’s balance of payments (ie., to eliminate the excess of the nation’s expenditites abroad over js foreign earnings) (5) Improve the nation’s. tetins of trade and welfare. | Protect domestic producers against dumping (damping refers to selling in a foreign market at below cost or below the price charged domestically). (7, Allow domestic industries to be established and grow until they become efficient (ihe infant-indusiry argument). (8) Take advantage of oligopoly power and external economies (strategic trade poticy).. (9) Protect industries important for national defense. ‘The first five arguments listed above are generally invalid (see Problem 6.24). The last four can be valid ‘with qualifications (see Problems 6.25 to 6.28).CHAP. 6] TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES os[l 6.6 ECONOMIC INTEGRATION ¢ 7 4 Economic integration refers to the formation of a,free-trade arca, a customs union, a common market oF an economic union among a group of nations. In a free-trade area, all tariffs are removed on trade between the :nember nations, but each nation retains its own tariff rates against nonmembers. A customs union is the same as a free-trade area except that a common tariff rate is applied against nonmembers. A conimon market goes beyond a customs union by also allowing for the free movement of Jabor and capital among the member nations. An economic union goes still further by harmonizing the monetary, fiscal and tax policies of the ‘member nations as well, ‘Most of the theoretical discussion revolves around the customs union, The static welfare effects of a customs union are measured in terms of trade creation and trade diversion. Trade creation results when domestic production is replaced by imports from a lower-cost and more efficient producer within the customs union. This increases welfare. Trade diversion results when imports from a lower-cost supplicr from outside the union are replaced by 8 higher-cost supplier from within: This usually reduces welfare {see Problem 6.30(4)). For a graphic representation of a trade-creating and a trade-diverting customs union, sce Problem 6.31. The dynamic welfare effects are more important and result from greater competition, economies of scale and the higher Jevel of investments made possible by economic integration (sce Problem 6.33). EXAMPLE 5, In 1960, the European Free Trade Association (EFTA) was formed by England, Sweden, Denmark, Switzerlnd, Norway, Ausra and Portugal, The complete elimination ofaifs on trade in industrial goods was achieved in 1967. By far he most successful and talked about ease of economic integration isthe European Economic Communi (BEC) or Common Market. It was formed in 1958 by West Germany, France, Italy, the Netherlands, Betgiam end Luxembourg. The common extemal rif wai-Set athe average ofthe 1957 tails of the six nations. Free trade in industrial goods within the BEC and common prices for agricultural producis ware achieved in 1968. Restrictions oa the” fire movement of boc and capital were reduced by 1970. In 1973, England and Denmark left the BFTA and together ‘with Iretand joined the EEC, Greece joined in 1981 and Spain and Portugal in 1986. The enlarged EEC has a populatior srealer than tha of the U.S. and represents the largest wading block inthe word. The formation of the et wade cretion in industrial goods but nade diversion in agricultural products The static welfare benefits appear to be ‘very Small, The dynamic welfure benefits are presumed to be larger but measurement is very difficult. Recenly many nations in Europe and ALtica have become astociated uth the FEC. So fs, aempts at esonomie imegation in Lain America, Asia and Africa have not been very successful (see Problem 6,34). In 1988, the U.S. negotiated a free-trade. agreement with Cenads. Glossary Advatorem Import tarlfl A tariff expressed as « fixed percentage of the valve of the imported commodity. Import quota A direct quantitative restriction on imports. New protectionism The proliferation since the mid-1970s of such nontariff trade barriers as voluntary export restraints and technical, administrative, and other regulations. Nominal taritf A tariff expressed as a percentage of the value of the traded commodity. Rate of effective protection The actual rate of protection that a nominal tariff rate actually confers to the import-competing industry. It is the tariff on value added. Protection cost of a tariff The real losses in a nation’s welfare because of inefficiencies in production ‘and consumption resulting from a tariff. Stofper-Semuelson thaorem The theorem that postulates that tariff protection leads to an increase in the income of the ntion's scarce factor.> 96 ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES (cHaP. 6 Optimum tariff The rate of tariff that maximizes the benefit resulting from the improvement in the nation's terms of rade against the negative effect resulting from the reduction in the volume of tiade. Dumping The export of a commodity at below cost or its sale abroad at a lower price than at home. Infant-Industry argument for tariffs ‘The argument that lariff protection is required to allow for the establishment and growth of domestic industries until they become efficient and can withstand foreign competition Strategic trade policy Trade policies that « nation can use to increase its welfare by taking advantage of | ‘oligopolistic power and extemal economies. Free-trade area The form of economic integration that removes all barriers on trade arnong members, but cach nation retains its own tariff rates against nonmembers. Customs unlon “The form of economic integration that removes all bariers on trade among member nations and harmonizes trade policies toward the rest of the world. Common market The form of economic integration that removes all bartiers on trade among member nations, harmonizes trade policies toward the rest of the world, and also allows for the free movement of Tebor and capitel among member nations. Economic union ‘The form of economic integration that removes all barriers on trade among member nations, harmonizes trade policies toward the rest of the world, allows for the free movement of labor and capital among member nations, and also harmonizes the monetary, fiscal and ux policies of its members. Trade creation - The replacement of domestic production by imports from a lower-cost producer within the customs union. Trade diversion “The replacement within a customs union of imports from a lower-cost supplier by goods from a higher-cost supplier belonging to the union. Review Questions 1. Whea a nation imposes an impor tariff, (a) the domestic price of the importable commodity rises, (4) domestic consumption of the imporable commodity falls, (¢) domestic production of the import-compeling, commodity increases, (d) the volume of imports ofthe importable commodity falls, (e) all of the above. Ans. (e) See Section 6.2. Sonlex ‘The cost of protection Is equal to the reduction in consumers’ surplus minus (a) the increase in the rent 10 producers, (6) the revenue effect of the tariff, (¢) the increase in rent to producers and the revenue effect of the tariff, Ans. (c) See Example | and Fig. 6-1. Qn apne po nn he ein of coma te cv wi op sey 4s (a) equal to the nominal tariff rate on the commodity, (b) greater than the nominal rate, (c) smaller than the ssa ahanal nwo ‘Ans, (a) That ince a = 0, f = £(6ce the formula in Section 6.3). D4. wit wees tthe fomula for the eeive wit at ia Seton 6.3, we en sey Ut if > Oa > i ten Fan sen Wsrh WIBt ‘ns, (c) See Example 2 and Problem 6.10.cHar. 6) ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES ” $. Which of de following is not a general equilibrium result of the imposition of an import tariff by 2 small nation: (a) prices on the world market remain unchanged; (b) prices for individuals in the nation cise by the foll amount ‘of the tariff; (c) prices for the nation as a whole remain unchanged; (d) domestic production of the commodity falls, while consumption and imports rise; (e) the nation's welfare declines. he StolperSanuelson heorem posta tha he imposition af ea by anton cates he real income of the 2 batons a) sec factor tos, (8) searce oir ily (e) abun Tctor tose) seats and sbundat factors to ‘Ans. (a) See Section 6.4 7. When a nation imposes an import tariff the nation’s offer curve will (a) shift away from the axis measuring its export commodity, (B) shift avay from the axis measuring its import commodity, (¢) not shift, (d} any of the above is possible ‘Ans. (a) See Fig, 63 and Example 4 8. The impo of ning i argon (ely impos he ais em of isan ees the ohne of nde, (0) nonce alos cts of nde ot ces vlan oF tae) wore the = S's nme and etc: vlme fae,” 4) ly mpres ean ors Ws at ees the volane oe ‘Ans, (d) See Seetion 6.4. . 93) The imposition of an import taiff by a nation will increase the nation’s welfare. (a) Always, (6) never, & (©) sometimes. - ‘Ans. (¢) See Example 4 10} The only arguments in favor of 2 tariff which could be vale (when qualified) are (a) protection of domestic Labor against cheap foreign labor, che scientife tariff, and the reduction of domestic unemployment; (b) correction of & deficit in the nation’s bulance of payments and improvement of the nation’s terms of trade; (¢) the infut-industry argument, strategic wade, and protection against dumping and for industries important for national defense; (d) all of the above. Ans, (¢) See Section 6.5 14) The form of economie integration in which the member nations eliminate tariffs on cade among themselves, adopt 12 common extemal tariff wall, and allow for the (fee movement of labor and capital within the union is the (a) free-trade area, (6) customs union, (c) common market, (4) economic union. Ans. (¢) See Section 6.6. ‘When impons from s lower-cost supplier from outside the union are replaced by goods from a highercost supplier from within, wehave (a) dynamic welfare effects, (b) rade creation, (c) rade diversion, (d) all ofthe above. Ans. () See Section 6.6. Solved Problems RESTRICTIONS ON THE FLOW OF INTERNATIONAL TRADE 6.1 Does free trade maximize world welfare? Explain, Free trade leads to the most efficient use of world resources and thus to maximum world ouput. Because of this, classical economists such as Adam Smith believed that free Intemational trade also maximized world - saoins62 63 ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES (CHAP. 6 welfare (see Problem 1.8), There is no question (and it was proved in Chapter 3) that free rade is better than autarky for each trading mation and thus for the world as a whole. However, free trade is a necessary but not sufficient condition for maximizing world welfare since the distitution of income among, people and nations is also important. Even when free trade does maximize world welfare, not every step toward reer trade when free trade itself eonnot be achieved will necessarily inereass world welfare. This somewhat stariling conclusion foliows from the “Theory of the Second Best,” which is studied in detail in a more advanced course. (a) Why do nations restrict international trade? (6) How do they restrict it? (a) Practically al nations of te world impose some resuctions on the Now of imemational tade, Trade restictions are invariably rationalized jn tems of nauonat welfere. tn realy, chey aze usally advocated ‘by and imposed o protect hove indusres and workers that would be hut by imports. Thus, ade restrictions generally bereft a ex atthe expense of many (who will have © pay higher prices for the domestically produced product). (2) There are two types of trade resictions: arf and nontarff restrictions. A arf is a tx on the traded commodity. The impon tari is much more comuon than the export tari. The late is prohibited by the U.S. Constitution buts applied by some LDCs on their radiional exports in order to get beter prices and raise revenues. The ad valorem tariff (expressed as a percentage of the value of the traded commodity) is ‘more common than the specie twiff (expressed as a charge per unt ofthe waded commodiy). Tho most important of the nostarf restrictions onthe flow of tude isthe quota, This i a direct quenitative restriction ‘on the quantity of « commodity allowed to be imporced or exported. Though a quots hes many of the same effcts a ats, iis generally more restive [sce Problem 6.9()]. (a) What is meant by the “new protectionism"? (6) To what proSiems does it give rise? (2) The new protectionism refers to the proliferation since the mid-1970s of voluntary export restraints and technical, administrative and other regulations. Voluntary export restraints (VERs) refer to situations whereby ‘an importing nation induces an exporting nation to “voluntarily” restrict its exports of a commodity for a specific period of time under the threat of higher all-round trade resvictions. The U.S. and cther industrial ‘countries have negotiated VERs with Japan, aewly industrelizing countries (such as South Korea, Singapore, ‘Taiwan, and Hong Kong) and other less developed couatties to limit their exponts of textiles, apparel, steel, automobiles, consumer electronics and other products. ‘Technical, administrative, and other regulations refer o health regulations, pollution standards, labeling, and packaging regulations, which though serving legitimate purposes have also (and sometimes primarily) been used to restrict imparts, (b) ‘The spread of the new protectionism restricts the low of international adc and the benefits from special- ition in production and nie. This bas coincided with (aad to some extent has neutralized) the benefits resulting from the sharp tariff reductions that have been negotiated since the end of World War Il. The spread of the new protectionism now represents the greatest threat to the liberal trading system that has been so-paastakingly been put together during the postwar petiod and which so well served the world economy. PARTIAL EQUILIBRIUM ANALYSIS OF TARIFFS 6.4 Figure 6-4 (which is the same as Fig. 4-3) shows that with free trade and zero transportation costs, the U.S. imports 60C/year froma the U.K, at Pe = $4.50/yard (reread Problem 4.14). If the U.S. now imposes an import tariff of $1 on each yard of cloth it imports from the U.K.. (a) what will Pc be in the U.S. and the U.K.? How much cloth will be traded? (6) What happens to the U.S, terms of trade? (c) What would happen instead if the Sc curve of the U.K. had been infinitely elastic (i.c., horizontal) ai Pc = $4.50? (a) Pein the U.S. will exceed Pe in te U.K. by SI (the import tariff), and in such a way het the volume of trade will be in equilibrium, This occurs when Pe = $4 in the U.K. and $5 inthe U'S, and 40C are waded (sce Fig, 6-4). This result is execly the same as when we had free wade but transportation costs of Sl/yard {see Problem 4.15(2)),CHAP. 6} ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES 99 65 HEE CEH oe (6) Since the U.S, government collects the tariff of $1 per yard of cloth imported, the U.S. is esentaly paying 2 pice of $4 for each yard of cloth imported rath than the price of $4.50 under Gee wade. Thus, by imposing an import tacff en cloth, the ULS. reduced its desuand of cloth imports and was able 1 impor cloth at a lower price. If the pice that the U.S. receives for is wheat exports remains unebanged inthe face ofthis reduction inthe pice of its cloth impons, then the US. tenns of trade (i.e, PylPua = PalPe) Jmprove. This isthe usual result. In goneral, the mor elastic the Sc cuve ofthe U.K., the stale the fall dn the Pe to the U.S., and the less the improvement in the U.S, terms of trade (his veal s eft for the sore advanced reader to prove for him- oF herself on Fig. 6). (©) Iethe Se curve of the U.K. were infinitely elastic (Ke., horizontal) a Pe = $4.50, the imposition af the ‘I taviff would leave the price at which the U-S. imports cloth from the U.K. unchanged atthe free-trade Pc = $4.50. Then, the Pe to U.S. consumers woutd rise by the full amount ofthe trff to $5.50, the U.S. cloth imports would fll t020C (see Fig. 6-4), and the U.S. terms of trade would remain unchanged. Though this is an extreme and unusual result, it was used in Example 1 and will be used in Problems 6.5 10 6.9 because it greatly simplifies the ana Suppose that the U.S. market demand and supply functions for cloth are given, respectively, by: QDe = 140 — Pc and Se = 20Pc — 20, where Pc is given in dollars. (a) Derive the U.S. ‘demand and supply schedules for cloth. —(b) Plot the U.S. demand and supply curves for cloth and. indicate the equilibrium price and quantity for cloth in the U.S. in the absence of trade. (c) Ifthe U.S. now allows free trade and Po = $2 on the world market, the world supply of cloth is infinitely elastic at Pe = $2 and we assume no transporation costs, what will Pc be in the U.S.7 How much cloth will the U.S. consume, produce and import with free trade? () The U, demand and supply schedules for cloth are oblained by substituting Various alternative Pe into he U.S. demand and supply farctions of cloth, as in Table 6.1.100 6.6 ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES {CHAP. 6 roo] 1] 273) 4] 5] 6] 7] QDe | 140 | 120 | 100 80 i] 40 2 oO es. |-20 | of] 2 | 4 | 6 | so | 100 | 1 (b) In the absence of wade, Po = $4 and the U.S. produces and consumes 60C (see point E in Fig. 6-5). (©) With free wade, Pe = $2 in the U.S. (the same as on the world market). At Po = $2, the U.S, consumes 100C, produces 20C nd imports 80C (see Fig. 6-5) ne ree , Cert ct ow ww © wm iw lo we ie mo Fe. 65 If, from the free-trade position in Fig. 6-5, the U.S. imposed a 50% ad valorem (nominal) tariff on its cloth imports, (a) draw a figure showing the new Pc in the U.S. and the consumption, production, trade and revenue effects of the tariff, as well as the world supply of cloth to the U.S. without and with the tariff. () On what do the size of the consumplion, production, trade and revenue effects depend? (c) What would constitute a prohibitive tariff on cloth in part (a)? (a) Since the free-rade Po = $2, the 50% ad valorem trft is equi to $1 per unit of cloth imported. Since ‘we assumed (in Problem 6.5) that the world supply of cloth tothe U.S. is infinitely elastic, Peto domestic consumers im the U.S. will rise by the fult $1 amoont of the tariff 1 $3 {see Problem 6.5(c)]. At Fe = $3, the U.S. consumes 80C (JH in Fig. 66), of which 40 (JM) are prodoced domestically and 40 (BH) ‘a imported, Thus, the consumption effect ofthe tiff equals ~20C (BR), the production effect (.e., the expansion of domestic production resulting from the tariff) equals 20C (GN), the trade effect (.e.. the reduction in impors) equels 40C (BR +"GN) aud the cevenue effect (i.c., the revenue collected by the goverment) equals $40 ($1 on each of the 40C imported, or NMHR). In Fig. 6-6, dashed lines Sp and ‘Srer are the worid supply curves of clot to the U.S. without and with the arf, respectively. (O) * For the same $1 increase in Pc in the U.S. as a result of the tariff, the consumption effect will be greater, the more elastic and flatter the De curve of tho U.S. in Fig. 6-6. Similerly, the more elastic the Se curve of the U.S., the greater the production effect. Thus, te more elastic te De and the Sc cuves ofthe U.S., the greater the trade effect (i.e; the greter the reduction in U.S. impors), and the smaller the revenve effect of the taf. Today, import taifs are imposed by DCs primarily for heir protection effeet rather ‘han for incr revenue effect. Revenues are today more effciennly resed in DCs through income taxes and67 68 CHAP. 6] ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES. 101 ‘other forms of taxation. However, this has not always been so. In the early days of astional sates end in LDCs today, tariffs were and are imposed primarily to generate revenues, since they are easiest so collect. (c)__A prohibitive tariff is one high enough to stop all imports of a commodity. For example, in Fig. 6-6, a0 ‘ad valorene tariff of 100% (equal to $2/vai) ar more imposed by the U.S. an its ctoth imports would make the price of imported cloth to domestic consumers equal to $4 ar more. Since the U.S. can satisty its entire demand for cloth through domestic production at Pc = S4 (see Fig. 6-6), the U.S. will import no cloth (e., the tariff is a prohibitive one). if transportation costs are considered, then an ad valorem tariff of even less than 100% ({.e., less than $2ait) can be prohibitive. ‘With reference to Problem 6.6 indicate (a) the total revenue of U.S. cloth producers under free trade and with the 50% ad valorem tariff. (b) How much of the increase in the total revenue of U.S. cloth producers with the tariff over their total revenue under free trade is absorbed by their higher production ‘cost for cloth? How muuch represents an increase in their reat? (e) Under frce trade, U.S, cloth producers sell 20€ (FG in Fig. 6-6) at the free-trade price of Pe = $2, and so their total revenue is $40, With the lriff, U.S. cloth producers soll 40C (JM) al Pe = $3 and receive 13120, or $80 more than under free trade, (6) The increase in production costs incurred by U.S. cloth producers to produce ake 20 additional units of ‘cloth (GN) with the tariff is given by the area under the Sc curve from point G to point Mf and equals $50 (ee Fig. 66). Thus, of the additional $80 received by U.S. cloth producers, $50 is absorbed by their higher costs of production, and the remsining $30 (FJMG} represents an increase in their rent (0, an increase in their total revenue wich is not required in the long run 10 induce thera to supply these ext 20 units of cloth, With reference to Fig. 6-6 (redrawn below as Fig. 6-7) and Problem 6.6, indicate (a) the reduction fn the consumers’ surplus as a result ofthe tariff and (6) the redistribution effect and the protection cost of the tariff. (c) To what is the protection cost ofthe tariff due? (2) Consumers’ surplus refers othe difference between what consumers are willing to pay to abina specific amount ofthe commodity and wht they actully pay. What U.S. consumers ae will to pay for 100C fs given by the area under the De curve up to point B = QABK = $450 in Fig. 6-7. Since they pay only OFBK = $200 under fre unde, the consumers’ surplos = FAH = $250 under free trade, With the tai, the U.S. consumes 80C. To get 80C, U.S, consumers are willing 1 pay OAHE = S400. Since they pay only OJHL = $240, the consumers’ surplus = JAH = $160 with the tariff, Thus, as the result of the tariff, ‘the consumers’ surplus falls from FAB = $250 to JAH = $160 or by FJHB = $90.102 69 ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES (CHAP. 6 ree (8) Of the fll in the consumers’ surplus of FJHB = $90 resuting from the tai, NMEIR = S40 is the revenue clfect ofthe tariff and FIMG = $30 is redistibued 1 U.S. cloth producers and represents an inrease in thei ret (sce Problem 6.7 and Fig, 61). The remainder of $20 (Le., GMN = $10 plus BHR = S10) represcots the protection cost of te tr othe U.S. economy, (©). The protection cos ofthe tariff arses from the inefficiencies associate withthe reduced velume of wade — the terms of tade remaining constant by assumption (see Problem 6.5), More specifically, when the U.S. imposes the wif, it produces 20 additonal units of cloth (GN in Fig. 6-7) atthe cost of TGMZ ~ $50 [see Prose 6.7¢5)]. But the U.S. could have imponed thes 20 aiionsl uit of cloth (GN) at the fee- trade price of Pe = $2 for alta expendizue of TGNZ = $40. This extra SiO (GNM in Fig. 6-7) expendicure presents the production component of the protection cost of the tari. It arses because les efficient domestic cloth production is substituted for more efficient foreign cloth production and represents scab ost for the U.S. economy. The consumption component of the protection cost of the rf othe U.S. is also $10 (BHR in Fig. 6-7). Mt arises because the impor tariff on cloth artifcaly increases Pe in relation (0 obher prices to U.S. consumers and eauses a distortion in consumption in the U.S. Starting at the free-trade price Pc = $2 in the U.S. in Figs. 6-6 and 6-7, (a) find the consumption, production and redistribution effects of a quota of 40C imposed by the U.S. on its cloth imports. (6) What is the revenve effect of the impor quota? Who captures it? (c) Which is a more restrictive barrier to trade, an import quota or an “equivalent” import tariff? (a) The U.S. impor quota of 40C raises Pe for U.S. consumers to $3 (dhe same as with the 50% ad valorem import tariff on cloth, which also allowed 40C af imports into the U.S., see Fig. 6-7). Thus, the consumption effect of the impont quota (BR = ~20C), the production effect (GN = 20C) and the redistribution effect (FING = $30) ore exactly the same as with the “equivalent tai” of 50% ad valorem on cloth imports, (8) If the goverament auctions off impor licenses t $1 for each of the 40C imports allowed, the revenue effect Of the import quota is also the same as that of the equivalent impor wiff (.e., NMHR = $40 in Fig. 62), However, the government seldom auctions off import licenses. lo that case, the revenue effect will be captured by importers, exporters or shared by both inthe form of higher prices and profits, and represents 4 rent for hem. The revenue effect will be captured by U.S, importers {and so the U.S. terms of trade remain unchanged) if U.S. importers ere organized and beheve 4s « monopolist while exporters are not ‘organized. This is the most likely result. The revenue effect will be captured by foreign cloth exporters (and the U.S. terms of trade deteriorate) if they are organized while U.S. cloth importers are not. If both importers and exporters are organized, ve have a case of bilateral monopoly where the revenue effect is shared by both, but the acta! result is theoretically indeterminate. Note that when the goverameat does not ‘auction off import licenses, it faces the problem of how to allocate these import licenses among potential importers of the commodi'.CHAP. 6] ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES 103 (©) An impor tariff increases tbe price of the imported commodity to domestic consumers and reduces the ‘olume of imports [see Problem 6.4 and 6.6(a)]. However, forign producers, by incrasing their production efficiency and by being able to export the commodity wt «lower price, can overcome the impor tari nd increase their exports. They cannot do this with an impor quote, since this fixes the quantity of imports allowed, regardless of price. Thus, an import quota isa more restitive barrier to unde than the “equivalent” import tif. With tsitf barriers having been reduced to their present low levels as the result of successfil international negotiations, quantitative restrictions on trade have increased in relative importance especialy in agriculture. GATT rules forbid the imposition of quantitative restrictions on trade except For nations in balance of payments difficulties and for those imposing similar quotas on domestic production as, for example, in agriculture. Recently, the U.S. govemment induced forign exporters of texttes, shoes, steel and automobiles (under the threat oF higher all-around trade reteictions) to impose volun’ary quotas on their expons of these commodities to the U.S. NOMINAL, VERSUS EFFECTIVE TARIFF RATE 6.10 Suppose that 1 (the nominal tariff rate on the final commodity) = 8.5 or 50%, i (the nominal tariff rate on the imported input used in the production of the final commodity) = 0.2 or 20%, and a (the ratio of the value of the imported input to the value of the final commodity) = 0.4, Find f, the effective Protective rate given to the domestic producers of the commodity. = 0.5 = (0.40.2) _ 0.5 ~ 0.08 _ 0.42 04 06 (06 Note that while the nominal tariff rete is computed on the value of the final commodity (as, for example, the ad valorem taciff) and, by affecting the price of the final commodity to consumers, is important for consumers in their consumption decisions, the effeciive tariff is important for producers in their production decision. Spe~ cifically, the theory of effective protection implies that those industies given a higher rate of effective protection ‘will expand, or expand more than the industries given a lower rate of effective protection—regardless of the level ‘of the nominal tarif rate, 6.11 Prove that if no imported inputs go into the domestic production of the final commodity, then f = « no impomed inputs go into the domestic production of the final commodity. a ~ 0, When @ = 0. the forma for f i.e, ¢ — ais — a) becomes 1 Omi) | T-0- ‘Thus, when there are no imported inputs, the cntre value of the fina] commodity represoats value edded in the nation, and sof = ‘Suppose there is no tariff on imported inputs and the ratio of the value of imported inputs to the value of the final commodity is 0.25, 0.5, oF 8.75. Find the effective protective rate in terms of the norninal tariff rate, in each of these three alternative cases, When a = 0.25, When a = 05, 1-090 1 4, {70s "asia" ™ Whena = 0.75, toe oz" a~* ‘Thus, when j = 0, the higher a, the greater /for any given £.6.13 6.14 ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES IcHaP. 6 Given a = 0.5 and ¢ = 0.4, find fwhen (a) i = 0.6, (b)i = 0.8 and (e)i = 1 (a) When = 0.6, Thus, iF > 1, F< @) When = 08, “This means that the domestic, import-competing industry is given no protection whatsoever, even though 10. (When 04 = @.5)1. 04-05-01 05 Os 05 ‘This means that not only is the domestic, importenmpeting industry not protected, but that itis acwually iscouraged. From the formula forthe rate of effective protection, we can scc that this will occur whenever a (Gee Section 6.3.) It > é and #2 0, then f> , and the greater the value of a, the more fexceeds + for amy value of «(se Example 2 and Problems 6.10 and 6.12). a = 0. then f= «regardless ofthe value of i (see Problem 6.11), Iai > t, then fis negative regardless of the value of. (©) When ere is more dian one imported input, each subject to a different impor. duty, then where Eal = ayy + aah + - > + ay ++ + oy, andthe subscripts 1,2, nn roer to the m imported inputs. Thus, Zai is the weighted average of the af values, one for each of the Jmpored Inputs, while Ea isthe sum of the raios of the value of exch imported input to the valus of the fina commodity. (c). The Himtaton of the theory of effective protection is its parial equilibrium nature. That i, the theory assumes a fired relationship betseen cach input andthe final commodity (i... a constant value of « for ‘ech inp) in computing f. Howover, these @ values usually change as relative factor prices change, and 0 aliable value off cannot be readily found. GENERAL EQUILIBRIUM ANALYSIS OF TARIFFS ‘Tariff ia a Smell Natlon 61S Explain how the first five effects listed in Section 6.4 arise when a small nation imposes an import tariff, (1) A smalt nation is by definition one that does not affect word prices by its treding. ‘Thus, the imposition of fan import tariff by the small nation reduces the volume of trade by an amount too small to affect world prices.CHAP. 6} "TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES. 105 6.16 6.17 (2) The imposition of a tariff by « nation in the face of unchanged world prices represents a 19x that has to be ‘aid ia Tall (in the form of higher prices) by individvals inthe nation. tn higher domestic prices for the imporable commodity, domestic producers expand the production of the imporable commodity until ts price rises to the level of the world price plus the tariff. Domestic ‘consumers will purchase less ofthe importable commodity a the higher tarfF.nelusve price that they must pay. With domestic production ofthe imporable commodity rising and domestic consumption faling, the irmpors of the corumodity by the small mation falls. Note that with a 300% Laff on cloth imports, the U.S. ‘would retum to its auarky production point A in Fig. 62. Thus, trl of 300% of more on cloth imports ropresents a prohibitive tariff forthe U.S. (4) Since domestic consumers pay a price forthe importable commodity which i higher than the world price by the amount of the import triff But the anf is collected by the government of the nation, the price of the importable commodity emsins unchanged a the world price level forthe nation as a whole. Wis assumed (hac the goverumeat then uses the tariff revenve to reduce taxes or provide (5) With tess specialization in production and a smaller Volume of trade unchanged commodity prices forthe nation asa whole, the small nation’s welfure declines. Note hat inference curve I’ in Fig. 6-2 s different from indifference curve I inthe right panel of Fig. 3-2 because te tariff changed the distbution af income in the US. 8 al services. Explain why the real income of labor (the scarce factor in the U.S.) rises when the U.S. imposes a tariff on its cloth impons. ‘When the U.S. imposes 1 uiff on its cloth impos, Pe/Py rises and the U.S. produces more cloth and Yess ‘wheat (compare point G with point & in Fig. 6.2). Since cloth isthe Z-intensive commodity, the celative demand for Lives, Asa result, wir rises and X is substiuted for L, so that K/L rises inthe production of both commodities. ‘As more K is used with each unit of Z, the productivity and the real wages of L rise in the U.S. Since it is ‘assumed that Z and X are fully employed before and after the imposition ofthe tariff, the rea income of L also rises in the U.S, Thus, labor onions in the U.S. and in other industal nations generally favor trade restrictions. ‘With the gain of Isbor usually smaller than the loss of owaers of capital (Ue abuadant factor in the U.S.), the ‘welfare of the U.S. as 2 whole falls (compare point J" to point F in Fig. 6-2). ‘Though we examined oxelusively the effecis of an impor tariff, the results would generally be the same for ‘an export tariff or any other trade restriction since they all shift produetion away from the commodity in which the nation has a comparative advantage and towasd the commodity in which the nation has a comparative disadvantage. Starting with the U.K. free-trade model in the left panel of Fig. 3-2, but assuming that the U.K. ow a small nation, draw a figure analogous to Fig. 6-2 showing the effet of the U.K. imposing a 100% tariff on its wheat impor. Avthe free-trade PeiPw 1 on the world market, the U.K. (now a small nation) produoss at point B and consumes at point £ in Fig, 6-8 (as in the left panel of Fig, 3-2). When the U.K. imposes a 100% tariff ‘on its wheat imports: (1) Poy remains unchanged at Py = 1 on the world market: (2) PwPc = 2 and PoP = W2 for individuals in the U-K.; (3) the U.K. produces 25W more and 38C less than with free trade (Compare point G to paint 8 in Fig. 6-8), consumption declines to 75W and S5C (point J*) and imports of wheat decline from SOW to 30W; (4) PolPw = Po = 1 for the nation as a whole because the U.K. goverment collects the 100% tariff on its wheat imports inthe form of 15W (42"; (5) the consumption point of the U.K. with tie tariff (point J) is inferior to its consumption point under free trade (point E); (6) the real income af owners of capital ihe scarce factor inthe U.K.) increases. ‘Tariff in a Large Nation 6.18 (a) Sketch the U.K, and the U.S. offer curves given in Table 6.2. (b).What is the volume of trade between the U.K. and the U.S.? What is the equilibrium Po/Py with trade? What are the terms of trade of the U.K. and the U.S.?106 ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES. (CHAP. 6 ow @ a a 0 w to @ m wo m0 te ie Big. 68 Table 6.2 4 tux. cyis_ [2s | 40 | 6 | 75 | 90 wis [1 | 2 [4 | o | 9% : 2 | 30 | 4 | | w | 9 & ox| as] » | as} o | » | Ce) Sce Fig, 69. () The U.K, exchanges 90C for 90W with the U.S. (poim Z in Fig. 69). With cade, the equilibrium PoPw = Pe = 1. The U.K. terms of rade = PylPy = Poly = Pe = 1. The U.S. terms of trade = PaPua = PulPe % (0P, A b ‘Starting withthe U.K. and the U.S, offer cyrves in Table 6.2. (a) show in tabular form what happens if the U.K. imposes a 100% tariff on its peat imports and (b) redraw Fig, 6-9 to show the effect Of the 100% tariff on wheat imports imposed by the U.K. (c) What is the new volume of trade? What are the new terms of trade of the U.K. and the U.S.? (d) How does the imposition of the 100% port tariff by the U.K. affect the welfare of the U.K. and the U.S.2 (e) How does the tariff effect the real income of capital owners in the U.K. ‘k {a) Since itis the U.K. that imposes jhe tariff, tis the U.K. offer curve that is affected, By imposing a 100% tariff on its whet impor, the UK. eow wants 100% more, or twice as auch, whe as before for each ‘quontty of cloth exported. The original offer cure of the U.K. and its new offer curve (U.K.") are given in Table 6.3. A ytCHAP. 6) ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES 107 Table 6.3 cfs [a [| o | 1] 9 wles || | [ «| c[ as [a [a [wo | 5] 0 wf wo [| » | [ m | 120 | 10 (®) See Fig. 610. (©) The U.K. now exchanges 60C for BOW with the U.S., down from 90C for 90W (compare point E’ with point £ in Fig. 6-0). The mew terms of trade of the U.K. equals Px/Pyy = Poly = Per = 413 and exceeds the original terms of Pe = 1. Oa the other hand, the U.S. terms of trade deteriorates from UP, = 1 10108 ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES ICHAP. 6 i i (a) The welfare ofthe U.K. is greater at point E” than at point if the positive effect ofthe tariff on the U.K. ters of trade exceeds the negative effect on the volume of trade. Starting from a zero tariff, asthe U.K imposes higher and higher import aif, te welfare of the U.K. rise up to point and thea declines. The tariff hat maximizes 2 nation's welfare i alld the opti tar. On the other hand, the U.S. is definitely ‘worse off at point £” than af point, bocause is terms of trade deteriorated and the volume of trade decfined. (©) According tothe Stolper-Sumucison theorem, the sel income of owners of capital (the seace factor in the U.K.) rises in the U.K. 6.20 Starting with the U.S, offer curve in Table 6.2, (a) show in tabular form what happens if the U.S. imposes a 100% import tariff. () Redraw Fig. 6-9 and show on it the effect of the 100% import tariff imposed by the U.S. (c) What is the new volume of trade? What are the new terms of trade. of the U.K. and the U.S.? (a) How does this tariff affect the welfare of the U.K. and the U.S.? (a) Since the U.S. imposes 2 100% impor tariff, the U.S. now wants 100% more, er twice as much, cloth 35 before for each quantity of wheat exported. The original offer curve of the US. and its new offer curve (.S.") are given in Table 6.4. (®) See Fig. 611 (©) The U.S. now exchanges 6OW for 75C with the U.K., down from 90W for 90C (compare point E* with point E in Fig. 6-11). The new terms of trade of the U.K. deteriorates from Py = | to Per = 4/5, while the new tims of bade ofthe U.S. improve from W/Pe = 1 to 1/Pee = WI4#5) = Si4 = 1,25, @ The UK. will be worse off at point £* than at point, because its terms of unde deteriorated and the volume of trade declined. The welfare ofthe U.S. increases ifthe positive effect of the U.S. import tiff ‘on the U.S. terms of trade exceeds the negative effect on the volume of trade. Ifthe 100% impor: tsiff {imposed by the U.S. represented the optimum trff forthe U.S., increases in the U.S, taf rate upto the 100% level increase U.S. welfre. Sul higher tariffs reduce the U.S. welfare, until a probibiive wi ends all ade (and all gains from trade) and the origin of Fig, 6-11 is reached. To measure the sizeof te optimum, lac, trade indiference curves nte needed, These are discussed in more advanced eourses and tex U.K. imposes a 100% import tariff and the U.S. retaliates with a 100% import tariff of its own. (b) What effect does this have on the welfare of the U.K. and the U. ‘move back to the free-trade equilibrium point? (a) See Fig. 6-12. (®) After uke UK. and the U.K. have imposed 100% import turfs, we get affer eurves U.K." and U.S." in Fig, 6-12. These offer curves cross at poim £", where 40C are exchanged for 40W and the terms of trade of each nation equals 1. Since, at point E", he tecms of wade of each nation arc the same as at point E (he free-trade equilibrium point) but the volume of trade is greatly reduced, both nations are worse off at Polat £" than at point £, Thus, if either netion imposes an import tiff in an attempt to inerease its welfare, it eauses a loss of welfare to its trade partner (see Problems 6.19 and 6,20). The treds partner is then likely to retaliate and impose a tariff of its own in order to recoup part of its loss. This process can be repeated ‘any numberof times. The final resuit is that both nations lose in the end (i.e, hey are worse off than under fre trade). Starting with offer curves U.S. and U.S. in Fig. 6-9, (a) draw a igure showing what happens if the — 5.2 (c) How can both nationsCHAP. 6} ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES 109 Voocidy 262 (©) Staring at poietE", bth ations ca increase their welae by a reciprocal sedition of tits. Tei joint Tes 3] Supt an lis asm “enor miniud onal ive bem eomaleey moved day (.e., 2 point E, the free-trade equiibriam point). Such a reciprocal reduction of tts (from their all-time tog 1 high rated inthe U.S. ender the Soot owl) Tori Ae of 1930) waste aim ofthe US. Recproal ‘Trade Agreement Aces passed in 1934 and itn regu renewed. With he US. Trade Expansion At 4 1962, ad baegeniog tthe ination fru known as tne General Agreemen ar eran Trade (GAT, (amin at ae on manftced good were lowered by about 35% in te vo-caled “Kennedy Round’ of oegovedons hat was completed in 1967. Under the autho of te Trade Reform Ae of 191, the U.S. negotiated tariff reductions averaging 31% in the “Tokyo Round” completed in 3979, so that today tuff mis on raft goods ce only about 6%- Under GATT res, redaction of tis ated 0 bya eons ee extended fo all other ans wih which the baring nas have "ns-fovore "ion areemens, Te “Uruguay Round of moira ae nepounons (1986-1990) sought to revens the tend of king ont wade bars, bing services and aati into GATT and inprove GATT Alaputesetlemen mechani. Fig, 6-13 6.22 With refejence to, Fig. 6-13, (a) what are the volume of trade and the terms of trade, with offer car UK, and 15.7 With offer cures UK” and U.S? (0) What impon wa on ‘Pheat must the UK. have imposed in order to go from offer curve U.K. to offer curve U.K."? (¢) What export ‘ani on clgh could the U,K. impose in oder, go from offer eurve U.K. to offer curve UK."? (@) With offer curves U.K, and U.S., the U.K. exchanges 80C for BOW with the U.S. (see point Ein Fig. 613), and the terms of trade are Py = 1 for the U.K. and Pe = | for the U.S. With offer curves U.K! and U.S., the U.K. exchanges SOC for 70W withthe U.S. (See point £'), and the tems of trade ae Pe = 75 forte UK ad Vr = 57 fore US. (0) For each quantity of cloth exports, offer eurve U.K." involves twice as much wheat imports as offer curve U.K. (soe Fig. 613), Thus, the U.K. must hate imposed a 100% import tart on wheat, or DEFD. 1, stead, we had used FE" as the base for computing the percentage, the riff of DE", collected by the U.K. ‘wheat, represents a 50% import tariff on wheat, or DE'IFE" (see Fig. 6-13). (ec) Weywould alco ge offer curve UK." and the results of par (a) ifthe ULK., ated of a import aif on what, imposed an export tariff on cloth of AEVAE’ = 25/50 = 1/2 or S0% (see Fig, 6-13. Note, however, that now the tariff of BE” is collected by the U.K. in cloth, England's export commodity, rather than in wheat (ts import commodity). Thus, the U.K. can shift its offer curve up aed to the eft and improve its terms of trade and Welfare (assuming no retaliation by the U.S.) by the use of an import tariff on wheal, an expon riff on cloth oF a combination ofthe two. Our discussion has been entirely in terms of import tariffs because the Constitution of the United States prohibits export tariffs, and impor tariffs are much ‘more widespread than export tarifs elsewhere in the wortd (see Problem 6.2(6)). i 7 mele:ngs + 6.23 ~ TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES (cHaP. 6 (a) Draw a figure showing the shifts in the U.K. offer curve in Table 6.2, ifthe U.K. imposes ¢ 50%, 160% or a 150% import tariff on its wheat imports. On the seme set of axes, draw the U.S. offer curve as a straight-line ray from the origin with a slope of 1. (&) What happens to the volume of trade, the terms of trade and welfare of the U.K. and the U.S. when the U.K. imposes the 50%, the 100% or the 150% import tariff on whest? (c) What isthe level of the optimum tariff for the U.K. in this case? On what docs the size of the optimum tariff depend? (a) In Fig. 6-14, offer curve U.K. is that of Table 6.2. Offer eurves U.K.z, UsK.p and U.K.« result when the U.K. imposes a 50%, a 100% or a 150% impor tariff on wheat, respectively. The straight-line offer curve fof the U.S. indicates thot the U.S. is willing to export any quantity of wheat at PolPy = 1 (.e., the U.S. offer curve is infinitely elastic; see Problem 5.20) ¥ (®) Under free trade, offer curves U.K. and U.S. in Fig. 6-44 cross at point £1, indicating that SOC we ‘exchanged for 90W atthe terms of trade of I for both nations. With offer curves U.K 2, UK.s and UK, the volume of tade falls o 60C for 60W, 40C for 40W, and 25C for 25W, respectively, bu the terms of trade of both nations remain unchanged at the value of 1 (See equilibrium points, Hy snd E.). Thus, the igher the level of the tariff imposed by the U.K., the smaller the volume of trade at unchanged terms of ‘rade, and so the smaller the welfare of both nations. We would get the same result if, before a very small nation imposes a uvif, its offer curve intersected the staight-lie segment of the osherwise bending offer ‘curve of is trade partner (see Problems 5.20 and 3.16). (€} ven in the absence of retaliation from the U.S., the U.K. cannot increase its welfare from the free-trade level by imposing a tariff. Indeed, by imposing any tariff the U.K. would emse a reduction in its welfare. ‘Also, the greater the tariff level, the greater the eduction in welfare. ‘Thus, when the offer curve of the trade pariner (here the U.S.) is ifinitely elastic, the optimum tan fora nation Goere the U.K.) is 2ero. By extension, we can say thatthe more elastic (., the smaller the curvature of) the offer curve of the trade partner, the smaller the lvel of the optimum tariff for amation, and vice versa. SOME ARGUMENTS FOR TRADE PROTECTION 6.4 Of the arguments for trade protection listed in Section 6.5, explain why (a) arguments 1 and 2 are ‘wong outright and (6) arguments 3, 4, and 5 are usually invalid.2X Lng CHAP. 6) ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICY YBO JURGigt 6.25 6.26 (a) Argument 1 states that trade protection is needed in order to protect domestic Inbor against cheap foreign labor. However, even if U.S. wages are higher than abroad, ifthe productivity of U.S, labor is euficinlly higher than abroad, the labor component ofthe U.S. costs of production i less than abroad and no prtetion is needed for domestic labor. Even if this is not the case, mutually advantageous trade based on comparative advantage can still take place and tariff protection is still nor justified. Argument 2 (the scientific tariff) is ‘wrong because it would eliminate al price differences and ide between nations (ad the gains from rade). (0) Arguments 3, 4 and 5 aze beggarthy-neighbor arguments for wade protection snd, 2s such, are usually invalid. Specifically, by imposing a trff, a-nation ean reduce domestic unemployment and improve its balance of payments, terms of trade and welfare. However, since this nation’s galas come st the expense of obser aations (which sufer increased unemployment and worsened balance of payment, terns of trade and welfare), other nations are likely to retaliate, and atl nations lose in the end, Domestic unemployment and deficits in the nation’s balance of payments should be corrected by appropriate monetary and fiscal policies tee Chapter 10) rather then by import tariffs designed to cut specific impomts, (a) Explain why trade protection may be justified in the case of dumping. (b) Are export subsidies a form of dumping? Why? (¢) How can trade protection be justified by national defense? How must this afgument be qualified? (2) Dumping is sometimes caried on forthe speciic purpose of driving foreign producers ofa given coramodity ‘out of business, after which the price is greatly increased, This is referred to as predatory dumping. Here, trade protection is justified to protect the domestic intasty; however, predatory dumping is often nat easy to prove. If, on the other hand, the dumping is prsistemr, domestic consumers benef from the continuing tower prices forthe imported items, and sos case agenst his typeof dumping can hardly be made. Dumping can also be sporadic in order to sel an unforeseen and teraperary surplus abroad without having to reduce domestic prices. (b) Export subsidies ae direct payments or the granting of tax rlicf and subsidized loans 10 the nation's exporters or potential exporters and/or low-interest loans fo foreign buyers 0 a to simulate the nation's exports. As such, export subsides can be regarded as a form of dumping. Although they are illegal by intemational agreement, many aaions provide them in disguised and not-o-dispuised forms. (€) Trade protection sometimes is advocated to protect industrics impomtant for natonal defense. This is « nonecoromic argument for protect, and the economist has no particular competence to evaluate its validity, except to point out that even inthis case, a direct production subsidy is generally a better method of aiding an industry important for national defense than trad protection. Something, more ean be seid, ‘Tat is, in case of localized wars (e.g., the Korean and Vietnam wars), the needed material for the wat effort such 4s cargo vestels, milimry clothing and shoes, etc.) might exsily be provided for and much mare cheaply from abroad than by producing it in the U.S. In tho case of a total war today, there would hardly be the Aime to utilize the protected industries. {a} Explain why and under what conditions the infant-industry argument for an impor tariff is valid. (6) How must this argument be qualified? (@) The infant-industry argument for tariffs is generally valid, especially for LDCs. It holds that a LDC may have 2 potentia) comparative advantage in « particular commodity, say textiles, bur thar because its initial production costs are tao high (due to lack of know-how and the initial small level of output), this industry ‘cannot be established or grow in the LDC in the face of foreign competition. An impor tariff is then justified ro help the LDC establish the imlustry and protect it during its “infancy,” until the industry has grown in size and efficiency and is able (o meet foreiga competion. AC thet time, the tariff is to be removed. (®) In order for the infant-industry argument tc be valid, not only must the tariff eventually be removed and the “grown up" industry be able to compete with foreign firms without protection, but the extra cerurn in the industry (after the removal of the protection) mast be high enough to justify the eass involved ducing, the period of protection. These costs arise because the commodity is produced domestically rather than {imported for less. It may also be difficult a prior t determine which industry or potential industry qualifies for this treatment, and to eventually remove the tariff once itis imposed. Economists also agree that what «tariff can do here, a direct subsidy to the infant industry can do better, This fs because a subsidy can beuz 6.27 6.28 ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES: (CHAP. 6 varied so ss to provide the infant industry with the same degree of protection as an equivalent import tariff ‘but without distorting relative prices and domestic consumption, However, a subsidy requires revenue, rather than generating it asthe tariff does, (@) Draw a figure showing the infant-industry argument for trade protection. (b) What is the relationship between the desite of LDCs to industrialize, infant industry, import substitution and the theory of effective protection? (a) In Fig. 6-15, Pvisthe word price of commodity in which the LDC has a pote comparative advantage. However, since the cost of producing this commodity in the LDC initially excoods Py, this industry could not be established in the LDC without sulfciemt protection agains foreign competition. Ths prtezton can be provided, and this industry established inthe LDC with an import aif on tis commodity which exceeds PaPe. As tine pastes and the industry acquires know-how, and as output expands and the industry ceaps the benefis of economies of seale, domestic costs begin (ofall (at ouput Q, in Fig, 6-15) and so the rate of protection cam be reduced, until ican be completely eliminated et Q» (where domestic costs equal Py). Pest output Qo, this commodity becomes an exportable for the LDC. However. as pointed out in Problem 6,26(b), an equivalen: production subsidy is beer than tani protection Fig. 6-15 (0) LDCs se industriafzation asthe key 1 ther economic development (see Problem $.21). However, industry ‘em ten nt be established ina LDC without some inital protection aginst foreign competition (the infant- industry argument for protection). With sufficient protection, the indusury can be established and grow, at least fora while, by replacing imports of the commodity with domestic production (.., by import substi- (ation). However, once all impors ofthe commodity have been replaced by domestic production, th process of indstielization may become stagnant (as aseurred in Argentina in the late 19305), unless the domestic industy can intease its efficiency to te point where it can compete with foreign fis without protection and actually succeed! in eatering the world market as an exporter of the commodity. But her, the higher elfective than nominal tariff rates that DCs maintain against intensive manufactred impors may prevent LLDCS from entering the world market as exporters of these commodities. At a series of United Nations Conferences on ‘Trade and Development (UNCTAD) held in 1964, 1968, 1972, 1976, 1980, 1984 and 1988, LDCs raised this and many other complaints against the ade policies of DCs and demanded, among, ‘other thiogs, preferential access for ther manuféctured expons to DCS as part of thor call for NIEO (see Section 5.6). Recently, LDCs have achieved some degree of success along these lines in their negotiations with the BEC end the U.S. (a) How can strategic trade policy justify trade protection? (b) What difficulties arise in carrying ‘out a strategie trade policy? (a) According to stategic made policy, a nation can create « comparative advantage through temporay trode protection in such fields as semiconductors, computers, lelecommunicalions, and other indusisies that are deemed erucal to fut growth inthe nation, Thess high-iechnology industries are subject 10 high risks, require large-scale production to achieve economies of scale and give rise to exteasive exteral economies ‘when successful. Strategic trade policy suggests that by encouraging such industries, the netion can enhanceCHAP. 6] ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES 43 {ts future growl prospects. This is similar to the infant-industey argument in developing nations, except thot it is advanced for industrial nations to acquire a comparative edvantage in crucial high-technology industries. Most nations do some of this. Indeed, some economists would go so far as to say thal great deal ofthe postwar industrial and technological success of Japan is duc to its strategie industrial and trade policies. (©) Thore am thee serious ditfieuhies in carrying out suategic uade policy. Fis, itis exitemely dificult to pick winners (i.e.. choose the industries that will provide large extemal cconomies in te Future) and devise appropriate policies to successtully nurture them. Second, since most leading nations undertake strategic trade policies at the same tive, their efforts are largely neutralized so thet the potential benefits to each may be small, Third, when a country docs echicve substantial sucess with strategie uate policy, this comes ‘al he expense of other countries (-c., iti a beggrt-thy-neighbor policy) and so other counties are likely to retaliate. Faced with all these practical dificulies, even supporters of strategie trade policy grudgingly ‘acknowledge that free trade is stl the best policy, after al ECONOMIC INTEGRATION 6.29 6.30 With reference to Table 6.5, (a) indicate whether we have trade creation or trade diversion when country A, which initially imposes a nondiscriminatory ad valorem impart tariff of 100% on commodity X, te (Column 3 in Table 6.5), forms a customs union with country B. (6) What if country A initially imposed # nondiscriminatory ad valorem import tariff of 50% on commodity X (column 4) before forming a customs union with country B? Tobte 6.5 wo @ @) Cy Px = Costot | PytoAwhen | Py to A whea Country producing X | fe = 100% be = 50% A si0 si S10 B 8 16 12 c 6 2 3 (a) Before the formation of the customs union and with te = 100%, countty A produces commodity X domestically. When country A forms a customs union with country B (and removes the 100% import tariff ‘00 commodity X from country B but retains it on country C), country A wil import commodity X from counaty B at Px ~ $8, rather than supplying it domestically at Px = $10. This isa case of trade creation. ‘Less efficient domestic production is replaced here by more efficient production in the union pasiner. {b) Before the formation of the customs union and with ty ~ 50%, country A imports commodity X from country Cat Py = $9, rather than supplying it itself at Px = $10. When country A forms a customs uaion ‘with country B (and removes the SO% import tariff on commodity X from country B but resin it on country ©), country A will now import commodity X from country B at Py = $8, rather than from county C at Py = $9. Bofore the formation of the customs union, country A imported comtmodity X from country C al Py = $9 but country collecid the revenue of $3 per unit of X imported: Thus, county A. was really paying a Py = $610 impor commodity X from couily C. After te formation of the customs union with country B, country A imports commodity X from country ® st the higher Py of $8. Thus, the foration of the customs union diverted trade from a more efficient, loner-ost source outside the union (02 less eflicent, higher-cost soure from within the union. This is case of trade diversion. —— (a) Explain why a trade-creating customs union increases the welfare of the nations forming it as well as the welfare of the rest of the world. (b) Explain why @ trade-diverting customs union will reduce the welfare of the test of the world and may reduce the welfare of the nations forming the customs anion,4 6.31 ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES ICHAP. 6 (a) We saw in Problem 6.29(a) that wade creation leads to more rational and efficient production within the customs union. Assuming that fll employment of all economic resources is maintained within the trade~ creating customs union, this leads (0 an increase in the output and welfare of union members. Part of the increase in the real income ofthe wade-creating customs union spills over into a greater demand for imports from the rest of the world, leading to an increase in the welfare of the rest of the world as well, (b) We saw in Problem 6.29(6) tha with trade diversion, more efficient production outside the union is replaced With less efficient production within the union. Since the released resoutces In the rest of the world can only be absorbed into Jess productive uses, the welfare of the ret of the world will fal. Similarly, if all ‘economic resources were fully employed before the formation of the union, the wede-diverting customs union can only lead to reduced welfare for he union members (because ofthe tess efficient use of resources). Howover, this reduction in welfare within the trade-diverting customs union is moderated or even reversed by the lower price pald by consumers and thet resulting greater consumption ofthe commodity. For example, in Problem 6.29(6), consumers pay a Px of $9 before the formation of the tade-diverting customs union and a Py of $8 afterward. In geaeri, the formetion of a customs union is likely to lead ty wade creation in some commodities and tude diversion in others, making it even more diffull to determine its net effect on wetfare. It wes primarily o avoid trade diversion from the BEC that the U.S. initiated (with the passage. of tho Trade Expansion Act of 1962 and under the auspices of GATT), the Kennedy Round of negotiations. ‘Since this dealt primerly with manufactured goods, the U.S. has demanded and recently obtzined some ‘elief from the diversion of trade that it suffered in agricultural products vis-i-vis the EEC. In Fig. 6-16, Dg and S¢ represent nation 2's domestic demand and supply curves of cloth. Nation 2 is assomed (0 be a small nation. Sr and S3q-7 are the foreign supply curves of cloth to nation 2 from nation 1 and nation 3, respectively, with a 100% nondiscriminatory ad valorem tariff (T) imposed by nation 2 on its cloth imports. With reference to Fig. 6-16, answer the following questio (a) What will be the price of cloth in nation 2 when nation 2 imposes a 100% nondiscriminatory ad valorem tariff on its cloth imports? How much cloth will nation 2 consume, produce and import? From ‘which nation will nation 2 import cloth? (b) What happens if nation 2 forms a customs union with nation 17 Is this a trade-creating or a trade-diverting customs union? What is the welfare gain or toss for nation 2? (c) What happens if nation 2 forms a customs union with nation 3 instead? Ts this a trade-creating oF a trade-diverting customs Union? What is the welfare gain ot loss for nation 2? PetsiCHAP. 6) ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES 4s 6.33 (@) Pe = Szin nation 2. At Pe = $2, nation 2 consumes SOC (JH), with 20C (JM) produced in nation 2 and 30C (MH) imported from nation 1. Nation 2 collects a tariff revenue of $30 (NMI). Nation 2 does ‘not import cloth from nation 3 because the teifFinclusive Pe = $3 (02). So far this i the same as in Fig. 6 (b) K€ nation 2 forms a customs union with nation 1, Pe = $1 in nation 2. At Pe = Sl, nation 2 consumes “TOC (FB), with 10C (FG) produced domestically and 60C (GB) imported from nation 1. The tariff revenue isappeass and area FGM represents a transfer from domestic producers to domestic consumers. This leaves ret static gains to nation 2 as « whole of S15, given by the sum of the areas of triangles GMN and BHR. ‘This isa trade-creating customs union, Note thal the analysis is of a partis: equilibrium type and, as such, it faces the shortcoming mentioned in Problem 6.14(¢) (©) I oation 2 forms a eustoms union with nation 3 instead (Le. it removes the tariff on sloth imparts from ration 3 only), Pe = ST.50 in nation 2, At Pc = S150, nation 2 consumes 6OC (KW), with ISC (KL) produced domestically and 45C (LW) imported from nation 3. Trade is diverted from nation 1 40 ration 3, because the lriff-inclusive Pe = S2 for impons from nation I. There is also some tride creation since sation 2 now imports 45C (from nation 3) instead ofthe 30€ (Crom nation 1) before dhe formation of any customs union, The welfare gsin in nation 2 from pure trade creation is $3.75 (given by the sum of the seas of tangles LMU and WAV). The welfare loss fom trtde diversion proper is S15 (the area of rectangle ‘NOVR). This esults from the higher cost of the imperts of 30C diverted fom nation | to nation 3. This is a wade-diverting customs union that reduces the welfare of nation 2 by $11.25 (S15 — $3.75). Note that the more elastic or ater are De and Se, the more likely i is thet even a trade-diverting customs union increases the welfare of the nation joining such a uoion. The theory of customs unions i an example of ‘he theory of the second bes (se Problem 6.1), which states (inthis context) that not every step in trade Tiberaization (when the first best offre trade cannot be achieved) will necessarily increase wolfe, t conditions are likely to lead to a trade-creating customs union? LAl) “The higher the pre-union impos daies of the member countries (sec Problem 6.28). (@) The larger the size andthe greater tie numberof countries in the union (since itis then more likely thatthe low-cost producers wil fall within the union). @) ‘The more competitive rather than complementary the pre-union economies (since there is then mare room {for specialization in production—and trade cretion—with the formation of the union} @) The closer geographically the member nations forming the ucion (since wansportation costs would then be less of an obstruction o trade creation) (6) The greater the pre-union trade amoag the member nations. Note that condition 3, 4 and 5 are some of the reasons forthe greater degree of success of the EEC as opposed to the EFTA. However, even the EEC has resulted in extremely small stati gains for the member nations (very rough estimates put these static grins at less than 1% of their GNP). State and discuss the dynamic gains to the nations forming a customs union. (2) Increased competition. That is, with. the formation of a customs union, fms in each member nation axe forced to compete with other finns within the customs union without the trde protection they previously enjoyed. The Test is thatthe less efficent firms are forced to increase their efficiency, merge or go out of bbasiness. Consumers within the customs union benefit from lower prices and beter-qvality products. 2) The possibilty of economies af scale made possible by the enlorgement ofthe free-trade arce beyond the rational boundaries of the member nations. However, i must be pointed cut chat even & small nation, not ‘a member of any customs union, can overcome the smallness ofits domestie market and achiove substantial ‘economies of scale in production by exporting to the ret ofthe world, 8). Stimulus to investment. This may arise from the interne! expansion of fms taking advantuge of economies ‘of scale and from greater investments by outsiders to setup factories within the'customs tnion in der to avoid the tariff wall, These are referred lo as tariff factories. A great nrany ofthese Have been set up within the EEC by the U.S. during the last two decades. Though these dynamic gains are presumed 10 be very signifcant in the EEC (indeed, the U.K. joined the EEC primarily because of them), they have eluded even rough measurement thus far.6 6.34 ‘TRADE RESTRICTIONS: TARIFFS AND OTHER COMMERCIAL POLICIES (CHAP. 6 Explain why economic integration among 2 group of LDCs may have difficulty succeeding. Pethaps the greatest stumbling block to suacessful economic intgration among a group of LDCs is thatthe resulting sti nd dynamic beasts will not be evenly distributed among the member nations. The more advanced saione gain most of the beset, giving rise to fear in the loging nations that economic integration wil retard rather han stimulate their economic development. Thus, there isa strong compulsion for these less advanced nations to withdraw from @ union, causing its collapse. This could be avoided by investment assistance and industrial planning (.., assigning eraininduswres 1 exch country within the union). ‘Another difculty is that many LDCs are wary of relinquishing any pat of their newly acquited naonal sovercigny toa supemational union body, as requlred for successful economic imegrtion. This i particularly tr in Afica, Other difficulties are the Tack of good transprtation and commonications among the member tutions, the great geographical distance separating them and the compotion forthe same world mazkets for their agricultural expors. ‘These difculies, panicuary the fist oe (i.e. the uneven distribution of the benefils) may explain the faire or stow progress toward esonomie inieration in LDCs. For example, the Cerual Ainerican Common Market (CACM) including Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua and Panama, afer some inal success, dissolved ia 1969. The East Africa Common Markt also dissolved. Others, such as the Latin ‘American Free Trade Association or LAFTA (which was superseded in 1980 by the Latin American Integration ‘Assocation of LAIA) and the Economie Community of West Africa are stil in their formative stage, and their success and economic significance renin in doubt. However, the Caribbean Free Trade Association (CARAETA), set up in 1968, was uansformed into a common market (CARICOM) in 1973.Midterm Examination 2. (a). State the law of comparative advantage for the case of two nations and two commodities. (B) State the Heckscher-Ohlin theory for the case of two nations and two commodities. {e)__ In what way is the Heckscher-Ohlin theory superior to classical trade theory? (a) Explain under what conditions the Heckscher-Oblin theory would not be valid. Are these conditions ‘common today? (e) In what ways must the Heckscher-Ohlin theory be extended in order to fully explain international trade today? 2, Given: (1) two nations (1 and 2) which have the same technology but different factor endowments and tastes, 2) two commodities (X and Y) produced under increasing costs conditions, and (3) no transportation costs, tis ox ather obstructions to trade. Prove geomesrically that wutually advantageous tade between the two nations is possible, [Vore: ‘Your answer should show the autarky (no-trade) asd free-trade points of production and consumption for ‘each nation, the gains from trade of each nation and express the equilinriura condition that should prevail ‘when trade stops expanding.) 3. Given: (1) two nations, the U.S. (the capital-abuadant nation) and the U.K. (the labor-abundant nation); (2) two commodities, wheat (the capital-itensive commodity) and cloth (the labor-intensive commodity); and (3) free trade, ‘Show graphically with (a) production possibilities curves and community indifference curves and (6) offer curves the effect of capital-biased technical progress in the U-K. on the U.K. terms of trade when all else remains constant in both nations. 4. (a) Draw a figure showing the consumption, production, trade, revenue and redistribution effetts af an import tariff wien the nation is assumed t0 be too small to affect world prices. What is the protection cost of the tariff? (b) What is the difference between the nowninal and the effective tariff rate on imports? What is the. significance of each? (c) Cam a nation increase its welfare by imposing a tariff? Why do nations impose tatiff and other trade restrictions? What are the meaning and importance of the tise of the new protectionism? (4) What is meant by strategic trade policy? What difficulties arise in carrying out a ctrategic trade policy? ANSWERS: 1. (a) The law of comparative advantage states hat even if nation hasan absolute disndvaniage (i... is less efficient) in the production of both commodities with respect tothe other nation, mutually advantageous trade could still take place between them, The fess efficient nation should specialize inthe production of and export the commodity in which its absolute disedvantage is less. Mis isthe commodity in which the nation has a comparative advantag. ‘On the other hard, the nation should impor the commodity in which its absolute disadvantage is greater. Tis {s the area of its comparave disadvantege. The only exception occurs when the absolute disadvantage which «ation has with respect to another nation is the same in both commodities. This i rather unususl () The 1-0 sheory can be expressed in the form of two theorems. (1) The H-O theorem seeks to explain the pattem of trade by postulating that each nation will export the commodity intensive in is sbundant and cheap factor and impor the commodity inieisive in is scarce and expensive factor. (2) The fecto-prce equalization ‘theorem postulates that ude wil lad to the equalization of relative and absolute facto prices between the ‘ho nations (under highly restrictive assumptions). 748 MIDTERM EXAMINATION (6) The 3-0 thoory is superior to classical theory because it socks co explain (I) the paler of trade (based on the A since it involves more of both X and ¥ sd lies on a higher community indifference curve. ‘Nation 2 starts at A’ in production and coasumption in autarky, moves to B in production, and by exchanging B'C’ of Y for C'E" of X reaches E" in consumption (which exceeds A'). At PPy = Pa = Pe‘, nation I wants to expor: BC of X for CE of ¥, while nation 2 wants to export BC’ (=CE) of ¥ for C'E’ («=BC) of X. Thus, Py ‘the equilibrium relative commodity price because it clears bath (the X and Y) markets. \._ K-biased technica progress inthe U.K. is one that increases the cloth output of the U.K. proportionalely more than its wheat output, In panel A of Fig. M2, the U.K. produces at polnt B on TT and consumes at point at tenns of tzade Pp, before the technical progress. At the same terms of trad of Pp ater K-biased technical progress, the U.K. would produce at point M on T’T’ and consume at point Yon community indifference curve IL. However, to reach 1, the U.K. has to export mich more cloth than fore technical progress. This causes the terms of trade of the ULK. to fall uni rade between the U.S. and the U.K. is once aguin balanced. This occurs at Po, at which the U.K. produces at point Non T'T’ and consumes at point R. To see thet Po is the new equilibrium Poy and trade is balanced, we turn to panel B. In panel B, tide was originally in equilibrium ar point Eat terms of rade of Pp. After‘MIDTERM EXAMINATION, ug technical progress in the U-K., the U.K, offer curve shifts to U.K.* and trade equilibrium is reached at point R st Pg < Pp. Since al unchanged terms of trade the U.K. wants to rade more after growth, in terms of trade deteriorate and the U.K. shares part of the benefit ofits grow with the U.S. Fig. M2 4. (@) In Fig. M-3, D and $ are the nation's demand and supply curves forthe imponble ebmmodiy. At the free- trade price of P,, the quantity demanded of the commodity in the nation is AG, of which AB is supplied ‘domestically and BG is imported. Dashed line Sy represets the nation’s fce-rade foreign supply curve ofthe imporsble commodity. ‘When the nation imposes an import tiff, dashed ine Sr + represents the arif-nelosive foreign supply. ‘Asa result, the commodity price in he nation rises, say to Pa At Pa, he quantity demanded is HM, of which HL is produced domestically and LM is imported. Thus, the consumption effect s (~)GF, the production effect {is BC, impors decline by GF plus BC and the government collecs MILCF in aif revenues. The consumers’ surplus falls by AGMH, of which ABLH is redistibuted to domestic producers and BCI. plus GEM represent the protection cost ofthe tiff 0 the nation, Fg M3 (8) The nominal tari rate is computed on the tte vee ofthe final commodity imposed white the effective tft rales computed on the domestic value added embodied inco the iipor-competing nel commodity. If there120 © @ MIDTERM EXAMINATION ‘re no imported inputs into the domestically produced commodity or if there are imported inputs subject to the ‘same nominal tariff rate as onthe final commodity, the nominal and effective taf rats onthe final commodity are idemical. When the domestic impor-competing indusury uses imported inputs subject to no import tart for toa lower nominal tariff rate than on the final commodity (ihe usual case), then the effective till rte on the final commodity exceed the nominal tariff rte, The effective arf rate measures the aewwal ate of procection that a given nominal tariff rate provides the impert-competing industry. Ths, while the nominal tari is important to constimers in their consumption decisions, the effective tariff is important to prodacers in their production decisions. ‘A ration can increase its welfare by Imposing 48 “optimum wtf, However, since the nation’s gain comes at the expense of other nations, we can expect obher nation to retaliate and impose tariff oftheir own. The resol i tat the volume of wade shrinks za, in the end, all rations usually lose, Tariffs and other trade restrictions axe usually advocated by and imposed to protect from foreign cormpetition those indusues in which the nation has a comparative igsdvantage, Thus, the benefit ofa few industries and workers is purchased atthe expense of the rest, who will face higher prices for the domestically produced commodity, While the average tariffs on manufactured gonds imports have declined during the postwar period to the point where they average only about 6%, the mumber and imponance of nontai(f fade baricrs oF new protectionism inthe form of voluntary export restraints and technical, administrative and other regulations have increased significantly since the mid-1970s to the poiat where today they represen the most serious threat to the world tring system. Strategic trade policy refers to trade policies that» ation ean use to increase its welfare by promoting such high-technology industries as semiconductors, computers and telecommunications. These industries are subject to high risks, require lrge-scale production to achieve economies of scale, and give rise to extensive extemal ‘economies when successful. Suatogic trade policy suggests that by encouraging such industes, the nation can. ‘enhance is future growth prospec. ‘Thero are serious dificuties in carrying out strategic trade policy. First, it extremely difficult to pick ‘winners (i... choose te industries tat will provide large external economies in he Furure) end devise appropriate policies to sucessfully nurture them. Second, since most leading nations undertake strategic trade potleies at the same time, thelr efforts are largely neutralized so thatthe potcatial benefits 10 essay be smal ‘whon a county does achieve substantial success with strategic trade policy, this comes atthe expense of other ‘counties (ie, it fsa beggar-thy-neighbor policy), and so other countries are Tikely to etalinte.Chapter 7 The Foreign Exchange Markets 7.1. DEFINITION AND FUNCTIONS “The foreign exchange market is the organiational (ramework within which individuals, fires and banks buy and sell foreign currencies or foreign exchange. The foreign exchange market for any cutency, say the dollar, i composed of all the locations, such as London, Zutich, Paris, Frankfurt, Singapore, Hong Kong, Tokyo, as well as New York, whece dollars are bought and sold for other currencies. By far, the principal function of the forciga exchange market is the transfer of funds or purchasing power from one nation and currency (0 ‘another (sce Problent 8.14). Other functions are to provide short-term credits to finance trade [see Problem 8.13(a)] and the facilities for avoiding foreign exchange risks or hedging (see Section 7.4). 7.2 THE FOREIGN EXCHANGE RATES ‘The foreign exchange rate is the domestic currency price of the foreign currency. This exchange rate is kept the same in all parts of the market by exbitage. Foreign exchange arbitrage refers to the purchasing of foreign currency where its price is low and selling it where the price is high. A rise in the exchange rate refers to a depreciation ora reduction in the value ofthe domestic currency in elation to the foreign eurrency. ‘A fall in the exchange rate refers to an appreciation or an increase in the value of the domestic currency. Since a nation’s currency can depreciate against some currencies and appreciate against others, an effective exchange rate Is usvally calculated. This is a weighted average of the nation’s exchange rates [soe Problem 13a). EXAMPLE 1. The exchange rte between the dollar (ihe domestic curency) and the pound refers to the number of Aoliarsrequied to purchase one pound, of Si, If his rate is $1.99 In London and $2.0| in New York, foreign exchange aubitageurs will purchase pounds in London and resell hem In New York, making a profit of 2¢ on each pound. As this cuts, the price of pounds in terms of dollars rises in London and flls in New York util they are equal, sy at $2.00, in both places. Then the possibility of caring a profit disappears and arbivage comes to an end. IF uhough time, the exchange rts () ies from $2.00 to $2.10 Gin both New York and London), we say thatthe dear has depreciated with respect to the pound because we now need more dollars to purchase each pound. On the other hand, when R fll, te ‘olla appreciates. This is equivalent to a depreciation ofthe pound (see Problem 7.3) 7.3. THE BQUILIBRIUM FOREIGN EXCHANGE RATE ‘in gencrel, the foreign exchange rate is determined by the intersection of the maskel demand cwve for ané the market supply curve of the foreign currency. The demand for foreign exchange arises primarily in the ‘course of importing goods and services from abroad and making foreign investments and loans (see Chapter 8). The supply of foreign exchange arises in the course of exporting goods and services and receiving foreign investment and loans. EXAMPLE 2. Figure 7-1 shows the foreign exchange market for pounds from the U.S. point of view, ine simplified {wornation world. The intersection of the U.S. market demand eure for pounds (De) and the U.S, market supply curve for pounds (S.) determines the equilibrium exchange rate of $2.00 = £1 and the equilibrium quantity of pounds demanded ‘and supplied per year of £6 billion. De is negatively stoped beccuse at lower R's, England becomes a cheaper and more saurative place in which to buy and invest and so U.S. residents demand a greater quantity of pounds. On te other hand, Ss usualy positively sloped because at lower R's, U.K. residents find it more expensive o buy end invest in the U.S. and, a5 2 result, Cy spond fewer pounds in the U.S. If for some reason, Dg sills up, the U.S. will face an excess 121122 ‘THE FOREIGN EXCHANGE MARKETS (CHAP.7 Billion B7year ‘quantity demanded of pounds (a deficit in the U.S. balance of payments) et the criginal equilibrium exehango rate. This can be corrected if the U.S. allows the dollar to depreciate (,c., R to rise toils new equilibrium level; see Problem 7.6). ‘The opposite occurs if Dr deeteases or St increases (see Problem 7.7). 7.4 HEDGING Since foreign exchange rates usually fluctuate through time, anyone who has to make or receive a payment in a foreign currency at a future date runs the risk of having to pay mote or receiving less in terms of the domestic currency than originally anticipated. These foreign exchange risks can be avoided or “covered” by +redging. This usually involves an agreement today to buy or sell a certain amount of foreiyn exchenge at some fulure date (usually three months hence) at a rate agreed upon today (ihe forward-exchange rate). EXAMPLE 3. Suppose that 2 U.S. firm owes £1,000 toa British exporter payable in three months. At today's exchange rate of sper rate of $2.00 = £1, the U.S. firm aves an equivalent of $2,000. Ifthe spt rate in thres manihs rose 19 $2.10, the U.S. firm would have to pay an equivdent of $2,100, or $100 more. But ifthe three-month forward rat were ‘$2.01, the U.S. could buy today £1,000 at $2.01 per pound for delivery in three months and avoid any further foreign ‘exchange risk. Afler dee months, when the payment is due, the U.S, firm would get the £1,000 i needs for $2,010, regardless of wiht che spot rate is at that tine. Similerly, if « U.S. exporter is fo receive £1,000 in tee months, he of she can sell this £1,000 for delivery in three months at ioday’s three-month forward rate, and avoid the tisk thatthe spot rate in three months will be very muck below today's spot rave. 7.5. SPECULATION Speculation is the opposite of hedging. While a hedger seeks to 2void ot cover a foreign exchange risk for fear of a loss, the speculator accepts or even seeks a foreign exchange risk or an open position in the hope of making a profit. If the speculator correctly predicts the market, he or she makes a profit. Otherwise, the speculator incurs a loss. Speculation usually occurs in the forward exchange market. EXAMPLE 4. If te forward cate on pounds for delivery in thee months is $2.00 and a speculator believes tht the spot rate of the pound in thes. mons wil be $2.10, he cin enter todsy into a forward contact to buy £1,000 in tree ‘months at $2.00 per pound. After thre maths, he wil pay $2,000 forthe £1,000, and if at that time the spot rate on the pound is indeed $2.10 (ashe antieipated), he can resell the £1,000 inthe spot masket for $2,100 and eam $100 on the transaction. 1f, onthe olkerAand, his expectations prove tobe wrong andthe spot rate of the pound afer three marths is instead $1.95, he will sill have to pay $2,000 forthe £1,000 that he receives on the matured forward transection, but the can only resell this £1,000 for $1,950 in the spot market, thus losing $50 on the transaction.CHAP. 7] ‘THE POREIGN EXCHANGE MARKETS 123 7.6 COVERED INTEREST ARBITRAGE Inerest arbitrage refers to the transfer of liquid funds ftom one monetary center and currency to another to lake advantage of higher rates of returns (interest). The resulting foreign exchange risk is usually covered or hhedged by a forward sale of the foreign currency to coincide wivh the maturity of the foreign investment ‘Thete is an incentive for covered interest arbitrage as long as the positive interest differential in favor of the foreign monetary center exceeds the forward diseount on the foreign currency. EXAMPLE 5. If the retum on three-month treasury bills is 12% (on w yearly basis) in London and 84% in New York, a US, resident can exchange her dollars for pounds atthe curent spot rate and invest them in London where she eams 4% more yer yoar or 1% more for he quarter. However, in three months, the U.S, resident may want to reconvert pounds mo dollars afd collect the extra interest cared. Since in three months, the spot rue of the dollar with respect to the ‘pound may be lower, hor extra interest gained may be wiped out or more than wiped out. To cover this exchange risk, ‘at the same time that the U.S. investor exchanges dollars for pounds to invest in London for uuee months, she will also ‘engage in a forward sale of an equal amount of pounds (plus dhe amount of interest that she will earn) for doliars for delivery in three months. If the Forward discount on the pound is 1% on a yearly basis, she will Tost 1/4 of 1% for the ‘quarter on the foreign exchange (ransuction, but will gain an extra 1% interest forthe quarcer, for a net riskless return of bout 374 of 195 on her foreign investment. However, as covered interest arbitrage proceeds, the postive interest differential in favor of London tends to decline ‘while the forward discount on the pound tends to irtase, until they are equal (interest parity; sce Problem 7.21). At interest parity, there is no further possibility of gain and covered interest arbitrage comes to an end. 7.7 EXCHANGE RATE DYNAMICS During the past two decades, there has been a great deal of exchange rate volatility (variability) and overshooting. Exchange rate overshooting refers to the tendency of exchange rates to immediately depreciate or appreciate by more than required for long-run equilibrium and then to partially reverse their movement as they move toward their new long-run equilibrium level (sec Example 6). The reason for this i that financial markets adjust much more quickly than trade flows to market disequilibria (see Problems 7.23 to 7.25). EXAMPLE 6. Suppose that fromm th long-run equilibrium exchange rate between the dollar and the pound, the supply of money inereases in the U.S. This will lower exchange rates in the U.S. and results in an outflow of investment funds to the U.K, as U.S. investors seek to take advantage of the now relatively higher interest rates in the U.K. This will ead to a quick increase in the U.S. demand for pounds and depreciation ofthe dollar, Over rime, however, as U.S. expors increase and U.S. imports decline in response to the dolar depreciation, the dollar appreciates, The only way for the U.S. dollar to first depreciate and then appreciate a it moves tawasd its new long;-run equilibrium level is for the dollar to first depreciate past its new long-run equilitriom level and then gradually appreciate toward its long-run equilibrivin level 7.8 THE BUROCURRENCY MARKETS The Eurocurrency marksts are the markets where Eurocurrencies are bought and sold. Euracurrencies refer to commercial bank deposits autside the country of issue of the currency. For example, a deposit denominated in U.S. dollar in a British commescial bank (or even in-a British branch of a U.S. bank) is called a Eurodollar Similarly, a pound sterling deposit ousside the U.K. is called a Eurosterling, and so on. The Eurocurrency ‘market consists mostly of short-term funds with maturity of less than six months. EXAMPLE 7, The Eurocurency market has grown from es tan $10 billion inthe envy 1960s cover $1 clon in 1990. More than half of the total value of Eurocurrencies isin Eurodollars. This market grow very rapidly, especially after 1973, as petroloum-exporting countries deposited outside the U.S. huge dollar amounts accomulatd from the sharp Increase in petroleum prices. Starting in December 1981, U.S. banks were exempled from federally imposed inerest ceilings and reserve and insurence requirements and were allawed to compete dell inthe Eucodellar marke.124 ‘THE FOREIGN EXCHANGE MARKETS (cHar.7 Glossary Forelgn exchange market The organizational framework within which individuals, ims and banks buy and selh foreign custencies or foreign exchange. Forelgn exchange rate The domestic currency price of the foreign currency. Forelgn exchange arbitrage Purchasing of a foreign currency where its price is low and selling it where the price is high. This keeps the exchange rate equal in all parts of the market. Depreciation An increase in the domestic currency price of the fareign cumency. Apprectation A decrease in the domestic currency price of the foreign currency. Effective exchange rate A weighted average of the exchange rates between the domestic currency and the currency of the nation’s most important tredo partners, Equilteriam exchange rate The exchange rate determined by the intersection of the market demand curve for and the market supply curve of the foreign currency. Hedging ‘The avoidance or the covering of a foreign exchange risk. Forward exchange rate ‘The exchange rate in foreign exchange transactions that calls for the payment or receipt of the foreign exchange one, three or Six months (usually three months) after the contract is agreed upon. Spot exchange rate The exchange rate in foreign exchange transactions that ¢alls for the payment or receipt of the foreign exchange within (wo business days of the transaction. Speculation The acceptance of a forcign exchange risk, or open position, in the hope of making a profit. interest arbitrage The transfer of liquid funds from one monetary center (and currency) to another in order to take advantage of the higher rates of return or interest Covered interest arbitrage The transfer of liquid funds from one monetary center to another (0 eam higher returns or interest, with the foreign exchange tisk covered by a forward sale of the foreign currency to coincide with the maturity of the foreign investment. Interest parity The situation where the postive interest differential in favor of the foreign monetary center is equal to the forward discount on the foreign currency. Exchange rate overshooting Tne tendency of exchange rates to immediately depreciate or appreciate ‘by more than required for long-run equilibrium and then to partelly reverse their movement as they move toward their long-run equilibrium levels Eurocurrencles Commercial bank deposits outside the country of i ue of the currency. Review Questions ‘The function of the foreign exchange market is 10 (2) tmnster funds from one sation to anoWwer, (5) provide short-term credits to finance trade, (¢) provide the facilities for hedging, (4) all of the above. ‘Ans, (d) See Section 7.1 2) 18 $3.60 is needed Yo purchase £2, the exchange rate is (a) $2.60 = £2, (6) $1.80 = £1, (c) £0.50 = 51, (a) £0.40 = SI. ‘Ans, (b) See Section 7.2 and Problem 7.4(@).CHAP. 7] ‘THE FOREIGN EXCHANGE MARKETS 125 rm extonge re tot ame nal psa te mit by) xen ais, (0) tat bag, (e) hedging, (2) speculation. ‘Ans. (a) See Section 7.2 and Example. |. ‘A change from $3 = £1 to $2 = £1 represents (a) &éepreciaton ofthe dollar, (4) an appreciation of the dollar, (@) an appreciation of te pound, (4) none of the above. ‘Ans, (b) See Section 7.2 and Example 1 Ope 8 Mexible exchange system, the exchange rate is determined by (0) the nation’s monetary authorit (b) he price of gold, (c) the forces of demasd and supply inthe foreign exchange masket, (4) exchange abitage, sae toa sins vom 5, seme prepa i eta stm, (4) tsps, (6) the pound depreciates, (c) the dollar appreciates, (a) none of the above. 3 Hedging refers to (a) the acceptance of a foreiga exchange risk, (b) the covering of @ foreign exchange risk, (c) foreign exchange speculation, () foreign exchange arbitrage. Ans, ion .o ca (Se San Yb et . 8. AUS exporter scheuled to reepHe £1,000 three months from today can hedge his foreign exchangf risk by (a) buying today £1,000 in the forward market for delivery in Uhrce months, (b) buying £1,000 in the market three months from today, (c) selling £1,000 in the spot market three months from today, (d) selling today £1,000 inthe Forward maet for delivery in thie month. Ans. (d) See Example 3 {fa forcign exchange speculator expects the spot rate ofthe pound thres months from today to be lower than today's onward rae on the pou for delivery in three months, she will (a) buy pounds forward today and resell them in the spot market three mond fom today, (b) buy pounds in the spot masket three manths frorn today, (c) sell ‘pounds in the spot make tes months from today, (d) sell pounds forward today and buy them inthe spot market three months from today. Ans. (d) This isthe opposite of Example 4. 4) Covered interest arbinage involves (a) the transfer of liquid funds from cue monetary center and currency ito ‘another to take advantage of higher interest rates inthe ater, (b) hedging, (c) earning extra interest in arskless way, (d) all of the above. ‘Ans. (d) See Section 7.6. AL. A liguid capital outflow from New York to London under covered interest arbitrage can take place if the positive interest differential in favor of London (a) is smaller than the forward discount on the pound, (6) is equal to the forward discount on the pound, (c}is larger than the forward discount on the pound, (4) is equal or larger than the forward discount on the pound. ‘Ans. (e) See Example 5. ad ‘An exemple of a Eurocurrency is (a) a dollar deposit outside the U.S., (4) a pound sterling deposit ouside the U.K., (o)m mark deposit outside Germany, (d) all of the above. ‘ns, (d) See Section 78.126 ‘THE FOREIGN EXCHANGE MARKETS icHap.7 Solved Problems ‘THE FOREIGN EXCHANGE MARKETS 1 12 (a) In what way is domestic trade different from foreign trade? (b) How is the foreign exchange ‘market organized? (c} What is its principal function? How is this accomplished? (c) What are he other functions of the foreign exchange market? How are these accomplished? nay Dot ade vlespyents mad an ive in ems fhe al ATE). Fog ade, Reet td uevelly involves payments and escipl it foreign curencics (ce Seco 1.1) Thus, forcign a a a anseof iy natal cueae fo orig cUneRles And te xchange of oon currencies for the national curmency- freien Oa ope met ray carne composed fale sn ris whe he ue The cig xh mi te ancy conse coed by & pane See a a a tm tea banks and brokers in these monelary centers, rer cn aft eg xctage malt tr ACHR Pv om na The ed a yore eae rake aa eet oo rized rane than sailed. Wih it a bank inuss it correspondent in a forcign moscasy enter to pay 2 specific amount ofthe local currency toa desigoated person, firm or account wneiany (ane Recionot be tong cxcge mate se smi con. Creat mad ws gods fat sin fr a so te bye ele gree a abe a ee oan pate tn on eco Sinan ene to pay atthe foreign department of his bank, which will eveatally collect the payment from thei sone ty athe on ne et epee vote ocean Teton change make aso provides to faces fr hedging (nd speculation This i secomplced iio fonvecd exchange matte (whichis part ofthe foreign exchange marke; se: Probeins 7.9 7.18) (a) How can a U.S. imporer pay a British exporter? (b) How can ¢ U.S. exporter receive pa froma British imporer? —(c) How can these be accomplished in the foreign exchange = Co As npr od extn cota fons Now Yak, Ln he a a i ee a Or hc py la, sch soe then exchange for pounds in London, New York or elsewhere woul Oa erie pymcn pt whe wold Meds Ney ‘London or elsewhere. Or he can receive payment in dollars which the British importer bought with ‘ork, in London, New York or elsewhere, ‘Pounds, Onna as ld npn beeps can edn Es hrm US, ml ns Pa osc ws. Ce ud mate Bach Ingen che sare favmeos in dollar Or, U.S exporters who are paid in pound: an sel hem for dlrs o Brith expo FO debs US nyu oho et on car ee Gollars from the British importer who needs dollars. Thus, the foreign exchange market operates with aoe en Ghee pone we enenaly pad with expos and ony The wl Glas gr set ‘currencies. " ‘THE FOREIGN EXCHANGE RATES 13 (a) What is meant by the exchange rate berween the dollar and the pound’) (6) Ifthe exchan between the dollar and the pound changes from $2.00 = £1 to $2.20 = £1, what does this ee the dallas? For the pound? (c) Ifthe exchange role between the dollar and the pound changes from $2.00 = £] to $1.98 = £1, what does this mean for the doller? For the pound? (ad) Wha by an effective exchange rate? How is it meesured?CHAP. 7] ‘THE FOREIGN EXCHANGE MARKETS 127 14 (a) The exchange rate between the dollar ad the pound refers to the numberof dolar required to get one ‘pound. For example, atone point in time, $2.00 might be required to purchase one pound. Then, the ‘change rate between the dollar and th pound could be expressed 2s $2.00 = £. This isthe formulation prefered by she U.S. andthe ove we wil continue fo use i his book. However, the exchange rate batween the dollar and the pound could also be expressed asthe numberof pounds required to purchase one dalla. ‘Thus, the above exchange rae of $2.00 = £1 could also be expressed as £0.50 = S1. Similaly, the ‘exchange rate between the dalla andthe French Crane (F) could be expressed either as $0.20 = Fl or #8 5 ~ SI. The exchange rte betwoon the dollar andthe German mark (DM) might be quoted as $0.40 = DMI or as DM2.5 = $1, There isan exchange rate Between the dollar and every other traded enreney (@) An increase inthe exchange rate from $2.00 = £1 1 $2.20 + £1 refers to 8 10%) depreciation ofthe olla with respect wo the pound, since 10%) more dollars are wow required to purchase one pound. This is equivalent to an appreciation of the pound with respect tothe dollar (since a smaller quenity of pouns is now requized to purchase one dollar). (©) A decteaze inthe exchange rate between the dllarand the pound from $2,00 = £1 to S1.98 ~ £1 represents 4 (1%) appreciation of te dollar, or conversely, a (1%) depreciation ofthe pound. (d)_Ancffectve exchange rate refers toa weighted average of ti cxchange rates between the domestic eureney and the curency ofthe nation’s most important trade partners, with weights given by the relative value of the nation’s tude with each of hese ade partners. (a) How can foreign exchange arbitrage take place if $1.98 = £1 in New York and at the same time $2.00 = £1 in London? () What happens as arbitrage takes place? (a) Forvign exchange arbitrageurs will buy pounds in New York at $1.98 per pound and immediately resell them in London for $2.00, making « profit of 2 cents or 1% on each pound so exchanged (nrinus the interest charge on the raaney during the time its ied up in arbitrage and the cost ofthe telegraphic transfer—both of which are very small). This probit margin may seem very small indeed, but on a transaction of one ruilion dollars, it means gain of almost $10,000 for only 2 few minutes work! Note also that the arbitrageur does not incur foreign exchange risk, except momeatarly, because he or she buys and immediately resell an equal amount of the foreign cumency. (D) As arbitrige continues, the dollar price ofthe pound tends to increase in New York (because ofthe inerease in demend for pounds) and to fall in London (because of the increased supply of pounds). This tends to reduce the profitability of arbitrage and to resul in approximately the same dolla price for the pound in [New York, London and in every other moneiary cenier where the two curencles are waded for each other. ‘When foreign exchange arbitrage docs not oecur either because of Jack of knowledge or because it is forbidden, wide differences can exist in different monetary centers in the exchange mite between the sume ‘wo currencies. What we have described above is two-point arbitage. Three-point arbitrage rests on s+ sentially the same principle but involves thee monetary centers and three currencies and occurs much less frequently. ‘THE EQUILIBRIUM FOREIGN EXCHANGE RATE, 18 With reference to Fig. 7-1, (a) what lies behind the U.S. demand for pounds? (5) Why is the U.S. demand curve for pounds (D.) negative sloped? (c) What lies behind the U.S. supply of pounds? (4) Why is the U.S, supply curve of pounds (S,) positively sloped? (e) Why is $2.00 = £1 the equilibrium exchange rate? (a) Behind the U.S. demand for pounds les the U.S. desire to import goods and services from the U.K. (in a twornation world), to make transfer payments tothe U.K., and to invest in and extend loans to the U.K. (ee Chapter 8). in addition, » demand for pounds may aise for speculation. (b) Dg Is negtively sloped because at lower exchange ratés (So that fewer dollars are required to get each pound). England becomes a cheaper and more attractive place in which to buy and invest $0, U.S. residents buy and invest more in Englend and demend a greater quantity of pounds. In eddition, speculators could also enter the (spot) market for pounds and buy reser quantities of pounds the lower the exchange rate (i they expect the exchange rate to rise in the flure; see Problem 7.22).128 16 Ww ‘THE FOREIGN EXCHANGE MARKETS, (cHap.7 (c) Behind the U.S, supply of pounds fies the U.K. desire to linpor goods and services from the U.S. and to” invest in and make loans to the U.S. (sce Chapter 8). In addition, a supply of pounds may also arise from speculators. 7 (d) Sx is positively sloped because at higher exchange ratcs (R's), it becomes cheaper and more attractive for UK. residents to buy and invest in the U.S. (since they now receive mote dollars for each pound) and so the quantity of pounds that they supply tothe US. asuaily increase (ce Chapter 9). Inston, the higher the exchange rate (andthe greater dhe eapectation that it wil fallin the future), the grecer the quantity of pounds supplied by speculators (se Problem 7.22), (©) Avexchenge es higher than $2.00 = £1, the quantity supplied of pounds exceeds the quantity demanded ‘of pounds (ee Fig. 7-1) and dhe exchange rule tends (0 fll. At exchange rates below $2.00 = £1, (QDs > OS; and the exchange rate tends to Hse. Only At $2.00 = £1 dacs QDe = QS (at £6 billion per year) and isthe exchange rate in equilibrium. In Fig. 7-2, De and Sy are the same as in Fig. 7-1. With reference to Fig. 7-2, (a) explain what fhappens when De shifts up to Dj and U.S. monetary authoritius keep the exchange rate fixed at $2.00 = £1. (4) What happens if the exchange rate is sllowed to vary? (c) What can cause the U.S. De to shift to Di? R= 8c so} [rit Billion Liveur Fig, 72 (a) With De aod S, the cauilbrium exchange rate is $2.00 = £1 and the equilibrium quantity demanded and supplied of pounds is £6 billion per year (point in Fig. 7-2), When Dg shifts up to Di, we see ftom the figure that st the unchanged exchange rate of $2.00 = £1, ODE = (10) > QSc = (6) by £4 billion per year (equal to $8 billion atthe exchange rate of $2.00 = £1). (®) If, on the otter hand, the exchange rte is allowed es vary (25 under a freely Actuating exchange rate system), the exchange rte wll rite to its new equilibrium level of $2.10 = £1, af which £8 bilion per ‘year arc demanded and supplied (point £' in Fig. 7-2). Thus, the depreciation of the dollar (and the appreciation ofthe pound) automatically corrects the U.S. excess of expenditures over earings inthe U.K. (aad the equal U.K. excess of earnings over expenditures inthe U.S.) (€) De shifts up Gc., the U.S. demands more pounds at each exchange swe) ifthe U.S. tastes for English soods increase, as the GNP of the U.S. rises (see Chapter 9) and if the gree of traded commodities in terms of the domestic currency rises faster in the U.S. than inthe U.K. ‘With reference to Fig. 7-3, (a) explain what happens when the U.S. Se shifts dawn 10 Sf and U.S. ‘monetary authorities keep the exchange rate fixed at $2.00 = £2, (6) What happens if the exchange rate is allowed to vary? (c) What can cause the U.S. Seto shift down?‘CHAP. 7] ‘THE FOREIGN EXCHANGE MARKETS 19 18 oof. 8 8 we Billion Evear Big. 73 (a) When Sy shifts dow to 8, we can see from Fig. 7-3 that at the unchanged rate of $2.00 = £1, QS? = (10) > QDe = (6) by £4 billion ($9.8 billion) per year (8) If, on the other hand, the exchange ate is allowed to vary, te exchange rate will fall to its new equilibrium level of $1,90 = £1, ot which £8 bilion per year are demanded and supplied (point Ein Fig. 7-3). Thus, the appreciation ofthe dollar (andthe depreciation of the pound) automaicaly corecs the excess expen dirres of the U.S. in the U.K. (andthe equal excess earnings of the U.K. inthe U.S.) (€) Se shifts dowa (.e,, the U.K. supplies more pounds to the U.S. a each exchange rate) if UK. tastes for ‘American produc increase, as the GNP of the U.K. iss (see Chapler 9), and ifthe inrease inthe domestic price of traded commodities is greater in the U.K. than in the U.S. ‘Draw a figure and explain what happens if Dz shifts up to Dj (as in Fig, 7-2) and at the same time, Se also shifts down to Sf (es in Fig. 7-9). In Fig. 7-4, the new equilibrium exchange rate with Dz and Sis $2.00 = £1 (the same as with Dz and, bu the new equiibriom quantity demanded and supplied is £10 billion per year (pei E” in Fig. 7-4. Note that Je this case, the result would be the same whether the U.S. operated under a fleibte ora fixed exchange rate system. In the real world, the demand and supply of each currency in terms of others aro constantly changing, ‘causing exchange rcs to fluctuate continuously (see the daily quotations of the most important cunacies in terms of dollars in the financial pages of any leading newspaper). Exchange rates also fluemte (Cough (oa much lesser extent), even under relatively fixed exchange rte systems (see Chapter 9). These continuous Auctuations Jn exchange rates give rise to the need for hedging and the opportunity for speculation in the forign exchange snarket130 7.0 TAL ‘THE FOREIGN EXCHANGE MARKETS IcHar. 7 (6) What is meant by a forward foreign exchange transaction? The forward exchange rate? Give an example. (c) What is the forward exchange market? (a) A spot foreign exchange transaction refers to the purchase or sale of foreign exchange for delivery within ‘ovo business days. The exchenge rate at which ths occurs i ealled the spot rute. For example, £100 could be obisined immediately by paying $2.00 per pound for a total of $200. () A forward foreign exchange transaction inzolves an aprecment today to buy or sell @ specific ammount of foreign exchange, et a specified future dite, at a race agreed upon today (the forward exchange rate). For example, 1 could enter into an agreement today to purchase £100 three months from today ai $2.02 = £1, ‘After three months, I get the £100 for $202, regardless of wha the spot rate Isat that time, (6) The forward exchange market is part ofthe foreign exchange market and refers lo the institutional framework ‘within which foreign excharge is bought and sold for future delivery at rates agreed upon today. The usual Forward exchange contract and rate are for one, dee or six months. Forward contracts for longer periods are rare because of the great uncerinty involved. However, forward contracts can usually be renegotiated for one or mote periods when they become due. The following problems will deal with three-month contacts and rates exclusively. (a) How is the equilibrium forward exchange rate determined? (b) What is meant by the pound being at g three-month forward premium? At a three-month forward discount? (a) Just as the spot exchange rate is determined by the intersection of the market demand curve for and the ‘market supply curve of foreign exchange for delivery within two business days (soe Example 2), so the forward exchange rate is determined by the intersection of the market demand curve for and the market supply curve of foreign exchange for future delivery, The demand and supply of forward foreign exchange arise inthe course of hedging, covered interest arbitrage, and foreign exchange speculation (see te following problems). The equilibrium forward rate may be equal to, above or below the coresponding equilibrium ‘pot rate. (®) The pound is said to be at a uce-month forward premium when the three-month forward rate is greater than the corresponding spot rate. For example, if the spot rate of the pound is $2.00 and the three-month forward rate is $2.02, we say thatthe pound is ata three-month forward premium of 2¢ oF 1% (or at a 4% {forward premium per year) with respect tothe dollar. On the other hand, if the pound spot rae is still $2.00 bat the three-month forward rate is $1.98, the pound is sald to be at a forward discount of 2¢ or 1% for thc three months or 4% per year. Unless otherwise indicated, forward premiums and discounts are expressed 1s percentages per year (Erom the corresponding spot rate). (a) What is meant by hedging? What gives rise to it? Who should hedge? (b) Can hedging take place in the spot market? How? (c) Why does hedging usually take place in the forward market? (a) Hedging refers to the act of avoiding or covering a foreign exchange risk. The need for hedging arises Decause (spot) exchange rites fluctuate continuously through time. As a result, people who expect to make ‘or recsive payments in terms of a foreign currency at a future date face the rick that they will have to pay ‘more or will receive less in terms ofthe domestic curency than they anticipated. Except for foreign exchange speculators who actually seek foreign exchange risks, everyone else with foreign exchange payables or receivables at a future date should (and usually does) hedge these foreign exckange risks. (®) Hedging can take place in the spot market. For example, a U.S. importer who anticipates making a future payment in pounds, and who worries thatthe spot rate of the pound wil! ise in the future (so that she will need more dollars than presenuy to buy the pounds she needs), can buy the pounds she needs in the spot market todey at today's spot rate and Teave them on deposit (and earn interest) in a London bank until needed fo make the payments. Similarly, a U.S. exporter who anticipates receiving a future payment in pounds can borrow pounds in London today, exchange them for dollars at today's spot rate, and then repay lhe loan in pounds when he receives the payment (in pounds) for his exports,cHaP. 71 ‘THE FOREIGN EXCHANGE MARKETS 131 (©) Hedging usually rakes place in the forward market because it is simpler and, at the same time, it does not tie up the individual's or firm's capital or funds. For example, the above U.S. importer, by purchasing pounds today and holding them unl the payment is due is, in effect, paying eash for her imports (the interest she receives on her pound deposits could be earned inthe form of a price discount from the exporter dy paying cash). 7.12 Suppose that the spot rate of the pound today is $2.00 while the three-month forward rate is $2.02. (a) How can a U.S. importer who has to pay £10,000 in three months hedge his foreign exchange isk? (6) Whol happens if the U.S. importer does not hedge and the spot rate of the pound in three ‘months is $2.22? $1.95? 1) The U.S. importer can hedge by buying £10,000 today for delivery in tree months at today’s three-month forward rate of the pound of $2,02. Thus, he willingly pays on his forward contract 2¢ more per pound (ot $200 forthe £10,000) than today's spot rate in order to insucehirmself against the risk thatthe spot rate of dhe pound in three months willbe much higher than $2.02. Afler three months, when his payment becomes due, the U.S. importer will pay $20,200 and get the £10,000 he need to make the payment, regardless of, ‘what the spot rte of the pound is at tat time, () Ifthe U.S, impomer does not hedge and the 7.22), she loses on te foreign currency transection per se. Buti the positive interest diferetial in favor ‘ofthe foreign monetary center exceeds the forward discount on ie foreign curency (when bth are expressed in percentage pe Yea), it pays 0, make the foreiga investment, ‘Suppose that the rate on three-month easury bills is (on a yearly basis) 12% in London and 8% in New York, and the spot rate of the pound is $2,00. (a) How cana U.S. investor undertake uncovered interest arbitrage? (2) What happens if the spot rate of the pound in three months is $1.99? $1.98? 1.967 (c) How can the U.S. investor undertake covered interest arbitrage if the pound is at a three- ‘month forward discount of 1% (per year)? How much would the U.S. investor eam on his foreign investment? (2) The U.S. investar can exchange dollars for pounds at today's spot rate of $2.00 per pound, and then use these pounds to buy unree-month British treasury bills in London and earn 4% more per year or 1% more for the three months than if he had used his dollars to purchose three-month U.S, treasury bills in New York. (6) Ifin three months the spot mie of the pound is $1.99, the U.S. investor will eam an extra 1% interest for the three months, but since he originally bought pounds at $2.00 and resells them at $1.99. he will lose V2 of 1% on the foreign exchange transection per se 0.005, or 1/2 of 15% {investment than if he had invested his money in U.S treasury bills in New York, If in three months the spot rae is $1.98, he will lose 1% on the foreign exchange transaction, and so he ears nothing extra by investing abroad. Finally, if the spot rate in three months is $81.96, he loses 2% on the foreign exchange transaction against the extra 1% in interest eared. Thus, he _ ears about 1% less than if he had invested his money in U.S. treasury bills. cis to avoid risks ofthis type that interest arbitage is usually covered. (c) The U.S, investor ean undertake covered interest arbitrage by (I) exchanging doflars for pounds at today's spot rate ofthe pound of $2.00, (2) using these pounds to buy three-month British treasury bills in London snd (3) engaging today in a forward sale of an equal amount of pounds (plus the ammount of Interest he will ‘ear for dollars at today's three-month Forward rete of the pound. The result is that he will guia an extra134 120 7A 12 ‘THE FOREIGN EXCHANGE MARKETS {CHAP. 7 1% in interest but wid lose 1/4 of 1% for the quarter on the forward contract, for a net riskless extra gain of (about) 3/4 of 1% on his foreign investment. There is an incentive for covered interest arbitrage, as iong as the positive interest differential in favor of London excocds the forward discount on the powed (both expressed on a yearly basis) Calculate exactly how many more dollars the U.S. investor of Problem 7.19(c) actually gains when ‘he uses $200,000 for covered interest arbitrage in London rather than to purchase U.S. treasury bills in New York. ‘The U.S. investor exchanges his $200,000 for £100,000 atthe spot rate of the pound of $2.00. He uses this {£100,000 10 bay British weasury bills in London, With the interest rate on U.K. ucasury bills at (2% per yea, the U.S. investor will cam 3% in interest forthe quarter (£3,000 on his £100,000 investment. Since he Knows that athe end of the three months he wil have £103,000, he will sll Use £103,000 today for dollars ip he focward market fo delivery in three months. Bur we wer told that the poond is at s forward discount of 1% per ‘yar or V4 of 1% (0.0025) for tce months with respect (0 the spot ale ofthe pound of $2.00. Thus, the thee: ‘month forward rate of the pound is: $2.00 ~ {0,0025)S2.00) = $2.00 ~ 0.005 = $1.995. Afier three months, the US. investor will sell his £103,000 a S1.995 per pounds and receive $205,485. He cams $5,485 on his foreign investment of $200,000, or about 2.75% for the quarter. This is $1,485.more than the $4,000 (or 0.75 percentage points more han the 2%) tat he would have eared forthe quarter ie had instead used his $200,000, to buy U.S, treasury bills in New York As covered interest arbitrage continues under the conditions examined in Problem 7.19, (a) explain ‘what happens to the positive interest differenti! in favor of London, What are the market forces that tend to bring this about? (b) Explain what happens to the forward discount on the pound. What are the’ market forces that bring this ebout? How far will covered interest arbitrage procecd? (@) As funds awe wansfered fom New York to London, the supply of funds is reduced in New York and inreated in Londan. This tends to cause the interest rate to rise in New York, say from 8% co 9%, and to fall in London, sy from 12% to 11%, so tat the positive interest differential in favor of London becomes 29% per year and 12 of 1% for a quarter. (©) Atithe same time, as the demand for spot pounds inxeases (60 as to uensfor pounds to London to eam the higher interest rte), the spot rate ofthe pound tends to increas. AS the supply of forward pounds increases (€0 cover the exchdage risk), the forward rate of the pound falls. For both reasons, the forward discount ‘on the pound increares, say from 4% to 2% on a yearly basis oF from 1/4 of 1% to 172 of Ue for a quarter, ‘When this occurs, the forward rate of the pound is said to be at interact pasty (ho 1% extra intrest for tbe quarter being exactly balanced by the 1% discount on forward pounds for the quarter) and covered Interest arbitrage comes to an end. Inthe real world, the postive inerest differential in favor of Landon ‘may have . exceed the forward discount on the pourd by atleast 1/4 of 19% on a yearly basis for covered ‘inerest arbitrage to take place ‘Suppose thatthe interest rate on three-month treasury bills is 12% in London and 10% in New York (a) How much-would U.S. investor eam on covered interest arbitrage if the three-month forward pound is at a 1% premium? What happens as covered interest arbitrage proceeds? (b) What would happen if the three-month forward pound is at 4% discount? (e) What is the relationship between the spot and the forward rate of the foreign currency? a) The U.S, investor will not only cam the extra U2 of 1% intrest forthe thee months, but she will also ‘eam another 1/4 of 1% on her forcign exchange transaction (by being able to resell pounds in the forward ‘market for delivery in three months ata price 1 of 1% higher than she paid). Ths, her total extra gain is about 3/4 of 1%. Hovever, a covered interest arbitrage proceeds, the positive interest differential in favor of London tends to fll [or the reason described in Problem 7.21(a)] from, say 2% to 1% per year, [A te same time, the spot rate of te pound rises andthe three-month forward rate of the pound fals [as in Problem 7.21(6)] unit the forward premium on the pound becomes a forward discount of 1% per year and is at inerest parity.CHAP. 7) ‘THE FOREIGN EXCHANGE MARKETS: 135 (H) With a posiivg interest differential of 2% (pe year) in favor of Landon but the sree-month forward pound 4% discount (per year), it does not pay for U.S. investors to undertake covered interest arbitrage in favor ‘of London. On the contrary, it pays for English investors to wansfer funds 10 New York. When they do that, they lose 2% interest but gain 4% on the foreiga exchange tastaction (by being able to buy back. ‘pounds with dollars ata rate 4% per year less than the rate at which they originally sold pounds for dlls). AAs this ovcurs, the positive interest differential in favor of London tends to rise (as fonds ere transferred ftom London to New York) and the forward discount on the pound falls (s British investors cover their ‘exchange risk) until the forward discount on the pound is at interest party. (©) Under normal conditions, the relauonship between spev and forward rats is determined largely by covered Interest arbitrage. IF interest rates are higher abrod, covered interest arbtrge tends to keep the fo currency ata forward discount with respect tothe spot rate equal to te postive interest differential in favor ofthe foreign monetary ceater if interest raes are higher domestically, coveted interest arburage tends 10 keep the foreign currency ata forward premium relative to the spot sate (end the domestic currency at forward discount) equal to the domestic positive interest eferential. However, this may not hold even approximately when covered interest arbitrage is forbidden or with large destabilizing speculation (see Problem 7.17). EXCHANGE RATE DYNAMICS 7.23, Explain why financial markets adjust much more quickly to a market disequilibrium and overwhelm adjustments in the real or trade sector in the short run. A change in interest rates, wealth, expectations, ad so on disturbs the equilibrium and leads cach investor to reallocate financial assets to achieve & new equilibrium or balanced portfolio. The adjustment involves a change. in the stock of the various financial aseis inthe portfolio. Having been accumulated over a longtime, the toll stock of financial aseis in investors’ portfolios inthe economy is very large in elation fo the yearly flows (additions to the stock) through usual savings and investments. Furthermore, any change in interest rates, expectations, oF cotter forces thet affect the benefits and costs of holding the various financial asseis are likely to lead to an ‘immediate or very rapid change in their stock, as investors allempt to quickly reestablish equilibrium in their portfolios. ‘For example, an increase in the Inierest rte abroad will lead investors co reduce their holdings af domestic ‘money ait domestic bonds and to increase their holdings of foreign bonds. This stock adjustment cant be very lange and vsully occurs immediately or over a very shor time. This isin contrast to a change ia the low of merchandise trade which results from, say, a depreciation ofthe nation’s curency and which takes place only _radully and over a longer period (previous contracts have to be bonored, and new orders may take many months 4o fulfil). Tus, siock adjustments in financial assets are usually much larger and quicker to occur than adjustments in trade flows. 7.24 Draw a figure showing that from a long-run equilibrium exchange rate R = $2/E1, the dollar immediately depreciates by 16% and then gradually appreciates by 6% (for a net depreciation of 10%) to its new tong-run equilibrium level, Figure 7-5 shows that atthe initial long-run equilibrium exchange rate of R = S2/C1, the dollar depreciates immediately by 16% to R = S2.32E1 at time fy as 0 result of quick adjustments in financial makes and then gradually appreciates by 6% (for a net depreciation of 10%) to its new long-run equilibsium level of R = $2.2041 as U.S, imports and exports gradually respon over time to the dallas depreciation. 7.25 Starting from interest parity, explain the exchange rate overshooting of the dollar that is likely to result from a reduction in the rate of interest in the U.S. relative to that in the U.K. (Hint: Use the theory of covered interest arbitrage.) ‘Starting from interes parity, the decline inthe rate of nterestin the U.S. makes the positive interest diferental in fevor of the U.K. larger than the forwrd disecunt on the pound. As azesult, more investments flow from the U.S, to Beitin under covered interest ebitage. Ax investors purchase pounds on the spot market (Co increase ‘cic investments in the U.K. In onder to tnke advange ofthe higher interest rate there) and at the same time sell pounds forward (to cover thelr exchange risk), the exchange or spot rate of the dollar rises (ue, the dollar136 ‘THE FOREIGN EXCHANGE MARKETS (cHaP.7 \eprecates) andthe forward raie of the pound increases, as required for interest parity to continue to hold, A rising forward rate on the pound means that the market expecis the pound to depreciate andthe dollar ro oppreciate inte future! The only way forthe dollar 10 depreciate immediately and then appreciate overtime as it moves {toward its new long-run equilibrium level is forthe dollar to immediately depreciate by more than required for the new long-run equilibium level and then appreciate gradually overtime to eliminate the overshooting. Exchange Rate Rast Fig. 7-5 ‘THE EUROCURRENCY MARKETS: 7.26 Give the reasons for the existence of the Eurocufrency market. (One reason forthe existence of the Eurodollar market i eetively high interest rates that foreign barks pay ‘on shor-erm doll depois, European banks seem able to opersteon a smaller spread between borrowing and tending ries than U.S. barks, Another reason is that originally the U.S. dolar was the mos important ntematodal ccurency, i., the vehicle eureney, in which to make and receive imeratinal peymeats, 20 that multinational corporations (MNCs) found it very convenient to keep some dollar deposits abroad. Today, almost half of the total value of Eurgeurencies isin cher leading currencies, such as the Brilsh poond, the German mat the French and the Swiss tranes andthe Japanese yen, A third reason for ths existence ofthe Eurodoliar maske is ‘at MNCs could overcome domestic credit restriction at home by borrowing inthe Eurodollas market, A foun reason i hat communist nations prefer to kecp dollar depesis outside the U.S. for fear thet the U.S. might freeze thee dllar deposits inthe U.S. ina poiial css.CHAP. 7] ‘THE FOREIGN EXCHANGE MARKETS 137 1a 7.28 Explain (a) how the Burocurrency market can create money and (b) why the U.S. money supply might not be affected by the creation of Eurodollar deposits. (e) The Burocurrency market can create mony in 4 manner analogous to the way the domestic banking system ‘can create money in a fractional bankiog system, such as we have today (see Section 9.4 of Schaum's Outline of Principles of Economics). For example, Eurodollars are created when a bank outside the U.S. ‘makes a dollar loud to firm that uses it to make a payment to anciher firm and the receiving firm deposits the dollars outside the U.S. Similarly, Eurodollars are created when 1 bank outside the U.S. that is short ‘of dollars borcows dollars frem another bank with onutilized dollars. Since there are no reserve requirements ‘en Eurocurrency deposits the money muliplier could he very large indced. In reality, vhe money multiplier js insiead believed (o be Very small because of leakages (tom the Eurocurreney market. These occur when ‘7, When a U.S. firm imports a good from England and pays for it by drawing on its pounds sterling balances in a. ‘cadeLondon bank, the U.S. debts curen account and credits its (a) official eserve acsount, (b) unilateral transfers, {e) serves ints caret account) api acebunt ‘Ans, (d) This isa deerease in U.S, bank assets abroad and so a U.S. capital inlow. See Section 8.5 and Example 4a). 8, When an English tourist spends $200 wonkh of pounds in New York for hotels and meals, the U.S, credits the services category (travel) in its current account and debils (a) convertible currency in its official reserve account, (b) merchandise category in its current account, (¢) capital account, () none of the above. ‘Ans, (¢) This is an increase in U.S. elsims on foreigners and is equivateat ro an increase in U.S, assets abroad, constituting 2 U.S, capital outflow. See Section 8.5 and Example 4(6). 9. The statistical discrepancy of —$11 billion was entered in the 1988 statement of U.S. international wansactions because (a) total credits exceeded total debits in the current and capital counts by $11 billion, (B) total debits exceeded total credits in all unree accounts taken together by $11 billion, (¢) total credits exceeded total debits in all three accounts taken together by S11 billion, (4) total credits exceeded rota debits in the capital and official reserve accounts by S11 billion. Ans. (c) See Section 8,6 and Example 5. 410. A defcit or surplus in the U.S. balance of payments is measured by the net balance of the (a) current account, (®) capital account, (e) alloestion of SDRs, (d) statistical discrepancy, (e) all ofthe above, Ans, (e) See Section 8.7 IL. A deficit or surplus.ta the U.S. balesce of payments can also be measured by the net balance of the change in (2) US. official reserve assets, (6) foreign offical assets in the U.S., (c) U.S. private assets, (d) U.S. official reserve assets and foreign offical assets in the U.S. ‘Ans. (d) See Section 8.7.144 ‘THE BALANCE OF PAYMENTS (CHAP. 8 12, The concept and the measure of a defcit and a surplus in te balance of payments are strictly appropriate only under ‘¥ (a) a fixed exchange rate system, (b) a freely flexible exchange rate system, (c) a managed fioating exchange rate system, (d) all of the above. ‘Ans. (a) See Section 8.7. Solved Problems BALANCE OF PAYMENTS ACCOUNTING 8.1 (a) Whatis meant by a nation’s balance of payments? What sits purpose? (b) What is an international economic transaction? Who is a resident? (a) A nation’s balance of imemational payments Is 2 sommary statement of all the economie transactions between the residents of the nation and the residents of other nations during a specified period of time, usually a calendar year. The U.S. and some othr nations also keep such records on a quarterly basis, The main purpose of the balance of payments is to inform goverment authorities of the nation’s intemational position and to help them formulate monetary, fiscal ané commercial polic {®) An international economic trnszetion refers to the exchange of a good, a service or an asst (for which ‘payment is normally required) between the residents of one nation and the residents of othcr netions. Diplomats, military personnel, workers who temporarily emigrate and tourists are residents ofthe nation in which they hold citizenship. Similely, a corporation isa resident ofthe nation in which itis incorporated, bot its forwign branches and subsidiaries are not. These distinctions are somewhat arbitrary and may Sead (o difficulties. For example, a worker who stars out by emigrating temporarily may end up revaiing permanently 8.2 (a) What are the three main accounts in the U.S. balance of payments? What does each measure? (b) How are credits and debits entered in (the current and capital accounts of) the U.S. balance of payments? . (a) ‘The te main accounts of the balance of payments are the Curent account, the capital account and the offical reserve acegunt, The current account shows the flows of goods, services and transfer payrnets. The capital accouat shoves the international flow of investments and loans. The oficial reserve aeconnt measures the change in U.S. official reserve assets andthe change in foreign offical assets in (he labiiies of} he U.S. during the year (8) Ail economic transactions that load to the U.S. receiving payments from forcigners are entered as eredis (+ in the cumem account or in the capital account ofthe U.S. balance of paymenis, Thus, U.S. exports of goods and services, U.S. ceils of transfer payments from abroad, and capital inflows ‘ato the U.S. ae entered as crcits. On the other band, all economic transactions which lesd tothe U.S. making payments to foreigners are entered as dobits (~) inthe current account or in th capital account. Thus, U.S. imports of goods and services, U.S. transfer payments to foreigners, and capital cutows from the U.S. are entered as bits ‘THE CURRENT ACCOUNT 8.3 With reference to the services category of the current account in, Teble 8.1. explain in detail what is ‘meant by and what is included in {a} tcavel and transportation, (6) receipts of income on U.S. assets abroad and payments of income on forcign assets in the U.S., .(c) military transactions and (A) other services. (a) Travel refers to the expenditures of U.S. tourists abroad for meals, hotels and for the purchase of pits (debit), and similar expenditures of foreign tourists in the U.S. (credits). Transportaion refers to the cipenditres of U.S. residents ((ourists, business executives and firms) for the services of foreign carrecsCHAP. 8) ‘THE BALANCE OF PAYMENTS 145 84 suchas astnes, vessels, trains, ef: (Jebits), and similar expenditures of forciencesidenis forthe services of US. caniers (reds). The U.S. had a nct debit balance for travel and transportation of (—)83 billion in 1988, (0) Receipts of income on U.S, assets abrocd refers to the interest, dividends, carnings of unincorporated afliates, reinvested camings of incorporated affiliates and other earnings which U.S. residents cam on their foreign investments or which arse rem their ownership of foreign assets (redts). Reesips of income on USS. assets abroad were $108 billion in 1988. Payments of income on foreign asses in the U.S, refers to U.S. payments of interes, dividends and ther earnings on foreign ivesimens in the U.S. (debits) in 1988, this was $106 bilfon. These two entries sro usually zeported separately (ater than only their balance) because of ther catively greater importance. (©) Miliary wansactons refers to U.S. expenditures sbroad for renting land, buidings and facilites for military installations, forthe purchase of supplies for the militay and for te expenditures of U.S. military personne! sroad. ‘The erect counterparts are the foreign purchases of U.S. militacy materiel, ie shang of the cost of keeping U.S. uoops and military insullations cbroad and the waining of foreign milla. In 1988, the USS. had a net debit balance of (—)S5 billion in military tansections. (a) Other services refers to banking, insurance, stock brokerage and similar services provided by U. to foreign residents (edits) and purchases by U.S. residents from foreign institutions (debits). hhore as credits are the expenditures to maintain foreign embassis in the U.S., and as debits, the U.S. expenditures to maintain embassies abroad. The U.S. had a balance on other services of (+)820 billion in 1988. Define the meaning and scape of (a) unilateral private transfers and (6) government unilateral transfers. {@) Private unitatera ransfers refers to gilts made by individuals and nongovernmental institutions to residents of other nations, The private tansfer payments made by U.S. residents (debits) may take the form of individuals’ contributions toa femine relief fund for aless developed country, the remittances ofan immigrant in the U.S; to relatives "back home,” or a CARE package seat to wederaourished children in a poor nation. ‘As the richest nation in the world, tho U.S. receives lite if any transfer payments (credits from the residents, ‘of other nations. The balance on private Wansfer payments forthe U.S, was ~S7 billion in 1988. (®) Government unilateral transfers refers to gifts or other payments (for which nothing direct is received in retum) made by the goverament of one nation to individual, inslitations or the goverament of another nation. The transfer payments made by the U.S. government (debits) take the form of economic ad (such as grants of money, consumer goods, capital equipment or technical aid) to loss developed nations ilitary ‘id (usually in the form of military materiel), and the remittance of old age pensions and other similar payments to foreign workers in the U.S. who reid abroad. U.S. residents receive few if any transfor ‘pe¥ments from foreign governments, The balance on government unilateral transfers fer the U.S. was ~$13 billion in 1988, and —$15 billion for private and goverment wailateral transfers together. Explain what is meant by (a) the merchandise trade balance. Was this balance favorable or unfa- vvorable for the U.S. in 1988? (b) Do the same for the goods and services balance and (c) for the curtent account balance, (@) The merchandise wade balance is oblzined by subtacting the value of the goods imported by a nation fom the value of the goods it exported. It is usually che first ara ofthe nation’s balance of payments to become avilable. In 1988, the value of U.S. exports of goods (credits) was $319 billion, while the value of U.S. ‘imports of goods (debits) was $447 billion. Thus, the U.S. had a negative merchandise tade balance of (=)8128 billion (see Table 8.1) (b) The goods and services balance is obtained by adding the nation’s merchandise trade belence and its balance con services. In 1988, the U.S. had a negative balance on goods and services of ()$112 bition. In the U.S. today, the goods and services balance receives exaggerated attention in relation tothe olher compostals. of the U.S. balance of payments. (©) The current account balance is obtained by adding the nation's goods and services balanes to its balance: fon unilateral transfers. In 1988, the U.S. had & negative current account balance of ()$127 billion. Note146 ‘THE BALANCE OF PAYMENTS IcHap. 8 ‘that all ie items entered in the curent account are of a flow nature, referring toa certain amount per quarter (or per year. THE CAPITAL ACCOUNT 8.6 (a) Whot does the U.S. capitel account measure? (b) What forms can U.S. capital outflows take? {e) What forms can U.S. capital inflows take?” (a) The U.S. capitel sceount measures the change in U.S. assets abroad and foreign assets inthe U.S., other than official reserve assets, Thus, while the current account measures the flow of goods, services and unilateral tansfers, the eaptal account measures the change inthe stock ofall nonrescrve financial assets. “The justification for excluding official reserve assets from the capital account is that changes in reserves reflect government polices rather than masket forces. (2) USS. capital ouffows can take she form of either increases in U.S, assets abroad (such as U.S. purchases of a foreign stock) or ruetions in foreign assets in the U.S. (such as the stle by foreigners of a US. stock). Both are caital outflows and recoded as debits (-~) because both lead ta a payment to forcigners. [Note tha the capital account includes only the change in the stock of nonreserve financial asscs. The changes ia financial reserve asses or intemationl reserves are included in the official reserve account (see Problem 8,10). (©) U.S. capita inflows can take the form of lther reductions of U.S. assets abroad (such asthe U.S. sale of ‘foreign stock or inereases in foreign assets in the U.S. (suc &s the purchase ofa U.S. stock by foreigners). Both are capital inlaws and recorded as credits (+) because both lead to the recep of a payment [rom foreigners. Once again, te capital account includes only changes in nonreserve financial assets, 8.7 (a) What form do U.S. investments abroad take? (b) Why does the U.S. invest abroad? _(c) Whet is the relationship between U.S. foreign investments and the flow of profits, dividends and interest 10 the U.S.? {a) U.S. investments abroad take the form of direct investments (such as the building ofa plant or the purchase of real esate or land abroad), the purchase by U.S, residents of forejen cesar (such us stocks, bonds and treasury bills) and inereases in U.S, bank deposits abroad. Direct investments and portfolio investments ‘with maturity of more than one year (€.g.. stocks and bonds) are referred t0 a5 long-term investments to listinguish them from portfolio investments with maturity af one year of tess (e.g., creasury bills) and bank deposits, which ar referred to as short-term invesuments. (b) The U.S. invests abroad to take advantage of higher profit rates and higher interest rates (or the expectation of higher rates) abroad, to overcome wade barriers andor to develop foreign sources of raw materials (©) U.S. investments abroad give sse to the flow of profits, dividends and interest to the U.S. These represent foreign payments to the U.S. for the use of (or forthe services received from the use of) U.S. capital and ‘are appropriately outered as credits ito the services category of the U.S. current account. Thus, capital ‘movements must be clearly distinguished from the resulting flow of payments and remens. The former are tntered into the capital account, the letter into the current account. 8.9 (a) What was the nature of U.S. privete capital outflows and inflows in 1988? (b) What was the balance in the U.S. capital account ia 1988? (a) From Table 8,2, we can see that U.S, direct invesuments abroad ($17 billion) were much smaller then foreign direct investments in the ULS. (S58 billion), and so were U.S. purchases of foreign securiies (88. billion, compared with $47 billion for foreign purchases of U.S. securities) and the increase in U.S. bank liabilities abroed ($54 billion, compared with $69 bitlion for the increase in foreign bank deposits iv the US. (6) The U.S. capi account shoved a total debit entry of $77 billion and a total credit eniry of $180 billion, for a net credit bafance of $103 billion. This is to be compared with a net debit entry of §127 billion in the. U.S. eumnt eccodntCHAP. 8) ‘THE BALANCE OF PAYMENTS 147 THE OFFICIAL RESERVE ACCOUNT 89 8.10 Bll ‘What is meant by (a) gold reserves? (b) special drawing rights? (c) a nation’s position in the International Monetary Fund? (d) convertible currencies? (2) Gold recerves refer to the gold in the hands of the nation’s monetary authorities. At the end af 1988, the U.S. held about $11 billion of gold reserves (a the old official price of $42.22 per ounce, but worth almost tem fumes more atthe fluctuating free-market price of gold; sce Chapter 12) (8) Special drawing rights (SDRs or “paper gold") are international reserves created om the books of the ernationel financial institution; see Chapter 12} and distributed in accordance with their importance in world trade. At the end of 1988, the U.S. had about $10 billion in SDRs. (€)_ A nation’s reserve position inthe Internaional Monetary Fund (IMF) refers to reserves paid by dhe nation, in gold or convertible currencies upon joining the IMF. These are available to the nation on demand with ro “strings” attached in the even! of balance of payments cifficulies (See Chapter 12). At the end of 1988, the U.S. reserve pasition in the IMF was $10 billion. (2) Convedtible currencies refer to U.S. dollars, British pound sterling, German marks, Swiss, French and Belgian fruncs, Japanese yen, Iulign lie, Canadian dollars, Dutch guilders and a fow other currencies which canbe exchanged easily for one another and are normally acceptable in payment for international transactions. ‘The U.S. dollar is by far the most important of the convertible currencies and represents a miajor portion of the reserves of most nations of the world. At the ead of 1988, the U.S. held $17 billion of (foeiga) convertible currencies. Thus, the U.S. overall total official interationa! reserves were S48 billion (S11 billion in gold, $10 billion in SDRs, $10 billion in its reserve position at the IMF, and $17 billion in convertible curencies). (a) What does the US. official reserve account measure? (b) What form do foreign official assets in the U.S. take? (c) How are changes in U.S. official reserve assets entered in the official reserve account of the U.S.? (d) How are changes in foreign official assts in the U.S. entered in the official reserve account of the U.S.2 (a) The official reserve account measures the change in U.S. reserve assets (old, SDRs, the U.S. position io the IME, and the U.S. holdings of forcign convertible currencies) and the changes in foreign ifial assets jn the US, ducing the year, (b) Foreign offical assets in the U.S. esually take the form of U.S. dollars and U.S. treasury bills, U.S. bonds and U.S. notes in the hands of foreign monetary authorities, (©) Increases in U.S. official reserve assets represent offical capital ouflows from the U.S. and are recorded. 4s debits (—) inthe U.S. official reserve account. Any decrease represents an official capita! infow and is recorded as a credit (+). Thus, the rule fordeciding on debits and credits isthe some es for privat capital, except that we are now dealing with offical capital. Thus, an inflow of (increase in) official reserves is a debit just ike an inflow or import of goods end services, white an outflow of (decrease in) official reserves is a credit just like an outflow oF export of goods and services. The reason fer this seemingly strange way of entering changes in offical reserve asses a credis or debits will become clear when we go-on We define the deficit or surplus in the nation’s balance of payments. Here, we ate simply interested in leaming how they are entered, rather than why they are entered thet ay. (a) Increases in foreign ofcal assets inthe U.S. represent oficial copital inflows to the U.S. and are recorded as credits (+) in the U.S. official reserve For example, an increase in foreign oiial holdings of U.S. dollars can be thought of as “securities” giving foreigners claims on U.S. goods and services and equivalent o an increase in foreign official assets inthe U.S, Onthe other hand, decreases in foreign oficial assets in the U.S. represent officiel capital ousfows from the U.S, and are recorded as écbits (~) in the U.S. officiat reserve account, (a) What was the nature of the changes in the U.S. official reserve account during 1988? () What ‘was the balance in the U.S. official reserve account in 1988? What was is significance?‘THE BALANCE OF PAYMENTS {CHAP. 8 (a) During 7988, U.S. official reserve assets increased (aa official capital outflow from the U.S, and a debity {6 $11 billion. Of this, $1 billion tock the form of & decrease in the U.S. reserve postion at the IMF and $5 billion represented an increase in U.S. official holdings of (foreign) convertible curences. Also included i the U.S. official reserve account is the increase in foreign officiel assets in the U.S. (an official capital inflow t0 the U.S. and a credit) of $39 billion, (®) With the increase in U.S. offical assets of (—)S4 bilion and the increase in foreige ofeial assets in the U.S, of (+)839 billion, there was a net credit balance of (+3625 billion la che U.S. official reserve account. ‘This means that there was an overcl ne increase in foreign oficial holdings of U.S. assets (e.g. of U.S. dollars) equal to $35 billion. Tt can, therefore, be infered that there must have boon an excess of U.S. expenditures abroad ovec U.S. earnings abroad equal to $35 billion on all but official wansoctions, This ‘was setted by foreigners increasing their official holdings of U.S, (reserve) assets (.e., dollars) equal to hat amount. DOUBLE-ENTRY BOOKKEEPING a2 8.13 {a) What is meant by double-entry bookkeeping? (b) Why isthe single entry, statistical discrepancy, ‘often required? (c) Identify the credit items and the debit items in all three accounts of the U.S. balance of payments. (2) Double-coury bookkeeping refers tothe accounting procedure whereby whenever eet or debit wanscton is extere in x onions balance of payments, an offcting dbit or ere, respectively, ofan equal emount Js also entered, Thus, total credits should elways equal tolal dcbits when the three accounts are teken together. The reason for dovble-entry bookkecping is tht, in general every transaction has two ses. We sel! something and we receive payment fori; we buy something and we bave to py fori (0) Tae special single eatry, sisal discrepancy, is quired whenever ‘oul credits a all three accounts of the balance of payments do not equal total debi, This often occurs becase some items escape recording ‘@ue to oversight, secret capital movements or srauggling) while others may be incorrectly entered. Thus, if overal total credits equal 100 while overall total debits are 105, we ned a credit eoty for saitial discrepancy of (+5. (©) The crest tems (+) in the U.S, balance of payments are (1) an export of goods and services and the receipt of uuiltral anafere (In the current aceeund, (2) capil inflows (in the capital account) and {3) an increase in foreign official assets in the U.S. and decrease in U.S, official reserve set (in he offal reserve account). Or he ther hand, the debi ems (~) are (1) an import of goods and services tod the making of niateral transers, 2) capital ourfows, (3) an increase in US, offal reserve asses a6 decease in forcign offical asst in the U.S. In short, «deca fa U.S. sels reculing frm the export of goods, services and reserves, as wel as capital inflows or imports no the U.S., are ees, while the opposite ae debits, How are the folowing transactions entered inthe U.S. balance of payments? (a) A U.S. firm exports ‘$100 worth of goods to the U.K., payable in three months. (6) After three months, the English importer pays by drawing down her dollar deposits ina New York bank. (c) What is leftof transactions. (o) and (®) if they occur within the same calendar year? If they do not? (@) The U.S. credits merchandise ia its eurent account for $100 and debits its capital account for $100. The reason for this is that by accepting payment in three months, the U.S. exporer is essentinly extending short-term loan to the foreign imporer. This is « U.S. short-term private capital outflow (an increase in U.S, assets abroad) and is entered as a debit. (The exporter usually then rediscounts the imporer's commercial obligation to pay at his bank. Thus, he gets his money immediately and his bank will collect the payment from the importer in three months.) (6) When, after ee months, the English importer pays by drawing on her dollar deposits or her bank's dollar deposits in a New York bank, the U.S. credis its capital arcount by $100 (2 reduction in U.S. assets ‘abroud—a capital inftow) and also debis its capital account by $100 (a decrease ia foreign bank assets in the U.S.—a capital outiow). () Uf wansections (a) and (6) occur during the sume calendar year, the debit of transection (a) the US.EX oo cHaP. 8] ‘THE BALANCE OF PAYMENTS Wwa0 Jurcig BAS 8.16 8.17 capital aocouat is balanced of neutralized by Ue ret of tancton (6) in the U.S. capital account, Ths, ‘what is left of transactions (a) and {b) in the U.S. balance of payments for that year is only the credit of $100 in the merchandise section of the current account [from transaction (0)) and the debit of $100 in the capital account [the reduction in foreign bank astets nthe U.S. from transaction (0) If, onthe other hand, transaction (a) occurred in October, November o¢ December, transaction (a} Would be included inthe U. balance of payments for that year, while transection (4) in the balance of payments forthe following yeae. ‘Assuming that the U.S. exporter of Problem 8.13(a) ships his goods to England on an English ship, how would the transaction be recorded in the U.S. balance of payments if payment were made (0) by a $20 deposit in the shipping company’s (or its bank's) account with a New York bank, (b) by drawing on bis (.e., the exporter's or his bank's) sterling balances in a London bank, (c) in cash with $20 worth of pounds sterling obtained from a New York bank, (d) in cash with a $20 bill which the shipping company then exchanges for pounds sterting in a London bank or (e) in cash with a $20 bill which the shipping company chooses to hold in its safe in te expectation that the -dollar will soon increase in value in relation to pounds sterling. (2) The US. debits by $20 the services category (wanspontaton) ofits cuent account and ere its capital account (an increas in foreign assets inthe U.S.—a capita! inflow) by $20. (©) The U.S, credits its capital account (a decrease in U.S. assels abroad—a capitat inflow) by $20. (©) The same as in part (6). (4) The same as in part (a), (2) The same os in part (a), How are the following transactions entered into the U.S. balance of payments? (a) An immigrant to the U.S. sends $100 to her relatives abroad, who exchange it for the local currency at local bank. {b) The U.S. government ships $200 wacth of food aid to In (a) The U.S. debits unilateral transfers (in its eurent sevount) for $100 and credits its capital account (an Increase in foreign assets in the U.S.) for $100. (0) The U.S. debits government unilateral transfers for $200 and credits merchandise exports also in its current ‘count, for $200. How are the following transactions entered into the U.S. balance of payments? (a) The U.S. gives $200 cash aid to the government of India. (6) India uses the cash aid to import $200 worth of ‘machinery from the U.S. (c) What remains of transactions (a) and (8) in the U.S, balance of ‘payments if they both occur during the same year’? (@) The USS. debits government woifaeral transfers for $200 [see Example 4(d)] and ereits foreign oficial asses in the U.S. in is offical reserve accouat for $200. (0) The U.S. credits merchandise expors in its current account for $200 and debits foreign official assets in ‘the U.S. in its oficial reserve account for $200, (©) The $200 cro and debit in he U.S. offical reserve account cancel out, and what remains of tansections (q) and (6) in the U.S. balance of payments for that year is a credit of $200 in merchandise export i its ‘current account and a debit of $200 in government unilateral transfers, aso in its curont account exactly 45 in Problem 8.15(6)). The U.S. “real” aid to Tndia takes the form of a shipment of machinery 10 India ‘without any net change in tho U.S. official recerve account. This aid represents a buréen on U.S. Payers, ‘but wot on the U.S. balance of payments. This isthe eason the U.S. often gives ted aid (i... cash aid (0 be spent in the US). How are the following transactions entered in the U.S. balance of payments? (a) A U.S. firm borrows $10 million in German matks ftom a U.S. bank and uses it to build a manufscturing plant in Germeny. (b) A French citizen borrows $10,000 from a French bank and uses it to buy U.S. stocks.150 8.19 8.20 ‘THE BALANCE OF PAYMENTS (CHAP. 8 (0) The US. eres its capital account (a reduction in U.S. claims on foreigners and equivalent toa reduction in U.S. assets abroad—a capital inflow) for $10 mallian sad debits its capita account (or deat investment Abroad capital outlaw) for 510 milo (8) Tae U.S. debits its capt! account (a reduction in foreign clams on the U.S. and equivalent to 2 eduction in foreign holdings of U.S. asseis—a capital outflow) for $10,000 and eredis its capital account (for an {increase in foreign holdings of U.S, sceurties—a capital inflow) for $10,000 (a) How do English commercial banks generate a supply of dollars? (b) How do they utilize them? (c)_ What happens if their dollar working balances rise above their desired level? Fall below seit desired level? () Repeat the entice process with pounds sterling balances for U.S. commercial banks. {a) English commercial banks generate a soppy of dollars when English exporers of goods and services carn dollars abrond and exchange thom for paunds sterling at English commercial banks, and when forcign Investors exchange dollar for pounds stelgg at English commrcrl banks inorder to inves in England. (H) English commercial hanks use their dollar balances when English importers of goods and services and English investors need collars to pay for ther foroign purchases and investments, (©) Faglish commercial banks can exchange ther excess dollar balances for pounds string at England's central ‘bonk. This increases England's official reserve of convertible currency dollars). On the other hand, English ‘commerciat banks can replenish their depleted dollar balances fom their central bank by paying in pounds sterling. This reduces England's official dalla eserves, (a) U.S. commercial banks generate a supply of pounds when U.S. exporters and foreign investrs exchange pounds for dollars at U.S. commercial banks. These pound balances ue used hea U.S. impomers and investors need them to make foreign paymcats. If the quantity of pousds supplied U.S, commercial baaks exceeds the quantity demanded. U.S. banks get rd ofthese excess pound balances by exchanging them for oTirs at the Federal Reserve Bank in their cstcl. Thus, U.S. offical reserves of convertible eureneies rise. When the opposite ecu, ey obtain poums by paying dollars and U.S, official reserves fll Are the following transactions entered in the U.S. balance of payments and, if so, how? (a) An English commercial bank exchanges $100 of its dollar working balances for pounds at England’s central bank. (6) An English commercial bank buys $100 from its central bank with pounds. (c) A U.S. commercial bank exchanges $100 worth of pounds for dollars at the Fed. (d) A U.S. commercial ‘bank buys $100 worth of pounds with dollars from the Fed. (a) Even though the U.S. is not directly javolved in this transaction, itis entered in the U.S. balance of ‘payments. This transaction it important from the'U.S. polat of view because ic represents a switch from foreign private assets to foreign official assets in the U,S. Thus, the U.S. debits its capital account (a reduction in forcign private assets in the U.S.—a capital outflow) for $100 and credits (an increase in) foreign official asses in its official reserve account for $100. (6) The U.S. credits its capital account (an increase in foreign private claims on the U.S. and equivalent o an {increase in foreign assets in the U-S.—a capital inflow) for $100 and debits (a decrease in) fereign official ‘assets In the U.S. in its official reserve account for $100 (e) Tho USS, credits its capital account (a reduction in U.S. claims on foreigners and equivalent to x decrease USS. private assets abroad—a capital inflow) for $100 and debits (an inerease in) U.S. official reserve assets of convenible currencies (pounds) in its official reserve account for $100. (Nate una foreign residents are not directly involved in this transaction.) (a) This enty is the opposite of the answer to part (c). ‘Are the following transactions entered in the U.S. balance of payments and, if so, how? (a) AU.S. ‘gold miner sells some newly mined gold to the New York Federal Reserve Bank. (b) A U.S. firm imports some nonmonetary gotd for industrial purposes. (a) Even though foreigners are not involved directly in this transection, the increase in U.S. official holdings ‘of gold represents, in a sens, a claim against foreigners since this gold con be used to make purchasesCHAP. 8) ‘THE BALANCE OF PAYMENTS 151 beoad. Thus, this ype of transaction is also entered inthe U.S: balance of payments. The U.S. debits (an increase in) its official reserve (gold) assis and, in order to preserve the equality of coal debits t total credits, credits (somewhat arbitrarily) the merchandise category of iis current account. Note thy! gold is in an uncer position as an international reserve since the U.S. goverment is trying to domonetze i (See Chapter 12). (b) Aa import of sonmoneiary gold for industal uses is just like the import of sny other commodity and is, toler as a debit in the merchandise category ofthe U.S. current sccaunt. The corresponding credit entry to record the payment for his impor ean occur ina numberof ways as indicated in Problem 8.14, depending ‘on the form the payment takes. MEASURING THE DEFICIT OR THE SURPLUS, OR OFFICIAL INTERVENTION 8.21 8.22 8.23 (a) Lf, for every debit or credit in the balance of payments, an offsetting ercdit or debit, respectively, ‘of an equal amount is entered, how can a nstion have a deficit or a surplus in the balance of payments? () How can a deficit or a surplus in the balance of payments be measured? {a) We have seen that because of double-eatry bookkeeping, total credits always equal total debits when the twee accounts are suramed (including the allocation of SDRs and the stalistica discrepancy). However, the Cefict or surplus is measured by summing all items in the balance of payments exeept those inthe nation’s ‘official reserve account. Only if the net balance on the nation’s official reserve acount were zero would the nation’s balance of payrvents be in equilibrium. (6) IE totat debts exceed tocal cre in the current and capital accounts (including the statistical discrepancy), ‘the net debit balance measures the deficit in the nation’s balence of payments. This deficit must be settled. (under a fixed exchange rue system) with 2n equal net credit balance in the official reserve account, On. the other hang, if total eredis exceed (otal debis in the current and capital accounts (and the statistical discrepancy), the net eredit balance measures the surplus inthe nation’s balanec of payments. This surplus snust be setled (under a fined exchange rate system) with an equal net debit balance in the offical reserve account, All wansaciions in the current and capital accounts are called autonomous items because they take place for business or profit motives (except for unilateral transfers) and are independent of balance of payments considerations. On the other hand, the items in the official wserve account are called aecont- rmodating ters because they result from or are needed to balance international transactions. Thus, a defici ‘na nation’s balance of payments is given either by the net debit balance inthe nation's autonomous items (or by the equal act credit balance in the nation's accommodating items, The opposite true for a surplus. (a) Why are the concepts and measurement of deficit or surplus not appropriate under a flexible exchange rate system? (6) What is the difference between disequilibrium and a deficit in the balance of payments? (a) The concept and measurement of deficit or surplus in the balance of payments are aot appropriate under 9 _freely exible exchange rate system because the tendency for a defict to occur would be prevented by a depreciation ofthe nation's cureney. Under 2 managed floating exchange rat system, part ofthe deficit would be carected by a depreciation of the nation’s curreney and part would be financed by a net credit balance in the nation’s offical reserve account, (6) Disequilibrium refers to an actual or potential deficit, A nation has @ poretil deficit whenever it imposes import or other restrictions specifically designed to suppress an actus! or open deficit. Then the nation is also in disequilibrium. (a) Assuming a fixed exchange rate system, measure what the U.S. balance of payments deficit would be for 1988 by summing all the autonomous items in Table 8.4. (b) Are the iteris in the balance of payments independent of one another, so that a change in one affects no other? (2). Summing (1 the curren account balance of —$127 billion, (2) the net increase in U.S, eases sroad (other, than U,S. official reserve asset) of ~$77 billion, (3) the net increase in foreign assets im the U.S. (other than foreign ofc ase fa the U.S.) of -+S180 billion and (4 he sttisialclscrepatcy of ~SLI billion152 ‘THE BALANCE OF PAYMENTS Ica. 8 gives the net debit balance of (—}$35 billion for the 1988 U.S, balance of payments deficit. offcal serlements balance deficit, to be distinguished from the basic balance deficit, which is measured ‘by cumming all the items in the current account and the longterm privste capital items, The later refers to direct Sovestetents and portfolio investments with maturity of more than one year. The IMF uses both balances and the U.S, neither. (®) The items in the balance of payments are interdependent rather than independent, so that a change in one has clther a diet or indiect effect on the others. For example, an attempt 10 reduce the U.S. deficit by reducing U.S. imports or foreign aid is aso likely to reduce U.S. exports, since foreigners will then have ewer dollars to spend on U.S. goods and services. Simiiany, ifthe U.S. tried fo reduce its long-term capital ‘outflows, the income of U.S. Favestments abroad would also be reduced. 8.24 From the June issue of Survey of Current Business (avallable at your library), construct for the U.S. for-the years 1980 to 1988 a table showing the total value of (1) exports of goods and services, (2) imports of goods and services, (3) balance on merchandise trade, (4) balanee on goods and services, (6) balance on current account, (6) increase (—} in U.S. official reserve assets, and (7) increase (+) in foreign official assets in the U.S. ‘ce Table 8.5, Note the sharp delriration in the U.S. balance an merchandise trade, balance on goods and services, and balance om surrent sccoust from 1980 to 1988. Table 8.5 Summary of U.S, Intemational Transactions, 1980-1988 Gillis of Dollars) Increase (~) } Increase (+) inS. | ia Foreign Exports of | imports of | Balance on | Bolance on | Belence on | Official Official Goods and ] Goods and | Merchandise | Goods and | Currear | Reserve | Assets in Year | Services | Services } Trude | Services | Accoum | Assets the US. o @ eo o 6) 6 o 1980 | 342 333 25 9 2 1s wei | 319 183 28 16 8 5 192 {352 =350 36 2 -7 3 19s3 | 337 ~3R -6 35 =a 5 see | 7 = 463 -3 -2 104 2 1s} 374 464 =m -9 | -us -2 1986 | 352 509 145 <7 | -13 ° 33 1987 | 446 -516 -160 19 -u4 9 8 1988 | 530 642 127 =a 327 40 8.25 Table 8.6 gives the international investment position of the U.S. (a) How does this differ from the US. balance of payments? (b) What docs this tell us about the U.S. international position and its change over time? (¢) To what problems can the changed U.S. international position during the 1980s give rise? (@) ‘The intemational investment positon of a nation messures the tol amount and the dsubution of the satoa’sassctsebroad and of foreign assets inthe nation atthe endof the yea. Thus, while the balance of payments isa Row concept, the internetionalinvesiment position (often called the balance of indebiedness) ‘of e nation isa stock concept. The later allows the nation to project the future low af income or earings {fom the nation’s fonsign investmentsCHAP. 8] ‘THE BALANCE OF PAYMENTS 153 in Selected Years, 1980-1988 (Billions of Dollars, book value at year-end) Invesument Category 1980 1984" 1985 198619871988 Net U.S, international investment position ....... 106 = 3 MIE 268 378-533 U.S, assets abroad... s+ OT 89695010737 1,253 ‘OMical ceserve assets... 35 48 aR ag Gold .. tenneeseeerers AL How uw un SDRS eee foe 3 7 zs 1 Resecve position in the IMF. 3 ou eB om 2 Foreign curwacies -...-..++ - @ 7 Bb FB 0 ‘Other government assets 85 was Private 56018 ...scscceevecssecsesesteseies SIT 76 819935103 1,120 Direct investments... to MS 2 23060" 308 327 Porcign securities .- : : 63 9 12 TS Bank claims 2.2.2... cesses 208 4644807549 Other... 3 0 Hl Foreign assets in the U.S, So. 899 1,061 1,34) 1548 1,786 Officiatassois m6 199-203, '242 “28322 Private assots 325 694 BSB 1,099,264 1.468 Diet investments Other ese seseesee 8 16 és 0272329 m2 529673992 sounce: US. Deparment of Commerce, Survey of Current Business, Washington, D.C.: U.S. Governnént Printing Office, ‘October 1972 and June 1989. (0) From Table 8.6 we can ste thatthe U.S. changed from a net international creditor to the exteat of $106 jon in 1980 toa very larg (indeed the world's largest) debior county (tothe extent of over $500 billion) in 1988, This occurred becausc frcign assets in the U.S. more than tipled berween 1980 and 1985 while USS. assets abroad only doubled (©). The sharp deterioration in the U.S. international position during the 1980s can create serious problems for the U.S. in the future. For one thing, the U.S. will have to make huge net payments (interest, dividends, and profits) to foreigners in the future, This has led some to sty that by incurring such huge and rising international debt, the U.S. is “mortgaging” its flare (.e., imposing a huge burden on future generations to service and repay the debt). Another problem is the danger of foreign domination.Chapter 9 Adjustment in the Balance of Payments: Automatic 9. TYPES OF ADJUSTMENT A deficit or surplus in a nation’s balance of payments may arise for many reasons (sce Problem 9.1) but ‘cannot continue indefinitely (see Problem 9.2), thus giving rise to tne need for adjustment, ‘Adjustment in the balance of payments may be classified as automatic (discussed in this chapter) or policy (Chapter 10}, Automatic adjustments can be brought about by variations in external prices (Section 9,2), in internal prices (Section 9.3), in national income (Section 9.4), or in national income, prices and monetary changes (Sections 9.5 and 9.6). For the sake of simplicity, we will limit our concept of the balance of payments to exports and imports only, unless otherwise indicated. 9.2. PRICE ADJUSTMENT MECHANISM UNDER A FLEXIBLE EXCHANGE RATE SYSTEM Under a flexible exchange rate system, a deficit in 2 nation’s balance of payments is automatically corrected by a depreciation of its currency, while a surplus is corrected by an appreciation (if the foreign exchange market is stable; see Problem 9.9). Assuming a stable market, a flexible exchange rate system Is feasible in the teal world only if the demand and supply of foreign exchange are relatively elastic. EXAMPLE 1, Ina two-nation world (the U.S. and the U.K.), a given deficit of £4 billion (AB in Fig. 9-1) in the U.S. balance of paymens is comectd by a deprecation ofthe dollar fom $2.00 ~ £1 to $2.40 = £1 with Dy and Se, but would requite a depreciation to $3.60 = £1 with DE and Sf. Since a deprecation ofthe dollar also cases domestic or internal prices in the U.S, to rise (see Problems 9.5 and 9.6), a large depreciation of the dollar (as with Dj and St) ‘would not be feasible.‘CHAP. 9] ‘ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC 155 ‘The U.S. demand curve for pounds (Dz) is derived from the U.S. demand curve for imports (Dy) and the foreign supply curve of imports 1 the U.S. (Su), both in terms of pours (sce Problem 9.7). Given Se, the more elastic Dy i, ‘the more elastic Dz is. Also, the U.S. supply curve of pounds (S,) is derived from the foreign demand cure for U.S. ‘exports (Dx) and the U.S. supply curve of exports (Sy), both in terms of pounds. Given Sx, the more clastic Dx is, the more elastic Sis (se Problem 9.8). If Dis inlasl, Seis negatively sloped and the Foreign exchange market may be unstable (see Problems 9.9 and 9.) 9.3 PRICE ADJUSTMENT MECHANISM UNDER THE GOLD STANDARD ‘Under the gold standard (1880-1914), the monetary authorities of each nation fix the price of gold in terms ‘of the nation’s currency and then stand ready to buy or sell any amount of gold at that price. This establishes 4 fixed relationship between any two currencies (the mint parity). Then, the exchange rate can only vary above and below the mint party (the so-called gold points) by the cost of shipping gold between the two nations or monetary centers. Under the gold standard, the exchange rate is determined by the forces of demand and supply between the gold points, and is prevented from moving outside the gold points by gold shipments (see Example 2). Adjustment under the gold standard was explained by the price-specie flow mechanism. This rests on two tbasic assumptions: (1) the nation’s money supply consists of gold or paper currency backed by gold and (2) 1 decrease in the nation’s money supply leads to a decrease in its general price level, while an increase in its ‘money supply leads to an increase in prices [the quantity theory of money: see Problem 9.16(6)]. Then, starting from condition of equilibrium, a deficit or surplus in the nation’s balance of payments will be suromatically adjusted by a change in internal or domestic prices (see Example 3) EXAMPLE 2. The setting of the price of gold at $35 per ounce by the U.S. and at £14 by the U.K. defines the fixed exchange rate of S3S/EI4 = $2.50£1 (ihe mint party) If the price of shipping £1 worth of gold between New York and London is 2.52, the exchange rate would be determined by demand and supply between $2.525 and $2.475 (the gold ‘oints) and prevented from moving outside this range by gold shipments (sce Problems 9.12 t0 9.15). EXAMPLE 8. Under the gold standard, a deficit in ratin'sbalonce of payments leads to an outflow of god and a decrease in the nation's money supply, which cases the general price level of the deficit nation to fll This in turn ftimulais the dfct nation's exports and leads to & reduction in its impons. The exact opposite occurs inthe surplus nation. This process continues unl the det (ond surplus hae been completly eliminated. In adltion, inferes tes tendo rie inthe defination (because ofthe reduction in its money suply) and fall nthe surphs nation (because of the increase in its money supply), causing short-term capital to flow from the surplus to the deficit nation and thus aid. tho adjuwiment proces. Indeed, monetary autores were expected wo reinforce this proces by further ighening credit inthe deft nation and expanding iio the surplus ration 9.4 THE INCOME ADJUSTMENT MECHANISM In examining the automatic price adjustment mechanisms, we implicitly assurmed that national income remained constant. However, a change in the level of trade affects national income which, in turn, induces a change in the value of imports. For example, starting from an equilibrium position in the balance of trade and less than full employment domestically, an autonomous increase in the value of exports (X) causes real national income (¥) to rise by an amount equal to the increase in X times the foreign trade multiplier, k. If the marginal propensity 10 save or MPS = AS/AY = 0, then k = VMPM, where MPM is the marginal propensity to import, or AM/AY. In this case, the induced inerease in M resulting from the inezease in Y equals the original autonomous increase in X and so the adjustmeat in the balance of payments is complete (see Example 4). If, on the other hand (and more realistically), MPS > 0, k = &MPS + MPM) and the induced increase in M falls short of the increase in X and the adjustment is incomplete (see Example 5).156 ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC icuar. 9 EXAMPLE 4, Given that (1) Y is at Jess than ful eraployment, (2) X = M originally, (9) X (which is exogenous or independent of ¥) rises by $100 and remains at this higher level (Uhus opening a surplus in the nation's balance of payments) and (4) MPS = 0 while MPM = 0.1, thea k 10 =. ‘MPM ~ 0. AY = (AX)(R) = (S100)(10) = $1,000 AM = (AY\(MPM) = ($1,000(0.1) = $100 ‘Since the induced increase in M of $100 equals the original autonomous increase in X of $100, X = M once again (but ‘ate Jevel $100 more than before) and so the adjustment is complete. Note that in order to isolate the automatic income adjustment mechanism, we implicitly assumed a fixed exchange rate system and also abstracted completely from other price and interest rate changes. EXAMPLE 5. Starting with the same given as in Example 4, except that now MPS = 0.15, we get 1 1 “ MPS + MPM" 0.15 + 0.10 0.25 AY = (OX) = (S100)(4) = $400 AM = (AY)MPM) = ($400\0.15) = $60 ‘Thus, an excess of X over M of $40 ($100 - $60) will persist and the adjustment is incomplete. If the nation anempted to increase its X from a position of full employment, only prices would rise. Also, 3X fell rather than rose, the nation might not be willing to let its reel income fall and allow the automatic income adjustment mechanism to operate. The above discussion aseumes a small nation, Ifthe nation is large, foreign repercussions must also be considered (see Problem 9.30). k 9.8 SYNTHESIS OF AUTOMATIC PRICE AND INCOME ADJUSTMENTS UNDER FLEXIBLE EXCHANGE RATES We have seen in Section 9.2 that under a flexible exchange rate system, a deficit in the balance of payments is corrected by a depreciation of the nation’s currency. This stimulates the nation’s exports and discourages its imports (thus encouraging the production of import substitutes in the nation), The resulting increase in production and income in the nation induces imports to rise and neutralizes part ofthe original improvement in the nation’s trade balance. If the deficit nation was already at full employment to begin with, the depreciation ofits currency results in domestic inflation and no comection of its deficit, unless domestic sbsorption falls. ‘Consideration of the income effects of a depreciation or devaluation is referred to as the absorption approach. EXAMPLE 6, We have seen in Fig, 9-1 that wth Dy and Sq, 8 20% deprecation of the dotlar from an exchange rule ‘of R= S210 R = $2.40 was required (o corect the deficit of £4 billion (88 billion t R = $2) inthe U.S. balance of ayments. But this did not take Into account the resulting increase in income inthe U.S, and ioduced cise in imports. ‘Thus, a larger depreciation ofthe dollar would bo required to corect the U.S. deficit lsce Problem 9.31(a)]. If, however, the U.S. was at full employment ro begin with, the deprecition of the doar would be accompanied by inflation which entirely eliminales the competitive advantage that the depreciation of the dollar was supposed to give the U.S. As a result, the U.S, deficit would remain uncorrected {see Problem 9.2((b)], unless domestic absorption falls (se Problem 9.32). 9.6 SYNTHESIS OF AUTOMATIC ADJUSTMENTS UNDER THE, GOLD-EXCHANGE STANDARD ‘The gold-exchange standard was established after World Wor Il and lasted until 1971. This was a fixed exchange rate system in which the dollar was pegged or fixed in terms of gold and other currencies were ‘pcggcd to the dollar. The exchange rates were then allowed to vary 1% above and below the fixed par values, and deficits or surpluses in the balance of payments could be settled in gold or in convertible foreiga exchange, especislly dollars.CHAP. 91 ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC 137 ‘Under the gold-exchange standard, the automatic adjustment mechanisms discussed, if allowed to operate, ‘would (0 Some extent reinforce each other and possibly lead to complete adjustment of balance of payments disturbances, EXAMPLE 7. Suppose that a nation tha was orginally in balance of psyment equilibrium starts importing (s (of change in stes) a commodity previously produced at home. The naion wi then face a decline in real 2 deficit in ts balance of payments, The decline in the nation’s real income will induce ts M to fll, partly newtlizing the original autonomous increase in its Mand deficit. The decline in real income is also likely to ause pricas in the deficit nation ta rise less rapidly than in the surplus nation. This encourages the deficit nation's X and discourages its M (Gee Section 9,3) and reinforces the adjustment proces. tn aditlon, the deficit nation's exchange rate is likely to deptciate ‘within the allowed Fimits), further encouraging its X and discouraging its M (see Section 9.2). Finally, the outfow of reserves from the dotcit nation reuls (unless netalized) ia conection of is money supply and a rie in its interest ‘ate. This i tnt, may lea tos redaction in invesiment (Drea national income (¥), and M, and also toa bslancing shoa-t2m capital inflow (see Example 3), reinforcing the austen process sl fucker. Ta the suplusnaion, dhe exaet oppesie is ikely to occur (ee Problem 9.34). Taken together, these cutomatc adjustment mechanisms, if allowed to operate, are likely to bring about complete adjusment in the balance of payments, The prolen i that nations may not be willing to alfow them to operste i, for ‘example, they lead to domestic unemployment or inflation) thus giving rise 10 the need for policies to complete the adjustment (see Chapter 10), Glossary Automatic adjustment A mechanism that operates without goverment intervention to comect balance of payments disequilibria, Adjustment policies Specific measures adopted by a nation’s monetary authorities for the purpose of correcting balance of payments disequilibria - Flexible exchange rate system An international monetary system in which balance of payments disequilibria are automatically corrected by exchange rate changes. Gold standard The intemational monetary system that operated from 1880 to 1914, under which gold ‘was the only intemationsl reserve, exchange rates fluctuated only within the gold points, and balance of payments adjustments took place as described by the price-specie-flow mechanism. Mint parity The fixed exchange rates resulting undet the gold standard from each nation defining the price of gold in its currency and passively standing ready (0 buy or sell any amount of gold at that price. Gold poltits The mint parity plus or minus the cost of shipping ane unit of the currency worth of gold between the two nations. Price-specie-flow mechanism The automatic adjustment mechanism under the gold standard. it operated by the deficit nation losing gold and its money supply falling, This caused domestic prices to fall, thus encouraging the nation’s exports and discouraging it imports unil the deficit was corrected. A surplks was corrected by the opposite process. Foreign trade multiplier (k} The ratio of the change in income to the change in exports or investment, or (MPS + MPM). Marginal propensity to save (MPS) ‘The ratio of the change in saving to the change in income, or ASIAY. ‘Marginal propensity to impart (MPM) The ratio of the change in imports to the change in income, or AM/AY. Forelgn repercussions The effect that a.change in a large nation’s income ard trade has on the rest of the world and which the rest of the world has on the nation.158 ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC (cHar. 9 Absorption approach Examines the effect of induced income changes of exchange rate variations. Gold-exchange standard The fixed exchange rate system that operated from the end of World War II until 1971, under which gold and convertible currencies (mostly U.S. dollars) served as international reserves. Review Questions ‘Automatic xdjustment of balance of payments disequiibrie cun be brought about by variations in (a) extemal prices, (6) ineral prices, (€) income, (4) all of the above. ‘Aus. (d) See Section 9.1 @ ‘Under a frely flexible exchenge rate system (and stable foreign exchange market) a deficit ina nation’s balance of. payments is dutomatiealy cortected by (a) a depreciation of 16 cumency, (b) an appreciation of is eutency, (€) domestic ination, (4) sein national income, ‘Ans, (a) See Section 9.2, ‘A depreciation of a nation’s curency usually causes intemal or domestic prices to (a) fall, (b)tise, (e) remain vunchanged, (4) any of the above. ‘Ans, (b) See Example 1. OQ rminsinaicnstetesineeston (endemic e nage Solari ese n oeiee pee oes ‘Ans, {¢) and (d) See Example t ‘The supply curve of foreign exchange of a nation is derived from (a) the foreign demand curve forthe nation's exports, (6) the nation’s supply curve of exports, (c) the uation’s demand curve for imports, (d) the foreign supply curve of the nation’s import. ‘Ans, {a) and (b) See Example 1. 6. Under the gold standard, (a) exch nation defines the price of gold in terms of its currency and then stands ready to buy and sell any amount of gold et that price, (b) there is a fixed relationship berween any two currencies ealled the mint pasty, (c) the exchange rate is determined by demand and supply between the gold points and is prevented from moving autside the gold points by gold shipments, (d) all of the above. ‘Ans. (d) See Section 9.3 and Example 2. 7. According 10 the price-specie-low mechanism, which sequence of evente was supposed to bring about adjustment in & dofict nation under the gold standard? {a} Redusion in ts money supply, ling internal prices, falling expos and rising imports, (6) Reduction in its money supply, rising internal prices, rising exports and falling imports, (¢) Reduction in its money supply, fatling internal prices, rising exports and falling imports, {a} increase in its money supply, sing intemal prices fling exports and nisng imports. Ans, (¢) See Section 9.3 and Example 2. (nest gots and hfs of gold and eden nthe money soppy in the dei nan lead to (a) reduction in its interest rate and a capital inflow (B)a reduction in its interest rate and a capital outowCHAP. 9] ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC 159 Cc) an increase in its interest rte and 2 capital outflow (Gd) an increase init terest rate and « capital ‘Ans, (d) See Example 3. 9. Inexamining the automaic income adjustment mechanism, we sssume (a) less than full employment, (6) a fixed ‘exchange rat system, (c) constant internal prices and inlerest rates, (d) all ofthe above. ‘Ans. (a) See Section 9.4 and Example 4. 10. Inthe real worl, the autoratic income adjustment mechanism, if allowed to operate, willing about (a) incomplete adjustment, (6) complete adjustment, (c) perverse adjustment, (d) any of the above, ‘Ans. (a) This is so because MPS > 0 (see Example 5). 11, The improvement in a nation’s balance of trade and peyments resulting from a depteciation of its currency is (@) reinforced by the induced fallin imports in the nation, <6) partly neutralized by the induced rise in impor, (©) pany neutralized by the induced fallin imports, (4) any of the above. ‘Ans. (b) See Section 9.5. 12, In the real world, the aulomalic income, price and interest adjustment mechanisms, if allowed to operate, are Hkely te (a) reinforce each other but still result in incomplete adjustment (b) reinforce each other and result in complete adjustment (©) work at cross purposes from each otber 2nd result in incomplete adjustinent (4) ork at ross purposes from each other and result in perverse adjustment ‘Ans, (b) See Section 9.6 and Exarnple 7. Solved Problems CAUSES AND TYPES OF DISEQUILIBRIA: NEED AND CLASSIFICATION OF ADJUSTMENTS 9.1 Discuss briefly (a) the short-run or cyclical reasons and (b) the long-run or structural reasons for Aisequilbria in a nation's balance of payments. (a) A cyetical expansion of national incor at home and contreton abroad will increase the nation’s imports, ‘reduce its exports and lead to deficit, Simlary, a higher rate of inflation at home than abroad will encourage. imports and discourage exports. A crop failure or stikt may have the same effect and lead (0a deficit. A deficit may also aise from intcmetional capital flows. (®) Some of the long-run or structural reasons fr disequilibria are: a diference in the rate of grow at home and abroad, changes in tastes or demati preferences, different rates of technological progress and changing {actor endowment (conditions of production or supply) and changes inthe economic andl political framework within which trade and payments ere conducted (such as the type and level of protection, formation of trading blocs, wars, ete). 9.2 Explain why (a) a deficit nation cannot continue to run deficits continuously and (b) a surplus nation is not willing to continue to ron surpluses indefinitely, (@)_A deficit nation can finance or sete the deficit in its balance of payments by drawing on its intemational reserves, by borrowing abroad or both. Since each nation has Timited reserves and its ability to borow si ee tn160 93 ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC (CHAP. 9 abroad on a continuous basis is also Timited by it ability to repay, the nation cannot continue lo run deficits indefinitely. The U.S. vas in this position in 1971 . (2) Once a surplus nation feels that its iaternational reserves are adequate, it becomes more and more reluctant {0 continue running surpluses and accumulating international reserves. After all, i would then be giving for sterile gold or foreign exchange. Germany and Jagan found dons are reluctant to continue lending to deficit nations indefinitely for fear of default. The oil-exporting nations ave already reached this position, Though the nced for and the burden of adjusument are greater and more immediate for deficit nations, they arc also felt by surplus nations. Distinguish between (a) automatic and policy adjustment mechanisms and (6) automat price and income adjustment mechanisms. (a) Automatic adjustment mechanisms are those which are activated by a balance of payments disequilibrium itself without any goverment action and which operate to reduce ar eliminate the disequilibrium (unless the government takes steps specifically designed to prevent their operation). These are (0 be distingwished from adjustment policies adopted by the government forthe specific purpase oF corceting the disequilibrium in the balance of payments, Note that while automatic adjustment mechanisms are triggered off as soon 2s the disequilibrium occurs, it usually tes some time to ncogaize the need for adjustment policies, to adopt them and for them to begin to operate, {b) The automatic price adjustment mechanism relics on price changes in the deficit and surplus nations to bring about adjustment. This operates differently undera flexible exchange rate system thea under the gold standard. ‘On the other band, the automatic Income adjustment mechanism relies on inévced vasitions in national income in the deficit and surplus nations fo be activated. For pedagogical reasons, each of these autornatic ‘adjustment mechanisms is originally studied separately. In the real world, this is unrealistic since to some extent Gey all operate simultaneously, as explained in Sections 9,5 and 9.6. ADJUSTMENT WITH FLEXIBLE EXCHANGE RATES 96 With respect to Fig. 9-1 (repeated below for easy reference in Fig. 9-2), (a) indicate what percentage depreciation of the dollar would eliminate deficit AB in the U.S. balance of payments if Dz and Se were the relevant curves. (b) How large a deficit would remain in the U.S. balance of payments ‘when the dollar depreciated as much as in part (a) but the relevant curves were instead DE and SZ? (c) What percentage depreciation of the dollar would be required to eliminate deficit AB with Df and Si? Ly Billion LiyearCHAP. 9), ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC 161 98 (2) With De and S,, a depreciation of he dollar from $2.00 = £1 1 $2.40 = £1 is requlred Wo eliminate deficit ‘AB (of £4 bilion) completely in the U.S. balance of payments, Using $2.00 as the bas, this represents & 20% depreciation of the dollar with respect to the pound [($2.40 — $2.00)/$2.00 = $0.40/$2,00 = 20%], (6) With a 20% depreciation, the quantity demanded of pounds by the U.S. would fall only from £10 billion. {0 £925 billion (the movement from B to G along DE in Fig, 9-2), white the quantity supplied would rise only from £6 bilion 10 £6.5bilion (te movement from A to Ftiong Sf), leaving a deficit of €3 billion pes year (FG in Fig. 9-2) in he U.S. balance of payment, (©) With DE and Sf, 80% depreciation of the dollar (o point B*) would be required to eliminate completely the same orginal deficit of AB in the U.S. balance of payments [($3.60 — §2.00)52.00 ~ S1.60/ 52.00 = 803}. Given Fig. 9-3, (a) explain, with respect to Panel A, why the foreign supply curve of imports to the U.S. (S4) shifls up when the dollar depreciates. (6) Why is the shift not parallel? (c) State, ‘with respect to Pane! B, the equilibrium price of U.S. imports in tems of dollars before the depreciation of the dollar, with a 20% depreciation and with an 80% depreciation (Dy refers to the U.S. demand curve for imports). Qy Gillon units) Fig. 9.3 (a) When the dollar depreciates, English exporters who supply the U.S. imports receive les in terms of pounds for each dollar eared in the US. If the dollar depreciates 20% or 0%, they receive 20% or 8O% less, respectively, This is ike a 20% or an 80% tax, respectively, on each dollar that English exporters ear in the U.S, and results in an upward shift in Sw which is, in percentage terms, of the same magnitude as the percentage devaluation ofthe dollar with respect to the pound, Thus, Sy (When measured in dollars) shifts ‘upward (0 Si, with a 20% depreciation of the dollar and to Sf, with an 80% depreciation (see Fig. 9-3, Panel A), To be noted is that Dy (ivhen measured in dallurs) js not affected by a depreciation ofthe dollar (6) Since Sy is positively stoped, the same given percentage calculated from rising supply prices gives ising absolute amounts and a nonpivallel shift. For oxample, point 4 (in Fig. 9-3, Panel A) is 20% above point Band sos L over K. Similetly, J is 80% above B and so is M over K.162 ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC ICHAP. 9 (©). The price of U.S. imports (Py) in dots is determined as usual atthe inerscction of Dy and Sy (th in Collars). Thus, with Dyc and Sy, Py, = $2.00 and Qu = 10 billion units (point # in Panel B). With Si Pu = $2.36 and Quy & 9.6 billion units (point G). With Spy, Py = 53.20 and Qui = 9 billion vnits (point E+), Nore that we have implicitly assumed that the U.S. impors only # single commodity from the U.K. ‘olherwise, Puy and Qhe would refer co price and quantity indexes, (The more advanced student should also be able to show chat points B, G and B along Dy correspond to points 8, G ond £* along DT in Bp. 92.) 9.6 Given Fig. 9-4, (a) explain why a depreciation of the dollar causes the foreign demand for U.S. exports (Dx) to shift up. Why is the shift not parallel? (6) What is the equilibrium P,, (in $) before the depreciation of the dollar, with a 20% depreciation and with an 80% depreciation? (Sx refers to the U.S. supply of exports.) (c) Why is depreciation not feasible to correct a deficit when Dp and Sr are inelastic? Ps fin 8) " Dy, (with 20% dopree) os ‘Ds (original ett ts wa Gq Cilion united lg. 94 (a) When the dollar deprecintes, say by AV or 80%, English imporers receive, respectively, 20% more ot {80% more dollars far each pound they spend on U.S. expors. This i Tike a subsidy on their purchase of LS. exports and causes their Dx (in terms of dollars) to shift up respectively, by 20% to DY or by 80% {o Df. Since Dx is nogativly sloped, a given percentage caleulced from falling demand prices gives falling solute amounts and a nonporalel shit, Not tht Sy (interns of dolar) is not affected at all by a Aepreciation ofthe dota (®) With Dy, the equilibrium Px = $2.00 and Qx = 6 billion units (point Ai Fig. 9-4) With Des Px 52.30 and Qx = 6.8 (point F), With Df, Px = $3.10 and Ox = 9 (point £*). Note that we have implicitly assumed thatthe U.S, exports only a single commodity 1 the U.K.; otherwise, Px and Qx would refer (© price and quantity indexes. (The more advanced student should algo be able to show that points A, F and * slong Sy correspond to points A, F and E* slong Sf in Fig. 9-2.) Ge) In Problem 9.4, we saw that the more inelastic Ds and Sz, the greater the depreciation necessary fo comect ‘deficit ofa given size, But the greater the depreciation of the domestic currency, the greter the inerease in Pw and Py, [see Problems 9.5(¢) and 9.6(b)] and the increase in the domestic general price level. Ths, ‘depreciation becomes less feasible to correct & deficit in the nation's balance of payments, In edition, the stoater the deprecation necessary, the more likely i isto induce destbiizing speculation,CHAP. 9) ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC 163 97 Putin 2) Py tin OL rr rr an et Libr CL of + @ thw a Ge eo “Coin, units) Wig. 9 With reference to Fig. 9-5, (a) explain why depreciation of the dollar with respect to the pound ceases a downward shift in the U.S. Dy in terms of pounds. What depreciation of the doar is indicated by the shift from Dyy to Dj in Panels A snd B? (b) Show that a movement from point B to point E down Su in Panel A corresponds to a movernent from B to E along De in Fig, 9-2, while a movement from B to G along Sy in Panel B corresponds to a movement from B to G along DZ. (¢) Given Sy, ‘what can you say about the shapes of Dy and D,? (2) When the dollar depreciates, the U.S. demand for imports (Dy) in terms of pounds shifls down and ta the Jef because U.S. importers recsive fewer pounds far each dollar spent on English imparts. In Panels A. and B of Fig. 9-5, Dic is 20% below Dy, and thus it refers to & 20% depreciatioa of the dollar with respect to the pound. The shift is not parallel because it i a constant percentage. Note thatthe English supply of US. imports (Sy) ia terms of pounds is aot affected by a depreciation ofthe dollar. (2) At point B in Panel A, Pyx = £1 times Que = 10 billion units equals £10 billion (point A on Dy in 9-2), while at point E in Panel A, Pyy = £0.89 times Q,, = 8.9 billion units equals £8 billion (point E on Py din £3164 98 99 ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC ICHAP. 9 De in Fig. 9-2). Turning to Panel B, we see that at y= £l times Quy = 10 Billion units equals £10 billion (point # on D? in Fig. 9-2), while at point G, Pyy ® £0.975 times Quy = 9.75 billion units ‘equals (about £95 billion (point Gon DY in Fig, 6-2). Thus, « movement from B to F down Sy in Panel ‘of Fig. 9-5 conesponds to a movemeat ftom B 10 £ up Dz in Fig. 9-2, while a movement rom B to G down Sy in Panel B of Fig. 9-5 comesponds toa movement from B 10 G up Df in Fig. 9-2. More generally, we can say thatthe U.S. Deis derived from the U.S. Du fom the U.K. andthe U.K. Sy tothe US. both in terms of pounds. (c) From Panels A and B in Fig. 9-5, we can say that given Sy, the more inolustic Dye is, the more inelastic DD is, Note that Dy is always negatively sloped, except when Dy. is vertical (in which case a downward shift in Dyq resulting from a depreciation of the dollar cannot be seen) and so Da is also vertical. With reference to Fig. 9-6, (a) explain why a depreciation of the dollar with respect to the pound ‘causes a downward shift in the U.S. Sx in terms of pounds. What depreciation of the dollar is indicated by the shift from Sx to $57 (6) Show that « movement from point A to point £ down Dx in Fig. 9-6 corresponds to a movement from A to E up Sz in Fig, 9-2, while a movement from A to F down D& comesponds to a movement from A to F up Si, (c) Given Sx and S{, what can you say about the shape of Dx and the shape of S:? (@ Whee the dollar depreciates, the U.S. supply of exports (Sx) in term of pounds shifts dow and to the right (e., inereases) because U.S. exporters now receive more dollars for each pound earned from exports. In x and thus refers to 2 20% deprection ofthe doltar with respoct tothe pound. ‘Tae shift is not parallel because itis a constant percentage. Note that when the dollar depreciates, the English demand for U.S. exports (Dx) in tens of pounds is not affected, 6) Mt point A in Fig. 9-6. Py = £1 times Qe 6 bition units equls £6 billion (pont A and, and in Fig 92). At point E on Sand Dy in Fig. 9-6, Py = £0.58 ties Qx = 8.2 blion units equals abou £8 blion (pot F on Sia Fig. 9). Than, a movemeat fom Ato F dowa Ds in ig. 9.6 comesponds 10 2 movemest tom Ato up Sn ig, 92. On th the handy st pont on Sy and Dk in Fg. 9.6, Pe 1089 tines ge ~ 72 llr ants cqoa abes) £6.5blion (pit F on 3 ia Fig. 92). Tas, ‘movement trom 4 to down Dy ia Fig. 9-6 comesponds toa movement from A fo Fup Sein Fe. 92. More generally, we can say that the U.S. Sc is derived from the U.K. Dx from the U.S. and the U.S. Sx to Ge UK, Doha tems of poo, (©) From Fig. 9-6, we can say thet, given Sx and Sj, the more inelastic Dy is, the more inelastic S; is, Since Sc increases as we move from A to E down Dx and from A to F down Df, both the coeficint of price clastcity of Dy and that of D§ exceed 1 (ic., m > |~1] and nf > |~Ip and so S; and SP ure both positively sloped. With reference to Fig. 9-7, (a) explain why a moyement from int A down DE* in Panel Rchnetponds fo a Showmeh Hod io up Set mPanel BO) Wik D, tne some ash Fg 9-2, explain why the foreign exchange market in Panel B of Fig. 9-7 is stable. (eo) At point Ain Panel A, Pe = El times Qe = 6 billion units equals £6 billion (point A on St* in Panel B, AUB = $2.00 = £1), When the dollar deprcites by 20%, Sy in Pancl A shifts dow to Sy (asin Tig. 9. 6) and resaks inde now equilibrium point HAC point H in Panel A, Px ~ £0.85 times Ox = 6.5 billion units equels£5.525 (point H on St" in Pancl B, at R_~ $2.40 = £1) Since @ movement from A to ff down Dx” results in a fall in QSx, ax" < |—1[ and ST” is negatively sloped. (If ny* = [-1|, S¢* would be vertical; Sf" would also be vertical if Sy is vertical so thats shift im Sx wih » depreciation canot be seen and Q8¢ reins unchanged.) (8) The forign exchange market of Panel B is sable because when QD, > Se, R automatically rises ta E** Ge, the doller depreciate) andthe U.S. deficit is eliminated. If QDs < QSs, R automatically falls to £** and the supus is eliminated, Eventhough SY” is negatively sloped, the foreign exchange marke! i stil stable here.CHAP. 9) ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC 165 Pen fy | t (il writs) Fig. 9.7 9.10 (a) Explain why the foreign exchange market of Fig. 9-8 is unstable, (De in Fig. 9-8 is the same as in Pane! B of Fig. 9-7.) (6) What are the general conditions for an unstable foreign exchange market? (a) IF for some reason there isa displacement from equilibrium poi &°in Fig. 9-8 so that R > $1.20 = £1, (OD; > OS and a deficit is opeaed in he U-S. batanse of payments. Then, R automatically rise dollar deprecates) end the U.S. defict becames even larger. On the ther hand, if < $1.20 = > De and the U.S. has a supivs, This causes R to fall (i,, the dollar to eppeeciate) and the surplus ses. Thus, a movement away from E” automatically moves us even furter away from E" and so the foreign ‘exchange market is unstable, (6) In order to have an unstable foreign exchange market, (1) S; must be usgatively sloped and (2) S- must be flaner and more elastic thua Din the vicinity of the equibrim point The sibility of the foreign exchange market can also be expressed in terms of the coefficient of the price elasticity of Dx (ies, mx) and the coefficient of price clestiity of Dac (.c., mu), with Dx and Dy expressed in terms of either the domestic of foreign currency. Given infinite or very large coefficients of price easicity of Sx and Sx Git, 6x = eq = ©), the foreign exchange market is stable only if + my > |— I]. IP ag + myx ~ 1, & depreciaion (of appreciation leaves the deficit or surplis unaffected.) This is knows as the Marshall-Lemer condition. (Uf ex and ty ave celatvely small, the foreign exchange market may be stable even if mx + mu <[~I]) Foreign exchange markets are usally stable and nx and ny sulfcienily elastic to make Rexible exchange rates feasible Billion Liyeor Fig. 9-8 Fig. 9-9166 SAL ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC ICHAP. 9 With reference to Fig. 9-9, (a) indicate whether the foreign exchange market is stable or unstable at equilibrium points 2, 3 and 1, (b) Explain why ata high enough R, OD, = 0 and ata low enough R,Oe (@) At equilibsium point 2, Seis negatively sloped and fatter or more elastic than Dg. Therefor, the foreign xchange market is unstable and a small displacement (rom equllbgum point 2 wil automatically push the ccononiy even furter away from point 2, unil sable equlibium poins 3 or {are reached. Howove, this requires such a large change in R that it is unfeasible to rely on Nuctuating exchange rates to correct balance of payments discquilibria, (8) The U.S. De touches the vertical axis (Le., @Dr = 0) at a igh enough R becuse with a high enough depreciation of the dolar, the U.S. finds imports so expensive that eventually it imports nothing and so OD, = 0. The U.S. 5; touches the vertical axis (Le., OS; = 0) ata low enough R because witha high ‘enough appreciation ofthe dollar. U.S. exports becoms so expensive that eventually the U.S. wil be unable to export anything and its OS: = 0. ADJUSTMENT UNDER THE GOLD STANDARD 9.12 9.13 Suppose that, under the gold standard, the price of 1 ounce of gold is set at $35 by U.S, monetary authorities and at £14 by the U.K. monetary authorities. (a) What is the relationship between the sollar and the pound? What is this called? (b) Ifo ship any amount of gold between New York and London costs 1% of the value of the gold shipped, define the U.S. gold export point or upper limit in the exchange rate between the dollar and the pound (R = S/£). Why is this so? (c) Define the USS. gold import point oF the lower limit in the exchange rate (R = S/E), Why is this so? (@) Since $35 = 1 ounce of gold = £14, the dollar price of £1 or the exchange rate (R= SUE) is fixed at $25/14 = $2.50. Thus, fixing the price of gold in terms of national currencies under the gold standard ‘establishes a fixed relationship or exchange rate between any two currencies. Thls is celled the mint parity (®) Since o ship $2.50 work of gold from New York to London costs 1% or 2.5¢), the U.S. gold export poiot ‘or the upper limit ofthe exchange rate (@ ~ $/£) equals $2.50 plus 2.5¢ or $2.525. The reason fortis is that no U.S. resident would pay more than $2,525 to obain £1, since he or she could buy $2.50 worth of {old from the U.S. treasury, sip it tothe U.K. ata cost of 2.5¢ aad sel itt the ULK. treasury for £1. ‘Thus, onder the gold standard, the exchange rate ofthe pound can never rise above (and he dolar depreciate pas the U.S, gold export point of $2.525. (©) Similarly, the exchange rate can never fall below (and the dollar appreciate past the U.S. gold import point ‘of $2.475. The reason for this is that no U.S. resident would accept less than $2.475 for each pound sold, since he or she could always buy a pound's worth of gold from the U.K. treasury atthe fixed price, import gold into the U.S. ata cost of 2.5¢ and resell to the U.S. treasury for $2.50. Thus, the U.S. sesident ‘can get pounds at $2.475 ($2.50 minus 2.5¢) and will not accept less upon selling them. Note that the shipping cost of gold includes not only the transportation cost bu also all alher handling charges, insurance and the interest forgone wihlle the gotd isin transit. With reference to Problem 9.12, draw a figure from the U.S. point of view, showing the mint parity, the U.S. gold export point and the U.S. gold import point, as well es a U.S. supply curve of and & U.S. demand curve for pounds that intersect within the gold points and above the mint parity. In Fig. 9-10, the mint party of $2.50 only serves to define the U.S. gold export point of $2.525 and the US. gold impor point of $2.475. Since under the gold standard the U.S. stands ready to sell any quanity of gold atthe price of $35 per ounce, no U.S, resident would pay more than $2.525 pet pound, because he or she ‘ould obtain any quenty of pounds a: that price by gold exports. Thus, the U.S. supply curve of pounds (S,2) hes a kink and becomes iafntely clastic or horizontal atthe U.S. gold export point. Similarly, since the U.S. stands ready to buy any quantity of gold at $35 per ounce, no U.S, resident Would sell pounds for Jess then 82.475, besause he or she could soll any quantity of pounds at that price by importing gold. Thus, Dy hes a kinkCHAP. 9} ADIUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC 167 9.4 9.15 US. Gold x Mint Parity $260 US. Gold M Point $2,475: Fig. 9-10 and becomes infinitely clastic at the U.S, gold import point. Under the gold standard, the portions of S¢ and Dy ‘ulside ae gold points (dashed in Fig. 9-10) re islevant. Figure 9-11 is the same as Fig. 9-10 except that two altemative and higher demand curves, Dz and Dg, have been added. With reference to Fig. 9-11, indicate what the exchange rate would be under & flexible exchange rate system and under the gold standard with {4} De, (b)DE (c)DE, (d) What is the size of the deficit in the U.S. balance of payments under the gold standard and with D{? How is this deficit settled” (a). Under a flexible exchange rate system, the equilibrium exchange rate is determined exclusively by the forces of domaad and supply. Under the gold standard, the exchange rte is determined by the forces of demand ‘and supply within the gold points, and is prevented from moving outside the gold points by gold shipments Thus, with Dz, the equilibrium exchange rate is $2.515 and the equilibrium quaniy is £6 billion per year (point A in Fig. 9-11) under both a flexible exchange rate system and the gold standard, The U.S. belance of payments is in equilibrium and there ae no gold shiproens. (H) If for some reason De sifts up to Df, the equilibrium exchange rate rises Wo $2.525 and the equilibrium ‘quantity increases to £7 bition per year (point B in Fig 9-11) under bath a flexible exchange rate system and the goid standard, The U.S. balance of payments is in equilibrium and there are no gold shipments. (©) With Dz and « flexible exchange rate system, the equllibrinm exchange rte Is $2,535 and the equlibrium ‘quantity is £8 billion per year (point C in Fig. 9-11). On the other hand, with the gold standard, gold abitrageurs sec to it thatthe dallar does not depreciate past the U.S. gold expont point and the exchange rate will be $2,525. (a) At the exchange rate of $2.525, ODE = £9 bilion (poin.F in Fig. 9-11) and exceeds QS: ~ £7 billion ‘on normal or autonomous transactions (poin 8). The excess demand for pounds of £2 billion pr year (BF represents the size ofthe deficit jn the U.S. balance of payments forthe year and is setsfed by £2 ‘worth of U.S, gold export [as described in Problem 9.1295)]. Note that the U.S. treasury docs not actively support the dollar but simply and passively sells any amount of gold requied to keep the exchange rate from rising cbove (and the dollar depreciating past) $2,525, However witha limited supply of gold reserves. ‘need arises to corect the deficit. Figure 9-12 is the same as Fig. 9-10 except that two alternative supply curves, Sf and Sz, have been added. With reference to Fig. 9-12, indicase wita( the exchange rate would be under a flexible exchange rate system and under the gold standard with (a) Sand (b)SZ. (c) What isthe size of the surplus in the U.S. balance of payments under the gold standard and with Si? How is this surplus settled?168 ADIUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC ICHAP. 9 $2535 US. Gold x Point $2525 a $2515 Mint Parity $2.50 US. Gold M Point $2.475 - 2, N. ee aa Bion Eipeur lg. 9-11 (©) Af, with an unchanged De, Sc shiis down (increases) to Si, the equilibrium exchange sate falls from $2.515 (ont Ain Fg. 9-12) wo $2-485 (point G), andthe eqilitrium quantity rises from £6 billion wo £9 bilion ‘es year—under both a flexible exchange rate system and the gold standard, The U.S. balance of payments romans in equilibrium and there are still wo gold shipments (8) With SZ anda flexible exchange rte sysem, the equilibrium exchange rate i $2.455 andthe equilibrium ‘quantity is £12 bilion per year (ointH), On the other Band, with te gold stndavd, gold arbitrgeurs see tot that the dolar doesnot appreciate asthe U.S. gold import point an the exchange rate will be $2.475. (rbot De anéS, shit at the same timo, the results bined in an analogous way and isleft as an exercise for the reader.) (©) However, atthe exchange rae of $2.475, QSi = £14 billion (point K) and exceeds QDe = £10 bilion on normal of autonomous transactions (point J). The excess supply of pounds of £4 billion per year (IK) represeas the size of the suplus in de U.S, balance of payments forthe yearend is salisied by £4 bition US. Gold X Point. $2.695- sis. Mint Parity S250 2.485. US. Gold M Point 52.475 32.468. ‘illion “tivenr| Big. 942CHAP. 9] ADIUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC 16 9.16 OT ‘worth of gold imports into the U.S. [as described in Problem 9.12(e)]. Note thatthe U.S. treasury passively ‘buys any amount of gold required (o keep the exchange rate ftom felling below (an the dolar appreciating past) $2.475. Since a surplus nation may not wish fo continue accumulating gold reserves past a certain ‘amount, a need aises to correct the surplus. The gold standard operated from about 1880 to 1914. State (0) the assumptions of the gold standard and the price-specie-low mechanism and (b) the ‘quantity theory of money. (a) (1) Each notion fixes the price of gold in terms of its currency and stands ready to buy end sel passively any amount of gold at that price, (2) each nation's money supply consists of gold or paper currency backed by gold, (3) the quantity theory of money holds so that the price tevel ofa nation varies diectly with is money supply and (4) expons and imports readily respond to price changes. (W) We start with the so-called equation of exchange, MY = PO ‘whore M refers to the nation’s money supply, ¥ tothe velocity of circulation of money, Pwo the price level and Q to physiet output. At the time ofthe gold standard, most economists (as characteristic of the classical school) beticved thar aside from temporary disturbances, an automatic tendency toward {ull employment ‘wes built into the economy (based on their assumption of perfect and insantencous flexibility in all prices, ‘wages and interest rates), Thus, they took @ to be fixed atthe full-employment level. They also believed ‘that ¥ depended on institutional factors and was constant. With V and @ relatively constant, a change in causes a dieet (end proportionate) change ia P. (a) Explain how a change in prices under the gold standard was supposed to eliminate the surplus in ‘a nation’s balance of payments. (b) How did David Hume ase his price-specie-flow mechanism'to show that the attempt of a nation (o accumulate gold continuously, as advocated by the mercantilists, ‘was self-defeating? (a) Under the gold standard, a surplus in a nation’s balance of payments leads to an inflow of gold and an increase inthe nation’s money supply. The increase in the money supply leads to an increase in the general price level of the surplus nation. This in tam stimulates the surplus nation’s imports and discourages its exports, unl de surplus is eauzely eliminated. This adjustment process can be visualized in Fig. 9-13. ‘This shows that Ge $2 bilom surplus of exports (X) over imports (M) at point A results in a continuous low of gold and ax increase im the nation's money supply until is price index has risen 20% and X = Mat point B. If te nation were instead criginally3t poincC, its deficit of $3 billion would be corrected automaticaly by a continuous gold loss and reduction in its money supply until its price index had fallen from 156 o 120 and X = Mat point 5. This adjustment process is reinforced by the reverse price movement inthe trade partrer XM Cillian 8)170 9.18 ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC (cuap.9 {6) The mercantilists believed that a nation could continve accumulating gold by exporting more than it imported {Gee Section 1.3). However, David Hume explained that an inflow of gold increased the money supply of the nation and is price level. This discouraged the nation's exports, encouraged is impons and ed to gold ‘outflows. Thus, th nation's attempt to accumulate gold continuously by stimolatng its exports and restricting its imports was futile or self-defeating (@) Explain how interest changes in the deficit and surplus nations help the adjustment process under the gold standard. (6) What were the “rules of the gold standard?” (@) The inflow of gold from the deficit to the surplus nation automatically results in an increase in the money supply of the surplus nation and a decrease in the deficit nation, This causes intrest rates to fallin the surplus nation and to rise in the éefiet ration and induces a balancing shor-term capital ow from the surplus (o the deficit nation, Although this induced short-term capital flow is of a once-and-for-all nature rather than continuous it helps the adjustment process (6) Under “the rules ofthe gold standard,” nations were supposed to relforce the adjustment process by further expanding eredit in the surplus nation and tightening it in the deficit nation. The adjustrvent process under the gold standard was remarkcbly smooth, and it now seems ro have resulted primarily from stabilizing short-term capital movements ral than from price changes (as it was once believed, and as described in Problem 9.17). See Section 12.1. ‘THE INCOME ADJUSTMENTS MECHANISM 9.19 9.20 Given: (1) a closed economy with no foreign trade, at ess than full employment with a constant price level and interest rates, (2) Savings (S) = domestic investment (1,) = $100 at the equilibrium level ‘of real national income (Ye) of $1,000 and (3) MPS = AS/AY = 0.25, while Ia is a constant at every level of national income and is determined exogenously (i.e., outside the model), If Iy now increases ‘autonomously by $100 and remains at this higher level, find (a) the domestic multiplier, &, (2) the new equilibrium level of national income, Yé, and (c) the induced change in $. (a) Show the results to pars (a), (6) and (e) graphically. -4¥.1 1, o 7 ai 7 MPS” 025 © AY = (Ane) = (6100}4) = $400 YE = Ye + AY = $1,000 + $400 = $1,400 © 4S = (QY}(MPS) ~ ($400,0.25)= S100 (@) Soe Fig. 9-14, [Note that the § function has & negative vertical imereept ( S Oat ¥ = 0) since the ‘ation may stl parchase So Imports with its international reserves, (8) We ean soe fom Fig. 9-16 tet if X fell autonomously by $100 from the original level of $300, Y= would {all 10 $600 ar which adjustment is complete with X = M = $200, (q@) What would happen in Fig. 9-16 if at the same time that X increased autonomously by $100, there ‘were also an autonomous increase in M of $100? () What is the difference between an autonomous change in M and an induced change in M? How do these differ from each other and from an increase in MPM? (@) An autonomous increase in M of $100 causes the eats M function to shift up by $100 to M' and leads 10 ‘YE = $1,000 and XK" = M = $400 (point £” in Fig. 9-17). If there had been an autonomcus decrease in M of $100 instead, we can see from Fig. 9-17 that this would have led to YE = $1,800 and X" = M’ 3400. (8) A change in M is autonomous if itis independent of Y. That is, te entire M function shifts vp oF down ‘So that more of less M will be purchased at each Y. This may result from a change in tates for impor. ‘On the other hand, a change in M is induced if it results from a change jn Y. This i reflected in a movernent ‘long an unchanged M function, MPM = AM/AY and refers to the slope of the M function. Thus, an Jnerease in MPM refers to an increase inthe slope of the M function and results in a decline in k (since & 4s the reciprocal or inverse of the MPM). The MPM for the U.S. is sbout 0.13; i has ineeased since the 1950s and is generally lower than the MPM in other industrialized nations. X, Min $)2 9.23 9.28 ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC ICHAP. 9 Given: (1) an open economy with a fixed exchange rate system and constant internal prices and interest rates, (2) S = Ly = $100 and X = M = $300 at Ye = $1,000 which involves widespread unemployment and (3) MPS = MPM = 0.25 where I, and X are independent of ¥ and exogenously determined. Now X increases autonomously by $100 and remains at this higher level, Find (a) k, (b) Yeand (c) OM and AS. (d) Is the adjustment in the balance of payments complete? {e) Show the time sequence of the adjustment with a figure similar to Fig. 9-15. Ay 1 1 @ = Ay 7 MPS + MPM ~ 0354025 ® G2 = (8100,2) = $200 Yq + AY = $1,000 + $200 = $1,200 © (AYMPM) = ($200)(0.25) = $50 (AY(MPS) = ($200)0.25) = $50 (@) Toe adjustment in Ue balance of payments is incomplete. Specifically, « surplus of $50 will remain in the ‘nation’s balance of tade (and payments) because the autonomous increase in X of $100 resulted in an induced increase in M of only $50. (e) Sec Fig. 9-18, With reference to Problem 9.23, state the equilibrium condition for Y (a) before X rose and (b) after X rose. (@) The equilibrium condition for ¥ before X rose is given by Injections = Leakages 4+X=S+M $100 + $300 = $100 + $300 $400 = $400 Since at Ye = $1,000, X = M = $00, the balance of trade (and payments is simultancously in equilibrium, (0) Starting from Ye, the equilibrium condition for ¥ after X rose is given by ‘Change in injections = Change in leakages Ok + AX = AS + AM 0 + $100 = $50 + $50 100 = $100CHAP. 9} ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC 1B 9.25, 9.26 s+ “io Fe | 690 eo Ye Xe ce ig. 9-19 [Note that Lis independent of Y, so that when ¥ rises from Yn to Yi, there is no induced change in domestic investmeat (ic., Al, = 0). Since AX = $100 while AM = $50, the nation faces » persistent surplus in its balance of payments of $50 per time period at Yi = $1,200. {@) Draw « Ggure for Problem 9.23 similar to Fig. 9-16. (b) What would happen if X had fallen rather than risen autonomously by $100? (a) The slope of the $ + M function ia Fig, 9-19 equals MPS + MPM = 0.25 + 0.25 = 0.5. Also, at poict Eaand Ye = $1,000, I, = § ~ $100, X = M = $300 and S + M = ly + X = $100 + $300 = $400. At point E” and YE = $1,200, S +'M = Te + X' = $500 but X" > M by $50, the same amount by which $ > Ig. Note that for simplicity, we have implicily essumed throughout that the la S, X and M. fonctions are straight lines (i... uke marginal propensities remain constan). Note that the horizontal ané vertical scales in Fig. 9-19 are different, () 1X had instead fallen autonomously by $100, we cun see from Fig. 9-19 that now Yi = $800, at which SM =, + X' = $300 with M > X’ by S50, the seme amount by which Ly > S. (a) Derive the X — M function from Fig. 9-16 (before the autonomous increase in X) and the $ — Jj function from Fig. 9-14 (before the autonomous increase in I.) and plot them on graph. (6) What isthe equilibrium Y in Fig. 9-20? Why? (c) What isthe usefulness of Fig. 9-20 as compared to Fig. 9-197 (a) From Fig. 9-16, we get that at Y = 0, X = $300 and M = $50; therefore, X — M = $250 ihe vertical Intercept in Fig. 9-20). The values of X — M at other levels of Y are similarly obttined. The X — M function is negatively sloped because we are subtracting rising M frert censtent X. That is, the balance oF trade deteriorates as Y rises, From Fig, 9-14, we get that at Y = 0, = ~S1SO-and la = $100; therefore, 5 ~ la = ~$150 — $100 = ~5250 (¢he vertical intercept in Fig. 920). The values of $ ~ I, at other levels of ¥ ae similarly obtained. The $ — 1g function is positively sloped because we are subtracting & ‘constant from rising S. (®) In Problem 9.24(a), we saw thatthe equilibrium condition for Y is given by W+x=S+M which, by transposing fy and M, gives xXoM176 xu Sot, fins) fs 9.27 9.28 ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC (CHAR. 9 Fig, 9-20 Graphically, Ye is given a We intersection ofthe X ~ M and S ~ 1, functions and equals $1,000 (the same a5 in Fig. 9.19). X ~ Mis often refered to as net foreign invesement (I) sige a trade suphis oF deficit must be financed by some sort of capital movement, Thus, the above equilibrium condition of X-M=S-h cam be rewriten 25 b=S-h hich equals Lthes (©) The usefulness of Fig, 9-20 over Fig. 9-19 is that in Fig. 9-20, we can read ofT move clearly and readily what the balance of trade is at Ye, Since in Fig. 9-20, the X — M and S — I, functions eross on the horizontal or income axis. X — M = ly = O(.c., X = M, as at point & in Fig. 9-19). (a) Redraw Fig. 9-20, showing what happens if there is an autonomous increase in X of $100. () What happens if there is instead an autonomous decrease in X of $100? (2) An autonomous increase in X of $100 causes the X — M function to shift vp venically by $100 t0 x" — Min Fig, 9-21, This gives ¥é — $1,200, at which X" — M = I= S ~ La = $50 (as at point "ia Fig. 9-19). Thus, the original ewronomous increase in X and trade surplus of $100 were partially neutrlized by the induced increase in M resulting from the increase in Ys to YE. (b) Stastng from equilibrium point in Fig. 921, if there isan autonomous fallin X of $100, we can see that now Ye = $800, at which X’ ~ M = fy = S — 1, = —$50 [the same as in Problem 9.25(0)). Thus, the original aufonormous decrease in X and trade deficit of $100 are panially neutralized by the induced fall Jn M resulting from che fallin Y. Note also that an autonomous fallin X has the same effect us an autonomous rise In M, aad view versa, ‘Staring from equilibrium point £ in Fig. 9-20 and widespread domestic unemployment, (a) show ‘what happens if 1s increases autoromously by $200 and remains at this higher level. (6) What if there is instead an autonomous deerease in ly of $100? (c) What if there is instead an autonomous increase in S of $100? An autonomous decrease of $100? (a) An autonomous increase in L of $200 causes the S — La function to shift down vertically by $200 to $ — U in Fig, 9.22 because the negative term is increased. This gives YE = $1,400, at which X ~ M = k= S— y= —S100 (6) If there is instead an autonomous decrease in lz of $100, S — ly shifts up vertically by $100, and we can see that now Y¢ = $800, at which X — M = ly = S — ly = $50.ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC 175 (©) An autonomous increase in $ of $100 causes the $ — fg funeton to shift up Vertically by $100 jus sin the case of autonomous deewease in 1, of $100, andthe result isthe same Staring ffom equilibrium point E in Fig, 9.22, if there is instead un aconomens decrease in $ of $100, we eat Sc thal now YE $1,200; at which X — M = I) = S — Ja = —$100 (nct foreign disinvestment), Nate that increases in X and help the balance of payments while inercases in M andy hut it Starting from equilibrium point £ in Fig. 9-22, (a) show what happens if there is an autonomous increase in Ty by $200, but the full-employment level of national income, Yp = $1,000. (b) What if Yp were $1,200? (a) Since we are told that Ye = Ye = $1,000 to begin with, real maioml income ceanoL new sist above Ye = $1,000 to YF = $1,400 as in Problem 9.28(a), whon S ~ Ig shifts down to S ~ 1. The result is tat only the domestic price level will rise. But a5 prices rise, the nation’s X fall and Its M cise. Both of ‘ese changes cause the (K — M) function to shi down unui it intersects Hhe $ — Uj funetion at Ye = ‘31,000, This occurs when the (X ~ M) function has shifted down to (X — M)'. (See Fig. 9-23.) The ‘result is equilibrium point E', al which Yi = Yr = Ye = $1,000 and (X - MY = k= S- ho $200, Thus, stating from full employment and equilibrium inthe balance of payments (point E in Fig, 9-23), an autonomous inercase in investment causes domestc inflation which opens a deficit n the nation’s balance of payments, (6) Starting {com equilibrium point E in Fig. 9-23 but with Ye = $1,200 instead, the downward shift in the S ~ Ly function to ~ Ij causes ral national income to ise from Yq = S1,000 to Ye = $1,200. Howe ever, domestic prices will aso have to rise sufficiently to cause the (X —. M) function to shift down 9 (K ~ My to give equilibrium point £°, ALE", YE = Yp = S1,200 and (KX ~ My == 8 ~ Le = ~5150, So far, we have implicitly assumed that Comesti prices remain constant until teal Ypis reached, after which, they rise. in tae veal work, we know tha prices can cist even a less than (oll employment sd rise fester as we approach full employment (eft to the Philips eure in your principles tex). So far in our discussion, we have atso implicitly assumed that the nation is small, so that there are ro foreign repercussions. We have aso assumed no acceterator. (a) What is ment by foreign repercussions? (b) What are the foreign repercussions resulting from an autonomous inerease in the exports of nation 1 and nation 27 (c) What are the foreiga repercussions on nation 1 resulting from ‘an autonomous increase in ly? (d) What is mesnt by the accelerator. How would its inclusion affect the above analysis? (@) Ina world of two large nations (nation I and nation 2), a change inthe level of tede of mation | also affects the level of national income of nation 2. This in tum affects the level of trade and income of nation 1 ond is a foreign repercussion for nation 1.176 ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC (Chap. 9 o ‘These foreign repercussions peter out and dampen the original autonomous increase in X of nation 1 ‘When foreign trade moliplier for nation | for an autonomous increase in its exports which replace domestic ‘production in uation 2 is given by ———____! __ ~ MPS, + MPM, + MPM(MPS MPS.) Which is smaller than & without foreign repercussions. ) Nation I Nation 2 + +x ST +X x me Co +x ‘These foreign repercussions peter out and dampen the effeet of the originat aulonomous increase in Ty in nation 1. For nation I, then 1+ (MPMYMPS,) MPs; + MPM, + MPMA(MPS/MPS)) which is larger than the multiptir in pat (6). Note that sis is hour the business eycle is propagated from cone navn to thers. Foreign repercussions canbe safely neglected only if the ation is very smal (a) The accelerator refers to the rigs in I as Y rises, so Wat the fy function is positively sloped rather than horizontal. Accelerators have fallen somewhat ino disuse, and so they have not been included. There is also a possibilty that X fll as Y rise or that K come out of past rather than eurent production. These complications have elso been implicitly ignored SYNTHESIS OF AUTOMATIC PRICE AND INCOME ADJUSTMENTS. UNDER FLEXIBLE EXCHANGE RATES 9.34 Assume that (1) a nation’s $ — 1, function is a straight line with slope of 1 while its X — M function ‘a straight line with slope of —1; (2) the S — ly and X — M fonctions intersect at Yu showing a deficit of $100 in the nation’s balance of trade and payments; (3) te full-employment level ‘of income Yy = $1,400; and (4) the foreign exchange market is stable. (a) Draw a Bgure showingCHAP. 9) ADIUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC "7 9.32 tate system; by how much will the X — M funetion have to shift up in order to correct the $100 deficit? (6) Show what happens if the full-cmployment level of income Yr = Yr = $1,000. (a) Tho nation i orginaly al point ia Fig, 9-24, with Yq = $1,000 and defi of S100. With a eable foreign exchange mare, he malion’scurency wil depreciate sufcienly to shit its X ~ M funtion up to (X — M)‘, so that it intersects the unchanged $ — I, function on the horizontal axis at Y = $1,200 (Goine£ in Fig. 9.23). The X ~ M faction had co shift up by $200 (EA in Fig 924) because the ke in the amon’ real income indves is impos lo vise (which reduces the original improvement). POT. Fig. 9.25 (®) Ute nation were aceady al follemployment at ¥_ = $1,000, the depreciation of its curency tends to shift its XM function up to (X ~ M0)" and correct the deficit as in part (a). However, the resulting demond-pull inflation wil eliminate the price advantage thatthe depreciation of the currency was supposed ‘the nation, so thatthe nation’s X - M function shifts back to its original postion and the deficit remains uncorrected (see Fig. 9-25), Suppose that a nation i a full employment without inflation but has a deficit in its balance of payments. (a) Explain why @ depreciation of the nation's currency will not correct the deficit unless real output Fises or domestic expenditures or absorption fall. (6) How can the nation’s output rise as a result of the depreciation? (c) How can domestic absorption fall automatically as a result of the depreciation? (@) How can the goverment help reduce domestic absorption and make the devaluation effective? (@) Depreciation ofthe nation’s currency stimuletas the nation's export and its production of import substitutes. However, unless real output can somehow be expanded andor domestic absorption reduced, this will lead ‘twexcess aggregate demand. The resulting infstion will theo wipe out the price advantage ofthe devaluation and the deficit will remain uncorrected. (6) gen if the nation i already at full employment, depreciation ofthe nation's curency coul national oxtput through the beer wilzation and dhe more economic allocation of existing cesources, ‘Though possible, this i by no means certain or sufcient, Thus, for depreciation tobe eectve, domestic absorption must fl (©) Domestic absorption can fall automaticaly asthe nation's currency deprecates because ofa real cash balance effect, money iluston and redistbutive effect. The real cash balance effec operates as follows: When a nation’s currency depreciate, domestic prices rise; ifthe money supply remains constant, real cash balances, fall and can be replenished only by reducing consumption or absorption. The money illusion ets absorption if consumers spend less when prices rise, even though their incomes have also risen. Finally, absorption falls if te depreciation redistibutes income to consumers with higher marginal propensities to save, How- ‘ever, these effects may be inoperative or insufficient (4) The government con help reduce domestic absorption (and allow the depreciation to be effective) by adopting expenditure-reducing polices, These are discussed in Choptr 10.178 ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC [CHAP. 9 SYNTHESIS OF AUTOMATIC ADJUSTMENTS UNDER THE GOLD-EXCHANGE STANDARD. 9.33 (a) Draw a figure similar to Fig. 9-10 and explain how the gold-exchange standard would operate if the par value is set or pegged at $2.50 = £1 and U.S. monctary authorities actively intervene in the foreign exchange market and sel or buy pounds for dollars to prevent the exchange rate from moving ‘more than 1% above or below the par value. (6) Could we have a fixed exchange rate system without ‘any connection with gold? US. Sells £2525 Por Value $2.50 US. Buys £2475 (a) Figure 9:26 is identical to Fig, 9-10 except that wo now have the per value instead of the mint party and Whe U.S. selling or buying price of pounds instead of the U.S. gold expo and gold import points. At R = $2,525, the U.S. sells pounds (out of its reserves) to prevent any further increase in & (or futher epreciation ofthe dollar), Thus, Sz has a kink and becomes infinitely elastic at R = $2.525. On the other hand, at R = $2.475, the U.S. buys pounds (adding (ois international reserves) to prevent any further decrease in R (or appreciation of the dolar). Thus, Dz becomes infinitely clastic at R = $2.475. Under this system, the exchange rate is determined by Dz and Se within the suppor prices (point Ein Fig. 9-26), snd is prevented from moving outside the allowed band of uctuation by ative intervention bythe monetary authorities (ima way analogous to thy discussed in Problems 9,14 and 9.15). The size of the intervention required determines the size of the nation's deficit or surplus and points to the need for adjustment. Under ‘he gold-exchange standard, it actually was nations other han the U.S. that generally intervened in foreign ‘exchange markeis with purchases of sales of doliars to keep exchange rates within the allowed band of fluctuation, For its part, the U.S. stood ready to exchange foreign offical holdings of dollars for gold on demand and atthe fixed price of $35 per aunce, This system operated from the end of World War IT until 1971, when it collapsed (see Chapter 12), (0) Wecoul have a fixed exchange ral system without any connection with gold if national monetary authorities ase only convertible currencies as international reserves 1o intervene in foreign exchange markets in order (a Keep exchange rates within the agrced band of fluctuation, This is essentially the system the operated from the collapse of the gold-exchange standard in 1971 uni] 1973, when @ flexible exchange system of sorts came into existence (ee Chapter 12), 9.34 (a) Bxplain in detail how a surplus in a nation’s balance of payments, resulting from an autonomous increase in its exports (from a position of less than full employment), may be corrected automatically under the gold-cxchange standard. (b) Explain why the surplus and deficit nations may not be willing to allow the automatic adjustment mechanisms to operate under the gold-exchange standard. What is the result of their unwillingness?CHAP. 9} ADJUSTMENT IN THE BALANCE OF PAYMENTS: AUTOMATIC 179 (©) Unless neotralized, he avionomous increase in exports causes the nation’s real national income to rise. This indvoes an increase in the nation's imports, which only pantally offsets the surplus (ince MPS > 0 in he real world). The increase in the real national income of the suzpls nation is also likely to eause ix prices to rise in relation to prices abroad. In atiton, its exchange rate i kely to appreciate (within the allowed limits). These encourage the soplis nation’s imports and discourage its exports and so reinforce the income adjustment mechanism, Furthermore, th inflow of reserves tothe surplus nation, unless neutralized, increses the nation's money supply and may isa to lower intrest rates. This tends to increase investment, income and imports and also stimulates 9 captal ouliow, all of which help the adjustment process. The exict ‘opposite is ikey to occur inthe deficit mation, andthis,togebes with oeign cepercussion, turer miaares the adjustment process. When considered together, these automatic adjustment mechanisms ar likely 10 bring about complete adjustment. (©) He the surplus nation were already at ful employment, an increase in its expos (ceteris porbus) would toad to excess aggregate demand and demané-pull inflation—and tis is usually not passively (oleraied. On the other hand, a deficit nation is usually not willing to allow its aalional income and employment to fll 235 required by the sulomatic income adjustment mechanism. The other part of the automatic adjustment ‘echanism—the onc that operate though change inthe meney supply, interest ates, investments, come ‘and imports and also through inteastlonal short-term capital lowi—may also not be allowed 10 operate fully because it would mean thatthe nations would have (o give up thee use of monetary policy to corect Lnemployment andlor inflaton fr the sake of external balance. The only way out ofthis impasse isto rely ‘on polices to complete the adjustment (see Chapter 10).Chapter 10 Adjustment Policies: Open Economy Macroeconomics 40.1 ECONOMIC OBJECTIVES OF NATIONS ‘Among the most important economic objectives of nations are the maintenance of internal and external balance. Internal balance refers to domestic foll employment with price stability. External balance refers to equilibrium in the nation’s balance of payments, Ifa conflict arses, internal balance usvally takes precedence over external balance. With at least two objectives, a minimum of two policy instruments are usually necessary to achieve both objectives completely. Each policy tool should be paired with the target on which it is most effective. 10.2. INTERNAL BALANCE WITH EXPENDITURE-CHANGING POLICIES Domestic unemployment can be corrected with expenditure-increasing (i.e., expansionary fiscal and monetary) policies. Expansionary fiscal policy refers lo an increase in goverment expenditures and/or reduction in taxes, Easy monetary policy refers to an inetease in the nation’s money supply and leads toa reduction in the nation’s interest ates, which stimulates investments. If unemployment is accomplished by a deficit in the nation’s batance of payments, the expansion in national income (lo eliminate unemployment) induccs a risc in imports and the reduction in interest rates may lead to a larger short-term capital outflow (or reduced inflow), both of which increase the deficit. IF unemployment is accompanied by a sueplus, reducing unemployment will also reduce the surplus. On the other hand, expenditure-reducing (i.e., restsictive fiscal and monetary) policies to curb inflationary pressures in the economy would increase a surplus but reduce 2 deficit. EXAMPLE 1, Table 10.1 gives the four possible combinations of internal and extemal imbalance, the expenditures ‘changing policies to achiove intemal balance in each case. and their effects on the external imbalance. ‘Table 10.1 Case Policy for Internal Balance Effect on External Balance 1 Unemployment with deficit Expansionary Worsens 1 Unemployment with surplus Expansionary Improves UL Infation with surplos Restrictive Worsens 1V Inflation with deficit Restrictive Improves [Note that in cases I and Il there is a confic between internal and extemal balance. Even if there is no confit (cases Il and IN), the use of fiscal and monetary policies to achieve intemal balance will improve the external balance, but are not likely to completely eliminate the external imbslance. Similarly, if extemal balance were givon priority, intemal balance could not be achieved (see Problem 10.5). To achieve both simoltancously, we need two policy tools, 103 EXTERNAL BALANCE WITH EXPENDITURE-SWITCHING POLICIES Extemal bslance can usually be achieved with expendiuure-switching policies, These refer primatily to de- ‘valuation and revatuation. Devaluation refers to an inerease in the exchange rate from one par value to another. 180CHAP. 10] ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS 181 ‘This normally stimulates the devaluing nation’s exports, reduces its imports and improves the nation’s balance of trade and payments, and so it could be used lo correct a deficit. A revaluation refers to the opposite and could be used to corect a surplus. EXAMPLE 2. Figure 10-1 shows an cconomy operating a point E, with unemployment and a deficit of $100 in ts balance of trade and payments (ease I in Table 10.1). To coneet the defcit, the nation could devalue its curency sufficiency to shift dhe X — M function up to (X — M)' so that it intersects the unchanged S — Ty funetion on the horizontal axis (S0 X = M) at the higher real income of Yz = $2,400. Note that (o cotrect a deficit of $100, the X — function had to shift up by $200 (£A in Fig. 10-1) because tke rise in the nation’s real income (from Ye to Y) induces its M 10 rise (which reduces the otiginel improvement). We can sometimes get 2 rough indication of the size of the evaluation required by the pucchasing-power-parity theory (ee Problem 10.9). However, ifthe ecanomy were already at fall ccaployment at point E, the devaluation would be effective only if domestic expenditues or absorption were reduced, automatically (by areal cash balance effect, money illusion, and redistributive effect) or by expenditure-reducing polices see Problem 10.10). 10.4 INTERNAL AND EXTERNAL BALANCE WITH EXPENDITURE-CHANGING AND -SWITCHING POLICIES By using an expenditure-changing (i.e, fiscal) policy for intemal balance and an expenditure-switching policy ‘devaluation or revaluation) for extemal balance, both objectives of internal and external balance can be achioved simultaneously. (Monetary policy will be reintroduced in the next section so that we may now avokd dealing with changes in short-term intemational capital movements.) eal domeatic expendivare oF absorption (Vi Fig. 10-24 182 ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS (CHAP. 10 EXAMPLE 3. In Fig. 102, the various combinations of exchange rates (R) and real domestic expenditure or absorgtion ‘W¢) tha give intemal balance are shown by the YY curve. The YY curve is negatively inclined, showing that an increase in N must be balanced by a decrease in the nation's (to reduce its trade balance) inorder to remain at full employment without ination, Poins above the eurve refer to inflaton, while points below to unemployment. On the other hand, the [EE cure gives ell points of extemal balance X = M (for zero net capital movements), The EE curve is positively inlioed, shoving that a devaluation (which improves the nation's trade balance) must be balanced by an increase in” (lo induce the nation's import to rise suficienty) to remain in extemal balance. Points above the FE curve refer to surplus, while poins below to deficit. The erossng of the two curves defines the four cases of intemal and extra imbalance shown in Table 19.1. Table 10.2 gives the fiscal and cxpendivuresswitching policies needed to reech internal and extemal balance siwltancously (point F In Fig. 10-2), starting from points A, 8, C and D. Table 10.2 Point Fiscal Policy for intemal Balance | Policy for Extemal Balance A (Unemployment with defici) Expansionary evaluation 8 Wnemployment with surplus) Expansionery Revaluation © oifaton with surplus) Restictive Revaluation D_ Caation with deficit) Restrictive Devaluation 10.5 INTERNAL AND EXTERNAL BALANCE WITH FISCAL AND MONETARY POLICIES During the post-World War II peried, nations were extremely reluctant to change the par value of their currencies to reach equilibrium, and did so only rarely, after long delays and when practically forced upon them, rather than as a matter of poliey (see Problem 10.16). One possible way out of this impasse was to view fiscal policy and monetary policy as two distinct policy insuuments and use fiscal policy for internal balance and monetary policy for external balance, so that both objectives could be achieved simultaneously ‘without any change in exchange rates. This can be shown with IS, LM and FE curves (sce Example 4), by having the IS and LM curves cross on the FE curve at the full employment level of national income (see Example 5). EXAMPLE 4. The JS curve shows the various combinations of interest rate {r) and national income (¥) that result in quiibriam in the goods market (i.e.. at which the quantity demanded of goods and services equals she quantity supplied). ‘Tho IS curve is negatively inclined because a lower ris associated with a higher level of investment and ¥ for equi inthe goods market. The Li curve shows the various combinations of rand Y af which the money market is in equilibrium: (Ge., at which the transaction and the speculative demand for maney equal te given and fixed supply of money). The speculative demand for money is invereely related tor, whi the wansuction demand for money is proportional :0 Y [see Problem 10.18(d)]. Equilibrium in the goods market in the money market and inthe balance of payments can be achieved simalianeously by using fiscal policy and monetary policy in such a way as to have the IS and the LM curves cross on he FE curve at the full employment level of national income. EXAMPLE 5. In Fig. 10:3, the nation isin equilibrium in the goods and money markets at point E (with r = 105% and Ye = 1,000) but faces recession or unemployment since the full employment level of national income Is Ye = 1.400. The nation also faces a balance of payments deficit because al Ys = 1,000, r would have to be 12% (point 1") tobe on tne FE curve, Aliematively, Y would have to be 800 (point #1) 10 be on the FE curve at r = 10%. Starting ai point E with unemployment and a deficit in is batance of payments, the nation cen use expansionary fiscal policy to shiftCHAP, 10] ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS 183 Yeriooe Yp=veoo Y Fig. 10-3 me IS curve to the right to IS" and tight monetary policy to shift the LM curve tothe left to LM’ so thatthe 1S" and the LM curves cross at point F on the FE curve, with r = 168% and Yp = 1,400. Then, the nation is in equilibrium in all the markets simultaneously. To see how the nation can reach equiibrivm in all three markets simultaneously at Yr ‘when capital flows are perfectly elastic and under Mexible exchange rates, see Problems 10,20 and 10.21. respectively. 10.6 THE POLICY MIX FOR INTERNAL AND EXTERNAL BALANCE In the previous section, we have scen that to achieve internal and extemal balance simultaneously without ‘changing the exchange rate, the nation must direct fiscal policy to achieve internal balance and monetary policy to achieve external balance. Ifthe nation di the opposite, the nation would move further away from both balances. This can be shown with an internal balance (/B) line and an external balance (EB) line. EXAMPLE 6, tn Fig. 10-4, movements slong the horizontal axis away from the origin refer to expansionary fiscal policy (ue., 6 higher government expenditures and/or taxes), white movements along the vertical axis away from the ‘origin refer to tight monetary policy {i.c.. to reductions in the nation’s money supply and increases in inesst rete). The JB line shows the various combinations of fiscal policy (G) and monetary policy (r) that result in intemal balance. There is iflation belove the 1B fine and wnemploymeat above it. The IB line is positively inclined because expansionary ical policy must be balenced with a suficienty right monetary policy to remain on the IB tie. On the other hand, the EB , I LEABL EL yeti Monetary policy finterest rate) Fiscal policy (goverment expenditures) Fig. 10-484 ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS IcHar. 10 line shows the various combinations of G and r that result jn extemal balance. There isa deficit below the line and 2 surplus above it, The EB fine is positively inctined because a higher G increases the level of national income (Y) and imports (M) and must be balanced with higher capital inflows (or smaller outfows), which require © higher r, for the ration to remain on the EB fine. The EB line is fattr than the 1B line becouse monetary policy als induces international shorirm capital ows. Only at point F, where the 1B and EB lines cross, isthe nation simultaneously in internal and cxtenal Balance, Starting at point Ao in Fig. 10-4 showing unemployment and defi, if the nation uses expansionary fiseal polity to reach point Ay on the 1B line, then tight monetary policy to reach Az on the EB line, and so on, the nation’s policies will converge on point F (where the IB and EB lines cross). I the nation uses instead easy monetary policy t0 reach point Aj on the IB inc, then contactinary fisal policy to reach A, and so on, the nation will move fartner away from point F 10.7 DIRECT CONTROLS With prices rising even at less than full employment and rising faster as full employment is approached, price stability becomes a third, distinct target (besides full employment and external balance). Since there is usually ‘trade-off between the unemployment and infaticn rates (te Phittips curve), anation with stronger inflationary pressures may have (o accept a higher rate of unemployment than a nation with weaker inflationary tendencies. If this is not sufficient or acceptable, domestic price and wage controls (incomes policy) may be necessary to curb inffation. On the other hand, if short-term intemational capital movernents do not readily respond to interest rate ‘changes, or if monetary pofiey is used along with Gscal policy for internal balance, then an external imbalance ‘can only be corrected with flexible exchange rates or suppressed with trade and exchange controls. The latter are interferences with the fee international flow of goods, services and capital and are of many kinds [see Problem 10.31(6)]. Finally, a nation could strive to also achieve a “reasonable” rate of growth by changing ils interest rate structure (see Problem 10.32). Glossary Internat balance The objective of having full employment with price stability. External bafance The objective of having equilibrium in the nation’s balance of payments. Fiscal policy A policy based on changes in goverment expenditures, taxes or both. ‘Monetary policy A policy based on the nation's monctary authorities making changes in the n supply and the effect that these changes have on domestic interest rales, Expenditure-changing policies Fiscal and monetary policies to change the level of aggregate demand. Expenditure-switching policies Policies based primarily on a devaluation or evaluation of the nation’s currency in order to switch the nation’s expenditures from foreign to domestic producers or vice-versa, n's money Devaluation The increase in the exchange rate from one par value to another made by the nation’s monetary ‘authorities. Revaluation A decrease in the exchange rate from one par value to another made by the nati "s monetary aunthocties. IS Curve The negetively inclined curve showing the various combinations of interest rates and national income levels at which the goods market is in equilibrium, LM curve The positively inclined curve showing the various combinations of interest rates and national income levels at which the money market is in equilibrium,CHAP. 10] ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS 185 FE curve The (usually) positively inclined curve showing the various combinations of interest rates and ‘ational income levels at which the nation's balance of payments is in equilibrium, 1B line The positively inclined line showing the various combinations of fiscal and monetary policies that result in intemal bslance. . EB fine The positively inclined tine showing the various combinations of fiscal and monetary policies that result in external balance. Trade and exchange controls A reference to tariffs, quotes, multiple exchange rales and restrictions on international capital movements Review Questions 4. “The mast important economic objective ofthe U.S. and most other developed nations usually (a) infernal balance, @) external balance, (c) a reasonable rate of growih, (d) en equitable distribution of income, ‘Ans. (a) See Section 10.1. 2, ‘To achieve three economic objectives simultaneously and completely, we usually ned at leat he following sumer ‘of economic policy instruments: (a) one, (B) wo, (¢) thre, (@) Four, ‘Ans. (€) See Section 10.1. nin er gym pans te st hme oer rie ‘Ans. (b) See Section 10.2 (exse Lin Table 10.1). 4. The use of expenditure-reducing policies to correct inflationary pressures in the economy will make (a) 8 surplus smaller, (6) a sutplus larger, (c) a deficit smaller, (d) a deficit larger. Ans. (b) and (¢) See Section 10.2 (cases Hl and IV in Table 19.1). 5. The appropriate expenditure-switching policy c@ comect a deficit in the balance of payments is (a) revatoation, (0) devaluation, (¢) monetary policy, (d) fiscal policy. ‘Ans. (b) See Seetion 10.3. 6 If the nation in Fig, 10-2 is on the YY curve above point F, the nation faces (a) unemployment and surplus, (2) infiation and surplus, (¢) internel bulence and surplus, (4) intemal balance and deficit. ‘Ans. (c) Since the nation is on the YY curve, the notion is in internal batance. Since the nation is above the EE curve, the nation has a surplus. 77. I the nation in Fig, 1-2 is on the Y¥ curve sbove point F, the nation can reach point F by (a) devaluation and ‘expansionary fiscal policy. (b) revaluation and restrictive sel policy, (c) devaluation and resuictive fiscal policy, {d) revaluation and expansionary fiscal policy. ‘Ans. (d) To reach F, the nation has to move dovn (revaluation) and to the right to increase WV (and this requires ‘expansionary Liscal policy). 8. Points above the LM curve refer to (a) excoss demand for money, (b) excess supply of money, (€) unemployment, (a) inflation. fans. (b) See Section 10.5.186 ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS (CHAP, 10 9. To eliminate unempleyment and a deficit in the balance of payments, the nation must employ (a) conttactionsry fiscal policy andeasy moneury policy, (b) expansionary fiscal policy andtight monetary policy, (c)conractionary ‘seal policy and ght monetary policy, (4) expansionary fiscal policy and easy monetary policy ‘ns. (b) See Section 10.5 ond Fig. 103, 10, If the nation in Fig. 10-4 is on the EB line below point F, dhe nation faces (a) unemployment and surplus, (b) unemployment and deficit, (¢) external balance and unemployment, (a) internal balance and surplus. ‘Ans. (c) Since the nation is on the EB line, the nation is in extemal belance. Since the nation is above the JB fine, the nation faces unemployment. 11, tf he sation in Fig. 10-4 is on the EB line below point F, the nation can reach point F by (a) eary monetary policy and restctve fiscal policy, (b) tight monetary policy and expansionary fiscal policy, (c) easy monetary policy end expansionary fiscal policy, (4) tight manelary policy and restrictive fiscal policy. ‘Ans. (b) To reach point F, the nation hat to move upward (Ugh monetary policy) and to the right (expansion of fiscal policy). 12, Trade and exchange controls refer to (o) tariffs, (4) quotas, (c) mulliple exchange rates, (d) restrictions on Intemational cepital movements, (e) all of the above. ‘Ans. (e) See Section 10.7. Solved Problems ECONOMIC OBJECTIVES OF NATIONS 10.1 (a) Identify several of the most important economic objectives or targets of nations. Which of these is normally given priority? (b) What are some of the most important policy instruments or tools that a nation can employ to achieve these targets? (c) How many policy instruments or tools does a nation need to.reach its objectives? (d) How does the nation decide which tool to use for each specific target? (a) Some ofthe most important economic objectives are (1) internal alunce, which refers to full employment (or an unemployment rate of no more than, say, 2 or 3%) and price stability (or a rate of inflaton of ro ‘more than 2 or 3% per year: (2) extemal balance or equilibrium in the balance of payments; (3) a reasonable rate of growth and (4) an equitable distribution of income. Most nations normally zegard internal balance 1s their most important esonomic objective, But they are sometimes foreed fo switch their priority to the external balance in the face of lage and persistent balance of payments disequibra (6) Some of the most important policy instruments available tow nation ae (1) expenditute-chaaging or demand Policies, which refer to fiseal policy (conducted by changing government expenditures and/or taxes) and monetary policy (which changes the money supply end affects interest mtcs); 2) expenditure-switching policies, which refer to devaluation and revelation (however, nations kave often been unwilling to uilize ‘cm and (3) dizeet contols, or interferences withthe operation of market forces and reer to price and ‘wage conols, and trade and exchange controls. Direct controls area last resort and ave usually employed ‘when olher policies have been found to be ineffective (©) Annttion generally needs an effective policy instrument or tool foreach independent objective or target that it wants to reach. Sometimes a single tool will help the neon approach more than one target, but i i ‘generally rare and coincidental that a nation will completely and similtaneously achieve more than one {target with a single tool—or more targets than the numberof tools at its disposal. (d) Esch tool should be paired with the target on which it is most effective, This is sometimes referred to a5 the principle of effective market classfication.‘CHAP. 19) ADIUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS 187 INTERNAL BALANCE WITH EXPENDITURE-CHANGING POLICIES 10.2 103 10.4 Suppose a nation faces domestic unemployment and a surplus in its balance of payments. (2) Explain in detail the expenditure-chauging, policics required to cure the unemployment. (6) What would happen to the nation’s extemal imbalance? Why? (@) Domestic unemployment can be corrected with expenditure or demnand-increasing policies, These refer to ‘expansionary fiscal and monetary policies. Expansionary fiscal policy refers to an increase in government ‘expenditure and/or a reduction in taxes. A reduction in taxes leads to an inereese in consumption, which 38 an increase im government expenditures, results in s muliple expansion in national income. On the other hand, easy monetary policy refers to an increase in the money supply and reduction in interest rates, Those ‘stimulate investment and also result in a multiple expansion in national income, (8) If domestic unemployment was accompanied by a surplus in the nation's batunce of payment (case Tl in “Table 10.1), the expansion in ational income (1o eliminare unemployment) indvees arise in impors, and the reduction in intrest rates (from the easy monctary policy) may lead toa lager shor-temm capital ouiflow (or reduced inflow), both of which reduce the surplus. Sometimes the original surplus could even turn into 4 deficit. This is more likely to occur when the original surplus is small, unemployment is trge (so that strongly expansionary fiscal and monetary policies ase needed), the marginal propensity to impert is high, ‘domestic prices rise as the economy approaches fall emplayment, and capital movements readily respond to the fallin the interest rate. Only rarely and by coincidence will the elimination of unemployment also lead to complete extenval balance. Suppose a nation faces domestic inflationary pressures (due to excess aggregate demand) and a surplus its balance of payments. (a) Explain in detail the expenditure-changing policies required to curb the inflationary pressures inthe economy. (b) What would happen to the nation’s external imbalance? Why? (2) Domestic inationary pressures resulting from excess agpregae demand canbe conected with expenditue- for demand-deereasing polices. These refer to restrictive fiscel and monetary policies. Restrictive fice] policy refers to a decease in govemment expenditures and/or an increase in taxes. An increase in wes leeds toa reduction in consumption, which as a decreasa in government expenditures result in x multiple contraction in ational income, On the other han, ight monary policy leads to higher interest rates, lower investments and a multigle contraction in national income. (©) I the domestic infaion was accomplished by a surplus in de nation’s balance of payments (case I ‘able 10.1), evbing the ittaton stimulates de nation's expos ard discourages is import, both of which Improve the nation’s trade balance. In addition, the Increase in domestic interest rates (from the tight monetary policy) may lead to a larger short-term capital inflow (or reduced outflow). With an improved trade balance and a larger capital inflow ora reduced outflow, the original surplus inthe nation's balance ‘of poymens will become even larger. Thus, the use of expenditure- or demand-ineteasng policies to achieve intemal belance will worsen the external imbalance. Suppose a nation faces domestic inflationary pressures due to excess aggregate demand and a deficit ints balance of payments. (a) What expenditure-changing policies are required (o achieve internal balance? (6) What would happen fo the nation’s extemal imbalance? Why? (a) Domestic inflationary pressures resulting from excess aggregate demand can be conected with expenditure ‘or demand-decreasing policies. These refer to restrictive fiscal and monetary policies which operate exactly 1s deseribed in Problem 10.3(a). (2) Ifthe domestic infation was accompanied by 2 deficit inthe nation’s balance of payments (case IV in Table 10.1), curbing the inflaton improves the nation’s trade balance and also leads to a larger short-term cepit inflow or reduced outflow [exactly as described in Probtem 10.3(6)]. These cause the nation’s deficit fo be reduced, climinated entirely or even tumed into a surpus. A surplus is more likey to arise the smaller the ‘original deficit, the more restrictive the fiscal ond monetary polices required to curb the inflation, the more ‘the nation’s trade balance improves asa result of curbing inflation andthe more responsive short-term capital188 ‘ADJUSTMENT POLICEES: OPEN ECONOMY MACROECONOMICS (CHAP. 10 movements are to a rise in interest rates, Only rarely and by coineideace will ihe expenditure- or demand- reducing policies imposed 10 correct the domestic inflation atso and at the same ime loed to complete external balance, Suppose that a nation used its expenditure-changing policies to achieve external rather then internal balance. (a) Explain how a nation facing unemployment and a deficit in its balance of payments (ase [ in Table 10.1) can eliminate its deficit. What would happen to its leve! of unemployment? (6) Construct a table similar to Table 10.1, showing the type of policy required to achieve external balance and its effect on the intemal imbalance for each of the four possible combinations of internal and external imbalance. (c) In which case does a conflict arise between external and internal balance? (@)_ The nation can corect the deficit in its balance of payments by expenditure-docreasing ({e., resuctive fiscal and monetary) policies. The resulting reduction in national income induces e decline in the nation's imports which improves its trade balance. In addition, the increase in the nation’s inlerdst rate ({rom ils ‘sesrietive monetary policy) results ia a larger short-lerm capital outflow of reduced outflow. In this way, the nation can porsue the precise expenditure-decreasing polices to achieve complete externa balance. However, this will, a the same time, make the domestic recession worse. @ ‘Table 10.3 Policy for Effect on ose External Balance {Internal Balance 1 Unemployment with deficit Restrictive ‘Worsens 1H Unemployment with surplus Expansionary Improves TIL Inflation with surplus Expansionary Worsens IV Infation with deficit Resrictive Improves (c)_Incases I and IH in Table $0.3, there isa confit between external and intemal balance. Even if there is ‘no conflict (eases If and IV), the us of fiscal and monetary policies to achieve external balance will improve th imermal imbalance, but only rarely and by chance will they completely eliminate it. situation similar to case I was faced by the U.S. in the early 1950s, 1960s and 1970s and by the U.K. in the mie-1960s, and while the U.S, gave priory to the intemal balance, the U.K. gave it to the exterafalance. In 1961, Germany faced case Il and also gave priority to the extemal balance. In gemeral, however, i is internal balance thet is given priority when & confit arises. EXTERNAL BALANCE WITH EXPENDITURE-SWITCHING POLICIES 10.6 (a) Explain what is meant by devaluation, Does this differ from depreciation? (6) Explain what is ‘meant by revaluation. Does this differ from appreciation? (c) Why are devalustion and revaluation referred to as expenditure-switching policies? —(d) Under what condition is a develuation or a reval- ‘ation effective in correcting a deficit or a surplus in a nation’s balance of payments? When are they feasible? (2) Devaluetion refers to an inezease in the exchange rte from one par value to another and could be ased as 4 policy instrument by & nation under a fixed exchange rate system to correct a deficit in is balance of ‘payments. On the other hand, depreciation refers to an inerease inthe exchange rate [see Problem 7.6(6)] resulting from the free operation ofthe market forces of demand and supply under a fcxible exchange rate system. Sometimes this distinction is not made and the ‘wo terms are used interchangeably. (©) Revaluation refers to a decrease in the exchange rate from one par value to another and could be used as policy instrument by a nation under a fixed exchenge rate system to comect x surplus in its balance of payments. On the other hand, appreciation refers to a decrease in the exchange rate [see Problem 7.7(0)]CHAP. 10) ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS 139 from tho free operation of the market forces of demand and supply under a flexible exchange rale system. Sometimes the two terms are used interchangeably. (©) Devaluation and revaluation ace eferred to as expenditure-switching policies because they switch expenditures from foreign to domestic goods and services and vice versa. More specifically, by increasing the price of a unit of the foreign currency, devaluation will make a nation’s imports more expensive in terms of the domestic curreney (see Problem 9.5) and its exports cheaper to foreigners in terms of the foreign ccurreney (see Problem 9.8). This causes expenditures to be switched from foreign to domestie goods as the nation satisfies more of its needs by domestic production rater than through imports, and as the nation’s expons rise. Similarly, a revaluation stimulates the nation’s imports and discourages its exports, thus switching expenditures from domestic to foreign goods and services. (2) As with depreciation or appreciation, devaluation or revaluation can correct a deficit or surplus in a nation’s ‘balance of payments only ifthe foreign exchange market i stable (se Problem 9.10), Ifthe foreign exchange. ‘market were unstable, a revaluation (not a devaluation) would be required to comrect a deficit, and a devaluation (aot a revaluation) would be needed to correct a surplus (sce Fig. 9-8). Assuming a stable ‘market, expendivure-switching policies become more feasible as policy instruments to correct balance of ‘Payments disequilibria, the more clastic isthe demand and sippy of foreign exchange [see Problem 9.6(¢)] 10.7. Assume that (1) a nation’s $ — I, function is a straight line with slope of | while its X — M function 2 straight line with slope of —1, (2) the S — Ig and X — M functions intersect at Ye = $2,000 showing a deficit of $200 in the nation’s balance of trade and payments and (3) the foreign exchange ‘market is stable. (a) Draw a figure showing how the nation can reach equilibrium in its balances oF trade and payments by altering the exchange rate. (b) If, at Ye = $2,000, the nation also faces ‘unemployment, what would happen (o ils level of unemployment as the mation’s deficit is corrected? (c) What woutd happen if the nation altered the exchange rate sufficiently to correct its deficit, but the nation initially faced excess aggregate demand and demand-pull inflation at Yr. = $2,000? (@) The nation is originally at point F in Fig. 10-5, with Ye = $2,000 and a deficit of $206. With a stubte forcign exchange market, the nation could corect the deficit by devaluing its currency sufficiently to shift its X — M function up to (X — M)', so that it imersects the unchanged S ~ I, function on the horizontal axis (60 X = M) atthe higher real income of $2,400 (point £" in Fig. 10-8). Note that to correct a deficit ‘of $200, the X ~~ M function had to shift up by $400 (EA in Fig, 10-3) because the cise in the nation's real income induces its impons to rise (which reduces the original improvement). (2) If, at point E, the nation faces unemployment with «deficit (case Lin Tables 10.1 and 10.3), the elimination of the deficit with a devaluation would reduce or eliminate unemployment and the nation may even face inflation. Specifically. if the full-employment level of ral national income with price stability, then unemployment would be reduced when the deft is elimi $82,400, the devaluation thot eliminates the defick will also and at the same time completely eliminate ‘unemployment. If ¥> < $2,400, say $2,200, then the devaluetion that seems to be required to corect the190 108 ‘ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS ICHAP. 10 deficit will not only eliminate unemployment, bot will tum it into excess aggregated demand and demand- pull inflation. "This in turn reduces the price advantage thet nation receives from the devaluation. (e) If the nation faced inftation with deficit at point E in Fig. 10-S (case IV in Tables 10.1 and 10.3), the devaluation would add to te excess aggregate demand and the resulting higher inflation rate would quickly ‘undo the price adventage of the devaluation [ie., the (X — MY’ function would shift back to its original position). fm this case, a devaluation by itself would be the wrong policy. Expenditure-reducing policies ‘are now required. These would etiminale or reduce the inflation, and thereby reduce the nation's deficit (Gee Problem 10.4) ‘Assume that (I) a nation's S — 1, function is a steaight line with slope of L/2 while its X — M function is a straight line with slope of — 1/2; (2) the S — Ly and X — M functions imersect at Ye = $2,000 showing a surplus of $100 in the nation's balance of trade and payments; and (3) the foreign exchange market is stable. (a) Draw a figure showing how the nation can reach equilibrium in its balance of trade and payments by altering the exchange rate, (b) If, at Ye ~ $2,000, the nation also faces ‘unemployment, what would happen to its tevel of unemployment as the nation’s surplus is corrected? {c) What type of internal imbalance would the nation face (together with the surplus) if the Full employment level of real national income with price stability, Yr < Ye = $2,000? (d) What would happen to the intemal balance if Yr = $1,400, $1,600 of $1,800 and the nation altered the exchange rate sufficiently to achieve external balance? (a) Te nation is originally st point Ein Fig, 10-6, with Yq = $2,000 and a surplus of $100. With a stable foreign exchange market, tie netion could comet the surplus by revaling its cuency suficiently to shit ts X — M function daw to (X — My, so tat it inersecte the unchanged S ~ Ty function onthe horizontal tis (G0 X = M) atthe lower real income of $1,600 (Poin £” in Fig, 10-6) Note thet to conecta surplus ‘f $100, the X — M function must shift down by $200 (in Fig. 10-6), because asthe X — M function shifts down, Y falls and induces a fall inthe nation’s imports which neutralizes part of te origina effect of te revaluation, Real income (YY (©) If, at point &, the nation faces unemployment with a surplus (case I in Tables 10.1 and 10.3), the elimination of the surplus with a revaluation would increase domestic unemployment. On the other had, a devaluation ‘Would reduce unemployment but would cause the surplus to become even greater. The nation would then be exporting its unemployment and this would invite retaliation by other nations that also fue defationary tendencies. This is indeed what happened in the 1930s (See Chapter 12). (©) Ifthe full-employment level of eal national income with price stability, Yr < Ye = $2,000, then the nation would initially face excess egeregnte demand and demand-pullinfiation together with a surplus at ‘point & (case If in Tables 10.1 and 10.3). The elimination of the surplus with 2 revaluation then reduces ‘he inflation, eliminates itor results in unemployment ‘51,400, the nation ends up with a lower excess aggregate demand end rate of inflaton as it revales lis curreney sufficiently to eliminate the surplus. If ¥> = $1,600, the nation eliminates the surplus and the inflation completely with the revaluation. If Yr = $1,800, the iflation would give way o unemploymentCHAP, 19), ADIUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS 191 2s the surplus is eliminated with the revaluation. This once again points to the conclusion that to achieve ‘complete intemal and extemal balance simultaneously, two policy tools are normally needed, Note also that ‘we have implicitly assumed that domestic prices remain constant unit full employment is reached. 10.9 Inthe real world, nations usually do not know the shape of the demand and the supply curve of foreign exchange and 0 they do not know how much to devaluc or revalue their currencies to correcta deficit ‘or surplus in the balance of payments. They can, sometimes, get a rough indication from the purchasing- power-parity (PPP) thcory. In its absolute version, this states that the exchange rate between two ‘currencies should equal the ratio of the price indexes in the two nations. In its more refined, relative formolation, it states that the change in the exchange rate should equal the relative change in relative prices in the two nations, With regard to the above, restate in symbols (a) the absolute version of this doctrine and (b) the relative version. What is their usefulness? (2) Letting a = our country (the U.S.) and b = the foreign couatry (lhe U.K.). then Ray ~ the price of foreign exchange inter of our currency (orS/f). The absolute formulation ofthe purchasing power-party doce can then be sited 25 where Ps = the price index in nation a and ?, = the price index in nation &. This says, for example, that i the price level in the U.S. is double the price level in the U.K., then the exchange rate should be $2, £1, The absolute formulation of the PPP theory is grossly incorrect and cannot be taken seriously because {t fas to take into account transportation costs and other obstructions to the free flow of trade, and it does ‘ot consider ceptal lows and noatreded goods. (®) Letting 0 = the base period and 1 = period 1, then according to the relative formulation: Rar _ FelPea Rao PulPoa ‘This says that the change in the exchange rate should be the same as the change in relative prices in the two nations. For example, assuming that Ps/Pus is fixed and is not affected by what nation a does (.c., nation a is very small), if nation @ were in equilibrium belore its prices rose by 100%, mulion a should devalue by 100% to retum to equilibrium, This relative formulation holds, asa first approximation, only if the disturbance results exclusively from different rates of inflation in the «wo nations, Even then, serious index number problems remain, With structural changes: changes in technology, resource supplics. tastes, long-term capital movements or with wat), even this formulation is useless, In these cases, the nation ‘could allow the exchange rate to freely fuctuate for a while to find its own equilibrium levet before repevging a 10.10 Suppose that a nation is at full employment without inflation but has a deficit in its balance of payments. (@) Explain why a devaluation will not correct the deficit unless real output rises or domestic expenditures or absorption fall, (6) How can the nation’s output rise as a result of the devaluation? {c) How can domestic absorption fall automatically as a result of the devaluation? (4) How can the government help reduce domestic absorption and make the devaluation effective? (@) A devaluation stimulates the nation’s exports and its production of import substitutes. Howover, unless real ‘output can somchow be expanded and/or domestic absorption reduced, this will lead to excess aggrogets demand. The resulting inflation will then wipe out the price edvantage ofthe devaluation ond the deficit ‘ill remain uncorrected, (©) Even if the nation is already at full employment, a devaluation could lead to higher real national output through the beter utilization and the more economic allocation of existing resources. Though possible, this is by no means certain or sufficient. Thus, for a devaluation to be effective, domestic absorption must fll. (©) Domestic absorption can fel automatically as a result ofa devaluation because of steal cash balance effect, ‘money illusion and redistributive effet, The reat cash balance effect operttes as follows: When a nation192 ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS tcap. 10 dovaluss, domestic prices rise; if the money supply remains constant, real cash balances fall and can be replenished only by reducing consumption or absorption. The money illusion cuts absorption if consumers spend less when prices rise, even though their incomes have also risen. Finaly, absorption fatls if the devaluation redistributes income to consumers with higher marginal propensities (o save, However, these effects may be inoperative or insufficient. (a) The government ean help reduce domestic absorption (and alfow the devaluation 10 be effective) by adopting cexpenditure-reducing policies. Tus, once again we sec thal to achieve simuitancous internal and external valance, (wo policy tools are quired. Note that up to the last sentence, the answer to this problem is ‘dential to that of Problem 9.32, except that we are now examining the effect of a develeation rather than of a depreciation. INTERNAL AND EXTERNAL BALANCE WITH EXPENDITURE-CHANGING AND -SWITCHING POLICIES 10.11 With reference to Fig. 10-7 (the same as Fig. 10-2 but repeated here for ease of reference), indicate (a) whet the YY curve shows, (B) why points A and B refer to unemployment, (c) why points C ‘and D refer to inflation and (a) why the YY curve is negatively inclined, (@) Each point on the YY curve refers to a particular combination of exchange rate (R) and real domestic ‘expenditure (W) that involves internal balance or full employment with price stability. (6) Point A involves the same R but lower N than (he point directly across on the YY curve. Thus, A involves tnemployment or recession, The same is true for point B and for any other point to the left and balow tho “YY curve, (©) Point C involves the seme R but higher N then the point dec across on the YY curve, Thus, C javolves ‘excess aggregate demand and inflaion. The same is true for point D and for any other point to the Fight ‘and above the YY curve. (@)_Staning fcom a point om the YY curve, «revaluation by iself (a downward movement) Jeads toa deterioration inthe nation’s trade balance and unemployment, which to be corrected requires an increase in real domestic ‘expenditures (a movement to wie right). Thus, the YY curve is negatively sloped. Alternatively, 2 devaluation {an upward movement) from a point on the YY curve improves the nation's tre balance and Jeads (0 ‘excess aggregate demand and inflatioa, Since vo cotect the inflaton, N must be reduced (3 movement 10 the left, the YY curve must be negatively inclined Exchange rate 02) Devaluation Revaluation o ‘Real domaestle expenditure or absorption (N) Fig. 10-7CHAP. 10) ADIUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS 193 10.12 10.13, With reference to Fig. 10.7, indicate (a) what the EE curve shows, (b) why A and D refer to deficit, (c) why B and C refer to surplus and (¢) why the EE curve is positively inclined. (@) Bach point on the BE curve refers to 2 particular combination of exchange rate (R) and real domestic expenditure (¥) that involves external balance or equilibrium in the balance of payments. (D)_ Point A involves the same N but lower R than the point directly above on the FE curve. Thus, A involves aan overvalued domestic currency and 2 deficit in the balance of payments. The same is tue for point D and for any other point below ad to the tight ofthe EE curve. CC) Point involves the seme NV bur higher then the point directly below on the EE curve. Thus, B involves ‘an undervalued domestic currency and a surplus inthe balance of payments, The same is true for pot C and for any other point above and to the left of the EE curve, (a) Starting from a point on te FE-curve, an increase in real domestic expenditures (@ movement tothe Tight in Fig. 10-7) by isl induces 2 rise in impors and opens a deficit in the naon’s balance of payments Which ean be corrected with 2 devaluation (an upward movement), Thus, the EB curve is positively stoped. Alwematively, a deerease in 8 (a movement (othe lft) from a point on the EE curve induces a fallin {imports and opens a swplus im the nation’s belance of payments which ean be comected with a revaluation (a downward movement). Thus, once again we see thatthe EE curve must be positively inclined. With reference to Fig. 10-7, (a) explain the type of fiscal and expenditure-switching policy required to achieve internal and extemal balance simultaneously, starting from points A, B, C and D. (b) Why was monetary policy omitted? (a) The nation is simultaneously in itera and external balance at point F, where the YY and EE curves cross. ‘To each point F from A, the nation must move to the right and up. This involves expansionary fiscal policy (o increase real domestic expenditure) and devaluation, From point B, the nation must move to the right (with exponsionary fiscal policy) and down (with revaluation). From C, the nation must move to the left (with restrictive fiscal policy) and down (with revaluation). From D. the nation must move to the left (with restrictive sal policy) and up (with devaluation). These polices are summarized in Table 10.2. (8) Monetary poticy could aiso have been used to achieve intemal balance. However, by affecting intrest ras, monetary policy not only affects the level of investments bat also induces changes in international capital ‘movements, Since this would greatly complicate our presentation inthis section, we postpone the introduction ‘of monetary policy until Problem 10.17, Thus, at ezch point on the EE curve, X — M equals a given autonomous level of net capital movement, There is a different EE curve for cach level of net capital ‘movement. With reference to Fig. 10-7, indicate whether a nation can achieve internal and extemal balance simultencously, (a) with an expenditure-switching policy only, if the nation is in internal Dalance ‘bt faces e deficit or surplus in its balance of payments and (b) with fiscal policy only, ifthe nation is in external balance but faces recession-or inflation, (a) Ifthe nation is on the YY curve below point F (60 thatthe nation is in intemal balance but faces a deficit inits balance of payments), a devaluation by itself could move the nation toa point straight up and on the EE curve. However, this would lead to inflation (see Fig. 10-7). To reach point F, ths nation should use -estietive fiscal policy together with devaluation. On the other hand, if te ration is on the YY curve above point F, a revalumtion by itself could move the nation o a point stright down and on the EE curve. This, however, would lead to recession. The nation can reach point F with expansionary fiscal poticy together ‘with a smaller revaluation. {®) ithe nation is on the EE curve below point F, expansionary fiscal policy by itself could move the nation to.3 point directly across and on the YY curve, but dis woold tead to « deficit (see Fig. 10-7). To reach jpoint E, the nation should use a weaker expansionary fiscal policy end devaluation. On the other band. if ‘the nation is on the EE curve above point F, the nation could reach the YY curve with restrictive fiscal policy. However, this would lead 10 surplus. The nation can reach point F with a weaker restrictive fiscal policy and revaluation.194 ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS (CHAP. 10 Bxchange rate (2) Devaluation . R | Revaluation Real domestic expenditure or absorpsian (N} Fig. 10-8 40.15 Starting from each point in Fig. 10-8 (the same as Fig. 10-7, except for the additional points), (a) set up a table indicating the fiscal and expenditure-switching policies required to bring the economy to intemal and extemal balance simultaneous)y (point F). (b) What causes the difference in the required policies to reach point F from the three points in each case? @ ‘Table 10.4 Fiscal Policy Policy for Case Point for Internal Balance External Balance 4 Expensionary Devaluation 1 a None Devaluation a Restrictive Devaluation a Expansionary Revaluation u a Expansionary None B Expansionary Devalustion c Restrictive Revalostion ML c Nore Revaluation c Bxpansionary Revaluation > Devaluation Ww o None oD Revaluation (©) Since point A’ is dceetly below point F, devaluation slone will corect the deficit and unemployment. From C’, a revaluation slone will bring the nation to F. Since B' is at the equilibrium R, expansionary fiscal policy alone will bring the nation toF. From D', restrictive fiscal policy alone is needed to reach F. These, however, occur enly rarely. On the other hand, (tom A", a devaluation alone could be used to reach EE, ‘but this would nor only eliminate unemployment but would also cause inflation, which could be correctedCHAP. 10) ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS: 195 with restrictive fiscal policy. Point C” is the opposite of AY and requires the opposite policies. From 3", ‘expansionary fiscal policy to eliminate unemployment not only eliminates the surplus but tums it into a deficit, eequiing a devaluation for correction. The exuet opposite is true for D 10.16 (a) Why were nations generally reluctont to use expenditure-switching policies to correct external imbalances during the post-World War Il period?” (b)To whet problem did this give rise? How could this problem be resolved? (@) Under the rules of the international monetary system set up after World War Il, nations in fundamentat disequilibrium were allowed to change the par value oftheir currencies (see Chapter 12). However, industrial ations found themselves very reluctant to do so. Surplus nations enjoyed the prestige of the surplus and the accumulation of reserves. Deficit nations refused to devalue out of national pride, since a devaluation was viewed as a sign of weakness. In addition, te U.K. end especially de U.S. Felt hat a devaluation ‘would impose an unacceptable burden on foreign holders of their currencies. Too frequent changes in ‘exchange rates were also believed to lead to instability. Thus, exchange rate changes occurred only inire- quently, when practically forced upon the nation, and certainly not as a matter of deliberate policy. Since 1950, the U.K. devalued only in 1967, France in 1957, 1969 and 1982, the U.S. not before 4971, while Germany revalued in 1961, 1969, 1971 and 1973 (see Chapter 12). (8) Since nations were generally unwilling to use expenditure-switching policies for external balance, they were Jeft with expenitute-changiag policies to comect both intemal and external imbalances, ‘This could be done by using fiscal policy for intemal balance and monetary policy for extemal balance. INTERNAL AND EXTERNAL BALANCE WITH FISCAL AND MONETARY POLICIES 10.17 With reference to Fig. 10-9 (adapted from Fig. 10-3), indicate (a) what the iS curve shows, (b) why the IS curve is negatively inclined, (c) the type of disequilibrium of points to the right end to the left of the curve, (a) the effect of expansionary and contractionary fiscal policies on the IS curve, (a) The IS curve shows the various combinations of interest rates (r) and national income (¥) at which the quantity demanded of goods and services is equal io the quantity supplied (.c., at which I + X = S + ‘My, so that the nation Is In equilibrium in the gocds market (H) The IS curve is negatively inclined because a lower ris associated with higher lovels of investment and Y (Qhrough the muliplier proces). i196 10.18 10.19 10.20 ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS icuar. 10 (6) Points to the eight of the IS curve refer to situations at which I + X S4M, (2) Expansionary fiscal policy increases government expenditures and/or reduces taxes (which increase private consumption) and shifts he IS curve to the eight because at each r the goods market is in equilibrium at igher Y. On the other hand, contractionary fiscal poticy shifts the IS curve tothe left. With reference to Fig. 10-9, indicate (a) what the LM curve shows, (b) why the LM curve is positively inclined, () the type of disequilibrium of points to the right and to the left of the curve, (@) the effect of casy and tight monetary policies on the LM curve. (@) The LM curve shows the various combinations of fatrst rales (rand national income £¥) st wich the uum demanded of money fr tancacton an specie purpsts seq othe gen and fied oppiy money, so thst the money market sn equibrum. The raaacion demand fr money which refers 10 ‘the active money balances to ‘on business transactions, varics directly with ¥. The speculative demand {for money, which refers othe Inactive money balenees mained to iake advantage of fate (enacil) investment opporunitis, vate inversely wil 7. (©) The LM care i postive inclined becouse, stating from 2 poi on the LM cure, ieressng wil reuse the qanntity of money demanded fr speculative purposes. Te resent ager supply of money sveble for transection purposes wil only be held a biger (e) To he right of We LM curve te tool demand for money exceed the given and fied suply of money, so thatthe money make snot i eulriom, To the let f te LM eure, there isan excess quan oF ‘money supplied. (2) Easy monetary policy inthe farm ofan increase inthe aion's money supply shits the LM curve tothe ight, 0 tha at cac r,t Be Biles to absorb the ices in the money supply. With reference to Fig. 10-9, indicate (a) what the FE curve shows, (6) why the FE curve is positively inclined, (¢) the type of disequilibrium of points to the sight and to the left of the curve, (d) the effect of a devaluation or depreciation and a revaluation or appreciation on the FE curve. (a) The FE curve shows the various combinations of interest rats (r) and national income (¥) at which the nation’s balance of payments isin equilibrium ata given exchange rete. The balance of payments is in ceqilibrium when a postive trede balance is matched by an equal capital outflow or vice versa. (0) ‘he FE curve is usualy positively inclined beceuse a higher r leads 10a greater capital inflow (or smaller conto) nd most be balanced with a higher Y and imports (M) forthe balance of payments to seman in ‘equilibrium. The FE curve is vertical if capital faws do not respond at all oa change in rand are horizontal with perfectly elastic capital flows, (©) Points tothe right of the FE curve refer to deficit inthe nation’s balance of payments because ata given r tnd eapital lows, Y and M are too high for balance of payments equilibriom. Points to the fet of the FE ‘curve refer to surplus inthe nation's balance of payments. (d) A devaluation or depreciation ofthe nation's currency shifts the FE curve down because the nation’s wade balance improves and so a lower rand smaller capcl inflows (or greater ouiows} are needed to keep the nation’s balance of payments in eqslibriam. (2} Draw a figure similar to Fig. 10-9 showing that the nation is in equilibrium in the goods market, in the money market and in the balance of payments at r = 10% and Ye = 1,000, but Yw = 1,400. (b) Draw a figure showing how the nation of part (a) can use fiscal end monctary policies to reach equilibrium in all three markets simultaneously without changing its exchange rate. : (a). See Fig, 10-10. (b) See Fig. 10-11,CHAP. 10) ‘ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS 197 ° Yerlom ype Yo Yeni yal 10410 Fig. 10-11 10.21 (a) Draw a figure similar to Fig. 10-10, but with FE horizontal to reflect perfectly elastic capital flows, ‘and show how the nation can reach full employment and equilibrium in all three markets with fiscal policy only. (b) What would happen if the nation used monetary policy instead? Yeni ypei0 ¥ Fig. 10-12 (2) The nation of Fig. 10-12 can reach Y= 1.400 with the expansionary fiscal policy that shifts the [S curve to IS". The tendency of r to rise (point E’) iaduces capital inflows tht shift the LM curve to LM" so that all thee curves cross on the FE curve at point F. This ease is particulaly relevant to small industializos counties of Western Europe, (B) {C10 reach Y= 1,400 the nation of Fig. 10-12 used an easy monetary policy thet shifts the LM curve 10 the cight to LM‘, 7 would tend to fall (point E"). This leads to capital outfiows that shift the LM curve back 19 LM, so that monetary policy would be completely ineffective in this case. 10.22. Suuting from Fig. 10-12, (a) show how the nation can reach Yq = 4,400 with easy monetary policy ‘only under flexible exchange rates or with devaluation or revaluation. —(b) What would happen if the nation used instead fiscal policy and changes in exchange, rates? (a) Stating from point £ in Fig, 10-13, the nation could use the easy monetary policy to shift the LM curve {o the right to LM" so as to cross the 1S curve at point E" at Y¥p = 1,400. However, at point" the nation has a deficit in its balance of payments because point £’ is to the right of the FE curve. Thus, the vation's, ccumreney depreciate. This shifts the FE curve to the right say, © FE’. Since with a depreciation, the nation’s exports (0 and imports (M) fall, the IS curve also shifts tothe right, say, 10 IS". The depreciation198 y ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS [cHaP. 10 veri Fig. 10.13 ‘will also increase domestic prices and the transection demand for money so that the LM" curve shifts back to the left part of the way, say, to LM” because the nation’s real money supply declines, In Fig. 10-13, the IS', LM” and FE' curves cross at point £" and all thee markets are in equilibrium simultaneously at ‘Yp = 1,400. This isthe end result of a process that may take several steps and doses of easy monetary policy to actually reach, . (®) Ifthe nation used fiscal rather than monetary policy and exchange rate changes to reach intemal and external ‘balance, we would then be back to the analysis of Section 10.4. ‘THE POLICY MIX FOR INTERNAL AND EXTERNAL BALANCE, 10.23 10.24 With reference to Fig. 10-14 (irom Fig. 10-4), indicate (a) what the IB line shows, (6) why points ‘A and B refer to unemployment, -{c) why points C and D refer to inflation and (4) why the IB line is positively inclined. (a) Each point on the TB line refers to a particular combination of fiscal policy (G) and monctary policy (r) ‘that yields intemal balance or full employment with price stability. (®) Point A involves the same G but higher r than the point directly Delow on the IB line. Thus, A involves ‘unemployment or recession. The same is (rue for point B and for any other point above and to the loft of the IB fine. (©) Point C involves the same G but lower r than the point directly above on the IB line. Thus, C involves ‘excess aggregate demand and inflation. The same is true for point D and for any other point below and to the sight of the IB lin. (@) Starting fom a point on the TB line representing unemployment, an increase in r or a tighter monetary policy by itself (an upward movement in Fig. 10-14) leads to unemployment, which to be comected requires tn inerease in G or expansionary fiscal policy (a rightward movement). Thus, the IB line is positively ‘Alematively, a reduction in r {a downsvard movement) from a point on the IB line results in inflaion, which to be corcted requires a decrease in G (a leftward movement). Thus, once again we see that the 1B line must be positively inclined. With reference to Fig. 10-14, indicate (a) what the EB line shows, (6) why points A and D refer to deficit, (e) why B and C refer to surplus and (d) why the EB line is positively inclined. (2) Pach point on the ED line refers to paniculer combination of fiscal policy (G) and monetary policy (F) that yields external balance or equilibrium in the balance of payments.CHAP, 16] ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS 199 Monetary policy (interest rate} Fiscal policy (government expenditures) Fly, 10-14 (©) Point 4 invalves the same G but lower r (and thesefore smaller short-term capital inflows or larger ourRows) than the point direlly above on the EB Tine. Thus, A involves a deficit inthe nation’s balance of payments. ‘The same fs true for point D and for nny ather point below and to the right ofthe EB tine. (©) Point B invalves the same G but higher r (and therefore smaller short-term capital outflows or larger inflows) than the point diretly below on the EB line. Thus, involves a surplus inthe nation's balance of payments, ‘The sime is te for point C and for any other point above and to the right of the EB line, (4) Starting from 6. point on the EB line, expansionary fiscal policy (a rightward movement in Fig. 10-14) induces the nation's imports to rise, Leading to a deficit in the nation's balance of payments, To correct the deficit in the nation’s balance of payments, an increase in r (an upwand arovement) is tequired to induce & smaller capital outfow or a larger inflow into the nation. Thus, the EB line must be positively inclined, 10.25 With reference to Fig. 10-14, explain the type of fiscal and monetary policy required to achieve simultaneous interoa! and external balance, starting from points A, B, C and'D. ‘The netion is simultaneously in intemal end external balance at point F where the 1B and EB lines cross. Te reach point F from point A, the nation must move to the righ and upward, This involves expansionary fiscal policy and tight monetary policy. From point B, the nation must move to the right (expansionary fiscal policy) and downward (easy monetary policy). From C, the nation must move to the lef (estctive fiscal policy) and. downward (easy monetary policy). From D, the nation must move tothe left (restitive fiscal policy) ead upward ‘Gght monetary policy). These policies are suramarized in Table 10.5. Table 10.5 Point Fiscal Policy for intemal Balence | Monetary Policy for Enteral Balance ‘A (Unemployment with defi) Expensionary Tight B_ (Unemployment with surplus) Expansionary Easy © Gafation with suplus) Restrictive Bay D_ Gofletion with deficit) Restitive Tight10.26 10.27 ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS IcHap. 10 (a) Why is the EB line fatter than the 1B line? What does this imply for the relative effectiveness of monetary policy to achieve extemal and internal balance? (6) When would the EB line have the same slope as the 1B line? What would happen in that case? (2) We saw in Section 10.2 that to correct unemployment or iallation, we eoutd use fiscal policy and/or monetary policy. The EB fine is fatter than the IB line because monetary policy, by altering interest rates, also induces changes in short-term international capital movements. The more responsive capital movements are to interest sale changes, the later isthe EB line relative to the 1B fine. This makes monetary policy relatively more effective in correcting external rather than internal imbalances. (®) The EB fine would have the same slope (and be coincidental with) the IB line only if shor-term international capital movements did not respond at all to changes in interest rates, In this case, monetary policy, 2s Ascal policy. can only affect the balance of payments through changes in astional income. Therefore, no useful porpose would be served by treating fiscal and monetary policies as two distinet policy instruments. The nation would once against be facing two targets with a single policy instrument ‘Staring from a point on the EB line below point F, show by arrows on a figure similar to Fig. 10-14 how a nation can reach point F by using fiscal poticy to achieve internal balance and monctary policy to achieve external balance. What would happen if the nation di the opposite? On the same figure, but starting from a point on the IB line above point F, show by arrows how the nation can reach point F, What ‘would happen if the nation did the opposite? In Fi started from point Ap and used fiscal policy to achieve internal balance and ‘monety poliey to achieve external balance, the nation would move from point Ay to point Ay, Az, and so on, converging on point F (see the dections ofthe arrows). If the nation did the opposite, it would move from Ay (0Aj, Aj, and so on, moving further away from point F. Staring from point Cy, the nation will converge on point F with the appropriate policy mix and move further away from point F with the wrong, policy mix (see the direction of the arrows from point Co in Fig. 10-15). hae i iy] im Monetary policy interest rate) i Fiseal policy (government expenditures) Mig. 10-15CHAP, 10) ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS 201 ‘Monetary policy linterest rate) ical policy (goverament expenditures) Fig, 10:16 10.28 Starting from each point in Fig, 10-16 (the same as Fig. 10-14, except for the additional points for eases Il and IV), (a) set up @ rable indicating the fiscal and monetary policies necessary to reach point F. (6) What causes the difference in the required policies to reach point F from the five points in each case? {c} Would different policies be required to reach point F from different points in cases Vand IE? Why? ® ‘Table 10.6 Fiscal Policy Monetary Policy for cose | Point for Tternal Balance External Balance 8 Expansiontsy Eay a Expansionary None 0 ae None Easy s Expansionary Tight a Restrictive Easy D Restictive Tight Db 7 Restrictive + None v oe None Tight D Restictive Ey 5 o Expansionary Tight () Since points 8* and D* are on a horizontal line through point F, only fiscal policy will be sufficient to reach point F. Since B** and D** are on & verical line through F, only monetary policy is required to reach F. These, however, oceur only ruely. On the other hand, from B’, an expansionary fiscal policy ‘lone could be used to reach IB, but this would turn the surplus in the balance of payments into a def10.29 ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS [CHAP. 10 policies. From 8”, the easy monetary policy to correct the surplus will result in inflation which, 10 correct, requires restrictive fiscal policy. Point D" is the opposite of B* and requires the opposite polices, (€)_ Since all points in case 1 are below and to the eft of point F, they all require expansionary fiscal policy ‘and tight monetary policy to reach F (see Fig. 10-16). The exact opposite is true for all points in ease IT. Discuss briefly some of the major shortcomings of the analysis of internal and external balance with monetary and fiscal policies. With respect to Section 10.6, short-term intémational capitsl movements may not respond to changes in interest rates, ther responsiveness may be erratic, ort may be a ace and forall reaction rather than the continuous process assumed by the model. tn the real world, we do not have exact knowledge as to the precise effect of fiscal and monetary policies, Inthe case ofthe U-S.. it may be difficult to coordinate fiscal and monetary policies since they are conducted by different governmental authorities. Time lags between the decision to adopt a policy ‘and its operation further complicate matters, The analysis also assumes no offsetting changes occurring in other ‘nations. Some of these same shortcomings also apply to the analysis in Section 10.4. DIRECT CONTROLS 10.30 10.31 (a) What complication arises when we allow for the possibility of ination before the fullemployrnent Jevel of national income is reached? (6) How can the nation achieve simultancous intemal and extemal batance in this case? (0) Inthe absence of inflation before fll employment, itera balance of fll employment with pice stability can be regarded as a single target requiring a single policy instrument to achieve. But whan ths is no the «ase, fall employment and price siabilty must be treated ns two distinct targets requiring two distinct policy instruments to achiews. Then the nation faces atleast three targets: fll employment, price stsbity end extemal balance. These cannot all be achieved simultaneously with only fiscal and monetary policies. (8) Since there is woually « wnde-off between the rete of unemployment andthe rate of inflation (the Pilis cure), a nation fcing stronger infstionay presures may have to accept a higher rate of unemployment than « nation facing weaker inflationary tendencies. The alternative is domestic wage and price contol or income policy to cub the (structural) inlaGon. The U.S. did just this in 1871-1972 bot without much (a) With monetary poliey available for conecting external imbalance, how can we explain the persistence in some nations of balance of payments deficits, year after your, during the gold-exchange standard period? (b) Whet other measure besides monetary policy, devaluation or icxiblc rates could the deficit nation adopt to correct its deficit?” (c) What objections could be raised against this. (2) Even though monetary policy was availeble for comecting external imbalances during the gold-exchange standard period (1846-1971), monetary policy was not generally used for that purpose. Thus, the US, uring most of the postwar period, seemed to have used monetary pelley primarily to reinforce fiscat policy for intemal balance. Even if monetary policy is wsed for extemal balance, shor-term international ca ‘movements may not respond to interest rale changes, may nol respond sufficiently or may even be destabilizing. " (©) ifthe nation did not use monetary policy for extemal balance or if it were ineffective, and ifthe nation were elo reluctant o devalue its euteney or unable or unwilling to adopt fluctuating exchange rates, then 4 persistent deficit could be suppressed with trade and exchange contols. These my take the form of import restictions, restrictions on foreign travel and tourist expenditures ebroad, restrictions on speculative short- term capital outflows, on the purchase of foreign secutites and on direct investments abrond. Under the most extreme form of exchange controls, all foreign exchange eamed must be sold or tured over 10 ‘government authorities, which then allocete it to users according to goverament priorities. This ean completely suppress the deficit but usually leads to black markets and comupioa, Another form of exchange control is maltiple exchange rates (.t., the use of a lower exchange rate for essential impons, such as machinery, and a higher one for nonesseatials).CHAP. 10) ADJUSTMENT POLICIES: OPEN ECONOMY MACROECONOMICS 203 10.32 10.33, (©) In general, trade and exchange controls have-been gresily reduced since the early 1950s, and the imposition ‘of new ones is prohibited, except temporarily and in special cases, under the present intemational monetary system (see Chapter 12). In any event, there are strong objections to trade and exchenge controls because ey distor resource allocation, impair economic efficiency and generally reduce the gains from trade, ‘A nation could also attempt to achieve a reasonable rate of growth by changing its interest rate structure and using shori-term intrest rates for external balance wiile using long-term interest rates for economic growth, (a) What is meant by the inlerest rate structure? What is meant by distorting it? How can this be accomplished? (b) Explain how a nation with a deficit in its balance of payments can correct lhe deficit and at the same time achieve a reasonable rate of growth (a) Inthe real world, there is no single rate of interest, Rather, there are many, depending on the risk involved, fon the length af time to maturity, etc. These differen intrest rates are not independent of cach other but interdependent, so that a change in one rate will affect to a greater or lesser extent all the others, For example, rising short-term rates generally exert a rising influence on long-term rates, The interest rate structure refers tothe relationship berween all these different rates of interest at a particular point in time. Ifthe government atempled to increase short-lerm rates but atthe suine time prevented this from pulling long-term interest rales up, the government would be distorting or twisting the natural interest rate structure. ‘The goverament could do this by open marker sales of treasury bills (which would depress their price and result in higher short-term rates) while at the same time making more funds available for longeterm in ‘vestments (in order to prevent long-term rates from being pulled up). ot (6) A deficit in the netion’s balance of payments could be corrected with tight monetary policy. This would increase short-term interest rates, which would reduce short-erm capital outflows or increase inflows and ‘0 correct the deficit, However, the rise in short-erm interest rates would also exert a rising influence on long-term interest rates, which would discourage long-term domestic investments and the long-term econermic ‘growth ofthe national economy. This could be prevented by making, atthe saine time, more funds avaiable for long-term investments, Thus, by breaking up monetary policy into its effect on short-term and long- ‘term interest rates, the nation can sive forthe Court target of « reasonable rate of economic growth. The 1S. seemed to have done this during the 19605. (a) Summarize the various measures that a nation could use to correct an external imbalance under a fixed exchange rete system. (6) Why is cooperation among nations often required in order for these measures to be successful? (@) Aside from domestic deflation, «nation can correct @ deficit in its balance of payments with a devaluation (Gimved at improving its trade balance), by forcing up is interest rates wit ightor monetary policy (in order to induce a larger sor-term capital inflow or.reduce the outflow), by holding ils rate of inflation lower than abroad or by direct controls on trade and payments (usually as a last resort to corect a persistent defci). A surplus nation could do the apposite to correct its surplus. (©) The above measures could be effective only if other nations cooperate and de not retaliate. Ifa devaluation by a nation leads 10 « comparsble devaluation by other netions, the trade balance will not improve. The ‘only result will be @ reduction in the volume of trade and in the gas from trade. Such competitive evaluations actually occured during-the 1930s (see. Chapter 12). Similarly, a nation's atempt to atirect foreign short-term capital by forcing it interest rates up may be completely neutralized by a similar increase in intrest rates abrond. The some would be tue if the nation achieved a lower rate of domestic inflation, but this reduction was matched by other nations. Finally, forthe direct controls on trade and payments lite with controls oftheir own, Imposed by one ration o be effective, other nations must not reiChapter 11 The Monetary Approach to the Balance of Payments and Flexible versus Fixed Exchange Rates JL. THE MONETARY APPROACH UNDER FIXED EXCHANGE RATES ‘The monetary approach to the balance of payments views the balance of payments as an essentially monetary phenomenon, with money playing the key role in the long run both as a disturbance and adjustment in the nation’s balance of payments. According fo the monetary approach, a deficit in a nation's balance of payments results from an excess in the stock of money supplied that is not eliminated or corrected by the nation’s monetary authorities. A surgfus results from an uncorected excess demand for money in the nation, Under ‘fixed exchange rate system, the deficit or surplus is automatically corrected in the long run by an outflow or inflow of money (inlemational reserves) that eliminates the excess supply of or demand for money. EXAMPLE 1, The manctary approsch postulates that the demand for money is givea by My = KPY, where kis the desired raf of nominal money balances to nominal national income, P isthe domestic pice level and Y is real ourpot {Go that PY is the nominal national income). Thus, with k = 14 and PY = 800, Mg = (WA) (800) = 200, The demand or money is also inversely elated to the rte of interest inthe nation, but for simplicity this is disregarded here. On the other hand, the bation’s ttl supply of money, My = m(D + F), where mis the money mutpir given bythe reciprocal ofthe legal reserve requirement (LR) in the nation of IRR. Dis the domestic credit created bythe nation’s authorities and F isthe nation’s intemational eserves. D + F isthe nation’s manerary base. Thus, with LRR = 0.2 (50 that m 5), D = 32 and F = 10, M, = (3) (32 + 10) = 210. Since M, > My, toe nation has & deficit in it Balance of payments, ‘which in ie Tong munis aufomatically comecied under a fined enchonge rate sysea by an outBow of money (reserves) equal 0 2, so that M, = (5) (32 + 8) = 200 = My 11.2 POLICY IMPLICATIONS OF THE MONETARY APPROACH UNDER FIXED EXCHANGE RATES ‘According to the monetary approach, a policy can only affect a nation’s balance of payments through its effect om the demand for and supply of money in the nation. Any policy that increases a nation’s demand for money relative to its supply leads to an inflow of money or reserves from abroad (an improvement in the nation’s balance of payments) under a fixed exchange rate system. On the other hand, an increase in the tation’s money supply relative to its demand results in an outflow of money or reserves, which worsens the nation's balance of payments. However, the effect of these policies is only temporary beceuse of the mone- larists’ belief that there is an muiomatic tendency toward equilibrium in the balance of payments in the long run, EXAMPLE 2, A devaluation of its currency by a defiit nation increases domestic prices and results in an increased Mg, the nation has « surplus in its balence of payments (@ The surplus in the nation’s balance of payments will be automatically corrected in the fong run under a fixed exchange ra system by an inflow of money (Intemational reserves) to the nation equal t0 10, $0 that F vill rise from 20 10 30 in the nation. Then, M, = 4(70 + 30) = 400 = Mu ® 11.3 Explain (a) in what way the adjustment process postulated by the monetary approach under a fixed ‘exchange rate system is similar and different from the price-specie flow mechanism advanced by David Hume, (b) why a nonreserve-curency country has no control over its money supply in the long tun, (c) why a reserve-currency country retains a great degree of control over its money supply. {@) The adjustment mechanism postulated by the monetary approach is similar to the price-specie-flow mech- ‘anism advanced by David Hume (see Section 9.3) in that both rely on an international flow of money or reserves from the deficit tothe surplus nation to automatically corect the balance of payments disequilibria ‘of both nations. However, while the intemational flow of money or reserves tends to reduce prices inthe deficit nation and increase prices in the surplus nation fo bring about adjustment sccording to the price- specie-flow mechanism, itis the international flow of reserves itself tht eliminates the excess supply of ‘money in the deficit nation and the excess demand for money in the surplus nation, without any change in pres, according tothe monetary approach. Indeed, according fo labs! monetarsts," the law of one price prevails, with prices in different nations differing caly by transportation costs, tariffs, and s0 on. (©) Starting from the condition M = M, and equilibrium in the balance of payments, if a non-reserve-currency ‘vountsy attempted to increase is ¢,(.e.<10 conduct ensy monetary policy), My > My and the excess money supply will ow out, and the nation would lose an equal amount of F. Taus, D will rie ond F wil fall by an equal amount, leaving the nation's money base (D + F) unehenged in the long run. The opposite would happen ifthe nation atempted to reduce is M,C... to conduct tight monctary policy). Thus, according to rmonetarsts, ¢ non-rescrve-currency country has no control over its money supply in the long run under a fixed exchange rate system. (©) According to monetarists, a reserve-curtency country, such as the U.S., resins & great deal of control over its money supply. ‘The reason is that if the U.S. increases its money supply (50 that Af, > M) a portion of its money supply willow auto the mation bu, tothe extent that receiving nations increase thei international reserves in the form of dollar deposits in the U.S., the attempt on the patt of the U.S. to increase its Mf, ‘will be successful. The same is tue ifthe U.S. attempted to reduce its money supply in onder to conduct tight monetary policy. POLICY IMPLICATIONS OF THE MONETARY APPROACK UNDER FIXED EXCHANGE RATES 11.4 (a) Explain how, according to the monetary approach, the imposition of an import tariff or quota can speed up the process of correcting a nation’s balance of payments deficit under a fixed exchange rate system. (6) What is the effect of an exogenous increase in domestic prices on a nation’s balance of payments? (c) What is the effect of an exogenous increasc in domestic interest rates on the nation's balance of payments? (@) The imposition of an import tariff or quota inereases domestic prices inthe nation and, as such, it increases the nation’s demand for money. On the assomption thatthe nation had a deficit in its belance of payments {o begin with, the increase in the nation's demand for money helps absorb the excess supply of money. which is the cause ofthe deficit. For this to have any effect on the nation's balance of payments, however. the nation’s monetary authorities must not match the increased demand for money with an equal increase enn ee20 as ‘THE MONETARY APPROACH & FLEXIBLE VS. FIXED EXCHANGE RATES (CHAP. 11 in the nation’s supply of money, otherwise the devaluation will have no effect, In any event, the improvement ‘would be only of temporary importance Gi... it would do no more than speed up the adjustment process) and be entirely unnecessary in the long run, because according othe monetary appreach there isan automatic tendeney toward equilibrium in he Balance of payments in the long run. (0) An exogenous increase in domestic prices in a nation, soy, #5 a reslt of an increase in the price of its petroleum imports, increases the nation's demand for money and, in general, has the same effect on the ‘nation’s balance of payments &5 9 devaluation of the nation’s currency. ©) An exogenous ineease im interest rates inthe nation reduces the speculative demand for money (since the ‘opportunity foregone ia holding inactive money balances inereases) Given the nation's money supply, the reduced demand for money results ether in am increased excess supply of money and det or in a redoced ‘excess demand for money and surplus, Explain how continuous growth affects a nation’s balance of payments under a fixed exchange rate system according (0 (a) the monelary approach and (6) the waditional income-multiplier approach. (c) Which of these two approsches seems to better cxplain the experience of Germany during the 1960s, when Germany faced high growth and balance of payments surplus? (@ Continuous growth leads 1 continuous increase in a nation’s demand for money. Ifthe nation’s monetary authorities do not change the domestic component of the nation’s monéy supply or increase it by les than the inerease in demand, the excess demand for morey will be met by a continuous inflow of money or ‘eserves and improvement inthe nation’s balance of payments under a fixed exchange rte system. On the ‘ther hand, if the nation's monetary authorities Increase the nation's money supply 10 match or exceed the increased demand for money, the eaton's balance of peyimeats will remain unaffected or will worten, (@) According tothe traditional income-muitipier approach, contnuens growth indvees 4 continuous tse in the nation's impoxs and, by isl ends to result in continuous balance of payments deficits fo the raion. “This suk i the opposite of thet postulated by the monetary approach, under which contimious grow, by ise, Lends to result in 2 continuous balance of payments Surplus for the nation. (©) Germany's experience of high growth and balance of payments surplus onder the fixed exchange rate symm prevailing in the 1960s is rather exsily explained by moneaists in terms of the smaller increae fp she money supply of Gsraany relative 1 its increased demand for money resulting fram growth. Though explanations are not lacking for Germany's experience along the titra! income-mukiplier approach, ‘hey seem somewhat strained and complex, THE MONETARY APPROACH UNDER FLEXIBLE EXCHANGE RATES 16 Explain why according to moneterists (a) nations retain control over their money supply under a flexible exchange rate system but not under a fixed exchange rate system, (b) nations could nat sterilize continuous money outflows or inflows under a fixed exchange rate system in onder to retain control over their money supply. @ any intemational flow of money or reserves under a flexible exchange rate system. Thus, the nation retains control over its money supply in the long ran, For example, if 2 nation in balance of payments equilibrium ‘creased is money supply (easy monetary policy), ls currency would depreciate and absorb the excess supply of money, without any outNow of money or reserves from the nation. Thus, the increase in the nation’s money supply would be retained inthe nation. On the other hand, ifthe nation reduced its money seal (gh mentary pai) te excess deed or money wou be cated by a agpeciatin o 3 curency, without any inflow of money oF reserves to the raion, AS 2 result, the nation’s emp! 10 reduce its money supply would succeed. Under a fixed exchange rate system, the attempt of a ‘nation to increase its money supply and conduct easy monetary policy would simply tead to the outflow of the excess supply of money inthe Jong run, while a nation’s attempt to reduce its supply of money and conduct tight mometery policy would simply lead to an inflow of money or reserves. AS a result, nonreserve-cortency nations have litle or no contol over their money supply in the long sun under a fixed exchange rae systemCHAP. LI] THE MONETARY APPROACH & FLEXIBLE VS. FIXED EXCHANGE RATES an (A éeficit ration eould not sterilize continuous intemetional money outflaws in the long sun under a fixed exchange rate system because the ation would run out of international reserves. On the other hand, a sunplus nation would run out of domestic assets backing the nation's money supply if it attempted 10 prevent continuous inflow of money or reserves from increasing the nation's money supply. In the long run, a surplus nation would elther have to give up its goal of domestic price stability or revalue its curency. ‘his i, im fact, what happened (o Germany during the 1960s, when the large inflow of reserves led to some {domestic inflation and to 2 revaluation of the mark in 1961 and 1969, 11.7 From s monetarist point of view, explain (a) the world-wide inflation during the middle anc! late 1970s, (b) the reeson for the relatively higher inflationary rates in the U.S., the U.K., France and Italy than in Germany, Japan and Switzerland, (c) the relationship between rates of inflation and ‘exchange rates. (According to monciarists, the workt-wide inflation prevailing during the middle and late 1970s sesited primarily ftom increases in the money supply of the world as a whole excboding the ral rate of growth of the world ceanomy. (8) Monetarsts explain the high infation rates in nations such as the ULS., the U.K... France and Italy by pointing ovt the fact that monetary shores in these nstions increased money Supply faster than the real of growth of these nations. On the other hand, Germany, Japan and Switzetand faced mich lower inflationary rates because thels money supply growth was slower than their real rate of growth. These later nations stl faced some infaion because they didnot allow their exchange rates to fresly appreciate under the managed exchange rate sysiem presently in effect and they did not succeed in completely steriizing inflows of money or reserves [tom nations facing excessive monsy growth (©) Nations increasing their money supply faster than their real rate of growth face domestic inflation under a fixed exchange rate system and depreciating curency under a Rexible exchange rate system. Under the present managed exchange rate system, they usally face alte ofboth. On the other band, surplus nations face some domestic inflation (if the world supply of money grows faster than the growih of the world ‘conomy) and some cuency appreciation. Exchange rales are als affected by expectations of the relative rates of inflation in diferent nations, with astions expested to have higher than average inflationary Tales facing depreciation of their currency and those expecied to have lower than averagsinfaion rates experi- encing appreciation of thei curency (ceteris parlbus). Note thatthe monctary approach stresses the role ‘of monetary variables and the long run, while traditional approaches siress real variables and the shor fun. ‘Some empiriet ests support the monelary approach, sori do na. But the numberof economists adhering to the monetary approach is growing. ‘TYPES OF EXCHANGE RATE SYSTEMS 11.8 Identify and indicate the most important characteristics of (a) a fixed exchenge rate system, (6) a freely flexible exchange rate system, (c) hybrid exchange rate systems. (©) The Bixed exchange rte system par excellence is the gold standard (1860-1914), Under it, the exchange rate can only flucuate within the gold points about the fixed mint parity (see Section 9.3) and gold is the ‘only reserve asst. Another fixed exchange rae system i the gold-exchange standard thal operated during the postwar period unlit it collapsed in 1971. Under this system, monetary authorities determine the band of allowed fluctuation in exchange rates about fied par values, and both gold and convertible currencies reused as international reserve assets. We can eso havea fixed exchange rate system withoot ay connection With gold. Here, monetary authorities determine the band of allowed fuctuation of exchange rates about fixed par values, ad only converible currencies are used as intematlonal reserves. The system that operated from August 1971 until March 1973 was ofthis ipe, Since the dollar was by far the most important reserve currency, this system was close to dollar stendtrd () Under a freely flexible exchonge rate system, a deficit or surplus in & nation’s balance of paymicnts is automatically corrected by a depreciation or appreciation, respectively, in the nation's currency. There is ro goveromeat intervention in foreign exchange meskes andro loss or accumulation of international reserves ‘by the nation. Indeed, international reserves are entirely unnecessary under such w system. This system was never adopt ‘purest form inthe real world212 ng 11.10 ‘THE MONETARY APPROACH & FLEXIBLE VS. FIXED EXCHANGE RATES (CHAP. 11 (0) Hybrid exchange rate systems refer to adjustable pegs, crawling pegs and managed floating, all of which ‘combine various characteristics of fixed and fleaible exchange rate systems. An adjustable peg system requites nations to periodically change par values when in balance of payments disequilibrium. To avoid large discrete changes, a crawling peg system changes par values by small amounts at frequent, specified Intervals unl the equilibrium exchange rate is reached. Under a managed exchange rate system, monetary authorities intorvene in foreign exchange markets 10 smooth out short-run fluctuations without attempting, to affect the long-run tend in exchange rates. (a) Are international reserves needed in hybrid exchange rate systems? (b) How can monetary authorities smooth out short-run fluctuations in exchange rates? (@) As opposed to freely flexible exchange rate system in which exchange rate changes abiomaicely and ‘quickly climinate balance of payments disequilibria so that there is no need for international reserves, hybrid exchange rate systems stil require nations to hold international reserves. But their nced for internation reserves is much smeller than under » uly fed exchange rate system because changes in par valucs oF exchange rates under hybrid systems correct part of balance of payments disequilibea (®) Under « managed floating system, monetary authorities can smooth out sior-run fluctuations in exchange rates by intervening in foreign exchange markets and supplying out of agatio’s intermatioai reserves a portion ofthe shart-run excess demand for foreign exchange in the marke (thus moderating the tendency for the nation’s curency 10 depreciate) and absorbing (and adding to it reserves)» portion of any short- run excess supply of foreign exchange in he market (thus moderating the tendency forte nation’s currency to appreciate). The feasibility ofthis policy of “leaning against the wind” resis on the fect that it dacs not require national monetary authorities to know the long-run trend in exchange ras (which they are often in 1 better positon to know then intemational speculators). (@) What is the purpose of the small band of fluctuation about the established par value under a fixed ‘exchange rate system? (6) What happens if the allowed band of fluctuation under 2 fixed exchange rate system is made wider and wider? (c) What is the relationship of an optimum currency area to fixed and flexible exchange rate systems? (@) The advantage of the small bund of fluctation about the established par value under a fixed exchange rate system is thatthe nation's monetary authorities will not have to intervene constantly in foreign exchange markets to maintain the established par value, but only when exchange rates tend to move outside the allowed band of fuctustion. This simplifies the maintenance of the ixed exchange rale system and reduces the cost of intervention in foreign exchange markets (©) If the allowed band of fluctuation about a par value under a fixed exchange rate system is made wider and ‘wider, more and more of required balance of payments adjustments take place by exchange rate changes, Feaving less ond less to be corrected by other means or financed by international reserve flows, At the limit, the band of allowed fluctuetion can be so large that practically all balance of payments adjustments arc ‘made automaticelly by exchange rte changes, thereby eliminating the need for any offcil imervention in foreign exchange markets. This is essentially @ exible exchange rate system. Rave Par Value. 200 se Fig. 1-1CHAP. 11] THE MONETARY APPROACH & FLEXIBLE VS. FIXED EXCHANGE RATES 213 (©) An optiqum currency area refers to a group of nations whose currencies are liaked through permanently fixed par values. The currencies of member nations could then be inked withthe currency of nonmembers through a fixed, flexible ora hybrid exchange rate system. Regions of a netion obviously form an optimum ‘currency area. On the international level, the European Monetary System (EMS) is similar to an optimum ‘currency area (see Section 12.7). 11.11 Starting from a par value of $2 = £1 and with exchange rates allowed to fluctuate by 1% on either side of the par value, draw a figure showing (a) a fixed exchange rate system, (6) an adjustable Peg system under which a deficit nation devalues by 6% or revalues by 6% at the ond of three months, (c) a crawling peg system under which the nation inereases its par value by 2% at the end of each of three months. (0) See Fig. 1. () See Fig. 11-2, (Seo Fig. 11-3, Rast an Par Value 200 vs our 7 5 ‘ ‘Manche Raut 200 ar Valuo 200 Fig, 11-3214 ‘THE MONETARY APPROACH & FLEXIBLE VS. FIXED EXCHANGE RATES (CHAP. 11 THE CASE FOR FLEXIBLE EXCHANGE RATES 12, a3 Identify and comment on each of the alleged advantages of a flexible over a fixed exchange rate system. (1) Batence of payments adjustments are continuous, malt ané smooth under a Nexible exchange rate syst, Balance of payments disequllibria are never alfowed wo become so large and cumulative, as may happen under a fixed exchange rate system, that a large and disruptive change in par values i require. (2) Only the exchenge rate neads to be changed in order to bring about a balance of payments adjustment under _aflexible exchange rate system, This is much more efficient than changing all domestic prices, as is required under a fixed exchange rate system. (The reasoning here isthe same as that used for changing to daylight savings time during summer months, i.e, i i8 easier to reset the nation’s clock then reschedule all events, Tor an hour earlier.) (3) Withexchange rates at al mes at or near equilibrium, the nation's comparative advantage is clearly evident. (Qn the other hand, under a fixed exchenge rate system, the exchange rate may be 100 ow so that commodity ‘may stem unduly cheap to foreigners. As a esul the nation may export a commodity in which it does not have a comparative advantage, The opposite is true when the exchange rate is too high. (4) Monetary policy is freed for use in achieving domestic goals other then extemal balance, This is no small benefit in view of the lctited range of effective policy tools at te nation’s disposal and the generally greater ‘number of national goals than policies. (5) Flexible exchange rates also allow each ratica to stive to achieve is own inflation-unemployment trade+ Off. Under a fixed exchange rate system, a nation wishing to tolerate high unemployment o keep the inflation sate lower than in other nations is constrained by the resulting balance of payments deficits. (6) No intervention in foreign exchange markets is required to keep exchange rates within allowed ins. Foreign ‘exchange market interventions are generally very complex, require highly skilled technjans to undertake, are time consuming and can have uncertain resus. (1D. With balance of payments disequilibria automaticaly adjusted under a flexible exchange rate system, the possibilty of policy mistakes is avoided, For example, under @ fixed exchange rate system, a nation may be forced to change is par value after strenuous and costly atfempls to kesp it, This Was usually the case ‘under the gold-exchunge standard, Suppose that the price of a commodity is $5 in the U.S. and £2 in the U.K., the actual exchange rate under a fixed cxchange rate system is $3 = £1, but the equilibrium exchange rate is $2 = £1, (a) Will the U.S. import or export this commodity? (6) Does the U.S. have a comparative advantage ‘or disadvantage in this cormodity? (c) What per-tnit tax or subsidy does the actual exchange rate involve? (@) The U.S, wil expor this commodity because # = $5 in the U.S, and P ~ $6 in te U.K. ‘exchange rate of $3 = £1 () At the equibtriem exchange rate of $2 = £1, the pre of the commodity is P = $5 in the U.S. ond P = ‘Hin the U.K. Thus, the U.S, has a comparative ditedvantage in this commodity even though the U.S. ‘exports it. As a result, the pattem of wade is distorted by the prevailing disequilibrium exchange rt. (©The actual exchange rate of $2 = £1 involves a St per-unit subsidy on exports of the commodity by the us. the actual COMPARISON OF FIXED AND FLEXIBLE EXCHANGE RATE SYSTEMS ad Explain how advocates of fiexible exchange rates might counter the argument that a fixed exchange rae system (a) results i a smaller degree of uncertainty in international trade and finance, (6) is ‘more likely to iead to stabilizing speculation, (c) results in greater price diseipline, (@) Advocates of flexible exchange rates point out that while exchange rates are certainly more stable on 8 day- to-day basis under a fixed exchange rate system, the lnrge discrete changes in par values that periodicallyCHAP. 11] ‘THE MONETARY APPROACH & FLEXIBLE VS. FIXED EXCHANGE RATES 2s become necessary undor a fined exchange mic syslem ar even more damaging and disruptive tothe snot flow of interostionsl trade and investments than the small continuous changes in exchange rates under a flexible exchange mite system. (©) _Advorates of flexible exchange rates feel thet stabilizing speculation is much more likely to take place when exchenge mies ae fer to adjust continuously, antomutically, and by small mounts than when they are prevented from adjusting until a large discrete change becomes unavoidebe. Under a fixed exchange rate sysem, speculators wil sell the curency when they expect it tobe devalued and purchase the currency ‘when they expect it to be revlued, ths amplifying exchange rate uctuations (destabilizing specultin). (© Advocates of flerble exchange rates concede that a fixed exchange rate system leads fo more monetary discipline Gi... to lower ination rate) than a flexible exchange rae system, However, they pot out that some of this greater price discipline is achieved atthe expense of the nation being unable to pursue its desied infaton-unemployeneat twede-of, ‘2.15 (0) What overall conclusion can be reached as to the advantages and disadvantages of fixed versus fiexible exchange rates? (b) What are the advantages and disadvantages of hybrid exchange rate systems? (@ When all relevant factors are considered, flexible exchenge rates do not compare unfavorably to fixed ‘exchange rates a5 far as the degree of uicertainty in international trade and finance is concemed, Flexible ‘exchange rates do seem more inflationary, but they also allow goveraments to pursue their desired infltion- ‘unemployment trade-off, ushampered by balance of payments considerations: Although the present system. 1 managed float rather than a frely exible exchange rate sysiem, i isthe elosest ofthe hybrid systems toa freely flexible exchange rote system.’ While many experts hive become somevhat dissatisfied with the present managed exchange rae system (primarily asa resalt ofthe large volatility and large and persistent ‘misalignment of the U.S. dollar during the 1980s), it is geneally recognized that no fixed exchange rate system could have survived the tunmoil ofthe early 1970s, ©) Am adjustable peg systom isthe closest of the hybrid systems to a Bed exchange rate system and, as ‘tshares some ofits disadvantages, peticulary the increased uncertainty andthe possbiliy of destabilizing ‘peesation arising from the large periodic exchange rate changes thet become nécesstry fo corect balance of payments disequilbria, A crawling peg system can avoid this disadvantage with small preannounced exchange rate changes, but only atthe expense of being somewhat more inflationary. A managed floating system is also more inflationary than fixed exchenge rtes. in addition, a nation cen manage its exchange ‘ates to be higher than equilibriom in order to stimulate its exports (a beagar-thy-ncighbor policy). The ability ofa nation todo this isSimited by the amount of intemational reserves of the notion andthe possibility of retalaton by the nation's trade parters. 11.16 How do (a) hedging and (b) speculation take place under a fixed exchange rate system? (a) Since, under a Gxed exchange rate system, the exchange rae can also Buctuate (within the allowed limits), there usually stil arises a need for hedging. This generally takes place as described in Section 7.4, except if the exchange rte i at or very close to the allowed limits of Suewation. If the exchange rate is at the upper limit allowed, then Importers end all others with foreign exchange payable ata future date need nat edge since the exchange rte can only fal! in the future. On the otber hand, if the exchange rate is atthe Tower limit alowed, then experiers and all others with fortign exchange receivable need not hedge since the exchange rate can only rise, This is true except when there isa feling tht the limits themselves may ‘be changed inthe ncor futur. In that case, all should hedge. (®) If speculators believe that the allowed limits of foreign exchange Muctustion will be malmained, they will sell the foreign euency when is exchange rate iss or near its upper limi inthe expectation that i will fallin the future) and buy it when at oF near its Tower limits (nthe expectation chet it will ise i te Forue). [In this ease, speculation is subilizing and eliminates or reduces the need of intervention (oy the monetary authorities) to keep the exchange rte within the allowed limjs. If, on the ther hand, speculators fel that ‘the monetary authorities will aot beable or wiling to continue to prevent a currency from depreciating past its upper limit, or appreciating pst its lower limi, then speculation will be destabilizing. This increases ‘the need of intervention and increases the probeblity thatthe speculators’ expectations will be fulfilled (sce ‘Chapter. 12),Chapter 12 The International Monetary System: Past and Present 12.1 THE CLASSICAL GOLD STANDARD PERIOD “The classical gold standard operated from about 1880 to 1914 and was characterized by relatively free trade and unrestricted infemnational capital movements. Adjustment under the classical gold standard was rather quick and smooth but is now believed to have occurred primarily through stabilizing short-term capital movements and changes in national income rather than through price changes, as described by the price specie-flow mechanism. EXAMPLE 1. During th classical gold standard period, London was the undisputed center of international trade and finance. in such a wotld, England usvelly nanced a deficit in its balance of payments by increasing is interest rate and attracting short-term capital rather than by 2 gold outfow. Furthermore, a gold outfow (othe extent that there was one) improved the nation’s wade balance primarily by reducing national income, rather than by causing a decline in domestic prices (which even then were Somewhat inflexible dourward). The opposite was tue when England had a surplus in its balance of payments (sce Problem 12.2) 12.2. THE INTERWAR PERIOD World War I brought the classical gold standart to an end. ‘The interwar period was characterized by generally chaotic conditions in intemational trade and finance. There were fluctuating exchange rates from the end of the war to 1925 (except for the U.S., which returned to gold in 1919). Starting in 1925, an attempt was made to reestablish the gold standard, but it collapsed by 1931 at the time of the Great Depression. There followed a period of competitive devaluations, 2s nations tried to export their unemployment (beggar-thy-neighbor policies). Tariffs, quotas and exchange controts also became widespread, with the result that the volume of ‘world trade was cut almost in half. Deflationary tendencies were completely overcome only as nations rearmed for World War I EXAMPLE 2. After World War J, London lost its position asthe single undisputed center of interaational trade and finance. With ¢ multicentered infemationsl Gnancial system (London, New York, Paris) interetional short-term capital movements were often destabilizing. This forced England off gold in 1931 and was an important reason for the collapse of the gold standard. Furthermore, nations generally did not follow the so-called rules of the game but sterilized or ‘neutralized international copital and gold movements, preventing them from affecting the nation’s money supply and initating the adjustment process (see Problem 12:6). There were also a numberof serious policy mistakes. For example, jin 1933-1934, the U.S. devalued the dollar to stiqwlate its economy even though it had a surplus in its balance of payments. 12.3. THE BRETTON WOODS SYSTEM ‘The basis forthe post-World War Il international monetary system was laid at Bretton Woods, New Hampshire in 1944 by the U.S. and the U.K, It can best be understood as an attempt to prevent a recurrence of the ‘chaotic conditions in international trade and finance that prevailed after World War I. The new system called for the establishment of the Intérnational Moneiary Fund (IMF) to oversee that nations followed an agreed- upon code of rules in their conduct of international trade and finance (see Example 3) and also to set up 216‘CHAP. 12}, ‘THE INTERNATIONAL MONETARY SYSTEM: PAST AND PRESENT 217 ‘borrowing facilities for nations facing temporary balance of payments difficulties (see Example 4). The Breiton Woods System operated until 1971, when it collapsed, EXAMPLE 3. Upon joining the IMP, each nation vas to fix the value ofits currency in terms of gold or dollars and then keep its exchange rate within 19 of is par valve (lhe gokéexchange standard). The par value could be changed only in ease of fundamental (ic, large and persistent) disequitiorium and with the permission of the IMF (execpt for changes of 10% or less), Temporary deficits were 10 be financed out of the nation's reserves and borrowing from the IMF. (For long-term development assistance, tbe World Bank was created). After a period of trasiion, comveribiliy of carrencies into one another was to be resumed and trade restrictions were to be gradually removed under the General ‘Agreement on Tariffs and Trade (GATT). EXAMPLE 4, Each nation was assigned a quota to the Fund. The size of e nation's uoti was based on its economic Importance and determined the nation’s voting power and its ability to borrow from the Fund. The nation was to pay 25% of its quola in gold and the remainder in its own cumency. In botrowing from the Fund, the nation would get convertible curoncies in exchange for depositing more ofits curency. until the Fund held no more than 200% of the nation’s quota in the nation’s currency. The netion could borrow no more than 25% of its quota per year, for a toal of 125% over five years. The nation's borrowing of the fist 25% of its quota (the socalled gold wranche) was praciclly ‘automatic. For each funher borowing (ihe credit tranches), rising inlrestrles were charged and more supervision of the Fund imposed. Repayments were to be made within tres to five years aud involved purchase of the nation's cuteney ‘with gold or other convertible currencies approved! by the Fund. 12.4 OPERATION AND EVOLUTION OF THE BRETTON WOODS SYSTEM In many ways, the Breiton Woods System operated as intended, but in some, it did not (se¢ Example 5). Furthermore, the system evolved over the years in several important directions in response to changing conditions (see Eximmple 6). In general, the Bretton Woods System served the world well—during its operation, world output rose rapidly and world trade even faster. EXAMPLE 5, Nations in fundamental disequilibrium found themselves very reluctant to change their par values. From 1950 to 1971, the U.K. devalued only in 1967, France onty in 1957 and 1969; Germany revalued in 1961 and 1969; the U.S., Japan and Hay never changed their par values, while Canad (defying the rules ofthe IMF) had Muctuatng rates from 1950 to1961 and shen again from 1970. The comvertiliy of te dollar was resumed soon After the war, major European cureacies became formally convenble in 1961 ané the Japanese yen in 1964, Several rounds of negotiations undee GATT reduced tiffs on manofactured goods to shout 7% nominally and (2% effectively by 1971. After several increases in quotas, the total resources ofthe Fund reached $28.5 billion by 1971 (of which $6.7 biion or about 73.5% vas he U.S. quota). By 1971, the Fund ad leat $22 billion (mos of it after 1956), of which $4 bilion was outstanding, “The communist nations, with the exception of Yugoslavia, were nol members of the IMF; nor was Swiverterd EXAMPLE 6. To supplement its resources, the Fund negotiated in 1962 the General Arrangements fo Borrow (GAB) up to $6 billion from the group of ten (most important industrial nations). Nations could supplement their regular IMF Dorrowing facilities by negotiating siandby arrangements with the Fund to borrow additional armounts in case of need, and by sweep arrangements with other nations. The Fund also began to allow nations to borrow up to 50% of thelr quota in a year (up from 25%). International reserves, were supplemented by a totel of $9.5 billion of special drawing rights {SDRs) or paper gold disuibuted by the Fund to nations according to their quotes, in three installments in January 1970, 1971, and 1972. In 1961, the U.S. and a group of industrial nalons established the gold poo! to sell gold on the London market to prevent the gold price from rising above the official levet of $35 per ounce, This was discontinued in 1968 ‘when a two-tier system was established, with the private price of gold determines by conditions of demand and supply ‘and allowed to sise above the official price. A Eurodellar metket centered in London also came into existence. Eurodollars are dollar deposits in banks outside the U.S. They amounted to about $46 billion at tke end of 1970. 12,8. THE U.S. BALANCE OF PAYMENTS PROBLEM ‘The U.S. balance of payments has been in deficit in almost every year since 1950, U.S. deficits were rather small, averaging about $1 billion per year from 1950 to 1957 but rose fo over $3 billion per year from 1958218 ‘THE INTERNATIONAL MONETARY SYSTEM: PAST AND PRESENT ICHAP. 12 (0 1970. The U.S. finsoced its deficits from 1950 to 1970 with a $13 billion loss of its gold reserves (which declined from $24 to SL! billion) and with over $40 billion by dollar outflows. The U.S. would not or could 10! adopt some policies to correct its deficit, and the policies that it did adopt faited to eliminate the deficit. EXAMPLE 7. Up to about 1949, the U.S. ran huge trade balance surpluses with Europe and extended Marshall aid to help Europe pay for them, With Europeen recovery more of less complete by 1950, the U.S. trade surplus declined and the U.S. balance of payments tumed into det. Up vo 1957, these deficits were small and allowed Europeza nations to build up their reserves. This was the period of the dollar shortage. Contributing to the much larger U.S. deficits since 1958 were frst the huge increase in captel outfows, then the Viemam War, and beginning with 1968, the viewal Aisappearance ofthe U.S. trade balance surplus, The U.S., qlte understandably, would not deflate its exonomy for the sake of extemal balance, and with dollars used as iatemational reserves it felt thet it could not devalue. Instead, it stimulated U.S. export, reduced military and other govemment expenditures abroad, tied foreign aid, imposed e tex on ‘the Purchase of fortign securities in 1963 and extended it to Tong-tenm bank loans to forcigners in 1965. Finally, in 1968 ‘timposed mandatory controls over U.S. direct investment abroad, I also intervened in the forward and spot markets and sold Roosa bonds (see Problem 12.12} 12.6 ‘THE COLLAPSE OF THE BRETTON WOODS SYSTEM ‘The immediate cause for the collapse of the Bretton Woods System was the expectation, beginning in March 1971 in the face of huge and persistent deficits, that the U.S. would soon be forced to devalue the dollar. ‘This led to a massive flight of liquid capital from the U.S. When some small European central banks attempted to convert part of their dollar reserves into gold at the Fed, the U.S. suspended the gold convertibility of the dollar (August 15, 1971) and imposed a 10% import surcherge. Had the U.S. nat done this, it would'soon have exhausted all ofits gold reserves, The fundamental cause of the collapse is to be found in the problems of liquidity, adjustment and confidence. Most of the increase in liquidity (., international reserves) under the Bretton Woods System was in the form of dollars arising from U.S. balance of payments deficits. But, as the U.S. was unable to adjust its deficits and too many unwanted dollars accumulated in foreign hands, confidence in the dollar was lost and the system collapsed. EXAMPLE 8. The Smithsonian Agreemteat in December 1971 provided for an increase in te offical price of gok! from ‘35 to $38 per ounce (a dollar devaluation of about 9%), end 2 further revaluation of a few currencies, especialy ke Yeo and the mark. Curreacies were allowed (0 Mctunte by 24% above or below their new par value ¢up from 1%), the USS. removed the 10% import surcharge, while the dollar remained inconvertblc into gold. But with another huge deGcit in he USS balance of payments in 1972, massive speculation against the dollar resumed in February 1973 and led to another develuation of the dollar, this time by 10% (echieved by an increase in the officiel price of gold to $42.22 per ‘gunce). When speculation agains! the dollar ared up again an March 1973, exchange rates were lft free to float except for some official intervention and ae sill osting today. 12.7 THE PRESENT INTERNATIONAL MONETARY SYSTEM ‘Since March 1973, all the large developed nations and many of the largest developing nations have operated ‘under @ managed floating exchange rate system, Under this system, nations’ monetary authorities intervene in foreign excharige markets to smooth out “excessive” short-in Fluctuations in exchange rates. The Jamaiaa Accords (ratified in April 1978) formally recognized this arrangement and allowed nations the choice of the ‘exchange rate regime. The present intersational monetary system hs also evolved in ¢ number of important ‘ways, including new allocations of SDRS, increased nations’ quotas in the IMF, renewal of the General Agreements to Borrow (GAB), the abolishment of the official gold price, and the formation of the European ‘Monetary Systems (BMS). Throughout most of the 1980s, the dollar feced great volatility and gross misalign- ‘ments, and by the end of the 1980s the U.S. had become the world’s largest debtor nation (see Problem 12.20)."A inumber of other international economic’probtems also remain (see Problem 12.21).CHAP. 12] ‘THE INTERNATIONAL MONETARY SYSTEM: PAST AND PRESENT 219 EXAMPLE 9. By 1990, one-third of the 151 member nations of the IMF had opted fora managed float. These included all the large industrial nations and many of the large developing nations, so that about 4/5 of world made moved among, nations with either independently or jointly managed exchange rates. Other developing nations pegged their exchange rates to the U.S. dollar, other major currency, or SDRs. A new allocation in 1979 and 1981 increased the total SDR ‘holdings of member nations of $20 billion. Since 1981, the value of one SDR is based on « weighted average of the U.S, doltar, the British pound, the German mark, the French franc, andthe Japanese yen. In 1989, one SDR was worth $1.35, ‘Through increased membership and periodic increases in member nations’ quotas, IMF total resources reached $120 billion, andthe total teserve position af member nations atthe IMF was $28 billion in 1989, The IMF increased its loans to cover balance of payments deficits resulting from temporury shor-lls in expons, Yn 1919, GAB was renewed and expanded. The gold price rose to over $800 per ounce in January 1980 bul fell to below S400 by the end of 1982 and reanained at that Jevel throughout the rest of the 1980s. EXAMPLE 10. In 1979, the European Economic Community (EEC) announced the formation ofthe European Monetary ‘System (EMS) as part of the EBC’s aim toward greater monetary integration. The main features of the EMS sre (1) the Creation of the Exropean Currency Unit (ECU), defined us a weighted everage of the BEC currencies, (2) having EEC ‘currencies (with some exception) fluctuate no moce than 2.25% with respect to established central rates oF par values, and (3) the establishment of the European Monetary Furd (EMP) to provide shor-term balance of payments assistance to BEC mations. The U.K. has thus far refused to join. Glossary Internationel Monetary Fund (IMF) The international institution created under the Bretton Woods System for the purposes of (1) overseeing that nations followed a set of agreed rules of conduct in international trade and finance and (2) providing borrowing facilities for nations facing balance of payments difficulties. Fundamental disequilibrium Large and persistent balance of payments deficits or surpluses. World Bank The intemational institution established after World War Il (o provide long-run development assistance to developing nations. Currency convertibiity The ability 1 exchange one national currency for another without any restrictions or limitations General Agreement on Tariffs and Trade (GATT) An intemational organization devoted to the pro- motion of freer trade through multilateral trade negotiations. Gold tranche The 25% of a nation’s quota paid into the IMF in gold and which the nation can bonow from the Fund automatically. Credit tranche The amount that ¢ member nation can borrow yearly from the IMF over and above the gold tranche. General Arrangements to Borrow (GAB) ‘The arrangements under which the IMF negotiated to borrow up to $6 billion from the “group of ten” (mast important industrial nations) and Switzerland to augment its resources if needed to help nations in balance of payments difficulties. Standby arrangements The advance permission for future borrowings from the IMF by # nation at the IMF, ‘Swap arrangements The arrangements under which national central banks negotiate to exchange each ‘other's currency, (0 be used to intervene in foreign exchange markets to combat international hot money ows. ‘Smithsonian Agreement The agreement, ceached in December 1971 in Washington, under which the dollar was devalued by about 9% (by increasing the price of gold from $35 to $38 per ounce), other strong20 ‘THE INTERNATIONAL MONETARY SYSTEM: PAST AND PRESENT (CHAP. 12 currencies were revalued by various amounts with respect to the dollar, the dollar convertibility into gold remained suspended, end exchange rates were allowed to fluctuate by 2.25% on either side of the new par values. Jemolee Accords The agreements, reached in January 1976 and ratified in April 1978, that officially recognized the managed float and led to the abolishment of the official price of gold European Monetary System (EMS) ‘The organization, formed in 1979 by EEC members, that has the responsibility of defining the European Currency Unit (ECU) of eccount, maintaining the fluctuation of exchange rates within 2.25% on either side of established central rates or par values, and oversecing the ‘operations of the European Monetary Fund (EMF), The U.K. is presently not a member. European Gurrency Unit (ECU) The unit of account, defined by the European Monetary System, based ‘on the weighted average of the currencies of the EEC members. European Monetary Fund (EMF) The institution of the European Monetary System that provides short- and medium-term balance of payments assistance to member nations. Review Questions 11. Which ofthe following statements with regard (othe classical gold standard is false? (2) London was the undisputed center of intemational trade and finance. (b) There was relatively free trade and unrestricted international capitel movements. (e) Inemational short-term capital movements were stabilizing. (d) Prices were highly flexible, both upward and downsvard. ‘Ans. (d) See Section 12.1. 2, Adjustment to balance of payments disequlibia under the classical gold standard is now believed to have occured primarily through (a) the price specie low mechanism, (6) gold shipments, (c) price changes, (d) stabilizing short-term capllal movements and changes in national income. ‘Ans. (d) See Section 12.1 3, Which of the folfowing statements with regerd to the interwar period is comet? (a) The gold standard operated lover the entire period. (6) Adjustment 10 balance of payments disequilibria was rather quick and smooth. (©) Generally chaotic conditions prevailed in international trade and payments. (d) There was relatively free trade ‘and unrestricted capital movements, Ans, (¢) See Section 12.2, 4. Adjustment to balieeof payment equi daring the interwar periods was tou ‘capital movements, (b) the price-specie mere. ‘Ans. (d) See Example 2. sbout by (a) stabilizing flow mechanism, (c) changes in national incomes, (4) none of the ‘5. The Bretton Woods Systom was (a) a gold standard, (b) a exible exchange rate system, (c) a pokd-erchange standard, (d) none of the above. ‘Ans. (c) See Example 3. 6. The Bretion Woods System (a) set up a code of rules for nations to follow in their conduct of international trade and finance, (b) set up borrowing facilities for nations in temporary balance of payments dificultes, (c) evolved ‘over the years in several important ways, (d) served the world falsly welt, (e) all of the above. ‘Ans. (e) See Sections 12.3 and 12.4.CHAP. 12] "THE INTERNATIONAL MONETARY SYSTEM: PAST AND PRESENT 221 7. Which of the following does not represent an evolution of the Bretton ‘Woods System as it operated van (974? (a) The General Arrangements to Borrow, » (6) standby amangements, .(c) flexible exchange rates, (d) special drawing tights, (e) the gald pool, ‘Ans, (c) See Example 6. 8 The U.S. balance of payments was generally (a) in surplus from 1946 to 1949, (b) in deficit from 1950 10 1957, bot the deficits were rather small, (c) in deficit from 1958 to 1970 and deficits were large, (all of the above. ‘Ans.(d) See Section 12.5. 9. On which of the following methods did the U.S. rely rest during the 1960s to comect the deficit ja its balance of payments? (a) Domestic deflation, (6) devaluation of the dollar, (¢) direst controls of specific items in the ‘balance of payments, (d) official intervention ia the foreign exchange marker, ‘Ans. (e) See Example 7. 10, The immediate cause forthe collapse of the Bretion Woods System was (a) the expectation thatthe U.S. would soan be forced to devalue the dollar, (b) the massive fight of liquid capital from the U.S., (c) the attempt by three small European central banks 1 convert part oftheir dollar holdings into gold atthe Fed, (d) all ofthe above. ‘Ans. (d) See Scetion 12.6. 11, The fundamental cause for the collapse of the Breton Woods System was (a) the Kguidty problem, (b) the adjustment problem, (€) the confidence problem, all ofthe above. Ans. (d) See Section 12.6. 12, The present international monetary system is (a) a gold standard, (b) 2 freely flexible exchange rate system, (c) a fixed exchange rate system but with more frequent exchange rate changes and a wider band of allowed flocmations, (4) a fluctuating exchange rate system but with some intervention by mionetary authorities to help ‘maintain orderly foroign exchange markets (managed float) Ans. (d) See Section 12.7. Solved Problems ‘THE CLASSICAL GOLD STANDARD PERIOD 12.1 (a) How would a deficit in England's balance of payments be adjusted ifthe price-specie-flow mech- ‘anism operated? (6) How did England in fact adjust a deficit in its balance of payments during the classical gold standard period”? (@) According tothe price-specie-flow mechanism, a deficit ip England's belance of payments would lead to gold outfiow and decrease in its money supply. England would then remain a full employment but would face declining doimestc prices (the quemtity theory of money). This would stimulate England's exports and discourage its impor's. The exact opposit= would occur in the surplus nation. This process would continue unil the improvement in England's balance of trade was sufficent to eliminate the deficit in its batance of eyments, (©) When England fooed a deficit in its balance of payments during the gold stendard period, it reacted by delibercely increasing its interest rate (then called the bank rare). With London the undisputed center of international ade and finance, short-term capital movements responded quickly and ina stabil ‘Thus, i is now Widely believed that Boglend financed its deficits primarily by short-term capital inflows rmther than by gold outflows. To the extect thet there were gold outflows, these had a deflationary impact ‘on the domestic economy which discouraged imports rather than causing a decline im domestic prices, 85m2 2 123 ‘TE INTERNATIONAL MONETARY SYSTEM: PAST AND PRESENT (CHAP. 12 described by the price-specie-flow mechanism. The reason for this is thot even during the clastical gold standard period, prices were hurdly flexible downward, ss theoretically assumed. Explain briefly how England scems to have corrected surpluses in its balance of payments during the classical gold standard period. ‘When England faced a surplos in its balance of payments during the classical gold standerd period, i usually seactod by reducing its interest rates, This resulled in a short-term capital oulow from England in place of a gold inflow to setle the surplus. Furthermore, to the extent that Englund did experience a gold inflow from a position of less than full employment, its trade balance worsened primarily as a result of an inerease in national {neome rather than because of a rise in domestic prices. Only if England sere at full employment or faced inflation ‘would a surplus in its balance of puyimcus settled by a gold inflow be eliminated by aa increase in domestic prices, as decribed by the price-specielow mechanism. ‘The reestablishment of the gold standard today could not work well, Discuss. During the heyday of the gold standard, seilement of the balance of payments disequilibria took the form of stabilizing short-term capital movements rather than gold shipments in the majority of cases. With London as the undisputed center of international ade and finance, there were no speculative or destabilizing capital move- ‘ments. However, in today’s multicentered world (New York, London, Zurich, Frankfurt, Paris, Milan, Tokyo) international short-term capital flows are likely to move erratically and in a destabilizing faskion from one monetary ‘center to another, In such a situation, adjustment to balance of payments disequilibria would have to come about ‘through changes in infernal prices and/or national income. A deficit nation would have to deflate and a surplus nation infste, and thus give priority to external over intental balance. This is entirely unacceptable in today’s ‘world. Primarily because of this, the reestablishment of the gold standard today should be considered us aaly a remote poss ‘THE INTERWAR PERIOD 124 2s (a) Why did nations lee their exchange rates fluctuate for several years immediately after World War 37 (6) How is this related to the purchasing-power-parity doctrine? (@) Because ofthe inflationary and structural changes that took place during World War [, nations did not know st what level to repeg their exchange rats after the war, Thus, they allowed their exchange rats to iuctuate fer several years in hopes of geting some idea from the market as o the appropriate Level at which to peg them. (8) The purchasing-power-parity (PPP) theory was developed by Gustav Cassell at the end of World War I for the specific purpose of estimating the equilibrium exchange rates to be reestablished sfier the war. However, ‘because of the major suuctual changes that occured in Englard and other major wading nations during the ‘war, the PPP theory gave very biased results (see Problem 10.5). For example, since England had liquidated a great deal of its Foreign investment to pay fr de war and had lost a grea: deal of hs competitiveness in {nlemational markels (especially to the U.S.). the estimated exchange rate of the pound with respect to ‘many other mejor currencies was grossly overvalued. (a) What was the immediate cause of the collapse of the gold standard in 1931? (b) What were the fundamental causes? (ec) What happened after 1931? (@) By 1931, many nations were holding strtng (and to some extent dollars and francs) in edition to gold as part of their intemaional reserves. These strfng holdings were becked and converible into gold st the Dank of England (so that this was really a gold-exchange standard). In 1931, massive flows of speculative funds led to fear a5 0 the continued gold convertibility ofthe overvalued povad This eaused a run on the ‘ery small gold rterves of England, forcing it off gold in 1931 and dealing a death blow tote system. (0 The fundemental causes of the collapse of the new system are tobe found in the breaking out ofthe Great Depression (10 which the new system contributed) and in the lack of an adequate adjustment mechanism. Specifically in the muticentred wosld then in existence, sheer interationl cpital movements WereCHAP. 12), ‘THE INTERNATIONAL MONETARY SYSTEM: PAST AND PRESENT 23 ‘often destabilizing. In addition, nations sterilized or neutralized changes in their money supplies arising from balance of payments disequiibria. This prevented adjustment through changes in pices and national {ncomes. However, itis likely that even a well-functioning intemationsl monetary system would have broken ‘down under the strain of the world depression. (©) The year 1981 was followed by a period of competitive devalutions (even from positions of surplus) as nations attempted to export their unemployment. By the time this process came to an end in 1936, the exchange rates among the major currencies were esseataly the same as in 1930, This was also 8 period ‘when many restrictions were imposed on intemational wade and finance, withthe result thet the volume of ‘wortd trade was cut almost by half. By 1939, depression had given way to full employment—and war. 412.6 (a) Explain how a decline in a nation’s money supply caused by a deficit in its balance of payments ‘can be sterilized. Why did nations usually do this during the interwar period? (6) Explain how an increase in the money supply caused by a surplus can be sterilized, Why did nations usually do this during the interwar period? (©) A nation could sterilize a decline in its money supply caused by « deficit in its balance of payments by ‘open market purchases of treasury bills from the public. This decreases private holdings of treasiry bills ‘and pots mare money'in circulation. During the inierwar period, natons generally did not follow the mules of the geme but sterilized deficis, preventing them from dosreasing the sation’s money supply. Since wages and prices were generally inficxible downward, a decline in the money supply would have had « further ‘eflatonary effect on the economy, end nations wanted to avoid this. @) A netion could sterilize an increase in its money supply caused by a surplus in its balance of payments by ‘open market sales of treasury bills to the public. Ths increases private holdings of weasury bills and was, used by surplus nations during the interwar period to prevent the surplus from increasing their money supplies. Increases in the nation’s money supply from a condition of recession and surplus would have helped to correct both. Nations, such as the U.S. in 1934, chose instead to stimulate their economies by devaluing their currencies. This added to deflationtry pressures around the world and represented a serious policy mistake. ‘THE BRETTON WOODS SYSTEM 12.7 With respect to the Bretlon Woods System, explain (a) what type of an exchange-mtc system it was and how it was set tp arid maintained, (2) how nations were supposed to finance and correct balance of payments deficits and (c) the rules on convertibility and trade restrictions. (@ The Brewon Woods System was a gold-exchange standard. Each nation was to ix the value ofits cureney in terms of gold or dollars and then actively intervene in the foreign exchange market to keep its exchenge tate from moving by more than 1% above or below its par value. The dolir was practically the only invervention currency (o that we truly had a gold-dollar standard) nti the ater pat of the 1950s and carly 1960s when the cureneies of most other industrial nations became convertible into dollars. Within the band of allowed fuctutions, the equilibrium exchange rate was determined by the forces of demand and supply. (Notions were supposed to finance temporary deficits in their balance of payments out of their iatemational reserves and by borrowing from the IMF—without domestic deflation (which wos unsccepteble), without evaluation (which could lead fo competitive devaluations) or import restrictions (which would also ead to retaliation). Borcowings from the IMF were to be for short periods (thee to five years) 30 a5 not to tie Lup the resources ofthe IMF joto long-rm loans. For long-term development assistance, the fnteretionel Bank for Reconstruction and Development, or simply the Worid Bank and its affiiees, the International ‘Finance Corporation and the Agedcy for oternational Development, were created, A change in the nation’s ‘exchange rate was to be used only to corect a fundametal ésequlibrium (which was never clearly defined, ‘but which we may take to mean a large and persistent disequilibrium). Thus: the Bretton Woods Systern, at least as conceived, combined stability with some flexibility. (©) _Aftr a period of transition fllowing the war, currencies were to be made convenible Into one another and into dollars. Nations were generlly forbidden to impose additional trade resricUons (otherwise convertibility ‘would not have much mesning) and were encouriged by the IMF (o remove unllaerally existing tradeth ‘THE INTERNATIONAL MONETARY SYSTEM: PAST AND PRESENT teuap. 12 restctions and to negotiate multisteral redactions under the'sponsorship of the General Agreement on ‘Fails and Trade (GATT). 12.8 If a nation's quota in the IMF was set at $100 million, (a) how and in what was this amount to be 29 id? How much could the nation borrow in any one year under the original cules? (6) Explain the procedure whereby this nation borrows from the Fund:the maximum amount allowed for the first your. (c} How much ciald the nation borrow in subsequent years? For how many years could this ‘ake place? Explain the procedure whereby this nation borrows the maximum amount allowed In each subsequent year (a) The nation kas 10 pay 25% of ils quote, or $25 milion, in gold and the remaining 75% ($75 milion) in the nation's euneney. Under the original rules ofthe IMF, a nation could borrow only 25% ofits quota in any one Year (©) The first year this nation can bortow $25 milion from the Fund in any convertible currency approved by the Fund. This i the gold wanche and can be dkawa from the Fund slenast automalcally, without any restrictions or conditions. Upon borowing this $25 millon, the neticn pays or deposits an aditional $25, railion of iis curency with the Fund, iacretsing the Fend's holdings of tis neion’s eurrency fram the. ‘original $75 million (75% of the nation's quota) to $100 million {100% of this nation’s quota. (0 Tue nation ean borrow a maximim of 25% of its quoti in each subsequent year until the Fund tid oo more than 200% of the nation’s quota in the nation's currency, Since after the first boroWing (the gold tranche), the IMF is elready holding 100% of the nation’s quota in the nation’s eurency, the nation can ‘borrow s maximum’ of 25% of its quota in cach of four subsequent yeats (th credit tranches) before reaching ts borrowing limit. As the nation borrows under each additional ereit tranche, it deposits $25 mition of its curency withthe Fund and feces increasing interest charges and supervision from the Fond. Thus, the ‘overall maximum that a nation could borrow over & period of five years was one gold anche end four rei wanches for x total of 125% ofits quota. (@) How and when was a nation to repay its IMF foant? (6) What would happen if the mation in Problem 12.8 (henceforth referred to as notion A) stopped borrowing from the Fund after the fits year, but before it repaid its loan, nation B borrowed $25 milion from the Fund in nation A’s currency? (@) The nation repays ity loans by repurchesing its currency from the Fund with other convenible currencies approved by the Fund, until the Fund is ones agein holding no more than 75% of the nation's quota in the potion's currency. The Fund aifows repayment (0 be mitde in currencies af whic tke Fund holds less then 75% (and up to 75%) of the issuing nations’ quota. Repayment must be made within three to five years, @) Hf nation B borrows $25 million of nation A's currency, after nation A has borrawed but not yet repaid its ‘old trenche, nation A’s repayment becomes unnecessary since the Fund will once again hold no more then "75% of nation A’s quoia in nation A's currency. If nation B instead borosed $50 million of nation A’s ‘currency, then not enly need nation A not repay its gold tranche, but it can also borrow another $25 milion * (ie super gold tranche) without repayment. OPERATION AND EVOLUTION OF THE BRETTON WOODS SYSTEM 412.10 How did she Bretton Woods System operate with respect to (a) adjustment to fundamental disequi- fibrie, (6) convertibility of currencies and (c) trade restrictions? (@) Under the Bretton Woods System, industrial nations Found themselves reluctant (o devalue or revafue even ‘when in fundamental éisegilibrium. They regarded a devaluation asa sign of Weakness end wed to avoid ‘was practically forced upon them, Similarly, they resisted 4 needed revaluation, preferring instead to continue accumulating reserves. By doing so, these nations gave up most af the Rexibility envisioned by the Bretton Woods System, as fer as adjastment to balance of payments disequlibria was concerned, On the other hand, Canada had flexible exchange rates from 1950 t0 1961 and then from 1970, white eveloping nations devalued all too often, But the fact thet the major industri] nations chose not to usecHar. 241 2 ‘THE INTERNATIONAL MONETARY SYSTEM: PAST AND PRESENT 25 ‘exchange rate changes 2s a policy instrament for extemal balance was crucial forthe survival of the systein ‘00 Section 12.6). (8) The major European currencies became convertible fer current account purposes, de facto in 1958 and de jure o- formally in 1961. The Japanese yen became formslly convertible in 1964. Restrictions on capital ‘eccount transactions were allowed in order to protect nations against the possibility of huge amounts of desiabilizng liquid capital movements (Aor money). These became larger, mare frequent and more disruptive toward the end of the 1960s and early 1970s, (©) Encouraged by the IMF, nations gradually dismantted the maze of trade restrictions imposed during the ‘war, so that tariffs on manufactured goods fell vo about 712% by 1971. Negotiations to reduce barriers to (wade in agricultural commodities and on light manufactures (which are of particular importance to developing. nations) were not so sueressful. By 1971, nontaiff ade barriers such as quotas and hesith and safely regulations were probably more important, quantitatively, than tariffs as obstacles to trade. Discuss briefly the evolution of the Bretton Woods System with regard to (a) the General Arrange- ments to Borrow, (b) standby arrangements, (c) swap arrangements, (d) spectal drawing rights, (@) the gold pool and (jf) Eurodollars (2) ‘The General Arrangements to Bomow (GAB) was negotisted by the IMF with the “group of ten and ‘Swizerland to supplement it resources if needed to help nations with balance of payrwons difficulties. The ‘mount involved was $6 billion, (This was over and abcve the periodic increases in the member netions’ ‘quotas which were envisioned in the Articles of Agreement that set up the Fond.) (9) Nations negotiated standby amangemen's with the IMF in order to supplement their interatonal eserves and the regular borovving fails available to them atthe Fund. Once negotiated, te nation could count, if and when the noed arose, on the immediate availability of the amount agreed upon, without any further ‘questioning or restrictions. A commniument cherge of 1/4 of 1% was imposed on the amount earmarked, ‘while an interest charge of up to 5.54% of more per year was imposed on the portion actualy drawa. These standby arrangements were usually negotiated for 2 frst Une of defense against unanticipated, huge and destabilizing hot money flows. In time, the IMF also began to allow nations to borrow up to 5O% of their ‘quotas in any one year. (© Swap arrangements are negotiated between central banks to exchange each other's currency, often be Used to intervene in he forward exetange marke io protect the nations’ curencies against hot money flows, ‘They are negotisted for specitied periods of time and with an exchange rate guarantee, When they become doc, they can cither be renegotiated or setded by a reverse transaction. The U.S. has negotiated many of these swap arrangements with the central banks of most indstal nations since the exly 19605. (4) Special drawing rights (SDRs) or paper gold are accounting entries into the books of the IMF. Under an ilerational agreement reached in 1967, $9.5 billion of them were distributed (In January 1970, 1971 and 1972) to IMF members according (o their quotas. They were intended to supplement existing intematknsl reserves in hopes thatthe U.S. would be successful in curbing is deficits and dollar outfiows, (©) The gold pool was an attempt, ststed in 1961 by a group of industrial ‘nations under the leadership of the U.S., to feed gold into the London gold market in order to prevent the privalé price of gold from rising above its oficial price of $35 per ounce. In 1962, the gold pool was exteaded on the buying side also, The ‘effort was discontinued in 1968, when a two-er system came into existence, (A) Eurodolias are dollar deposited in European banks to eam higher rates of interest. Total deposits of Eurodollars grew rapidly in the 1960s and by the end of 1970 amounted to over $46 billion. Eurodollars, together wih other Buropean curencies deposited ouside their domestic market (Eurocurencies), amounted to over $60 billion in 1970, The existence of a Burodolla market can reducé te effectiveness of monetary policy inthe U.S., as U.S. firms (especially muNinational conporations) baru in this market, when short- term intrest rates vse in the U.S. as a result ofa tight monetary potiy. ‘THE U.S. BALANCE OF PAYMENTS PROBLEM 12.12 How did the U.S, use (a) monetary policy and _(b) offi intervention in the foreign exchange market in an stempt to eliminete the deficit in its balance of payments?. (c) Why did U.S. monetary226 a3 ‘THE INTERNATIONAL MONETARY SYSTEM: PAST AND PRESENT {cHaP. 12 authorities sell Roosa bonds to foreign official holders of dollars? (Roosa bonds are medium-term “Treasury instruments denominated in doliars but with an exchange guarantee.) (@) Throughout the 19605, the U.S. generally adopted a tighter monetary policy and maintained higher shor ‘erm interest rates than were justified by internal conditions, inorder to reduce the short-term capital OuLROW {from the U.S. of stimulate an inflow. At the same time, it strived to keep long-term interest rates relatively tow in onder not to diseaurage domestic growth (see Problem 10.52(H)}. (8) U.S. official intervention in the foreign exchenge market took the form of forward sales of strong European ‘currencies, such as the German mark, for dollars so as to increase the forward discount om these strong ‘currencies and thue discourage an outflow of figuid funds from the U.S. under covered interest arbitrage (Gee Section 7.6). U.S. monetary authorities also intervened i the spot market by purchasing dollars with ‘olber currencies. The foreign exchange for these interventions in the forward and spot markets was usually ‘obtained by swap arrangements with ether central banks. (©) Starting i the erly 1960s, U.S. monctary authorities sold Roosa bonds in order to absorb the excess dollars in the hands of foreign central banks and thus avoid conversion into gold at the Fed. Such conversions would have forther reduced U.S. official gold reserves and further weakened the dollar (see Section 12.6). ‘Thus, Roosa bonds only indirectly helped the U.S. balance of payments What were (a) the major benefit of and (b) the major cost to the U.S. resulting from the fact that the dollar was the central reserve currency in the Bretton Woods System? (c) Did this benefit exceed the cost? (@ The major benefit received by the U.S. as a result of the fact that the dollar was used as an intemational ‘reserve asset was that the U.S. could finance its deficits by using its own currency (and so receive seignorage). If the U.S. had faced the same discipline os other nations (which could finance their deficits only from their gold reserves and othar convertible carcncies accumlsted through surphise), the U.S. would have ex- bused gold reserves Inthe carly 1960s and would have been forced to comes is deficis then, As it was, the U.S. could continue to un defics by paying with its own currency, until bythe end of 1970s, foreignsrs eld over $50 billion in dors against the $11 billion of US. gold reserves, (@) The major cost or disadvantage for the U.S. resulting fom the se ofthe dllar asthe central reserve cureney was thatthe U.S, feed much gene serous policy limitations than master uatonsincorecting its balance of payments defcis. Thos, he U.S. freedom to use monetary policy for intemal belance was ‘more reticied than in mest ober ations (se Problem 12.12(e],s0 that he U.S. had wo rely more heavily ‘on fiscal policy, Furthermore, with other nations holding huge amounts of dollars as international reserves. the U.S. felt that it could not devalue its currency (as for example, the U.K. did in 1949, 1957 and 1967), (© Whether the use of the dollar as an international reserve asset conferred more benefits than costs cn the US. isa dific, perhaps impossible, question to answer objectively, and there are conficting opinions (One thing i cxctain—the U.S. did no encourage the ws ofthe dollar an ntemational reserve sit ater ‘World War i ht ost occured THE COLLAPSE OF THE BRETTON WOODS SYSTEM a4 Hed the U.S. agreed to convert dollars into gold for the Buropean central banks that demanded such a conversion in August 1971, the U.S, would have soon exhausted all of its gold rescrves. Comment. Just before August 15, 1971, some small European central banks presented part of their dller holdings at tbe Fed tobe converte into god. They did this in the belie that a devaluation ofthe dalla was imminent. Such 1 devaluaion would have reduced the velue of thelr dollar reserves. Since the amount of dollars held as ofc feseres abroad was two or dnee'imes larger than U.S. gold reserves, ifthe U.S. had agreed to convert into old the dollars presented to it in August 1971, othe central banks would have rushed into convert ther doller holdings into gold before U.S. gold reserves were exhausted. Thus, the U.S. was forced o suspend the gold converibiiy ofthe dallar on August 15, 1971, This pot an end to the goldexchange sianderd and essentially put the world on a pure dolar standard. At the same time, the U.S. imposed a 10% import surcharge, which it promised to remove when othr nation, particularly Japan ahd Germany, revalued their eurercies to correct the ‘vervalustion ofthe doa.CHAR. as 1216 12 ‘THE INTERNATIONAL MONETARY SYSTEM: PAST AND PRESENT 2 (a) Why were foreigners eager to accept dollars in payment for U.S. deficits in the early 1950s rather than demand gold ia the first place and from the very beginning? () How did all this change in the 1960s? (c) How did the U.S. respond to the changed conditions of the 1960s? (d) What were the immediate causes for the collapse of the Bretton Woods System? (©) As part ofthe Anictes of Agrecment seting up the Bretton Woods Sysiem ater World War I, the US. tmade a sanding commiiment to exchange into gold and on demand any dolar presented to the Fed, at the fixed gold pie of $35 per ounce. This commitment together wih the fact hat the U.S. came out of World ‘War II with by far the strongest economy in the world and holding most of the world’s gold reserves, made the dollar “as good a8 gold." In addition, dalle deposits camed intrest, while gold did not, Furthermore, dolls were mich more convenient than gold as # medium of exchange for itematonal sansactions, For all ofthese fessons, nations were eager to accept payment in dllars and accumulate thom as international reserves, Ths was tre ual te late 1950, which became kaown asthe dollar shortage period. (©) 4s a result ofthe large and persistent U.S. balance of payments deficits since 1958 and the continuing ‘cline inthe US. gold stock, foreign offi! dollar holdings became equal to U.S. gold reserves inthe ‘arly 1960s and became much lager with cach passing yea. I then became evident that if the need arose, the U.S. wovld no fonger be able fo hosor is commitment to eXchange all forign held dll into gold ‘$35 por ounce. This made foreigners est eager to accep dolla (As European central banks bostme nervous sbout coniing 1 accumulate more doar nd threatened ‘onversin info gold, the U.S. crested Roosa bonds (se Problem 12.12) and took stronger messes 10 comet its balance of payments deft (When the U.S. balance of payments deficits persisted and actually increased in 1970, the feling became. ‘widespread that the U.S. sould soon be forced to devalue the dolar. This caused x massive fight of liquid capital from the U.S. and led the central banks of Belgium, the Netherlands and Switzerland to demand the conversion of dollars into gol, forcing the U.S. on August 15, 1971 to suspend the gold comversbilty of the dollar. (a) What was decided by the “group of ten” under the Smithsonian Agreement in December 1971? (b) What happened in February 1973? (c) In March 19737 (@) to meetings held atthe Smithsonian Institution in Washington in December 197%, the “group of ten” (most important industisl nations) decided to increase the price of gold frum $35 to $38 per ounce (this implied ‘2 devaluation of the dollar of about 9%) and to revalue by various amounts the yen, the mark, the Belgian franc and the Dutch guilder. The result was a realignment ofthe exchange rate of the dollar by about 17% ‘with respect tothe yen, 14% wih respect tothe mac, 129 withthe Belgian frane and Dutch gullder, 9% ‘withthe pound and the franc, and by various smaller percentages with respect to ell other currencies, for ‘an overall trade-weighted devaluction of the dolar of about 8%. The effect of this was to remove part of| ‘he overvaluation of the dolar. I addition, the allowed band of fuciuations ebove and below the new por values was increased to 24%, snd the U.S. rescinded the 10% import surcharge that it hed imposed on ‘August 15, 1971. Nixon hailed ths as “the most significant monetary agreement inthe history ofthe world” and promised that “ihe dolise wuld never again be devalued.” This essentially put the world on a pare dollar standard, (b} As e result of another huge deficit in the U.S. balance of payments in 1972, it was felt that the Smithsonian ‘Agreement was not working and that another devaluation ofthe dollar would be needed. Even though this inference was questionable (since it normally takes from two to three years for devaluation 10 be fully effective), it was nevertheless widely held. This led to renewed speculation against the dollar and became selfflfiled in February 1973 when the U.S. was once again forced to devalue the dolar, this time by about 10% (achieved by an increase in the official price of gold to $42.22 per ounce). In the meantime, the dollar romeined incoavestble into gold (€) In March 1973, speculation against the dollar flared up again and left most of the world's mejar currencies fluctuating, wit exchange rates determined by conditions of demand and supply but with some intervention by monetary authorities to maintain orderly markets.208 ‘THE INTERNATIONAL MONETARY SYSTEM: PAST AND PRESENT IcHaP. 12 12.17 (a) What is meant by intemational liquidity? Why is liquidity needed? How was it provided during the postwar period until 1973? (b) How is the problem of providing adequate liquidity related to the adjustment problem? (c) How were the problems of liquidity and adjustment related to the problem of confidence? Why did these represent the fundamental causes of the collapse of the Bretton Woods System? {©} Intemational liquidity cefers mainly to official intemational reserves, These include official holdings of gold, convertible currencies, SDRs, and the reserve postions in the IMF (see Problem 8.4), International liquidity is needed so tha: nations can temporarily nance deficits, without direct trade restrictions, and while allowing. other more acceptable adjustment assures, to operate to corect balance of payments deficits. “Too Title” iguidity hampers the expansion of world trate; “too much” leads to world inflationary pressores. Until 1973, most of the inerease in intemational liquidity was provied by dollars and ather conventible currencies (Gee Table 12.1), ‘Table 12.1 International Reserves (Billions of Dollars, End of Year) 1949 | 1959 -| 1969 '| 1970 |-1971 | 1972 | 1973 Gold (at oficial price) x | a fw | a a Foreign exchenge n w ) 3 | 4s ar | ios | 13 SDRs = }o}- 3 wo | ou Reserve positions inthe IMF” | 2 3 7 8 1 7 Totals 4 | 51 | 9 | 9 | 14 | 160 | 104 SouRce: IMF, Intenaronat Financial Statistics Yearbook, 1979 wi 1981: (©) Converiblecureneis become par ofinterpatonal reserves when he issuing nations unbalance of payments deficits and pay for them with teir own currencies: Most of the inerease in inlemationa liquidity until 1973 was provided by eonvenible cumencies (see Table 12.1). This is a reflection of the fact thatthe -djustment mechanism di not work wel in the postwar pesiod so hat ations, especially the U.S., continued ‘to rum huge deficits and add to world liquidity. (©) The less adequate isthe adjustment mechanism, the larger are the balance of payments deficits incveced by he major industrial nations, the longer they persig in time, ard thus the more they add (0 world liquidity (lo the extent that nations finance the deficits with their own currencies), But as the world's holdings of aay comency continue to increase, confidence inthe curéncy decreases. These closely elated problems of ligutiny, adjustment and confidence were the fundamental tauses forthe collapse of the Breton Woods System in 1971. ‘THE PRESENT INTERNATIONAL MONETARY SYSTEM 12,18 How are the international monetary arrangements in existence since 1973 different fram the pre-1971 system, with regard to (a) exchange rates and (b) price and ownership of gold? (c) How well is the present international monetary system operating? (@) As opposed to tte Breton Woods Systm, the exchange rate of most major currencies such asthe dollar, the pour, the saa, the yon, and the frane have been fluctuating since 1973. Some currencies, particularly Latin American ones, ere lied tothe doller, otter curencies are ted tothe pound, while sill others are ‘uctuating withthe mark, ehus beginning to form currency blocks, Still other currencies are tied to SDRs. Most monctary authorities intervene in foreign exchange marke o prevent unnecessarily wide fluctuations in their exchange rates. As a result, there is sll a need for ingeruationl reserves, although it isnot as great as under the ixed exchange rate system provaling before 1971,CHAP. 12) ‘THE INTERNATIONAL MONETARY SYSTEM: PAST AND PRESENT 29 12.19 12.20 12.21 (8) Since 1968 there has been free market price of gold, but until 1971, this did not move to far from the ‘offical gold price of $35 per cunce. In 1971, the oficial price of gold was rated to $38 per ounce and the free market price began to rise well above it. Starting in 1975, U.S. sesdenis were allowed forthe first time since 1933 to buy gold, but in the face of an almost nonexistent demand, the price of gol fll below $000 per ounce. The pice of gold rose to over $800 per ounce in January 1980 but fell below S400 per ‘ounce by the end of 1982 and remained at tht level throughout the rest ofthe 1980s, (©The manoged floating exchonge rate system in operation since 1973 {see Problems 11.8(c) and 11.9(5)} ‘worked remaskably wel, considering the sharp increase in petroleum prices since the Fal of 1973, the huge problem of recycling petrodolars, and the dovble-igit, world-wide inflation and recession during the late 1970s and early 1960s. Throughout al ofthese upheavals, foreign exchange markets remained rolatvely calm and world trade continued to expand, The great volatility and large and persistent misalignment ofthe USS. doll during the 1980s, however, are now leading expert opinion to favor the impasition of some restraints on exchange rate fuctutions. ‘The establishment of a freely flexible exchange rate system today is unlikely. Discuss. ‘Under a frely Aexible exchange rate system, exchange rates are determined exclusively by the forces of demand and supply without aay foreign exchange market iniervention on the part of monetary authorities. Under such a tly self-adjusting system, the need for international eserves would virally disappear and monelary authorities could devote most oftheir energies to achieve internal balance. However, exible exchange rates are {nlaonary, and exchange rates may fluctuate too widely forthe smooth conduct of international trade and finance. ‘This may vduly distort the world’s specialization panem. AS a result, tis rather unlikely thet the present managed ‘exchange rate system will evolve into a truly freely flosible exchange rate system. Indeed, itis more likely that ‘more restrictions will be imposed in the future on exchange rate uctiations, (a) What are the most serious monetary problems facing the world economy today? (b) How do ‘these involve the United States? Ce) What is proposed to solve these problems? (@) The most serous monetary problems facing the world economy today are the excessive volalityof exchange rates end the persistence of large disequiibria in exchange rates. Since 1973 exchange rates have been characterized by vey large volatility and overshooting. This cen discourage the low of iterntional rade. More serious i the fact that under the present managed floating exchange rte system, large exchange rae ployment or inflation (or bot) forthe sake of extemal balance. The only way out of this impasse isto rely on policies vo complete the adjustment. ‘A nation could correcta deficit in its balance of payments by devaluing its currency, by holding is inflation rate lower than abroad, by increasing is short-term interest rate, or by direct controls on ade and payments ‘A devaluation will make the nation's impor more expensive to domestic buyers and its exports cheaper to foreigners. This usually improves the balance of rade and payment ofthe netion. The seme results could be achieved by holding the demestc rate of inflaton lower than abroad. On the other hand, an increave inthe 1's short-term intrest ate usually reduces short-term capital outiows from the nation or increases inlows, thus improving its balance on capital aceéunt and payments. Finally, and usally as last resort to core its deficit, amelion could impose restrictions on imports and capital ouiows (rect controls) while giving subeidies and other inducements to its exports and capt] inflows. For s devaluation tobe effective o corect a deficit, the foreign exchange market must be stable (otherwise che devaluation will increase the deficit, and a revalynion would be required instead), A devaluation is also a feasible policy ifthe demand and supply for foreign exchange are “relatively” elastic, Final, for a devaluation to be effective fom a condition of full employment, domestic absorption must be reduce, ether automatically or with expenditure demand decreasing policies, The same is tue ifthe nuion attempts to comet ihe deficit by holding down its rate of inflaton. For an improvement to oecur inthe capital account, capital movements ‘must be responsive to higher domestic rates of interest Finally, forall the above measures and for direct contols to be effective, oher nations must cooper and not realiae. “The nation could devalue is eurency to comet the deficit and use expendtue-ncreasing polices wo elimina unemployment—unless the devaluation tans the unemployment into excess aggregate Jemand an inl which case expenditre-decreasing policies are required: A devaluation racy eliminates prevsely deficit ané unemployment. In any oven, both targets must be approached with coordinated poices. IF onthe other hand, the nation is unwiling to devalue, then it could use expansionary scal policy to eliminate unemployment and tight monetary policy (to alact foreign short-term capt) to comet its deficit, I shor-amm ‘aterational capital movements do not respond sufccaly or respond inthe wrong direction, the nation may have to impose direct controls on capital movements and tade, If the nation faces unemployment, infiation and a deficit, the mation may have to accept a higher mc of unemployment to hold its Sflation lower than abrod. IF this is unacceptable, woge and price contol (incomes, policy) may be necessary to curb inflation. Holding down the domestic inflation betow the rate of ination abroad wil also reduce the deft fhe diet persists, the nation will either bave to devalue 4s curency (1 improve is ade balance) andor increase its short-term intrest rites (to ateet foreign shor-teem capita), If these do not work, restrictions on eapitel outflows and wade may be nocessary 10 eliminate the defi. Fluctuating exchange retes will comect the deficit automatically ifthe foreign exchange market is stable end if domestic absorption is reduced when the nation isa full employment. I is the policy instruments at its disposal ocheve intemal balance and ts ‘The most serious monetary problems facing the world economy today are che excessive volatility of exchange rates and the persistence of large disequilibria in exchange rates. Since 1973 exchange rates have been characterized by very large volatility and overshooting. This can discounge the flow of international trade. More serious isthe fect that under the present managed floating exchange rate system, large exchange rate disequilibria, can arise and persist for several years. This was cently the case for te U.S. dollar during the 1980.Bt FINAL EXAMINATION (8) The excessive appreciation of the dollar during the first half of the 1980s has been associated with huge trade efits for the U.S, and almost iresistble calls for increased wade protection, Indeed, by the middle of 1985, large budget dofiits and capital inflows had turned the U.S. from 2 creditor eution into a dabror nation, (or the first time since 1914. By 1989, the U.S. was by far the world's largest debtor nation, This requires huge payments to service the debt and led to fears of foreign domination in the U.S. {€)_ The persistence of disequilibrium and great volatility of exchange rates have Jed to renewed catls for reform of ‘the present international monetary system along the lines of establishing target zones of allowed fluctuations for the major currencies and for more international cooperation and coordination of policies among the leading ‘ations. The earlier debate on the relative merits of fixed versus exible rats has been superseded by discussions ‘of the optimal degree of exchange rate flexibility and policy cooperation. In February 1987, the leading five industrial nations ugreed at Louvre to cooperate closely to foster stability of exchange rales around then prevailing levels, Despite heevy intervention in foreign exchange markets by these countries’ central banks, exchange rates continued to Muctuate by side margins from the rates prevailing atthe ime of the Louvre agreementIndex ‘The letter p following » page number refers to a Problem Absolute advantage, 2, 4, 7-89 ‘Absorption, 156, 158, 17ap, 18t, 192p ‘Accelerator, 175 ‘Accommodating items, 151p ‘Accouniing, balance of paysments, 138, 144p Ad valorem tariff (See Tariff, nominal) ‘Adjustable peg system, 205, 206, 211p ‘Adjustment in balance of payments (See Balance of payments adjustment) ‘Agoney for Intemational Development (A1D), 2239 “Appreciation, 121, 124, 126p, 188p Arbitrage, 129, 1Z?p ‘Aucarky, 17, 20, 43—44p Autoraatic adjustment mechanism, 154, 157, 160p ‘Autonomous items, 1S1P Balance of indebtedness, 153p Balance of payments: accounting, 138, 144p efit, 140, 142, 151D sefined, 1, 3, 138, 142, (4p isequilbeiam, 15ip posposes, 144p atistios, 138, 142 sinplus, 140, 142, {51p Balance of payments adjustment automatic, 154, 157, 160p income, 155, 170p policy, 154, 157, 160p, 180, 186p price, 154, 169p under a flexible exchange rte system, 154, 160 under a managed flosting exchange rate system, 205, 210p under the goit-exchange standard, 156, 178p, 217 ander the gold standard, 158, 166-170p with exchange controls, 184, 203p Balance of payments problem of U.S., 217, 225- 2269 Balance of trade, 138, 145p, 152-1539 Baner terms of trade (See Commodity terms of tade) Basic balance, 152 Beggar-thy neighbor policies, 111p, 215p Bias in growth: favoring exports, 77-78p Fevoring imports, 77-78 Biased fector grow and the terms of trade, 69, 77— - 78p Brain desin, 90p Bretton Woods System: description, 216-217, 223p fundamental cause of collapse, 218, 226-228p ‘immediate cause of collapso, 218, 226-2287 ‘operation and evolution, 224p Buy American policy, 989 ial controls, 184, 218 direct, 138, 144—145p longeterm, 139, 146 officiel, 139, 147p pontolio, 138-139, 146p short-erm, 139, 146p speculative, 227p (See also Speculation) ont bank cooperstion, 218, 222) ‘Classical School of Economics, 7-8p, 52-53p. ‘Commercial policy, 91-96, 97p-116p (See also Taste nd Quotis) Commodity tem of rade, 40, 8p, %p Common Maske (See Evtopetn Economic Community) Community inference curves, 37, 41, 42-450 Comparutive advantage, 2, 8p. 16, 20, 22p, 34 5p, 15p Comparative disadvantage, 2, 8p CCompurive sae analis, 76 ‘Compensation principle, 4Sp ‘Complete specialization, 17-18, 20, 23-24p, 29 Confidence probiem, 218, 2289 ‘Constant costs, 16, 22-29p Consumers’ suplus, 2, 101-1029 ‘Consumption fontier, 17, 20, 2324p onveribie curencies, 147p, 217, 223p Covered intrest bimage, 133, 1339 ‘Crawling peg sytem, 205, 206, 211-2129 Credit ances, 217, 228, 2249 Guency: converibitty, 1d7p, 217, 219, 2249 ovefvaluaion of te dollar, 227 ‘Curent eccoun balance, 138, |4¢p Gastoms union: dynamic effects, 95, 96, 113p theory of, 95, 96, 113p ‘oycie! isequlniam, 155p236 Deficit in balance of payments, 140, 142, 1Stp Deflation, 190p Demand for money, 204, 206, 208p Depreciation, 121, 124, 127p, 168p Devatustion: competitive, 216, 2229 defined, 180-181, 188-189p of doll, 217-218, 225-226 and domestic absorption, 181-182, 184, 191p effect on domestic prices, 189-190p effeciveness of policy, 188-189p Differentiated products, $7, 58, 65p Direct controls, 184, 202p Direct investments: defined, 138, 146 of foreign nations in U.S,, 139, 146p of U.S. abroad, 139, 1469 restrictions on, 218, oller devaluation, 218, 227p foreign holdings of, 146p, 217-211 a reserve currency, 145-146p, 225p shortage, 218, 2279 surplus, 218, 227P Double-entry bookkeeping, 139-40, 148-1499 Dumping: defined, 94, 110-119 persistent, 94, 110-111p predatory, 94, 110-111P sporadic, L10-111P Dynamic analysis, 7475p 226p Economic integration, 95, 113p Economic union, 94-95, 115p Ecouomies of seule and ide, 67-58, 6465p Bffective tiff rate, 92, 106-109 ‘Effective exchange tate, 121-122, 126-1279 Elasticity (See Price elasticity Income elasticity) Energy crisis, 219, 228-2309 Bagine of growth, 73, 88p Equation of exchange, 167-168 Equilibrium: exchange rie, 121-122, 127-128 ‘income, 170-176p, 187-188 relative commodity price, 37, 40, 42 Eurocurreney markets, 123, 1369 European Curteaey Unit (UCU), 220 European Economie Community (EEC), 95, 219 ‘European Free Trade Association (BFTA), 95 European Monetary Fund (UMF), 220 Buropean Monetary System (EMS), 220 Exchange controls, 184, 203p Exchange rte: defined, 121, 124, 1269 Exchange rue (Cont) dynamics, 123 effective, 121, 1269 equilibrium, 121-122, 124, 127—128p forward, 122, 124, 127-128p sultple, 2029 overshooting, 123, 136-137 spot, 124, 127-128 ‘Exchange rate system (See Intemational monetary system) Expenciture-changing policies, 180, 184, 187p Expenditure-switching policies, 180, 184, 188p Exportable commodiey, 72 Export-based growth, 77p, 89 External balance, 180, 181, 188p Factor: ‘endowments, 19-20, 34-35, 58, 74p growth, 70-71, 7677p mobility, 12p, 61-62p Price equalization, 56, 60-62p everibilry, 57-58, 61-62) substitution, 57, 58, 61-62p Feetorl terms of bade: double, 88p single, 88p : FE cure, 182-183, 185, 195-1989 Fiscal policy defined, 180, 184, 186p and internal balance, 180, 181-182, 184, 187-1869 Fixed exchange rate systems: advantages, 206, 214-215p disadvantages, 214-215p dollar standard, 218-219, 2239 goldexchange standard, 156-157, 158, 178-179, 2p, 216-217, 223-224p (See also Bretton ‘Woods System) gold standard, 155, 157, 166-170p, 211, 216, 221-222) Flexible exchange rates: adventages, 205-206, 214-215p and balance of payments adjustment, 154-155, 160-165p, 211-212p disadvantages, 214-215p Foreign aid, 145p, 149p. 218 Foreign exchange arbitrage, 121, 124, 127p Foreign exchange matket, 121-123, 124-133p Foreign exchange rate (See Brchange fates) Foreign repercussions, 156, 157, 175-176 Foreign tede muldplier, 155-156, 157, 170-172p Forward discount, 123, 130p, 134-135p Forward exchange market, 122, 130-13 1p Forward exchange rate, 122, 124, 130-133p Forward premium, 130pFree trade area, 95, 96 Free trade, classical arguments for, 2, 8p, 54p, 97- sap Full employment income, 175p, 180, 182-183, 1969 Fundamental disequititrium, 217, 219, 223p Gains from trade, 2-3, 8-14p, 17, 19, 22-34p, 37- 39, 45-50p General Agreement on Tariffs and Trade (GATT), 109p, 114p, 217, 219, 223-224p, 230p General Arrangements to Borrow (GAB), 217, 219, 225 General equilibrium model, 54p Gold: itage, 167-168 points, 155, 157, 166-168 price, 166-168, 217, 218, 225p, 227-228 reserves, 139, L47p, 217-218, 224-226 Gold exchange standard, 156-157, 158, 178179, ‘2p, 216-217, 228-224 (See also Bretton ‘Woods System) Gold standar: adjustment process under, 255, 166-170p, 216, 22-222 assumptions of, 169p historical experiesce with, 155, 216, 221-2229 rules ofthe game, 155, 170p ‘Gold tranche, 217, 219, 2249 Great 216, 2229 Group of Ten, 217, 225p, 2279 Growth, economic, 184, 198-199 Heckscher-Ohlin Theory, 56-58, 59-62) Hedging, 122, 124, 130-131p Ht money, 225p Hume, David, 169-170p, 209p Immiseriing grow, 89p Import function, 170-172p quota, 91, 95, 989, 102-103p substiution, 87p tariff, 91,987 mportzble commodity, 72 Import-based growth, 77~78p Income adjustment mechanism, 155-156, 160p,170- 176 Income elasicity of demand, 88p Income policy, 184, 202-203p 237 Incomplete specialization, 19, 20, 21p. 32-Mp Increasing costs, 18-19, 20, 30-34p Indtference curves (See Community indifference eurves) Infant industry argument, 94, 96, L1I-113p Init and devaluation, 180-£2, 187-192 and flexible exchange rates, 154, 161-162p, 210 2p Inerdependence, 1, 3, 69 Interest: arbitrage, 123, 124, 125p, 133-135p party, 123, 124, 133-135p Inerest rte and capital mobiliy, 123, 133-135p, 184 Incemal balance, 180, 181, 182, 183-186, 186-188p, 192-202p Intemational Bank For Reconstruction ond Development (BRD), 217, 219, 223p Intemational commodity agreements, 72, 87p Intemational debt problem, 230p Intemational Finaice Corporation (IFC), 223p JIntemationa liquidity, 218, 227-228 Jtemationel Monstary Fund (IMP): ‘establishment of, 216-217, 223p fonetions, 216-217, 219, 2239 ‘operation, 217, 224-225 ‘Special Dravwing Rights (SDRs), 138-140, 147p, 217-219, 225, 228 Intemationel monetary reform, 218-219, 227-229 ntomationel monetary system: Bretton Woods, 216-217, 218, 223-225p, 226- 228 dollar standard, 218, 227p gold standard, 155, 166-170p, 216, 221-222 gold-exchange standard, 156-157, 158, 178-179p, 2p, 206-217, 223-224p managed floating, 218-219, 228-229p Interotional eserves, 139, 146-147p, 217-218 Inernational rad, basis of 1-3, 8-1Sp, 17, 19,22-34p Iverregional trade, 1, S-6p Interwar period, 216, 222-223p Inrs-industry trade, 57, 59, 64-65p Lnvestrnent iret, 138, 146p domestic, 170-175 foreign, 138-139, 146p 1S curve, 182-183, 184, 195-198 Jamaica Accords, 218,220. Kennedy Round, 109p, 113-114p K-saving technical progress, 69-70, 72, 7778p, 79p.238 Labor-ntensive commodity, 57, 59, 63-Gtp, 69, 76=18p Labor theory of value, 3, 4, Ip, 22p Latin American Free Trade Association (LAFTA), 116 Law of comparitive adventage, 2-3, 4, 8-9p, M8p Leontif paradox, 56-57, 58. 59p, 63p Less developed countries (LCDs): demands for a NIEO, 72, 87> import substitution, 87p industilization, 72, 86-87p, 88, 111-L12p regional integration among, 95, 1I6p trade problems, 72, 86-89p UNCTAD, 1125, Liquidity (See Intemational Liquidity) EM curve, 182-183, 184, 195-198 Long-tesm capita: account, 138-139, 146p definition, 138-139, 1469 movements, 138-139, 146 saving technical progress, 70, 72. 77-7Bp, 80-832 Law of reciprocal demand, 54p Law of one price, 209p Macrosconomic, 1,3. 72 Managed floating system, 140, 205, 206, 211-213p, 2153p farina propensity to: Sport, 155-156, 157, 170-172p save, 155-186, 157, 170-1729 tate of substitution, 37, 4, 43-44p Marginal rte of transformation, 16-17, 20, 23-24p, 30-33p, 35p Marshall-Lemer condition, 165p Mercantlism, 1-2, 7p Microeconomic, 1,3, 7p Mint paiy, 155, 157, 166p Monetary approach ‘othe bane of payments, 208-205, 296, 208-211 Monetary bese, 204, 205, 208p Monetary policy: defined, 180, 184, 186-1879 and extemal balance, 180, 182-183, 193-198 Money Dlsion, 181, 191-192p Money suply under the gold standard, 155, 169- 170p Most-favored-naton principle, 109p ‘Multinational corporation (MNC)}: 89p Moltipe exchange rates, 202-203p Maliptic: domestic, 170 foreign, 155-156, 170-172p with foreign repercussions, 175-176p Mi [Net IMF position, 139, 1449, 147) Neutral technical progress, 69-70, 72, 7678p, 82-839 [New Intemational Bconomic Onder (NIEO), 72, 73, 87p ‘Newly industrializing countries (NICS), 72, 73 New protectionism, (See nontariff trade barriers) Norzinal wif, 91, 92, 95, 103—04p Noneconomic arguments for mriffs, 111p Nontartf inde barriers (NTBS), 91, 98, 229, 230 Offer curve definition, 39-40, 41 Official reserve account, 139, 146-147p Open economy macroeconornes, (See Balance adjacent) Opportunity costs, 3, 14p, 16, 20, 229 ‘Optimum currency area, 205, 206, 212p ‘Optimum tariff, 94, 96, 106-110p (vervaluton of dollr, 26-22p Paper gold (See Special Drawing Rights) Par value, 134-135p, 155p, 211p, 217 Pegged exchange rate, 96 Policy instruments, 186p Portfolio investments, 138-139, 146) Price adjustment mechanism, 154-155, 156, 160-170p, 176-1779 Price elasticity, 155, 162-168 Price of gold, 166-169p, 217-218, 225— 2p Price-specie-flow mechanism, 155, 157, 169p, 2085p Price and wage controls (See Income policy) Private capital movements, 138, 145—146p Product eye, $8, $9, 60p Production possibility curve: efined, 16-17, 20 . ‘under consent cost, 16-17, 21p, 22-29p under increasing costs, 18-19, 30-34p Prokbitve tariff, 10lp, 105p Protection cos of tiff, 91-82, 95, 98-103p ‘Purchasing power party theory: absolute, 181, 19%) relative, 181,"191p ‘Pure theory of tae, 1, 3, 7p, 16-20, 20-36p, 37- 41, 4155pQuantitative restrictions (See Quotas) Quantity theory of money, 155, 169p Quotas, 91, 95, 8p, 192-1039 Rate of exchange (See Exchange rate) Real cash balance effect, 181, 191-192p Recession, 182-183, 188, 198 Reciprocal demand (See Oifer curves) Resiprocal Trade Agreement Act, 109p Regions of recent seement, 72,73, 889 Relative prices, 1012p, 16 Reserve curencies, 147p, 226p Reualistion, and optimum wif, 94, 105— 1p Revaluation, 181, 184, 188-189p Revenue effect of tariff, 91, 98-102p Ricardo, David, 2-3, 10p, (2p Roles ofthe gue, 155, 170p, 206-217 Rybezynski theorem, 69, 72, 73p, 7778p Savings funtion, 170-1769 Scientific tariff, 94, 97p, 1p SDRs (See Specil Drawing Rights) Second bes, theory of, 96) Seigncrge, 2269 Serves, 138, 141, L4-145p Short-term capital movement, 139, 146 Smit, Adam, 2, 4, 7-8, 57-98 Smithsonian Agreement, 218, 219-220, 227 Smoot Hawley Tatiff, 109p ‘Special Drawing Rights (SDRs), 139-140, 147p, 217— 219, 225p, 2289 Specialization complete, 17, 2, 2tp, 24-28p incomplete, 19, 20, 21p, 32-34p Speculation: defined, 122, 124, 131-132p destabilizing, 1329, 215p subilcig, 132p, 2159 Speculative demand for money, 182, 1969 Spot exchange rae, 122, 123, 124, 130- Bip ‘Standby arrangements, 217, 225p ‘Static analysis, 76p Suurtcal discrepancy, 140, 142, 148p Stolper Samuelson theorem, 92-94, 95, 97 ‘Supply of money, 204, 206, 208p ‘Surplus in balance of payments, 140, 142, 151- 152p ‘Swap arangements, 217, 259 239 Taft ‘ad valorem (See Nomintl) arguments for, 94, 110-11 1p balance of payments effect, 98, 111p ‘consamption effect, 91, 98-103p cost of protection, 91-92, $5, 98-103p effective, 92, 96p, 103-104) fectores, ISP large nation, effet of, 94, 105~110p nominal, 91, 92, 95, 103-104p ‘optimum, 94, 96, 105-1109 preferences for developing counties, 72, 87p, 111— 112p, 225p prohibitive, 101p, 10Sp protective effect of, 94, 98-103p, 112, L13p redistribution effect of, 91, 98-103p revenue effect of, 91, 98-102p seientifi, 94, 97p, 1p smal nation, effect of, 92-94, 104-105p terms of reds effect of, 94, 105-110p Tass: ‘changes in, 70-72, 83-B6p differences in o bas for trade, 85-86 ‘Technical progress, 69-70, 76-3p ‘Technological gap model, 58, 59, 60p, 65p ‘Tons of trade: commodity, 40-41, 42p, 52-S3p, 87-89p double fectoral, 88 Income, 88p siugle factoral, 85> Tied cid, 149p, 218 Tokyo Round, 1099 ‘Tae: and growth in developing counties, 72, 86— 8p creation, 95, 96, 113-1155 diversion, 95, 96, 113-115 estrctions, 91-94, 97-98 ‘Trade und exchange controls, 184, 185, 202-203p ‘Tranche (IMF), 217, 219, 22¢p ‘Transaction demand for money, 182, 196 ‘Transfer payments (See Unilateral transfers) ‘Transformation curve (See Production possibilities curve) ‘Transportation costs, 58, 66-68) ‘Travel expenditures, 144-145 ‘Twortir gold price, 217, 2259 Uncovered position, 122, 130p Underdeveloped countries (See Less developed countries) Unilateral transfers, 138, 142, 145p United Nations Conference on Trade and Development (UNCTAD), 112p, 217-218, 227p, 152-153p balance on current account, 138, 141, 1469 balance of intemational indebtedness, 152-153p balance of paymemis, 140, 151-153p gold loss, 218, 225-207p gold reserves, 139, 147p, 217-218, 224-226p {import propensities, 153-156, 157, 170-173p import surcharge, 218, 226 liabilities to foreign officietholders, 139, L46p. 1SLp Unstablo foreign exchange market, 123, 132-133p INDEX ‘Value added, 92, 103-104p ‘Voluntary expontresraints (VERS), 102-102p ‘Wage and price contro (See incomes policy) Welfare gain with trade, 17, 19-20, 22°34p World Bank (See International Bank for Reconstruction and Development) World trade, expansion of, 217, 22%p

International Economics 3rd Salvatore

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