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International
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Sixteenth Edition
Thomas A. Pugel
New York University
INTERNATIONAL ECONOMICS: SIXTEENTH EDITION
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Pugel, Thomas A.
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In memory of my parents, Adele and Edmund, and my
parents-in-law, Vivian and Freeman, with my deepest
appreciation and gratitude for all that they did to benefit
the generations that follow.
About the Author
Thomas A. Pugel
Thomas A. Pugel is Professor of Economics and Global Business at
the Stern School of Business, New York University, and a Fellow of
the Teaching Excellence Program at the Stern School. His research
and publications focus on international industrial competition and
government policies toward international trade and industry. Professor
Pugel has been Visiting Professor at Aoyama Gakuin University in
Japan and a member of the U.S. faculty at the National Center for
Industrial Science and Technology Management Development in China.
He received the university-wide Distinguished Teaching Award at New
York University in 1991, and twice he was voted Professor of the Year
by the graduate students at the Stern School of Business. He studied economics as
an undergraduate at Michigan State University and earned a PhD in economics from
Harvard University.
vi
Preface
International economics combines the excitement of world events and the incisiveness
of economic analysis. We are now deeply into the second great wave of globalization,
in which product, capital, and labor markets are becoming more integrated across
countries. This second wave, which began in about 1950 and picked up steam in the
1980s, has now lasted longer than the first, which began in about 1870 and ended with
World War I (or perhaps with the onset of the Great Depression in 1930).
As indicators of the current process of globalization, we see that international
trade, foreign direct investment, cross-border lending, and international portfolio
investments have been growing faster than world production. Information, data, and
rumors now spread around the world instantly through the Internet and other global
electronic media.
As the world becomes more integrated, countries become more interdependent.
Increasingly, events and policy changes in one country affect many other countries.
Also increasingly, companies make decisions about production and product development based on global markets.
My goal in writing and revising this book is to provide the best blend of events
and analysis, so that the reader builds the abilities to understand global economic
developments and to evaluate proposals for changes in economic policies. The book
is informed by current events and by the latest in applied international research.
My job is to synthesize all of this to facilitate learning. The book
Combines rigorous economic analysis with attention to the issues of economic
policy that are alive and important today.
Is written to be concise and readable.
Uses economic terminology when it enhances the analysis but avoids jargon for
jargon’s sake.
I follow these principles when I teach international economics to undergraduates and
master’s degree students. I believe that the book benefits as I bring into it what I learn
from the classroom.
THE SCHEME OF THE BOOK
The examples presented in Chapter 1 show that international economics is exciting
and sometimes controversial because there are both differences between countries and
interconnections among countries. Still, international economics is like other economics in that we will be examining the fundamental challenge of scarcity of resources—
how we can best use our scarce resources to create the most value and the most
benefits. We will be able to draw on many standard tools and concepts of economics,
such as supply and demand analysis, and extend their use to the international arena.
We begin our in-depth exploration of international economics with international
trade theory and policy. In Chapters 2–7 we look at why countries trade goods and
services. In Chapters 8–15 we examine what government policies toward trade would
bring benefits and to whom. This first half of the book might be called international
microeconomics.
vii
viii Preface
Our basic theory of trade, presented in Chapter 2, says that trade usually results
from the interaction of competitive demand and supply. It shows how the gains that
trade brings to some people and the losses it brings to others can sum to overall
global and national gains from trade. Chapter 3 launches an exploration of what
lies behind the demand and supply curves and discovers the concept of comparative
advantage. Chapter 4 shows that countries have different comparative advantages for
the fundamental reason that people, and therefore countries, differ from each other
in the productive resources they own. Chapter 5 looks at the strong impacts of trade
on people who own those productive resources—the human labor and skills, the
capital, the land, and other resources. Some ways of making a living are definitely
helped by trade, while others are hurt. Chapter 6 examines how actual trade may
reflect forces calling for theories that go beyond our basic ideas of demand and supply and of comparative advantage. Chapter 7 explores some key links between trade
and economic growth.
Chapters 8–15 use the theories of the previous chapters to analyze a broad range
of government policy issues. Chapters 8–10 set out on a journey to map the border
between good trade barriers and bad ones. This journey turns out to be intellectually challenging, calling for careful reasoning. Chapter 11 explores how firms and
governments sometimes push for more trade rather than less, promoting exports
more than a competitive marketplace would. Chapter 12 switches to the economics
of trade blocs like the European Union and the North American Free Trade Area.
Chapter 13 faces the intense debate over how environmental concerns should affect
trade policy. Chapter 14 looks at how trade creates challenges and opportunities
for developing countries. Chapter 15 examines the economics of emigration and
immigration and the roles of global companies in the transfer of resources, including
technology, between countries.
The focus of the second half of the book shifts to international finance and
macroeconomics. In Chapters 16–21 we enter the world of different moneys, the
exchange rates between these moneys, and international investors and speculators.
Chapters 22–25 survey the effects of a national government’s choice of exchangerate policy on the country’s macroeconomic performance, especially unemployment
and inflation.
Chapter 16 presents the balance of payments, a way to keep track of all the economic transactions between a country and the rest of the world. In Chapter 17 we
explore the basics of exchange rates between currencies and the functioning and
enormous size of the foreign exchange market. Chapter 18 provides a tour of the
returns to and risks of foreign financial investments. Exchange rates are prices, and
in Chapter 19 we look behind basic supply and demand in the foreign exchange
market, in search of fundamental economic determinants of exchange-rate values.
Chapter 20 examines government policies toward the foreign-exchange market, first
using description and analysis, and then presenting the history of exchange-rate
regimes, starting with the gold standard and finishing with the current mash-up of
different national policies. Well-behaved international lending and borrowing can
create global gains, but Chapter 21 also examines financial crises that can arise
from some kinds of foreign borrowing and that can spread across countries, a clear
downside of globalization.
Preface ix
Chapter 22 begins our explication of international macroeconomics by developing a framework for analyzing a national economy that is linked to the rest of the
world through international trade and international financial investing. We use this
framework in the next two chapters to explore the macroeconomic performance of a
country that maintains a fixed exchange-rate value for its currency (Chapter 23) and
of a country that allows a floating, market-driven exchange-rate value for its currency
(Chapter 24). Chapter 25 uses what we have learned throughout the second half of the
book to examine the benefits and costs of alternatives for a country’s exchange-rate
policy. While rather extreme versions of fixed exchange rates serve some countries
well, the general trend is toward more flexible exchange rates.
In a few places the book’s scheme (international trade first, international finance
second) creates some momentary inconvenience, as when we look at the exchangerate link between cutting imports and reducing exports in Chapter 5 before we have
discussed exchange rates in depth. Mostly the organization serves us well. The understanding we gain about earlier topics provides us with building blocks that allow us to
explore broader issues later in the book.
CURRENT EVENTS AND NEW EXAMPLES
It is a challenge and a pleasure for me to incorporate the events and policy changes that
continue to transform the global economy, and to find the new examples that show the
effects of globalization (both its upside and its downside). Here are some of the current
and recent events and issues that are included in this edition to provide new examples
that show the practical use of our international economic analysis:
• The euro crisis that began in Greece in 2010 spread to several other countries in
the euro area and during 2011–2012 seemed to threaten the continued existence of
the euro itself. Still, in the face of continued weak economic performance in the
euro area, Latvia adopted the euro at the beginning of 2014, bringing the number
of countries in the euro area to 18.
• Beginning in 2007 the United States rapidly expanded its production of natural gas
using horizontal drilling and hydraulic fracturing. A large number of U.S. firms
sought approval to export natural gas, but a U.S. law prohibits export unless it is in
the national interest. The U.S. government has been slow to act; as of mid-2014,
only one U.S. facility had received full approval to export.
• Immigration continues to be a hot issue. In 2014 Swiss voters approved limitations
on immigration into the country. Prime Minister Cameron pledged to greatly reduce
immigration into Britain by 2015. In 2013 the U.S. government again failed to pass
a revision of its immigration laws.
• Chinese government holdings of foreign exchange reserve assets reached $4 trillion
in mid-2014, the result of continued official intervention to prevent the exchangerate value of China’s currency from rising too quickly.
• Pressure from the growth of the countries’ exports led to rapidly rising wages for
workers in China and in India.
• After nearly two decades of negotiations, Russia joined the World Trade
Organization (WTO) in 2012.
x
Preface
• In 2013 the members of the WTO reached a new multilateral agreement on
trade facilitation, but in 2014 its implementation was held up by a single country, India.
• In response to rapidly growing imports, American steel producers sent a large
number of new complaints to the U.S. government, alleging dumping by foreign
producers and seeking hefty new antidumping duties.
• The WTO ruled that European governments had violated WTO rules by offering
massive subsidies to Airbus and that the U.S. government had violated WTO rules
by offering massive subsidies to Boeing. But, then, the situation seemed to reach
a stalemate.
• After approval from the U.S. Congress, the United States implemented free-trade
agreements with Colombia, South Korea, and Panama.
• In 2012, Venezuela became a member of MERCOSUR, the South American
regional trade area.
• Croatia joined the European Union in 2013 as its 28th member country.
• The first phase of the Kyoto Protocol was completed in 2012. For a number of
reasons, the effects were minor, and global warming continues as a major global
environmental challenge.
• Led by increases in international financial investments and computer-driven trading, the size of the foreign exchange market continued to grow, with trading of one
currency for another reaching $5 trillion per day in 2013. Foreign exchange trading
has more than tripled since 2004.
• The market-driven exchange-rate value of the Japanese yen increased during the
week after a tsunami caused the nuclear disaster at Fukushima in 2011, prompting
a large official intervention in the foreign exchange market.
• Starting in 2008, the International Monetary Fund (IMF) rapidly expanded its lending to countries in crisis, with loans outstanding reaching $125 billion in mid-2014.
Most of these IMF loans are to advanced countries—Iceland, Greece, Ireland, and
Portugal—a sharp contrast to the lending to developing countries that had been
predominant since 1980.
• The United States pursued a third round of quantitative easing during 2012–2014 as
a continuation of unconventional monetary policy for an economy stuck in a liquidity trap. In this third round, the Fed bought about $1.5 trillion of Treasury securities
and mortgage-backed securities, but this round seemed to have less effect on the
exchange-rate value of the U.S. dollar than did previous rounds.
IMPROVING THE BOOK: TOPICS
In this edition I introduce and extend a number of improvements to the pedagogical
structure and topical coverage of the book.
• The euro crisis that began in 2010 and intensified in 2011 and 2012 has had
profound effects on the member countries of the euro area—the countries that
have replaced their national currencies with the euro in a monetary union.
Preface xi
This edition interweaves the causes and impacts of the euro crisis across its
chapters. The overview of the euro crisis in Chapter 1 shows that it began in
different ways, as a fiscal crisis in Greece and as a burst housing-price bubble
in Ireland that led to a banking crisis. Portugal then had a debt-driven crisis, and
contagion spread the crisis pressures to Spain and Italy. The European Central
Bank needed to play a key role, and a new program announced in July 2012
and adopted in September was the turning point in addressing the worst of the
crisis. I then present discussions of important aspects of the crisis in a series of
new shaded Euro Crisis boxes, which join the other six series of boxes: Global
Crisis, Focus on China, Global Governance, Focus on Labor, Case Studies, and
Extensions. For the Euro Crisis series, the new box in Chapter 16 shows how
attention to current account balances and net international investment positions
of the countries at the center of the crisis would have given signals of rising risk.
Chapter 18 has a combination of a Global Crisis and Euro Crisis box, which
shows how a key parity relationship among interest rates and exchange rates
weakened under crisis conditions. The new box in Chapter 21 explains how the
euro crisis was actually three interrelated crises that reinforced each other—
sovereign debt or fiscal crisis, banking crisis, and macroeconomic crisis. While
the sovereign debt and banking crises have calmed, the macroeconomic performance of the euro area remained very weak and Greece was in depression. The
concluding section of Chapter 25 examines the benefits and costs of European
monetary union, with special attention to fiscal policy. The euro area lacks areawide taxation and government spending, National fiscal policies have a double
edge, as both the principal remaining tool for national governments to address
their macroeconomic performance problems and a potential source of instability
that can threaten the entire union.
• The global financial and economic crisis that began in 2007 is the most important
global trauma of the past 70 years, and it was a major contributor to the onset of
the euro crisis. A new section of the text of Chapter 21 describes the global crisis,
including the start of the crisis as the result of losses on sub-prime mortgages in
the United States and on assets backed by these mortgages, and the terrible worsening of the crisis in 2008 with the failure of Lehman Brothers. This discussion
of the global crisis also shows how the analysis of the series of financial crises
that hit developing countries during 1982–2002 helps us to understand the causes
and spread of the global crisis. The Global Crisis series of boxes examines other
aspects of the crisis, including the collapse of international trade (Chapter 2),
the avoidance of new protectionism (Chapter 9), the use of quantitative easing
as nontraditional monetary policy once short-term interest rates are essentially
zero (Chapter 24), and the increased use of currency swaps among central banks
(Chapter 24).
• China continues its rise as a force in the global economy. The presentation of
China’s global role, including the series of boxes Focus on China, continues to
be a strength of the text. Chapters 1 and 20 discuss the development of China’s
controversial policies toward the exchange-rate value of its currency. In the box in
Chapter 9, the presentation of China’s rising involvement in the dispute settlement
xii Preface
•
•
•
•
•
•
process at the World Trade Organization, both as a respondent (alleged violator)
and as a complainant, has been updated and rewritten. Among other recent cases,
the WTO ruled in 2014 that China’s restrictions on exports of rare earths were a
violation of its WTO commitments.
A major strength of the book remains in-depth analysis of a range of trade
and trade-policy issues. The discussion of monopolistic competition and intraindustry trade in Chapter 6 has been expanded to incorporate the conclusions
from research based on differences across firms in their cost levels. Opening to
international trade favors the survival and expansion of lower-cost firms. This discussion also includes an estimate of the global gains from greater product variety.
The section on trade embargoes in Chapter 12 has been revised, with a current
case, Iran, being used as the example of the effects of international sanctions on
the target country. Estimates of national factor endowments presented in Chapter 5
are completely updated and include better data on physical capital stocks and
more countries in total. Data on national intra-industry trade shares in Chapter 6
include new estimates for 2012.
Chapter 13 on trade and the environment continues as a unique and powerful
treatment of issues of interest to many students. The discussion of global warming has been revised to incorporate data and projections from recent studies. The
discussion of the Kyoto Protocol has been updated to include the outcomes from
the first phase that ended in 2012 and the continued increase in global greenhouse
gas emissions.
The box on the fiscal effects of immigration in Chapter 15 has been substantially rewritten to incorporate the results of a recent Organization for Economic
Cooperation and Development study of the effects of immigrants on government
revenues and expenditures.
In Chapter 18 a new section of text explains the definitions and uses of real
exchange rates and effective exchange rates. The four ways to measure the
exchange-rate value of a currency had previously been a box in the chapter, but the
increasing importance of these concepts motivated the shift to a text section.
Chapter 21 has been substantially revised. It incorporates the global financial and
economic crisis into the text of the chapter and has a new box on the euro crisis.
Some other aspects of the chapter have been streamlined. The short subsections on
the Brazilian mini-crisis of 1999 and the Turkish crisis of 2001 have been removed,
as has one of the two boxes on the International Monetary Fund.
I used the latest available sources to update the wide range of data and information presented in the figures and text of the book. Among other updates, the book
offers the latest information on international trade in specific products for the
United States, China, and Japan; national average tariff rates; dumping and subsidy cases; levels and growth rates of national incomes per capita; trends in the
relative prices of primary products; patterns of foreign direct investments broadly
and by major home country; rates of immigration into the United States, Canada,
and the European Union; the U.S. balance of payments and the U.S. international
Preface
xiii
investment position; the sizes of foreign exchange trading and foreign exchange
futures, swaps, and options; levels and trends for nominal exchange rates; effective
exchange-rate values for the U.S. dollar; evidence about relative purchasing power
parity; the exchange-rate policies chosen by national governments; the flows of
international financing to and the outstanding foreign debt of developing countries;
and gold prices.
NEW QUESTIONS AND PROBLEMS
In this edition I provide additional opportunities for students to engage with the book’s
contents by adding new questions that students can use to build their facility in using
the concepts and analysis of international economics.
• Forty-eight new questions and problems have been added, two new questions and
problems to each of the chapters that have end-of-chapter materials. These new
questions and problems are targeted to cover chapter topics that were previously
underrepresented.
• A discussion question has been added at the end of each Case Study box, a total of
24 new questions that focus on the issues raised in the case studies.
FORMAT AND STYLE
I have been careful to retain the goals of clarity and honesty that have made
International Economics an extraordinary success in classrooms and courses around
the world. There are plenty of quick road signs at the start of and within chapters. The
summaries at the ends of the chapters offer an integration of what has been discussed.
Students get the signs, “Here’s where we are going; here’s where we have just been.”
I use bullet-point and numbered lists to add to the visual appeal of the text and to
emphasize sets of determinants or effects. I strive to keep paragraphs to reasonable
lengths, and I have found ways to break up some long paragraphs to make the text
easier to read.
I am candid about ranking some tools or facts ahead of others. The undeniable
power of some of the economist’s tools is applied repeatedly to events and issues
without apology. Theories and concepts that fail to improve on common sense are not
oversold.
The format of the book is fine-tuned for better learning. Students need to master
the language of international economics. Most exam-worthy terms appear in boldface
in the text, with their definitions usually contiguous. The material at the end of each
chapter includes a listing of these Key Terms, and an online Glossary has definitions
of each term. Words and phrases that deserve special emphasis are in italics.
Each chapter (except for the short introductory chapter) has at least 12 questions
and problems. The answers to all odd-numbered questions and problems are included
in the material at the end of the book. As a reminder, these odd-numbered questions
are marked with a ✦ .
xiv Preface
Box
Shaded boxes appear in different font with a
different right-edge format and two columns
per page, in contrast to the style of the main
text. The boxes are labeled by type and provide
discussions of the euro crisis that began in 2010,
the global financial and economic crisis that
began in 2007, the roles of the WTO and the IMF
in global governance, China’s international trade
and investment, labor issues, case studies, and
extensions of the concepts presented in the text.
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Acknowledgments
I offer my deepest thanks to the many people whose advice helped me to improve
International Economics in its sixteenth edition. My first thanks are to Peter H.
Lindert, my co author on several previous editions. I learned much from him about
the art of writing for the community of students who want to deepen their knowledge
and understanding of the global economy.
I love teaching international economics, and I am grateful to my students for the
many suggestions and insights that I have received from them. I thank my friends and
colleagues from other colleges and universities who took the time to e-mail me with
corrections and ideas for changes. I especially thank my faculty colleagues at the NYU
Stern School for information and suggestions. I am indebted to Natalia Tamirisa of
the International Monetary Fund for providing the data used in Figure 13.6, Carbon
Tax to Stabilize Atmospheric Carbon Dioxide; to Richard M. Levich of the NYU
Stern School of Business for providing data used in the box “Covered Interest Parity
Breaks Down” in Chapter 18; and to Ravi Balakrishnan and Volodymyr Tulin of the
International Monetary Fund for the data used in Figure 18.3, Uncovered Interest
Differentials: The United States against Germany and Japan, 1991–2005. I also thank
my brother, Michael Pugel, who shared with me his knowledge of technology issues
from his perspective as a patent attorney and electrical engineer.
I express my gratitude to the reviewers whose detailed and thoughtful comments
and critiques provided guidance as I wrote the sixteenth edition:
Adhip Chaudhuri, Georgetown University; Baizhu Chen, University of Southern
California; Tran Dung, Wright State University; Wei Ge, Bucknell University; Pedro
Gete, Georgetown University; Kirk Gifford, Brigham Young University; Nam Pham,
George Washington University; Courtney Powell-Thomas, Virginia Tech University;
Farhad Saboori, Albright College; George Sarraf, University of California–Irvine;
Paul Wachtel, New York University; Lou Zaera, Fashion Institute of Technology.
I remain grateful to the reviewers whose suggestions for improvements to the previous editions continued to redound to my benefit as I prepared the sixteenth:
Vera Adamchik, University of Houston–Victoria; Gregory W. Arbum, The
University of Findlay; Manoj Atolia, Florida State University; Mina Baliamoune,
University of North Florida; Michael P. Barry, Mount St. Mary’s University; Trisha
Bezmen, Old Dominion University; Frank Biggs, Principia College; Philip J.
Bryson, Brigham Young University; Philip E. Burian, Colorado Technical University
at Sioux Falls; James Butkiewicz, University of Delaware; Debasish Chakraborty,
Central Michigan University; Roberto Chang, Rutgers University; Shah Dabirian,
California State University Long Beach; Jamshid Damooei, California Lutheran
University; Manjira Datta, Arizona State University; Dennis Debrecht, Carroll
College; Carol Decker, Tennessee Wesleyan College; John R. Dominguez, University
of Wisconsin–Whitewater; Eric Drabkin, Hawaii Pacific University; Robert Driskill,
Vanderbilt University; Patrick M. Emerson, Oregon State University; Carole Endres,
Wright State University; Nicolas Ernesto Magud, University of Oregon; Hisham
Foad, San Diego State University; Yoshi Fukasawa, Midwestern State University;
John Gilbert, Utah State University; Chris Gingrich, Eastern Mennonite University;
xvii
xviii Acknowledgments
Amy Glass, Texas A&M University; Omer Gokcekus, Seton Hall University;
William Hallagan, Washington State University; Tom Head, George Fox University;
Barbara Heroy John, University of Dayton; Farid Islam, Woodbury School of
Business; Brian Jacobsen, Wisconsin Lutheran College; Geoffrey Jehle, Vassar
College and Columbia University; Jack Julian, Indiana University of Pennsylvania;
Ghassan Karam, Pace University; Vani V. Kotcherlakota, University of Nebraska
at Kearney; Quan Le, Seattle University; Kristina Lybecker, The Colorado
College; John Marangos, Colorado State University; John Mukum Mbaku, Weber
State University; John McLaren, University of Virginia; Michael A. McPherson,
University of North Texas; Matthew McPherson, Gonzaga University; Norman
C. Miller, Miami University; Karla Morgan, Whitworth College; Stefan Norrbin,
Florida State University; Joseph Nowakowski, Muskingum College; Rose Marie
Payan, California Polytechnic University; Harvey Poniachek, Rutgers University;
Dan Powroznik, Chesapeake College; Ed Price, Oklahoma State University; Kamal
Saggi, Southern Methodist University; Jawad Salimi, West Virginia University–
Morgantown; Andreas Savvides, Oklahoma State University; Philip Sprunger,
Lycoming College; John Stiver, University of Connecticut; William J. Streeter,
Olin Business School–Washington University in St. Louis; Kay E. Strong, Bowling
Green State University–Firelands; Kishor Thanawala, Villanova University; Victoria
Umanskaya, University of California-Riverside; Doug Walker, Georgia College
and State University; Dr. Evelyn Wamboye, University of Wisconsin–Stout;
Dave Wharton, Washington College; Elizabeth M. Wheaton, Southern Methodist
University; Jiawen Yang, George Washington University; Bassam Yousif, Indiana
State University Hamid Zangeneh, Widener University;
I offer my thanks and admiration to the great group at McGraw-Hill/Irwin who
worked with me closely in preparing this edition, including Michele Janicek, lead
product developer; Christina Kouvelis, senior product developer; Lisa Bruflodt, senior
project manager; and Sourav Majumdar, project manager at SPi Global.
My final acknowledgment is in remembrance of the late Charles P. Kindleberger,
who was one of my teachers during my graduate studies. He started this book over
60 years ago, and I strive to meet the standards of excellence and relevance that he
set for the book.
Thomas A. Pugel
Brief Contents
1
International Economics Is
Different 1
21 International Lending and
Financial Crises 502
2
The Basic Theory Using Demand and
Supply 13
22 How Does the Open Macroeconomy
Work? 539
3
Why Everybody Trades: Comparative
Advantage 31
23 Internal and External Balance
with Fixed Exchange Rates 565
4
Trade: Factor Availability and Factor
Proportions Are Key 47
24 Floating Exchange Rates and
Internal Balance 603
5
Who Gains and Who Loses from
Trade? 66
6
Scale Economies, Imperfect
Competition, and Trade 88
25 National and Global Choices:
Floating Rates and the
Alternatives 628
7
Growth and Trade
8
Analysis of a Tariff
9
Nontariff Barriers to Imports
APPENDIXES
117
A
The Web and the Library: International
Numbers and Other Information 655
B
10 Arguments for and against
Protection 192
Deriving Production-Possibility
Curves 659
C
Offer Curves
11 Pushing Exports
D
The Nationally Optimal Tariff
E
Accounting for International
Payments 673
F
Many Parities at Once
G
Aggregate Demand and Aggregate
Supply in the Open Economy 680
H
Devaluation and the Current Account
Balance 690
137
160
222
12 Trade Blocs and Trade Blocks
13 Trade and the Environment
252
275
14 Trade Policies for Developing
Countries 309
15 Multinationals and Migration:
International Factor Movements
16 Payments among Nations
334
370
17 The Foreign Exchange Market
389
18 Forward Exchange and International
Financial Investment 405
664
667
677
SUGGESTED ANSWERS TO
ODD-NUMBERED QUESTIONS
AND PROBLEMS 694
19 What Determines Exchange
Rates? 433
REFERENCES 731
20 Government Policies toward the
Foreign Exchange Market 464
INDEX
743
xix
Contents
Chapter 1
International Economics Is Different
Four Controversies 1
U.S. Exports of Natural Gas
Immigration 4
China’s Exchange Rate 5
Euro Crisis 7
1
Adam Smith’s Theory of Absolute
Advantage 32
Case Study Mercantilism: Older Than Smith—
and Alive Today
Economics and the Nation-State
Factor Mobility 11
Different Fiscal Policies
Different Moneys 12
11
12
Chapter 2
The Basic Theory Using Demand
and Supply 13
Four Questions about Trade
Demand and Supply 14
14
Demand 14
Consumer Surplus 16
Case Study Trade Is Important 17
Supply 18
Producer Surplus 19
Global Crisis The Trade Mini-Collapse
of 2009 20
A National Market with No Trade 22
Two National Markets and the Opening
of Trade 22
Free-Trade Equilibrium 24
Effects in the Importing Country 25
Effects in the Exporting Country 27
Which Country Gains More? 27
Summary: Early Answers to the Four Trade
Questions 28
Key Terms 28
Suggested Reading 29
Questions and Problems 29
xx
1
Chapter 3
Why Everybody Trades: Comparative
Advantage 31
33
Ricardo’s Theory of Comparative
Advantage 35
Ricardo’s Constant Costs and the
Production-Possibility Curve 38
Focus on Labor Absolute Advantage
Does Matter
40
Extension What If Trade Doesn’t
Balance?
42
Summary 43
Key Terms 44
Suggested Reading 44
Questions and Problems
44
Chapter 4
Trade: Factor Availability and Factor
Proportions Are Key 47
Production with Increasing Marginal Costs
48
What’s Behind the Bowed-Out Production-Possibility
Curve? 48
What Production Combination Is Actually
Chosen? 50
Community Indifference Curves 51
Production and Consumption Together
53
Without Trade 53
With Trade 54
Focus on China The Opening of Trade and
China’s Shift Out of Agriculture 56
Demand and Supply Curves Again 58
The Gains from Trade
58
Contents
Trade Affects Production and
Consumption 59
What Determines the Trade Pattern? 60
The Heckscher–Ohlin (H–O) Theory 61
Summary 62
Key Terms 63
Suggested Reading 63
Questions and Problems 63
xxi
Chapter 6
Scale Economies, Imperfect Competition,
and Trade 88
Scale Economies
89
Internal Scale Economies 90
External Scale Economies 91
Intra-Industry Trade 92
How Important Is Intra-Industry Trade? 93
What Explains Intra-Industry Trade? 94
Chapter 5
Who Gains and Who
Loses from Trade? 66
Monopolistic Competition and Trade
Who Gains and Who Loses within
a Country 66
Short-Run Effects of Opening Trade 67
The Long-Run Factor-Price Response 67
Three Implications of the H–O Theory
69
The Stolper–Samuelson Theorem 69
Extension A Factor-Ratio Paradox 70
The Specialized-Factor Pattern 72
The Factor-Price Equalization Theorem 72
Does Heckscher–Ohlin Explain Actual Trade
Patterns? 73
Factor Endowments 74
Case Study The Leontief Paradox
International Trade 76
What are the Export-Oriented
and Import-Competing Factors?
75
78
The U.S. Pattern 78
The Canadian Pattern 79
Patterns in Other Countries 79
Focus on China China’s Exports and
Imports 80
Do Factor Prices Equalize
Internationally? 82
Focus on Labor U.S. Jobs and Foreign
Trade
95
The Market with No Trade 97
Opening to Free Trade 98
Basis for Trade 99
Extension The Individual Firm in Monopolistic
Competition 100
Gains from Trade 103
83
Summary: Fuller Answers to the Four Trade
Questions 84
Key Terms 85
Suggested Reading 85
Questions and Problems 85
Oligopoly and Trade
104
Substantial Scale Economies 105
Oligopoly Pricing 105
Extension The Gravity Model
of Trade 106
External Scale Economies and Trade
Summary: How Does Trade Really
Work? 111
Key Terms 114
Suggested Reading 114
Questions and Problems 114
Chapter 7
Growth and Trade
109
117
Balanced Versus Biased Growth 118
Growth in Only One Factor 120
Changes in the Country’s Willingness
to Trade 121
Case Study The Dutch Disease and
Deindustrialization 123
Effects on the Country’s Terms of Trade
Small Country 124
Large Country 124
Immiserizing Growth
Technology and Trade
124
126
128
Individual Products and the Product Cycle
129
xxii Contents
Focus on Labor Trade, Technology, and
U.S. Wages 130
Openness to Trade Affects Growth 131
Summary 132
Key Terms 133
Suggested Reading 134
Questions and Problems 134
Chapter 8
Analysis of a Tariff
Case Study Carrots Are Fruit, Snails Are Fish,
and X-Men Are Not Humans 178
Domestic Content Requirements 179
Government Procurement 180
How Big Are the Costs of Protection?
181
As a Percentage of GDP 181
As the Extra Cost of Helping Domestic
Producers 182
International Trade Disputes 183
137
Global Governance WTO and GATT: Tariff
Success 138
A Preview of Conclusions 140
The Effect of a Tariff on Domestic
Producers 140
The Effect of a Tariff on Domestic
Consumers 142
The Tariff as Government Revenue 145
The Net National Loss from a Tariff 145
Extension The Effective Rate of Protection 148
Case Study They Tax Exports, Too 150
The Terms-of-Trade Effect and a Nationally
Optimal Tariff 152
Summary 156
Key Terms 157
Suggested Reading 157
Questions and Problems 157
Chapter 9
Nontariff Barriers to Imports
160
Types of Nontariff Barriers to Imports
The Import Quota 162
160
Quota versus Tariff for a Small Country 162
Global Governance The WTO: Beyond
Tariffs 164
Global Crisis Dodging Protectionism 167
Ways to Allocate Import Licenses 168
Extension A Domestic Monopoly Prefers
a Quota 170
Quota versus Tariff for a Large Country 172
Voluntary Export Restraints (VERs)
Other Nontariff Barriers 175
Product Standards 175
Case Study VERs: Two Examples
173
America’s “Section 301”: Unilateral Pressure 183
Focus on China China in the WTO 184
Dispute Settlement in the WTO 186
Summary 187
Key Terms 188
Suggested Reading 189
Questions and Problems 189
Chapter 10
Arguments for and against
Protection 192
The Ideal World of First Best 193
The Realistic World of Second Best
196
Promoting Domestic Production
or Employment 197
The Infant Industry Argument 201
How It Is Supposed to Work 201
How Valid Is It? 202
Focus on Labor How Much Does It Cost to
Protect a Job? 204
The Dying Industry Argument and Adjustment
Assistance 206
Should the Government Intervene? 206
Trade Adjustment Assistance 207
The Developing Government (Public Revenue)
Argument 208
Other Arguments for Protection: Noneconomic
Objectives 209
National Pride 209
National Defense 210
Income Redistribution 210
The Politics of Protection
176
194
Government Policies toward Externalities
The Specificity Rule 196
211
The Basic Elements of the Political–Economic
Analysis 211
Contents
When Are Tariffs Unlikely? 212
When Are Tariffs Likely? 213
Applications to Other Trade-Policy Patterns 214
Case Study How Sweet It Is (or Isn’t) 215
Summary 217
Key Terms 219
Suggested Reading 219
Questions and Problems 219
Chapter 11
Pushing Exports
222
Dumping 222
Reacting to Dumping: What Should
a Dumpee Think? 225
Actual Antidumping Policies: What Is
Unfair? 226
Proposals for Reform 229
Case Study Antidumping in Action 230
Export Subsidies 233
Exportable Product, Small Exporting Country 234
Exportable Product, Large Exporting Country 236
Switching an Importable Product into an
Exportable Product 237
WTO Rules on Subsidies 238
Should the Importing Country Impose
Countervailing Duties? 239
Case Study Agriculture Is Amazing 242
Strategic Export Subsidies Could Be Good 244
Global Governance Dogfight at the WTO 246
Summary 248
Key Terms 249
Suggested Reading 249
Questions and Problems 250
Chapter 12
Trade Blocs and Trade Blocks 252
Types of Economic Blocs 252
Is Trade Discrimination Good or Bad? 253
The Basic Theory of Trade Blocs:
Trade Creation and Trade Diversion 255
Other Possible Gains from a Trade Bloc 258
The EU Experience 259
Case Study Postwar Trade Integration in
Europe
260
North America Becomes a Bloc
262
NAFTA: Provisions and Controversies
NAFTA: Effects 264
Rules of Origin 265
263
Trade Blocs among Developing Countries
Trade Embargoes 267
Summary 272
Key Terms 273
Suggested Reading 273
Questions and Problems 273
Chapter 13
Trade and the Environment
275
Is Free Trade Anti-Environment? 275
Is the WTO Anti-Environment? 280
Global Governance Dolphins, Turtles,
and the WTO
282
The Specificity Rule Again 284
A Preview of Policy Prescriptions 285
Trade and Domestic Pollution 287
Transborder Pollution 290
The Right Solution 291
A Next-Best Solution 293
NAFTA and the Environment
294
Global Environmental Challenges
295
Global Problems Need Global Solutions 295
Extinction of Species 296
Overfishing 298
CFCs and Ozone 299
Greenhouse Gases and Global Warming 300
Summary 305
Key Terms 306
Suggested Reading 306
Questions and Problems 306
Chapter 14
Trade Policies for Developing
Countries 309
Which Trade Policy for Developing
Countries? 311
Are the Long-Run Price Trends Against
Primary Producers? 313
Case Study Special Challenges of
Transition
314
xxiii
266
xxiv Contents
International Cartels to Raise Primary-Product
Prices 319
The OPEC Victories 319
Classic Monopoly as an Extreme Model for Cartels 320
The Limits to and Erosion of Cartel Power 322
The Oil Price Increase since 1999 323
Other Primary Products 324
Import-Substituting Industrialization (ISI)
324
ISI at Its Best 325
Experience with ISI 326
370
Accounting Principles 370
A Country’s Balance of Payments
Current Account 371
Financial Account 373
Official International Reserves
Statistical Discrepancy 375
334
Foreign Direct Investment 335
Multinational Enterprises 337
FDI: History and Current Patterns 338
Why Do Multinational Enterprises Exist? 340
Inherent Disadvantages 341
Firm-Specific Advantages 341
Location Factors 342
Internalization Advantages 343
Oligopolistic Rivalry 344
Taxation of Multinational Enterprises’
Profits 344
Case Study CEMEX: A Model Multinational
from an Unusual Place
Summary 365
Key Terms 367
Suggested Reading 367
Questions and Problems 367
Chapter 16
Payments among Nations
Exports of Manufactures to Industrial
Countries 329
Summary 330
Key Terms 331
Suggested Reading 331
Questions and Problems 331
Chapter 15
Multinationals and Migration:
International Factor Movements
Effects on the Government Budget 361
External Costs and Benefits 361
Case Study Are Immigrants a Fiscal Burden? 362
What Policies to Select Immigrants? 364
345
MNEs and International Trade 347
Should the Home Country Restrict FDI
Outflows? 349
Should the Host Country Restrict FDI
Inflows? 350
Focus on China China as a Host Country 352
Migration 354
How Migration Affects Labor Markets 357
Should the Sending Country Restrict
Emigration? 360
Should the Receiving Country Restrict
Immigration? 361
371
374
The Macro Meaning of the Current Account
Balance 375
The Macro Meaning of the Overall
Balance 380
The International Investment Position 381
Euro Crisis International Indicators Lead the
Crisis
383
Summary 385
Key Terms 386
Suggested Reading 386
Questions and Problems 386
Chapter 17
The Foreign Exchange Market
389
The Basics of Currency Trading 390
Case Study Brussels Sprouts a New
Currency: € 392
Using the Foreign Exchange Market 393
Case Study Foreign Exchange
Trading 394
Interbank Foreign Exchange Trading 395
Demand and Supply for Foreign Exchange
Floating Exchange Rates 397
Fixed Exchange Rates 399
Current Arrangements 400
Arbitrage within the Spot Exchange
Market 401
Summary 402
396
Contents
Key Terms 402
Suggested Reading 402
Questions and Problems 403
Chapter 18
Forward Exchange and International
Financial Investment 405
Exchange-Rate Risk 405
The Market Basics of Forward Foreign
Exchange 406
Hedging Using Forward Foreign Exchange 407
Speculating Using Forward Foreign Exchange 408
Extension Futures, Options, and Swaps 410
International Financial Investment 412
International Investment with Cover 413
Covered Interest Arbitrage 415
Covered Interest Parity 416
International Investment without Cover 417
Case Study The World’s Greatest Investor 420
Does Interest Parity Really Hold? Empirical
Evidence 422
Evidence on Covered Interest Parity 422
Evidence on Uncovered Interest Parity 423
Case Study Eurocurrencies: Not (Just) Euros
and Not Regulated 424
Global Crisis and Euro Crisis Covered
Interest Parity Breaks Down 426
Evidence on Forward Exchange Rates and
Expected Future Spot Exchange Rates 428
Summary 428
Key Terms 430
Suggested Reading 430
Questions and Problems 430
A Road Map 435
Exchange Rates in the Short Run
The Law of One Price 441
Absolute Purchasing Power Parity 441
Relative Purchasing Power Parity 442
Case Study PPP from Time to Time 443
Case Study Price Gaps and International
Income Comparisons 444
Relative PPP: Evidence 446
The Long Run: The Monetary Approach
Exchange-Rate Overshooting 452
How Well Can We Predict Exchange
Rates? 455
Four Ways to Measure the Exchange
Rate 457
Summary 459
Key Terms 460
Suggested Reading 461
Questions and Problems 461
Chapter 20
Government Policies toward the Foreign
Exchange Market 464
Two Aspects: Rate Flexibility and Restrictions
on Use 465
Floating Exchange Rate 466
Fixed Exchange Rate 466
Defense through Official
Intervention 470
436
The Role of Interest Rates 437
The Role of the Expected Future Spot Exchange
Rate 438
The Long Run: Purchasing Power Parity
(PPP) 440
449
Money, Price Levels, and Inflation 449
Money and PPP Combined 450
The Effect of Money Supplies on an Exchange
Rate 451
The Effect of Real Incomes on an Exchange
Rate 451
What to Fix to? 467
When to Change the Fixed Rate? 467
Defending a Fixed Exchange Rate 469
Chapter 19
What Determines Exchange
Rates? 433
xxv
Defending against Depreciation 470
Defending against Appreciation 472
Temporary Disequilibrium 474
Disequilibrium That Is Not Temporary
Exchange Control 477
International Currency Experience
The Gold Standard Era, 1870–1914
(One Version of Fixed Rates) 481
Interwar Instability 484
475
480
xxvi Contents
The Bretton Woods Era, 1944–1971 (Adjustable
Pegged Rates) 486
Global Governance The International
Monetary Fund 487
The Current System: Limited Anarchy 492
Summary 496
Key Terms 498
Suggested Reading 499
Questions and Problems 499
Chapter 21
International Lending and Financial
Crises 502
Gains and Losses from Well-Behaved
International Lending 503
Taxes on International Lending 506
International Lending to Developing
Countries 506
The Surge in International Lending, 1974–1982 507
The Debt Crisis of 1982 508
The Resurgence of Capital Flows in the 1990s 509
The Mexican Crisis, 1994–1995 510
The Asian Crisis, 1997 512
The Russian Crisis, 1998 512
Global Governance Short of Reserves? Call
1-800-IMF-LOAN 513
Argentina’s Crisis, 2001–2002 516
Financial Crises: What Can and Does Go
Wrong 517
Waves of Overlending and Overborrowing 517
Extension The Special Case of Sovereign
Debt 518
Exogenous International Shocks 520
Exchange-Rate Risk 520
Fickle International Short-Term Lending 520
Global Contagion 521
Resolving Financial Crises
522
Rescue Packages 522
Debt Restructuring 523
Reducing the Frequency of Financial
Crises 525
Bank Regulation and Supervision
Capital Controls 527
How the Crisis Happened
528
Summary 534
Key Terms 536
Suggested Reading 536
Questions and Problems 536
Chapter 22
How Does the Open Macroeconomy
Work? 539
The Performance of a National
Economy 539
A Framework for Macroeconomic
Analysis 540
Domestic Production Depends on Aggregate
Demand 541
Trade Depends on Income 543
Equilibrium GDP and Spending
Multipliers 543
Equilibrium GDP 543
The Spending Multiplier in a Small Open
Economy 545
Foreign Spillovers and Foreign-Income
Repercussions 547
A More Complete Framework:
Three Markets 549
The Domestic Product Market 550
The Money Market 552
The Foreign Exchange Market (or Balance
of Payments) 554
Three Markets Together 557
The Price Level Does Change 558
Trade Also Depends on Price
Competitiveness 559
Summary 560
Key Terms 562
Suggested Reading 563
Questions and Problems 563
Chapter 23
Internal and External Balance with Fixed
Exchange Rates 565
526
Global Financial and Economic Crisis
Causes and Amplifiers 530
Euro Crisis National Crises, Contagion, and
Resolution 532
528
From the Balance of Payments to the Money
Supply 566
Contents
From the Money Supply Back to the
Balance of Payments 569
Sterilization 572
Monetary Policy with Fixed Exchange
Rates 574
Fiscal Policy w ith Fixed Exchange
Rates 575
Perfect Capital Mobility 578
Shocks to the Economy 580
Internal Shocks 580
International Capital-Flow Shocks
International Trade Shocks 582
Imbalances and Policy Responses
580
584
Internal and External Imbalances 584
Case Study A Tale of Three Countries 586
A Short-Run Solution: Monetary–Fiscal Mix 589
Surrender: Changing the Exchange
Rate 591
How Well Does the Trade Balance Respond
to Changes in the Exchange Rate? 594
Global Crisis Liquidity Trap! 616
Case Study Can Governments Manage the
Float?
619
Global Crisis Central Bank Liquidity
Swaps
622
Summary 623
Key Terms 625
Suggested Reading 625
Questions and Problems 625
Chapter 25
National and Global Choices: Floating
Rates and the Alternatives 628
Key Issues in the Choice of ExchangeRate Policy 629
Effects of Macroeconomic Shocks 629
Case Study What Role for Gold? 631
The Effectiveness of Government Policies 635
Differences in Macroeconomic Goals, Priorities,
and Policies 636
Controlling Inflation 637
Real Effects of Exchange-Rate Variability 639
How the Response Could Be Unstable 595
Why the Response Is Probably Stable 596
Timing: The J Curve 597
Summary 598
Key Terms 600
Suggested Reading 601
Questions and Problems 601
National Choices 641
Extreme Fixes 643
Currency Board 643
“Dollarization” 644
The International Fix—Monetary Union
Chapter 24
Floating Exchange
Rates and Internal Balance
Exchange Rate Mechanism 646
European Monetary Union 647
603
Monetary Policy with Floating Exchange
Rates 604
Fiscal Policy with Floating Exchange
Rates 607
Shocks to the Economy 609
Internal Shocks
Case Study
609
Why Are U.S. Trade Deficits
So Big? 610
International Capital-Flow Shocks
International Trade Shocks 613
xxvii
612
Internal Imbalance and Policy
Responses 614
International Macroeconomic Policy
Coordination 615
Summary 652
Key Terms 653
Suggested Reading 653
Questions and Problems 654
APPENDIXES
A The Web and the Library:
International Numbers and Other
Information 655
B
Deriving Production-Possibility
Curves 659
C
Offer Curves
664
645
xxviii Contents
D The Nationally Optimal Tariff
E
Accounting for International
Payments 673
F
Many Parities at Once
667
677
G Aggregate Demand and Aggregate
Supply in the Open Economy 680
H Devaluation and the Current Account
Balance 690
Suggested Answers to Odd-Numbered
Questions and Problems 694
References
Index
743
731
Chapter One
International
Economics Is Different
Nations are not like regions or families. They are sovereign, meaning that no central
court can enforce its will on them with a global police force. Being sovereign, nations
can put all sorts of barriers between their residents and the outside world. A region or
family must deal with the political reality that others within the same nation can outvote it and can therefore coerce it or tax it. A family or region has to compromise with
others who have political voice. A nation feels less pressure to compromise and often
ignores the interests of foreigners. A nation uses policy tools that are seldom available
to a region and never available to a family. A nation can have its own currency, its own
barriers to trading with foreigners, its own government taxing and spending, and its
own laws of citizenship and residence.
As long as countries exist, international economics will be a body of analysis distinct from the rest of economics. The special nature of international economics makes
it fascinating and sometimes difficult. Let’s look at four controversial developments
that frame the scope of this book.
FOUR CONTROVERSIES
U.S. Exports of Natural Gas
Natural gas has wide-ranging uses as a source of energy, from heating homes and
commercial buildings, to generating electricity, to the production of such products as
steel, paper, cement, and glass, to providing the feedstock for the production of chemicals, fertilizers, and plastics. For the U.S. market for natural gas during the decade to
2006, several trends were clear. U.S. production of natural gas had been about flat
since the mid-1990s. As U.S. consumption increased, imports rose from 13 percent
of consumption in the mid-1990s to over 19 percent in 2006, with nearly all of the
imports from Canada through pipelines. The cost of production from new wells in the
United States (and in Canada) was rising, as the lowest-cost sources (using standard
production technologies) were exhausted. The typical producer price of natural gas in
the United States rose from $2 per million British thermal units (MMBtu) to $6 in the
mid-2000s. The expectation was the United States would soon need to ramp up highcost imports of liquefied natural gas (LNG) to meet continued growth in consumption.
1
2
Chapter 1
International Economics Is Different
Then a revolution in extraction technology hit and everything changed. U.S. producers used the combination of hydraulic fracturing and horizontal drilling (a process called
“fracking”) to extract natural gas from shale deep underground. U.S. production of
natural gas increased by 31 percent during 2006–2013, and imports fell to 11 percent of
U.S. consumption. The typical producer price of natural gas hovered at about $4 during
2009–2013, and the price briefly fell below $2 in early 2012.
As U.S. production continues to increase, U.S. firms should be looking for new
customers. But, if the new customers are foreign, then expanding exports can be controversial, and the United States is a sovereign nation. A 1938 law prohibits exports
unless the exporting firm can convince the government that the exports are in the
“public interest.” The definition of public interest in the law is not precise but broadly
includes adequate supply for domestic users and consumers, environmental impact,
geopolitics, and energy security. (There is an exception for exports to 20 countries
with which the United States has free trade agreements. However, with the exception of South Korea, the most promising potential foreign buyers of U.S. natural gas,
including Japan, India, China, and some European countries, do not have free trade
agreements with the United States.)
Should the United States export more natural gas (than the very small amount it
has been exporting by pipeline to Canada and Mexico)? That is, are larger amounts of
natural gas exports in the U.S. public or national interest? Dow Chemical led a group
of major U.S. users of natural gas that urged caution and limits on U.S. exports. In a
Wall Street Journal article,1 Andrew N. Liveris, chairman and CEO of Dow Chemical,
argued that plentiful low-cost U.S. production of natural gas should be used within
the United States to produce general benefits rather than short-term profits to U.S.
exporters that lead to long-run costs to the rest of the economy. He concluded that the
United States must “consider what is in the nation’s best interest . . . before it exports
all of its gas away.”
How would exports work? The new large buyers would be in Asia and Europe, so
U.S. firms could not send gas to them by low-cost pipelines. Instead, the gas would
need to be liquefied and sent in special ships, an expensive process that costs about
$4 to $5 per MMBtu. Could U.S. firms still make a profit? U.S. natural gas prices are
about $4, so the combined cost of natural gas and getting it to, say Japan, is about $9.
After the tsunami that caused the disaster at Fukushima in 2011, Japan shut down all
of its nuclear generation of electricity and greatly increased its demand for natural gas,
nearly all of which is met through LNG imports. Prices rose to $14 to $19. At these
initial prices and cost, a U.S. firm that could export to Japan would earn a large profit
from the arbitrage ($5 to $10 per MMBtu). The more typical price for Japan LNG
imports has been about $10, so there would still be an arbitrage profit, but it would
not be as large.
What would happen if the U.S. government permitted substantial amounts of
ongoing U.S. exports? Are the effects as dangerous as Dow Chemical suggests? Let’s
preview some of the results from the economic analysis of international trade in
Chapters 2 and 8. First, the United States will not “export all of its gas away.” Instead,
1
Andrew N. Liveris, “Wanted: A Balanced Approach to Shale Gas Exports,” The Wall Street Journal
(February 25, 2013).
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3
the international natural gas market would reach an equilibrium. The extra foreign
demand would increase the U.S. price somewhat. U.S. production of natural gas
would increase somewhat, and U.S. consumption would decrease somewhat. (In an
importing country like Japan, comparable effects would occur. For Japan, which has
almost no domestic production, the price in Japan would fall and consumption would
increase.) Second, there will be winners and losers, as Dow indicates. In the United
States, natural gas producers and export distributors would benefit and U.S. consumers and users would be harmed.
Third, what is the overall effect on the U.S. national interest? Economic analysis
provides a clear answer. If we ignore environmental effects, as Dow does, the United
States gains from the increased exports of natural gas. U.S. producers gain more than
U.S. consumers lose. Interestingly, Dow Chemical will still get much of what it wants
even in this freer trade situation. The large LNG transport costs will keep the U.S.
price low, about $5 less than in importing countries like Japan. Chemical firms and
other industrial users in the United States will still have an advantage internationally
based on their access to relatively low-priced U.S. natural gas.
What about environmental effects? First, noxious chemicals are used in the fracking process, and these can leak into groundwater supplies if the fracking is not done
carefully. Second, burning natural gas releases carbon dioxide, a greenhouse gas that
is contributing to global warming, and there is a risk of leaks of methane, another
greenhouse gas, during the extraction process. A more subtle analysis of the effects
on greenhouse gas emissions would also examine the alternative to increased natural
gas use. For example, if natural gas replaces coal, then the net effect is to lower greenhouse gas emissions. Adverse environmental effects are actual or potential negative
spillovers (a “negative externality”), and the full cost of producing and using natural
gas increases. Chapter 13 provides economic analysis of the interplay between environmental issues and international trade. With external environmental costs, the country will export too much. Most observers think that the risks of chemical leaks are not
large in the United States because government regulations and the threat of damage
lawsuits impel producers generally to be careful. If the net effects on greenhouse gases
are also not that large, then the over-exporting effect is not large.
What has actually happened? As of mid-2014, the U.S. government had only provided full approval to one LNG export facility, and it was expected to begin exporting
at about the end of 2015. Six other facilities had conditional approval that their exports
would be in the public interest, but they had not yet received separate approval for
compliance with environmental and safety norms. Another 26 applications were under
review.
National government officials have the power to enact policies that can limit international transactions like exporting. If the whole world were one country, the issue
of shifts in selling would be left to the marketplace. Within a country, it is usually
impermissible for one region to restrict commerce with another region. But the world
is split into different countries, each with national policies. Overall, the U.S. economy
is likely to benefit from increased exports of national gas. This is the essence of both
comparative advantage as a basis for international trade and the gains from trading,
topics examined in Chapters 2–7. The slow process of facility approval is a reflection
of the controversy about allowing U.S. exports of natural gas. Powerful users like Dow
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Chemical can pursue their own benefits by seeking to limit exports through political
action. Environmental groups can focus on their own interests. Economic analysis
provides a sound way to add everything up to get to the national interest, but that does
not make the controversy go away.
Immigration
About 230 million people, 3 percent of the world’s population, live outside the country
of their birth. For most industrialized countries (an exception is Japan), the percentage of the country’s population that is foreign-born is rather high—14 percent for the
United States and for Germany, 20 percent for Canada, 12 percent for Britain and for
France, 15 percent for Sweden, and 27 percent for Switzerland and for Australia—and
rising. Many of the foreign-born are illegal immigrants—over one-fourth of the total
for the United States. The rising immigration has set off something of a backlash.
In 2007 the U.S. Congress considered and rejected a bill to enact comprehensive
reform of U.S. policies toward immigration. The bill, backed by President Bush and
many congressional leaders, would have shifted U.S. policy toward favoring new
immigrants with more education and skills, created a new temporary guest worker
program, increased requirements for employers to verify the legal status of their
employees, built new fences along the U.S. border with Mexico and added new border
guards, and created a complex process for illegal immigrants to gain legal status. After
different groups in the United States raised their objections, including conservatives
who focused on the latter provision and labeled it an unacceptable amnesty, support
for the bill unraveled. A renewed effort to pass a comprehensive reform of U.S. immigration laws failed to gain traction in Congress in 2013.
In the absence of federal changes, individual states have enacted hundreds of state
laws about immigrants in recent years, many of them tightening up against illegal immigrants. For instance, Arizona has passed a series of laws, beginning in 2004, that stop
government assistance to illegal immigrants (unless federal law explicitly requires it),
that can revoke a firm’s right to do business if it employs illegal immigrants, that make
it a crime for an illegal immigrant to solicit work or hold a job, and that require police to
check the immigration status of any person whom they suspect is an illegal immigrant.
The latter requirement is likely to encourage racial profiling. The sheriff of Phoenix has
been particularly outspoken and aggressive in arresting illegal immigrants.
Anti-immigrant rhetoric and actions have been rising in other countries. Voters in
France, the Netherlands, Austria, Denmark, and Norway have shifted toward candidates who promise to reduce and restrict immigration. In 2014, Swiss voters, driven by
concerns that rising immigration was hurting employment of Swiss nationals, pushing
up housing prices, and overburdening transportation systems, passed the Stop Mass
Immigration referendum to impose numerical limits for foreign workers by 2017. In
Britain, Prime Minister David Cameron pledged to achieve a large reduction in net
migration into the country by 2015. Because Britain cannot do much to limit immigration
from fellow European Union countries, the government has tightened immigration from
other countries, including reductions in visas for college students. In the Australian election of 2010, the leader of one of the two major parties was an immigrant and the leader
of the other was foreign-born to Australian parents. However, both were compelled by
public opinion to promise to substantially reduce immigration by tightening policies.
Chapter 1
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5
Opponents of immigration stress a range of problems that they believe arise from
immigration, including general losses to the economy; the fiscal burden that may arise
from immigrants’ use of government services (such as health care and schooling);
slow integration of immigrants into the new national culture, values, and language;
increased crime; and links of some immigrants to terrorism. What should one make
of the claims of the opponents? Most immigrants move to obtain jobs at pay that is
better than they can receive in their home countries, so it seems important to examine
the economic effects.
How much harm do immigrants do to the economies of the countries they move
to? International economic analysis helps us to think through the issue objectively,
without being diverted by emotional traps. The answer is perhaps surprising, given the
heat from immigration’s opponents.
As we will see in more depth in Chapter 15, such job-seeking immigration brings
net economic benefits not only to the immigrants, but also to the receiving country
overall. The basic analysis shows that there are winners and losers within the receiving
country. The winners include the firms that employ the immigrants and the consumers
who buy the products that the immigrants help to produce. The group that loses is the
workers who compete with the immigrants for jobs. For instance, for the industrialized
countries, the real wages of low-skilled workers have been depressed by the influx of lowskilled workers from developing countries. Putting all of this together, we find that the net
effect for the receiving country is positive—the winners win more than the losers lose.
It is important to recognize economic net benefits, but there will be fights over
immigration as long as there are national borders. National governments have the
ability to impose limits on immigration, and many do. If legal immigration is severely
restricted by national policies, some immigrants move illegally. Migration, both legal
and illegal, brings major gains in global economic well-being. But it remains socially
and politically controversial.
China’s Exchange Rate
An exchange rate is the value of a country’s currency in terms of some other country’s currency. Exchange rates are often sources of controversy, with conflict over the
exchange-rate value of China’s currency (the yuan, also called the renminbi) as the
most intense in recent years.
In 1994 the Chinese government switched from a system of having several different exchange rates, each applying to different kinds of international transactions, to an
unofficial but unmistakable fixed rate to the U.S. dollar. In fact, the exchange rate was
locked at about 8.28 yuan per U.S. dollar from 1997 to 2005. During the Asian crisis
of 1997–1998, the U.S. government praised the Chinese government’s fixed exchange
rate as a source of stability in an otherwise unstable region.
However, by 2003 the U.S. government had begun to complain that China’s fixed-rate
policy was actually unacceptable currency manipulation. In 2004 the U.S. trade deficit
(the amount by which imports exceed exports) with China was $161 billion, a substantial part of the total U.S. trade deficit of $609 billion with the entire world. These deficits
were headed even higher in 2005, and the pressure from the U.S. government intensified.
Bills introduced in the U.S. Congress threatened reprisals, including large new tariffs on
imports from China, unless the Chinese government implemented a large increase in the
6
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exchange-rate value of the yuan. The European Union also had a large trade deficit with
China, and it was also pressuring China to revalue the yuan.
Can keeping the exchange rate steady be manipulation? What this must mean is that
the exchange-rate value should have changed but did not. What was the evidence? The
bottom-line evidence was that, especially after 2001, the Chinese government continually had to go into the foreign exchange market to buy dollars and to sell yuan, to keep
the market rate equal to the fixed-rate target. If it had not done so, the strong private
demand for yuan would have led to a rise in the price (the exchange-rate value) of the
yuan. (Equivalently, the large private supply of dollars that were being sold to get yuan
would have led to a decline in the value of the dollar against the yuan.)
There was evidence that the exchange-rate value of the Chinese currency was too
low, but by how much? Various estimates of the degree of undervaluation were offered
by economists, and most were in the range of 15 to 40 percent. Even for the experts,
there are challenges in making this estimate.
First, while China had substantial trade surpluses with the United States and the
European Union, it had trade deficits with many other countries, including South
Korea, Thailand, the Philippines, Australia, Russia, Japan, and Brazil. Overall China
had a trade surplus. It was not that large in 2004, though it was increasing.
Second, China has a remarkably high national saving rate. For a typical developing
country, its low saving rate usually leads to a trade deficit, but China is not typical. So
there is some economic sense for China to have a trade surplus.
Third, as the official pressure built on the Chinese government to change the
exchange rate, private speculators began to move “hot money” into the country in
the hopes of profiting when the value of the yuan increased. A substantial part of the
government’s purchase of dollars was buying this hot money, and the hot money flow
will reverse once the speculators think that the play is done.
For a few years, the Chinese government resisted the foreign pressure to change
its exchange-rate policy. The fixed exchange rate to the U.S. dollar had served the
Chinese economy well. The Chinese government did not want to appear to be giving
in to the foreign pressure, and it stated repeatedly that it alone would make any decisions about its exchange-rate policy as it saw fit for the good of China’s economy.
Then, on July 21, 2005, the Chinese government announced and implemented
changes in its policy toward the exchange-rate value of the yuan. It increased the value
from 8.28 yuan per U.S. dollar to 8.11 yuan per dollar, a revaluation of 2.1 percent.
(Yes, that does look odd, but the lower number means a higher value for the yuan.
Welcome to the sometimes confusing world of foreign exchange. As stated, the numbers show a decrease in the value of a dollar, which is the same as an increase in the
value of the yuan.) Thereafter, the Chinese government followed a policy best described
as a “crawling peg,” in which the government allows small daily changes that result in
a slow, tightly controlled change over time in the exchange-rate value. By July 2008
the yuan had increased by a total of about 21 percent, to a value of about 6.83 yuan per
dollar. But the Chinese government was worried about the worsening global financial
and economic crisis. The government decided to return to a steady fixed rate to the U.S.
dollar, and the yuan was kept at about 6.83 per dollar for nearly two years.
China continued to run a trade surplus and foreign investment continued to flow into
China. China continued to intervene in the foreign exchange market, buying dollars
Chapter 1
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7
and selling yuan, to prevent the yuan from appreciating. China continued to add the
dollars to its holdings of official international reserve assets. These government holdings of foreign-currency-denominated financial investments and similar assets had been
$166 billion at the beginning of 2001, grew to $711 billion in mid-2005, and reached
$2.45 trillion by mid-2010.
As the world recovered from the worst of the global crisis, the United States and
other countries resumed pressure on China to increase the exchange-rate value of the
yuan. Although again there was a wide range of estimates, a number of credible analysts
concluded that the yuan was still undervalued by perhaps 15 to 30 percent. On June 18,
2010, the Chinese government resumed allowing a slow increase in the exchange-rate
value of the yuan, and by August 2014 it rose in value by another 11 percent.
While foreign pressure may have had some effect, the most important reason
that China’s government resumed yuan appreciation was that conditions in China’s
national economy had changed. As the government intervened in the foreign exchange
market to buy dollars, it was also selling yuan. The yuan money supply in China grew
too rapidly, encouraging local borrowing and spending that created upward pressure
on the inflation rate in China. Given these conditions, the increase in the exchange-rate
value of the yuan can assist the Chinese government to manage its domestic economy
better, through at least three channels. First, it lowers import prices in China, thereby
reducing inflation pressures in China. Second, it slows the growth of China’s exports,
removing some of the demand pressure on the prices of resources and products. Third,
it reduces the amount of intervention needed, reducing the pressure for growth of
China’s domestic money supply.
The international controversy over China’s exchange rate was very much alive
in mid-2014, as exchange market intervention continued and China’s official international reserves rose to a staggering $4 trillion in June 2014. As the conflict over
China’s exchange-rate policy shows clearly, policy decisions by one country have
effects that spill over onto other countries. The exchange rate is a key price that affects
international trade flows of goods and services and international financial flows.
In the second half of this book, we will examine in depth many of the issues raised
in the description of this controversial situation. For example, in Chapter 16 we will
examine trade surpluses and trade deficits in the context of a country’s balance of
payments. In Chapter 18 we will explore foreign financial investments and the role
of currency speculation. In Chapters 22–24 we will examine how exchange rates and
official intervention in the foreign exchange market affect not only a country’s trade
balance but also its national production, unemployment, and inflation rate. And in
Chapters 20 and 25 we will look at why a country would or would not choose to have
a fixed exchange rate.
Euro Crisis
The European Union (EU), founded in 1957–1958, is the most successful regional
trade agreement. It has expanded from 6 countries to 28 and has largely eliminated
barriers to trade in goods and services and movement of people and financial capital
among its member countries. As a major step toward economic and monetary union,
11 EU countries established the euro as their common currency in 1999, with the
European Central Bank (ECB) in charge of monetary policy for the new euro area.
8
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International Economics Is Different
In its first decade the euro worked well. With national currencies replaced by the
euro, the transactions costs of doing business across euro-area countries fell, risks of
unexpected exchange-rate changes within the area were eliminated, international trade
among the euro-area countries increased, and financial markets became more integrated. By 2009 the number of EU countries in the euro area had increased to 16 (and
two more would join by 2014). The annual growth of real GDP for the euro area was
a little more than 3 percent during 2006–2007, unemployment fell below 8 percent,
and the annual inflation rate was a little above 2 percent.
The global financial and economic crisis began in 2007. The United States had had
a credit boom that increased debt generally, with a surge specifically in sub-prime
mortgages, those made to high-risk borrowers, that were then packaged into debt
securities and sold to investors. The credit boom had funded a housing bubble, with
U.S. housing prices rising rapidly and peaking in April 2006. When sub-prime mortgages increasingly went into default, investors, including many financial institutions,
that had purchased the mortgage-backed securities suffered losses. Short-term debt
markets froze as financial institutions and other investors became wary of lending to
other financial institutions.
The global crisis intensified with the failure of Lehman Brothers in September
2008. Europe was involved in four major ways. First, some European countries had
their own credit booms, with housing bubbles in Ireland, Spain, and several other
countries. Second, many European banks bought mortgage-backed securities and suffered losses on their holdings. Third, the freezing of short-term funding markets hurt
many European banks. Fourth, the recession that began in the United States spread to
other countries. As U.S. production and income declined, the United States imported
fewer foreign goods and services. That is, other countries exported less, and aggregate
demand for their products fell.
Along with the rest of the world, the euro area went into a deep recession, with real
GDP falling by over 4 percent during 2009. Government policy responses, including
aggressive actions by the U.S. Federal Reserve, had largely stabilized financial markets by late 2009. The recession in the euro area ended in mid-2009, and it looked like
the euro area was on a steady path to recovery.
Two festering problems were about to explode, causing several national crises that
eventually threatened the euro’s existence. First, the recession drove increased fiscal
deficits in most euro-area countries. Greece’s fiscal deficit was almost 16 percent of
its GDP in 2009, and its outstanding government debt rose to 130 percent of its GDP.
Second, burst housing bubbles in some countries led to rising defaults on mortgages,
threatening the solvency of the banks that had made the loans. The Irish government
addressed the weakness of its banking system by decreeing in 2008 that the government guaranteed all deposits and debts of large Irish banks. As bank losses mounted,
the government provided massive assistance. Ireland’s fiscal deficit jumped to
30 percent of its GDP in 2010, and outstanding government debt rose from 25 percent
of GDP in 2007 to over 100 percent by 2011.
With the success of the euro in integrating financial markets across the euro area,
and with generally strong economic performance, the interest rates on the government
debts of different countries were very close to each other up to 2008. Essentially,
the markets viewed the credit risk of the Greek government and other euro area
Chapter 1
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9
governments to be nearly the same as the risk of the German government. In 2009,
with the realization that the Greek deficit was much larger than the Greek government had previously indicated, the interest rates on Greek government debt began
to rise well above those for Germany’s government debt, with the interest rate on
10-year Greek government bonds close to 5 percentage points higher by April 2010.
The Greek government concluded that it could not take on such expensive financing, and the euro crisis began. In May 2010 the Greek government received a bailout
package of €110 billion (equal to U.S. $138 billion at the exchange rate at that time
of about $1.256 per euro), funded by the other euro-area countries through the newly
formed European Financial Stability Facility (EFSF), the EU, and the International
Monetary Fund. To access periodic loans to cover its fiscal deficits, the Greek government had to reduce its fiscal deficit over time by reducing government expenditures
and raising taxes, and to enact structural reforms to loosen regulations on labor markets and product markets.
Driven by concerns about the rising costs of the bank bailouts, the interest rates on
Irish government debt spiked beginning in March 2010. In November the euro crisis
spread, with the Irish government receiving a bailout package that totaled €85 billion.
In Portugal a credit boom led to a mix of excessive government debt and excessive
private debt. The interest rates on Portuguese government debt rose rapidly, and the
Portuguese government received a bailout package of €78 billion in May 2011.
Investors increasingly wondered about other euro countries, and the euro crisis
expanded and intensified in mid-2011. Spain had its own housing bubble that had
burst in late 2007, and a number of Spanish banks were shaky. The Spanish fiscal deficit was close to 10 percent in 2009 and 2010, and it was expected to continue at that
high level. Yet, Spain began with a relatively low government debt, so that by 2010 its
outstanding government debt was only about 60 percent of its GDP. Still, beginning
in April 2011 nervous investors drove up interest rates on Spanish government debt.
Italy had a large outstanding government debt, which had been above 100 percent
of GDP since the euro began, but it had a relatively manageable fiscal deficit, below
5 percent in 2010 and falling. Nonetheless, interest rates on Italian government debt
spiked beginning in June 2011. And, by July 2011, jitters in the debt markets increased
generally as euro-area leaders began to discuss that Greece would have to default on
it government debt, and as fears intensified that Greece would be forced to try to find
a way to exit from the euro.
Spain and Italy were too large—the EFSF and the International Monetary Fund did
not have enough resources to provide Spain and Italy with bailout packages comparable
to those provided to Greece, Ireland, and Portugal. The European Central Bank (ECB)
had the resource capability to respond, but its role had been limited, and even somewhat
perverse, to this point in the euro crisis.
By statute the ECB’s primary objective is price stability (a low inflation rate,
defined as less than but close to 2 percent), and the ECB is prohibited from direct lending to national governments or direct purchase of national government debt. Although
not prohibited, the ECB was reluctant to purchase existing national government debt
in secondary markets as this was viewed as too close to direct purchase. Through
its new Securities Market Program, the ECB purchased modest amounts of existing Greek, Irish, and Portuguese government bonds during May 2010–March 2011,
10 Chapter 1
International Economics Is Different
and modest amounts of Spanish and Italian government bonds during August 2011–
February 2012, with total purchases of about €212 billion. Yet, in 2011, the ECB also
became worried that the area’s inflation rate was rising above its target. In two steps
(April and July) it raised its interest rate target (in the middle of the crisis) by half a
percentage point, even as a new euro-area recession began in the middle of the year.
The ECB reversed the interest rate increase in December.
By November 2011 the interest rates on 10-year Spanish and Italian government
bonds were 4–5 percentage points higher than the rates on comparable German bonds.
In December the ECB finally swung into serious action, announcing a series of two large
offerings (December 2011 and February 2012) of long-term loans to banks in the euro
area. The banks, net new borrowing was about €520 billion in total. Banks used some
of these funds to buy government bonds, and Spanish and Italian interest rates declined.
The respite was short-lived. In March 2012 the Greek government received a second bailout program that added €130 billion to the first one, and the Greek government
defaulted on its privately held bonds, decreasing its outstanding debt by €100 billion.
Investors again became worried about risks in individual euro-area countries and risks
to the continued existence of the euro. Interest rates on Spanish and Italian government bonds jumped again.
On July 26, 2012, ECB President Mario Draghi delivered a speech that more fully
addressed the crisis and began to wind it down. He stated that “the ECB is ready
to do whatever it takes to preserve the euro. And believe me, it will be enough.” In
September the ECB approved the new Outright Monetary Transactions program. To
prevent distortions in financial markets, the ECB is willing to purchase potentially
large amounts of national government bonds if the government also has a program
with the European Stability Mechanism (ESM—the EU is fond of acronyms), which
replaced the EFSF. The ECB insisted on a program with the ESM because the ESM
imposes conditions for national adjustment (the ECB cannot do so).
In July the interest rates on Italian, Spanish, Greek, Portuguese, and Irish bonds
went into rapid decline, and by 2014 all 10-year bond rates except those of Greece
were back to within 2 percentage points of the rates on German government bonds.
The worst of the euro crisis was over, although in late 2012 Spain received a loan
from the ESM to recapitalize its banks and in March 2013 Cyprus received a bailout
program.
Each country must choose a policy for the exchange rate (international value) of its
currency, and the countries of the euro area have chosen monetary union, an extreme
and controversial form of “fixed exchange rates” within the area. Monetary union
is a step well beyond a regional trade bloc, and we discuss the euro and its crisis
throughout the second half of the book. In Chapter 16 we examine current account
balances and net international financial asset positions as indicators of potential problems in the countries at the center of the euro crisis. In Chapter 21 we describe and
analyze financial crises that have occurred during the past 40 years, and we explicate
the euro crisis as a set of three mutually reinforcing crises—sovereign (government)
debt crisis, banking crisis, and macroeconomic performance crisis. In Chapter 25 we
specifically analyze the benefits and costs of European Monetary Union. Two controversies emerge. First, what is the cost to a member country of giving up both national
monetary policy and the ability to change its exchange rate with other member
Chapter 1
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11
countries? Second, is it possible to manage the tension between national fiscal policy
as an important tool for the government to improve the country’s macroeconomic
performance and national fiscal policy as a source of instability (and even crisis) for
the monetary union?
ECONOMICS AND THE NATION-STATE
It should be clear from the four controversies described above that international economics is a special field of study because nations are sovereign. Each nation has its
own government policies. For each nation, these policies are almost always designed
to serve some group(s) inside that nation. Countries almost never care as much about
the interests of foreigners as they do about national interests. Think of the debate about
U.S. exports of natural gas. How loudly have Americans spoken out about the harm to
Japan because of the high cost of its natural gas imports?
The fact that nations have their sovereignty, their separate self-interests, and their
separate policies means that nobody is in charge of the whole world economy. The
global economy has no global government, benevolent or otherwise. It is true that
there are international organizations that try to manage aspects of the global economy,
particularly the World Trade Organization, the International Monetary Fund, the
United Nations, and the World Bank. But each country has the option to ignore or defy
these global institutions if it really wants to.
Among the most important policies that each country can manipulate separately
are policies toward the international movement of productive resources (people and
financial capital), policies toward government taxation and spending, and policies
toward money and exchange rates.
Factor Mobility
In differentiating international from domestic economics, classical economists
stressed the behavior of the factors of production. Labor, land, and capital were
seen as mobile within a country, in the sense that these resources could be put to
different productive uses within the country. For example, a country’s land could
be used to grow wheat or to raise dairy cattle or as the site for a factory. But, the
classical economists believed, these resources were not mobile across national
borders. Outside of war land does not move from one country to another. They also
downplayed the ability of workers or capital to move from one country to another.
If true, this difference between intranational factor mobility and international factor
immobility would have implications for many features of the global economy. For
instance, the wages of French workers of a given training and skill would be more or
less the same, regardless of which industry the workers happened to be part of. But
this French wage level could be very different from the wage for comparable workers
in Germany, Italy, Canada, or Australia. The same equality of return within a country,
but differences internationally, was believed to be true for land and capital.
This distinction of the classical economists is partly valid today. Land is th...
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