This summary on International Economics is written 2012-2013 - the title of the book the summary is based on is unknown - when you know - please leave a note in the 'comment' section

Chapter A: Globalisation

Globalisation is the growth of international economic activity relative to overall
economic activity. It can also be defined as the “increase in international trade as a percentage of world output, the increase in international investment as a percentage of total world investment, and the increase in the proportion of people living and working in countries other than their country of birth.” Globalisation can therefore be split up into three components:

• International trade.
• International investment: the acquisition of assets located in one country by another country.
• International migration.

International trade, international investment, and international migration have been expanding rapidly since World War II, and this wave of globalisation has been accompanied by unprecedented rates of economic growth. Looked at over a longer horizon, globalisation has been part of a 200-year burst in economic growth that has taken the world to levels of human welfare not even imaginable for most of human history. Globalisation has expanded and contracted throughout human history, and even over the past century the process has fluctuated greatly.  
 
Economic models are useful because they provide a formal, logical, and simplified framework of economic activity that aid in the comprehension of the working of the real economy and the influence of economic policies on economic outcomes. There are four types of economic models:
 
Partial equilibrium model:
Focuses on individual markets, firms, and industries (one sector of the economy while the situation in rest of the economy remains constant). Helps to highlight some details about international trade that are less obvious in the general equilibrium models.  
 
General equilibrium model:
Traces the economy-wide and worldwide effects of trade, investment, and immigration.  Takes into account the need to simultaneously maintain equilibrium in all sectors of the economy.
 
Static model:
Describes how key variables will eventually change as a result of a one-time change in policy or economic circumstances. Does not show how long it takes an economy to achieve its final equilibrium of how the variables change during the transition.
 
Dynamic model:
Describes the path of change of variables over time as a result of a one-time change or continued changes in policies or external circumstances. Two-country models show that international trade, international investment, and immigration have effects on foreign economies, thus making it clear that international economic activities have international consequences.
 
The linkages are between:

• Present economic events and past economic events,
• Present economic events and other present economic events,
• Present economic events and future economic events.

 
There is, therefore, interdependency between events in an open economy. An open economy is an economy that does not severely restrict international trade, international investment, and international migration and permits these international economic activities to interact with domestic economic activity. Openness in an economy may boost economic growth but it does not automatically imply convergence.  
 
In the year zero (B.C./ A.D.), the average per capita income was $444 U.S. After the beginning of trade and the launch of technology, which increased productivity and opened up the economy, GDP skyrocketed. This occurred around 1870 B.C.  
 
According to David Ricardo, nations trade due to comparative advantages (L-productivity differences). This is referred to as the classical explanation of trade. The neoclassical explanation, according to Heckscher and Ohlin, nations trade due to different factor endowments and f-intensities. Four famous theorems are the HOS, Factor Price Equalization, Stolper-Samuelson, and Rybzinski theorems. Newer theories (added since 1976) have shown that nations trade due to economies of scale (increasing returns to scale) and due to imperfect competition.

Chapter B: Open Economies

The Circular Flow of an Economy
In this global economy, national economies are linked to the rest of the world's
economies in a variety of ways. The circular flow diagram makes it clear how the
different sectors of an individual economy are linked together and that a change in behaviour in any one sector affects all other sectors.  
 
An economy exists in the simplest case of households and producers. In a more
complex case, an economy also contains the government and the financial sector. It would still be an example of a closed economy, however, because it excludes interactions with the rest of the world.
Adding a foreign economy allow the economy of a country to import and export consumption and intermediate goods, and invest in capital and government goods. Additionally, international transfers by individuals and governments, international asset sales and purchases, and returns to foreign-owned assets can take place.
 
Individuals, firms, and governments of an open economy export goods and services to and import goods and services from individuals, firms, and governments in other countries. Individuals, firms, governments, and financial intermediaries in an open economy sell assets to and buy assets from individuals, firms, governments, and financial intermediaries in other open economies. Foreign investment generates earnings flows in the form of profits, dividends, interest payments, capital gains, royalties, and rents.  
 
The sum of all these international transactions depends on the incentives faced by the individual consumers, producers, savers, investors, and government officials who actually carry out the transactions, but choices are constrained by the interdependence of all economic activity.
A large part of international trade in intermediate goods is explained by outsourcing. Vertical specialization is related to the increasing trend for firms to engage in outsourcing of certain parts of a production process. Vertical specialization is the common situation where producers acquire materials, parts, components, etc., from other firms so that they can concentrate on one stage of production rather than all stages.  
 
Balance of Payments
The balance of payments (BOP) account is where all international transactions related to trade and investment are recorded according to a standard format. The debit and the credit side on the balance of payment should be equal; there should never be a BOP deficit or surplus. On the debit (left hand) side of the BOP, the import goods and services are recorded, and on the credit (right hand) side of the BOP, the export goods and services are recorded. 
 
Every transaction that takes place must be recorded on both the debit and the credit side of the BOP. For example, if the U.S. sends blankets to Asia for relief, the amount is recorded on the credit side but also on the debit side as a gift. Although the balance of payments data are difficult to compile and somewhat inaccurate, they still present a reasonably good picture of recent trends in globalisation. The United States today trades and invests across its borders to a greater extent than ever before.  
 
The BOP consists of a current account and a capital account (now called the financial account). The current account records the value of a country's international trade of goods and services, factor payments and asset returns. The financial account lists a country's international payments related to the sale and purchase of assets.  
 
A surplus on the current account is a net capital export. A deficit on the current account is a net capital import. The U.S. balance of payments in 2001 showed a very large current account deficit and an equally large financial account surplus. They therefore covered their deficit on the current account with a surplus on the financial account to still obtain a net BOP equal to approximately zero.  In 2002 there was concern about whether the U.S. current account deficits were sustainable and how an eventual adjustment would affect the U.S. and foreign economies.  
 
The net flow of payments for goods and services (X-IM), asset purchases (S_F) returns on accumulated foreign assets (r_F), and transfers across a country’s border (Tr_F) must equal zero. To summarize this into a formula: (X-IM) + S_F + r_F + Tr_F = 0. The current account equals (X-IM) + r_F + Tr_F and the financial account is denoted by S_F. Since the sum of the BOP must equal zero (foreign payments must equal foreign receipts), the current account must equal the foreign account. We therefore obtain the following equation:
 
  (X-IM) + r_F + Tr_F = S_F.
 
The net sum of the value of the foreign assets and domestic assets is referred to as the international investment position.  The international investment positions of countries show that the growth in international investment has increased cross-border ownership sharply throughout the world over the past two decades.  
 
The U.S. used to have the highest international investment position of the world. The domestic owned assets were higher than the foreign owned assets. However, the foreign owned assets have increased more rapidly (and has now surpassed) the domestic owned assets, resulting in a negative international position. This is explained by the large surplus on the financial account. The growing negative net investment position of the United States is a logical counterpart to the large financial account surpluses in the U.S. balance of payments over the past two decades. The U.S. current account and net investment position deficits were necessarily matched by other
countries' surpluses.  
Foreign Exchange Rates
The growth of international transactions has increased the size of foreign exchange markets, which includes all markets where national currencies are exchanged and exchange rates are determined for most currencies. The forces of supply and demand determine the foreign exchange rate, which in equilibrium are equal. In this state the BOP also has a net sum of zero of international payments.
 
Exchange rates are important because they state one country's prices in terms of
another country's and, hence, help determine the competitiveness of exporters in foreign markets and importers in domestic markets. Exchange rates are determined by the flows of payments recorded in the balance of payments; shifts in exports, imports, transfers, asset returns, and international investment alter exchange rates. Exchange rates are the 'prices' that balance flows between countries. Exchange rates also aid in explaining the changes in the U.S. balance of payments over the past few decades.

Chapter C: A General Equilibrium View of the Gains of Trade

There are always two basic ways of producing every product: make it yourself or make something else and exchange it for the desired product. The former option is referred to as direct production and the latter option is referred to as indirect production. The foreign revenue acquired from an export is used to acquire the desired product overseas. International trade reduces the opportunity costs of indirectly producing importable products. Opportunity costs state the costs of doing one thing in terms of the other things that could have been done had the resources not been used to perform the first task. lnternational trade can be viewed as a form of technological progress because the shift from self-sufficiency to free trade increases the amount of real output the economy provides its citizens by using its available resources.  
 
The better way to produce a product, directly or indirectly, is the one that uses the fewest resources, and therefore, has the lower opportunity cost in terms of foregone production of other welfare-enhancing goods and services.  
 
The differences in views of international trade probably reflect the fact that, in the words of Frédéric Bastiat as quoted at the start of this chapter, the public 'takes account of the visible' and economists take 'account both of the effects which are seen, and also of those which it is necessary to foresee.'  
The Small-Country General Equilibrium Model

The small country general equilibrium model of international trade shows that
international trade permits an economy to exchange less valued goods and services for more highly valued goods and services, and it permits producers to specialize by producing the products for which they enjoy a comparative advantage. The model also shows that when an economy opens its borders to international trade, all other things equal, one industry expands and the other contracts, and consumers reallocate their income.  
 
General equilibrium is needed to break open the closed economy. Protecting import-competing industries reduces production in export industries. A general equilibrium model illustrates the complete economy instead of just one economic sector, and it shows that trade affects all sectors of that economy. ln general, whenever the relative prices of goods are not the same at home and abroad, international trade improves national welfare.
 
The small country general equilibrium model assumes that foreign prices and quantities produced by foreign industries aren’t influenced by the actions of citizens. It only shows how one country is affected by international trade and it assumes that other countries aren’t affected. The world price ratio is therefore treated as constant.
 
The small country general equilibrium model uses a production possibilities frontier (PPF) to represent the supply side of the economy. It reflects all the possible combinations of products that a country can produce/ supply which fully exhaust the available amount of resources and technology. In the textbook a specific example is used in which the PPF line depicts the possible combinations of the products food and clothing which fully exhaust the available amount of technology and capital labour. No points on the graph that extend beyond the PPF line are possible combinations of food and clothing. A closed economy must produce and consume at points located on or below the PPF line.  
 
The PPF line also represents the amount of one good a producer must give up in order to be able to produce an additional other good. The more a producer can produce of one good, the more valuable the other good becomes.  
 
The increasing opportunity cost and preference of customers for variety is reflected in the bow of the PPF line. Such a PPF curve is said to be concave to the origin. The opportunity costs of production are equal to the marginal benefits of consumption when the PPF line and the indifference curves are tangent. Indifference curves represent the demand side of the economy and consumer preferences. The point at which the indifference curves and the PPF line intersect (have the same slope) produces the welfare-maximizing production/ consumption function. At this point, the trade-off permitted by the PPF is exactly the trade-off that people would be willing to accept.
 
If the world price ratio differs from the domestic price ratio, an open economy can use foreign trade to reach consumption outside its PPF. The world price ratio is equal to the slope of the consumption possibilities line (CPL). The CPL reflects all the possible combinations of products that a consumer can select given their real income and the relative prices of goods. The CPL also represents the amount of one good a consumer must give up in order to be able to consume an additional other good. The more a consumer has of one good, the more valuable the other good becomes.  
 
If a small open economy continues to produce at the point where the PPL intersects the indifference curve, it can consume anywhere along the CPL. Welfare maximization will now be at the point where the indifference curve is tangent to the CPL. At this point, the relative marginal gains are equal to the world price ratio (denoted by r). The fact that trade permits an open economy to attain a consumption point that lies outside of its PPF implies that the economy can achieve a greater amount of real output for the same amount of available productive resources. This is called economic growth.  
 
In the process of specialization (referred to as division of labour by Adam Smith), people increasingly concentrate on a few tasks rather than performing every job necessary for their existence. When combined with exchange, it permits them to produce greater amounts of real output. By specializing, production is shifted and an even higher CPL can be reached. A combination of exchange and specialization therefore allows a country to obtain a higher welfare level since a higher indifference curve comes within reach. Similarly, trade and growth also achieve synonymous welfare gains.   
 
Gains from international exchange refer to the gains in welfare that result from the ability to exchange goods with foreigners. Thereby domestic consumers can substitute relatively cheaper foreign products for relatively more expensive domestic products. They can now spend their real income in the world market instead of just in their domestic market. It is important to note that the benefits from trade are derived from importing, not exporting. How much a country gains from trade depends on how many imports it gets in exchange for what it exports. Most people, however, make the mistake of equating exports with national welfare, while exports are actually the cost of acquiring imports.
 
Gains from specialization are the gains an country can derive by shifting domestic production of goods that are relatively cheaper overseas to goods that are relatively more expensive in the rest of the world. An open economy thereby shifts resources to where opportunity costs reflect the world price ratio for goods.
 
Exchange and specialization must go hand in hand, since although an economy can gain from exchange without specializing, but it cannot gain from specialization without trading with foreigners. By specializing, open economies can gain more from trade.  
 
The Two-Country General Equilibrium Model
Although every country has a different PPF line, all countries gain from trade.  This is illustrated by the two-country general equilibrium model. This model shows that international trade changes production and consumption patterns in both domestic and foreign economies. Say we have two countries, each with a unique PPF line, that begin engaging in trade (with no barriers to trade and no transportation costs). One country’s exports are the other country’s imports. They also specialize in the products for which it has the lower opportunity costs. Consequently, the relative price line in each country shifts in the direction of the other country’s price ratio until relative prices are equal in both countries. Each country attains a higher indifference curve, production and consumption shifts, and welfare increases.
 
The two-country general equilibrium model is slightly altered when relative prices differ due to preferences. Each country will consume more of the product it “prefers” and thereby exchange more of the other product to obtain more of the preferred product. Preferences change as people’s incomes rise. The indifference curves will therefore differ between in high-income economies and low-income economies. Income elasticity of demand for a product equals the percentage change in the quantity demanded relative to the percentage change in income. Engel’s law states that the proportion of national income that is spent on an inferior product like food declines as economies grow and per capita income rises due to the low elasticity of demand for food is low (less than one). Another alternative model includes PPF lines which are bowed inward
rather than outward, in which case the opportunity costs decrease as production levels increase.
 
The two-country general equilibrium model also predicts that countries will trade more if their PPF’s and opportunity costs differ a lot. Yet in reality, however, dissimilar countries do not always trade more than similar countries. Most trade occurs among similar highly-developed economies. In 1998, 58.5% of trade was between high-income countries. The trade between high-income economies and low/middle-income economies (dissimilar economies with different productive capacities) totalled about one-third of world merchandise trade in 1998.    
 
Comparative Advantage
The two-country general equilibrium model illustrates the principle of comparative advantage, which says that countries will export goods that have relatively low opportunity costs at home and import those that have relatively high opportunity costs.
 
Comparative advantage is synonymous to relative advantage, but not to absolute
advantage, which was exposed by Adam Smith. He published this concept in his book Wealth of Nations which was published in 1776. The economist who is usually credited with first exposing the concept of comparative advantage is David Ricardo, who described comparative advantage in his 1817 book On the Principles of Political Economy and Taxation. Ricardo demonstrated that trade was beneficial whenever countries had different opportunity costs and, therefore, a comparative advantage, regardless of whether they had an absolute advantage in producing anything.  
 
We will now look at two examples to illustrate the concept of comparative advantage. We assume that all following production lines take the same amount of capital, so we look at the labour cost.

It is logical that country A will specialize in Product X and Country B will specialize in Product Y. Both countries have both an absolute and a comparative advantage in producing their respective products. We will now look at an example in which Country A has an absolute advantage in producing both product X and Y, but only a comparative advantage in producing Product X
 
Again labour costs of production are illustrated. If we look at the ratios of producing product X against producing product Y, we see that for country A this is a ratio of 2 to 3, while for country B this is a ratio of 2.5 to 3. Therefore, country A has a comparative advantage in producing product X and country B has a comparative advantage in producing product Y.  
 
The two-country general equilibrium model of international trade is the most popular version of the Heckscher-Ohlin (HO) model. This model illustrates that countries import the good in which they have no comparative advantage and that they export the good in which they do have a comparative advantage.  
 
Exchange rates translate domestic price levels into a common unit of account that permits individual exporters and importers to make the decisions that result in an economy exploiting its comparative advantage.  
 
Increasing Returns to Scale and Trade
Nations trade with each other because the people, firms, and governments in each nation are motivated by price differences caused by differences in factor endowments, technologies, consumer tastes, or increasing returns to scale. Increasing returns to scale can also be called economies of scale and represents a situation where the unit cost of production decreases when overall levels of production increase.
 
Intra-industry trade is the international trade of products that are produced in the same industry. The apparent conflict between the general equilibrium model of international trade, the observations that a large proportion of trade is intra-industry trade, and that most trade takes place among similar countries has been partly addressed by developing the increasing returns to scale model.  
 
The increasing returns to scale model of trade drops the assumption of perfect
competition and instead assumes that producers become more efficient and prices drop as they produce larger quantities of similar products. In this case, not only dissimilar but also similar countries can enjoy higher welfare levels from trade.   
 
A country can obtain a more favourable trade-off between lower prices and costs from increasing returns to scale and greater variety from a larger number of industries if nations can trade freely.  

Chapter D: A Partial Equilibrium View to Why Nations Trade

We will now concentrate on how individual markets, producers, and consumers are affected by trade using the partial equilibrium model of international trade, which focuses on one market or one segment of the economy and ignores what happens elsewhere. Partial equilibrium models are useful for studying important details about the causes and effects of international trade.  
 
A partial equilibrium supply and demand model for a single market can be derived from the general equilibrium model that we used in the previous chapter to represent the whole economy. Partial equilibrium models may better reflect the incentives that drive individual behaviour since the aggregate gains in welfare described by general equilibrium models are the net outcome of economic activities undertaken by individuals who pursue their own interests and are not aware of exactly how their particular activity affects the overall welfare of society.  Yet partial equilibrium models are quite unrealistic in that they “assume all other things remain equal”.
 
The two-country partial equilibrium model also lets us estimate the changes in
consumer and producer surplus in two countries. Producer surplus represents the net gain to producers from being able to participate in a particular market. Producer surplus equals the total revenue minus the marginal variable costs. To put this into a formula: PS =TR – MVC. Consumer surplus represents the net gain to consumers from being able to participate in a particular market. Consumer surplus equals the marginal revenue minus the price. To put this into a formula: CS = MR – P. The sum of the producer surplus and the consumer surplus equals the total gains in exchange. You can see this on the following slide copied here below:
 
The partial equilibrium approach complements the general equilibrium approach in that it also finds net welfare gains from free trade in each country that participates in trade. The partial equilibrium model of trade also shows that in each country there are gains as well as losses, but in each case the gains are greater than the losses so that free trade brings net gains to both countries. Import-using consumers gain and import-competing domestic producers lose welfare, but the consumers gain more than the import-competing firms lose. In the case of exports, consumers lose welfare when the competition from foreign consumers forces them to pay more for products, but the exporting producers gain more welfare than the consumers lose. The two-country partial equilibrium model of trade provides a convenient framework for estimating the market-by-market welfare effects of an economy's shift from self-sufficiency to free trade.  
 
Transportation costs drive a wedge between what a producer earns from exports and what a foreign consumer pays for those same imported goods. Economic history makes it clear that transport costs are important determinants of international trade, and the declines in transportation costs have played a very important role in expanding world trade, as the transport cost model suggests.
 
An increase in transport costs reduces the gains from trade for both the importing and exporting countries. A decline in transport costs increases the gains from trade. Most of the increase in trade during the past two centuries is due to improvements in the efficiency of transportation.
 
Many factors make exporting and importing difficult, and the costs that exporters and importers face help to explain why international trade is much smaller than our models of trade predict. The finding that international trade is much smaller than trade theory predicts is often referred to as 'the missing trade.' An often ignored reason why international trade is not as large as models suggest is that trade requires costly and difficult international marketing.  
 
Shrinkage implies the damage and theft that result in not all shipped goods reaching their destination.
 
Estimates of the gains from trade based on partial equilibrium analysis and actual supply and demand curves suggest that the gains from trade are 1 to 2 percent of GDP, which is much smaller than economists' enthusiasm for free trade suggests. The partial equilibrium models do not capture other gains from trade, however.  
 
Profit-maximizing firms equate marginal revenue with marginal cost. Monopolists, however, do not do so because they can manipulate price (since they are the price-setters). The result is that prices exceed marginal cost, and the quantity supplied is less than it would be under perfect competition. The consequent loss in total welfare is therefore reduced by the “dead-weight” loss of imperfect competition. A dead-weight loss is a welfare loss caused by a certain distortion. International trade, however, can negate this dead-weight loss and reduce monopoly profit. International trade increases the level of competition in an individual economy, which changes how producers behave and, possibly, improves efficiency and speeds up technological progress.
Increased competition also reduces discrimination and waste. X-efficiency is a concept of Harvey Leibestein, which states that efficiency in production is determined by competitive conditions. It is not a constant, which is rigidly defined by a production function.
 
The price advantage given by comparative advantage may not be enough when it
comes to exchanging products with other countries; exporters must gain a competitive advantage by offering products with greater value.  A product's value equals the total perceived benefits of a product. It is denoted by V, and is defined as V = B/P, where B and P are benefits and price, respectively; this equation is known as the value equation. The comparative advantage that economists talk about is related mostly to the variable P; marketing tends to focus on the B term in the value equation. If costly marketing activities are necessary to enter new markets, then potential exporters need a substantial comparative advantage, before they decide to seek export sales. A second implication of the need to market overseas is that international adjusts
sluggishly to changes in comparative advantage.

Chapter E: Trade and Growth

Both per capita output and international trade have grown rapidly over the past 200 years. Many studies on the relationship between trade and growth confirm a strong positive statistical relationship between international trade and economic growth across all countries and time periods. Trade and growth achieve similar gains in welfare since they lead to higher consumption points, which lay on higher indifference curves. Growth is needed to close the embarrassing gap between the rich and the poor countries.
 
Compounding
The power of compounding implies that any continuous growth process will always outgrow any one-time gain in welfare, no matter how large the one-time gain. The compounding formula is:  
 
PCGDP_T = PCGDP_t=0(1+R)^T, where: R is the annual growth rate, T is the number of years.
 
The power of compounding implies that if international trade can raise a country's growth rate even just a little, the effects on human welfare will eventually be very large-certainly much greater than the one-time increases in welfare suggested by the static models of Chapters 3 and 4. To see how significant the effect of compounding is, we will use an example in which you can see how great an impact the difference of 1% will make after compounding an initial value of $2000 for 100 years.  
 
PCGDP_T=100 = $2000(1+.025)¹⁰⁰ = $23,627.
PCGDP_T=100 = $2000(1+.035)¹⁰⁰ = $62,383.
 
The formula for doubling time is: DT ≈ 70/g, where g is the growth rate. So if you have a 25 population growth rate in China, it will take 35 years to double the current population.
 
The Solow Growth Model  
The Solow growth model shows that without technological progress, which is
stimulated by innovation and research and development (R&D), no constant rate of investment (no matter how high) can generate permanent economic growth. This is due to the fact that eventually diminishing returns to investment cause income gains to no longer add enough to savings to cover depreciation. Capital (input), denoted by K, and Income (output or GDP), denoted by Y, then attain their respective steady state (equilibrium) levels K* and Y*. If the current level of capital (K) is greater than the equilibrium level (K*), then depreciation exceeds investment and K shrinks until it reaches its steady state. If the current level of capital (K) is less than the equilibrium level (K*), then investment exceeds depreciation and K grows until it reaches its steady state.   
 
Economic growth can be a result of opening up of trade and increased savings (a rate which must always be positive and no greater than one). An increase in the saving rate increases the steady state. Short term, trade raises Y* to Y’ and in the long term to Y**. The long term adjustment of capital is from K* to K**. Trade therefore causes transitional growth by shifting the production function up.
 
The Cobb-Douglas function  , where: a equals the production elasticity of capital,  b  equals the production elasticity of labour, and y depicts technology. Under the Cobb-Douglas function, a + b  = 0 since there is a constant returns to scale. Technological progress ( y ), given that K and L remain the same, neutralizes the effect of diminishing returns by lifting the production function from f1(K) to f2(K).
The Solow growth model suggests that without technological progress, increased international trade and specialization can only cause medium-run economic growth as a result of the economy's adjustment to a new steady state. Permanent and continuous economic growth is possible if the production function continuously shifts up, which in turn requires continued technological progress.
How Can Trade Stimulate Economic Progress?
If international trade causes permanent economic growth, it must be because it in some way encourages and facilitates innovative activities that increase the economy's rate of technological progress. There is statistical evidence of a relationship between international trade and economic growth, but we can’t infer that international trade causes economic growth with 100% certainty. We therefore need other models to verify the statistical relationship. Economists have thus studied how international trade can stimulate technological progress, and they have suggested models that highlight learning by doing, externalities to investment, externalities to exporting, and the role of international competition. Learning by doing is also referred to as the learning process, which is depicted by the learning curve. It shows that the unit cost of cumulative output decreases since employees learn to produce more efficiently.
 
The most practical insight into how trade might cause technological progress is provided by the Schumpeterian model of technological progress, which relates innovation to:

• Eventual rewards,  
• The availability of the resources needed to create new knowledge,  
• The efficiency of research and development activity,  
• The willingness of society to incur short-run costs to generate long-run technological progress.  

The Schumpeterian model of technological progress is based on Joseph Schumpeter's concept of creative destruction, which is that continuous technological competition among profit-seeking entrepreneurs brings about innovation. Creative destruction is defined as the constant scrapping of old technologies to make way for the new. Schumpeter also made the important point that innovation and the creation of new knowledge require scarce resources, which implies that innovators must some way recover the costs they incur.  
 
Schumpeterian innovation models usually assume that entrepreneurs compete for temporary monopoly profits by engaging in costly research and development (R&D) activities in order to gain an advantage over their competitors.  
The quantity of innovations is equal to one divided by the product of the quantity of resources per innovation and the resources applied to innovation. If the quantity of innovations decreases, the rate of interest at which the future profit is discounted increases and the resource requirements in R&D activity increases. When the quantity of innovations increases, the potential profit for the successful innovator increases, the amount of resources devoted to R&D increases, the efficiency with which the innovators use resources in R&D activity increases, and value of innovators for future gains relative to current costs increases.
 
Schumpeterian innovation models assume that the level of R&D activity and the
resulting rate of technological progress are a profit maximization problem that depends on:

• The productivity with which R&D activity generates innovations,  
• The costs of acquiring the resources to carry out R&D,  
• The benefits that entrepreneurs expect to reap from an innovation.  

The first two items determine the costs of innovation (CoI). The latter item determines the profits from innovation (PVI). The intersection of the CoI and PVI curves determines the amount of resources devoted to R&D activity. By weighing the costs and profits of R&D, the economy's equilibrium rate of technological progress can be found; the faster the process of creative destruction, the faster are technological progress and economic growth, and the faster human welfare improves.  
 
International trade can enhance technological progress by:

• Expanding the market for, and thus increasing the eventual gains from,
• innovation,
• Facilitating the flow of knowledge across borders and thus making it easier to create new knowledge
• Improving the allocation of resources and thus making more resources available to innovation.

Combining two economies into one shows how economic integration through free trade increases the rate of technological progress because the combined market implies greater potential profits from innovation and more potential entrepreneurs can draw on greater resources to innovate. You may, however, also get more competitors when opening up the economy, and this may negate the effect.

 
Drivers of the differences in per capita income are therefore the capital-labour ratio and the human capital-labour ratio. Note that per capita income and wages are not the same thing!
 
You either talk about FDI inflows or FDI inward stock (accumulated flows). The older the stock, the less valuable it is.  
 
Low value goods are consumer goods and high value goods are producer goods. The Production Sophistication Index (PSI) depicts that high value-added products are likely to be exported by high-income countries. High value (high-tech) products have higher PSI’s than low value (low-tech) products. The Country Sophistication Index (CSI) depicts that the more high value-added products in a country’s exports, the more advanced its export structure is. High income countries also have higher CSI’s than lower income countries.  

Chapter F: Protectionism

A country’s trade policy contains the laws, regulations, rules, and procedures that apply to international trade. There are two types of tariffs (taxes on imports):
 
Ad valorem tariff: A tax on imports specified as a percentage of the value of the product being taxed.
 
Specific tariff: A tax on imports specified as a specific money amount.  
 
The two-country partial equilibrium model of a tariff, which assumes both countries are large enough to influence each other's prices, shows that the imposition of a tariff by one country on the other's exports changes the prices of all products in both economies by shifting the international supply curve. The domestic price thereby increases and the domestic import quantity decreases. Correspondingly, the amount of foreign exports decreases and the price abroad decreases.
 
Consequently, domestic prices increase and foreign prices fall. This causes a transfer of welfare from domestic consumers to domestic producers in the importing country and a transfer of welfare from producers to consumers in the exporting country.  
 
A tariff also causes a transfer of consumer surplus in the importing country to the government in the form of tariff revenue, which benefits the recipients of the government transfers or services that the tariff revenue pays for. A tariff causes a transfer of some producer surplus from the exporting country to the government of the importing country.
 
A tariff causes deadweight losses in both importing and exporting countries due to the distortion of prices and the reduced volume of trade. The net world welfare loss of a tariff equals the deadweight losses, but the importing country most likely loses less than its deadweight losses because it gains some welfare at the expense of the exporting country, and consequently the exporting country loses more than its dead-weight losses. A tariff tends to change the terms of trade in favour of the importing country.  
 
An important result of the general equilibrium model is the Lerner symmetry theorem, which states that import restrictions end up also restricting exports because the tariff shifts resources from the export to the import industries. The converse is also true: If a government acts to expand exports, the shift in resources necessarily causes imports to increase as well.
 
Effective tariffs
The effective protection that a tariff provides to a certain industry is measured as the size of the tariff relative to an industry's value added. Say that half of the total cost ($10,000) of a producing a pickup truck consists of actual production costs ($5000). Suppose that a 25% ad valorem tariff causes the domestic price to rise by 20% from $10000 to $12000 (the remaining 5% is absorbed by foreign suppliers).  This will cause the value added to increase from $5000 to $7000, thus by 40%! This 40% is called the effective tariff.   
 
An effective tariff, however, can also be negative. Suppose that the government
imposes a 25% tariff on production parts. If there is no tariff on the finished goods, the truck producers will see their value added squeezed. The 25% tariff causes a 20% increase in the price of production parts. The actual production cost therefore increases from $5000 to $6000. If the truck producers face sharp competition, they cannot raise their price to compensate for the increased production costs, and so the value added decreases from $5000 to $4000.  
 
Quotas
A quota is a limit on the quantity of a certain product that is permitted to cross the border. It was formally called a quantitative trade restriction. Compared to a tariff, a quota has similar effects on consumer surplus and producer surplus in importing and exporting countries. Prices in the importing country increase, resulting in an increase in the producers’ surplus and a decrease in the consumers’ surplus. Prices in the exporting country decrease, resulting in a decrease in the producers’ surplus and an increase in the consumers’ surplus. Dead-weight losses also result in both countries.
The difference between the effects of a tariff and a quota, however, is that a tariff creates government revenue and a quota creates quota rent. Quota rent is the arbitrage profit that accrues to importers when a quota is binding and keeps the quantity imported below its free-market equilibrium level. There is some ambiguity as to who gains the rent created by a quota; the matter largely depends on who markets the product in the importing economy. The welfare effects due to the imposition of a quota therefore include changes in consumer and producer surplus and quota rent.
 
Assuming a fixed set of supply and demand curves and the efficient rationing of import permits, there is always an equivalent tariff for any given quota and there is always an equivalent quota for any given tariff. Economists do not necessarily view tariffs and quotas as equivalent because the assumption of fixed supply and demand curves is unrealistic in an ever-changing world. Additionally, lucrative import permits are seldom rationed efficiently.
 
If the demand increases, for example, a tariff and a quota that were equivalent will result in very different price and welfare effects. New and different market equilibriums are created. If the prices rise in each situation, the results will also differ depending on the imposition of a tariff or a quota. In the case of a tariff, the quantity imported increases. In the case of a quota, the import quantities remain unchanged. If demand increases, there is a greater gain in consumer surplus under a tariff. Dead-weight loss is also less under a tariff.
 
A voluntary export restraint (VER) is identical to an import quota, except that it is administered by the exporting country and the exporters are usually allowed to capture the associated quota rents.  
Other trade barriers that countries can inflict on their fellow countries are:

• Export quotas to insure against domestic shortages,
• Bureaucratic restrictions on international trade,
• “Buy domestic” regulations,
• State and provincial restrictions on foreign trade.

The costs of protection as described by the dead-weight losses in the partial
equilibrium models are understated because people often engage in rent seeking; that is, they exert considerable effort and incur substantial costs in order to influence their governments' trade policies. Rent-seeking activities use costly (scarce) resources to obtain transfers but do not add to output or overall welfare. Costs of resources used in rent-seeking must be added to costs of protection and are a net cost to society. Potential importers seek this rent and consumers may attempt to protect themselves from these rent-seeking activities. When the government is limited in what it can do for special interests, the incentives for engaging in costly rent seeking are diminished, but it is inherently difficult to decide and enforce what government should do and what
should be beyond the reach of legislators and bureaucrats.
 
In the Schumpeterian environment of creative innovation, lobbying for protection against foreign competition may be motivated by desire to slow the process of creative destruction and extend the period of profits for domestic innovators. If such dynamic rent is successful, technological progress will slow, and welfare gains from economic growth will be lost. The welfare costs of dynamic rent seeking (obstructive activity) can be very large and consist of:

• The resources spent on obstructive activity rather than production,  
• The opportunity costs of the lost future economic growth when the obstructive activity succeeds (which can be magnified through the compounding effect).

Chapter G: Governmental Trade Restrictions

The fact that international trade causes an economy to shift factors of production from one industry to another introduces a number of potential problems that were not brought out in the analysis of international trade in Chapters 3, 4, and 5. The models in Chapters 3 and 4 ignored the adjustment costs that may fall on certain people when an economy shifts to free trade. All other things equal, an economy where factor markets are flexible should experience less pressure for protectionist trade policies because the gains from trade are greater and the adjustment costs are lower.
 
Available evidence shows that international trade does not affect the long-run level of employment in an economy, but it may change the wages earned by workers. If trade expands the output of a relatively labour intensive industry, the return to labour (the wage) decreases, and along with that, the return to capital.  
 
In the short run, a shift to free trade may even reduce welfare. Technological progress and factor accumulation have much greater effects on factor returns in the long term than in the short term. Only in the long run does the economy reach the standard free trade triangle linking points P and C.  
 
The general equilibrium model gives a better picture of how people are actually affected by international trade than the partial equilibrium model because it looks at all sectors of the economy, not just a single market, which means that it does a better job of tracing the various interrelated costs and benefits of free trade on different markets and groups of people throughout the economy.  
 
However, most people have difficulty tracing all the direct and indirect effects that an increase in international trade has on their lives; therefore, the partial equilibrium model remains useful for analysing how people react to international trade and why governments restrict trade.
 
The Stolper-Samuelson Theorem, which is based on the general equilibrium model of international trade, states that when an economy shifts from self-sufficiency to free trade, the real income accruing to factors used relatively intensively in the growing export industries rises, and the real income to the factors used relatively intensively in the shrinking import-competing industries falls. So not only do the prices of the abundant factor rise with free trade, but also do the real values of the earned income.
 
The fact that international trade has only had a modest effect on income distribution can be explained by the fact that a portion of international trade among developed countries is driven by increasing returns to scale instead of by factor endowments. An additional explanation for the modest effect is that most people own one more than kind of factor of production.  
 
Arguments Favouring Protection
A few logically sound arguments showing protection may raise overall national welfare have been developed, although each of these arguments is based on a rigorous set of assumptions that are difficult to satisfy in the real world. The assumptions that must be satisfied for the logical arguments for protection to be valid are unlikely to hold in the real world. Some logically sound arguments for protection include:
 
The infant industry argument.
There are two criteria for the infant industry. The Mill test is the criterion that an infant industry must be able to eventually operate successfully without trade protection and government support. It must therefore become competitive and gain a comparative advantage. The Bastabie test is the criterion that an infant industry must eventually generate welfare gains that exceed the short run costs of protection, all properly discounted.  
 
The strategic trade argument.
A strategic trade policy is a government policy that interferes with the free flow of trade in order to protect or promote industries that are deemed to have exceptional growth prospects or beneficial effects on the country's economic performance. Strategic trade policies influence the growth of preferred domestic industries. Relative prices at which trade occurs can bring two countries very different gains from trading.
 
The national security arguments. 
There are also arguments for economic sanctions against allegedly objectionable
behaviour by foreign countries and for protecting industries important for national security. Trade sanctions are trade restrictions imposed by one country in order to punish another country or persuade another country to change objectionable policies or behaviour. They thereby impose costs on nations applying the sanctions, and they are usually not very successful in achieving their objectives.  
 
The various logically sound arguments for protection, such as the infant industry, strategic trade, and national security arguments, assume that there will be no foreign retaliation, that government policy makers have thorough information about market conditions now and in the future, and that government policy makers use their complete information objectively and without being swayed by lobbyists or political expediency. Both the infant industry and strategic trade arguments are logically sound and do not deny the gains from comparative advantage. They both also implicitly assume that the discounted value of the gains to the overall economy outweigh the discounted value of the costs incurred by the overall economy.
Political Economy Models
 The political economy refers to the field of study that combines economics and political science in order to explain the relationship between political activity and its economic effects.  
 
Political economy models have been applied to the analysis of international trade policy, and, while none of the models explains all trade policies, together these models explain a large portion of the changes in trade policies observed in democracies.  
 
The median voter model relates trade policy to the percentage of voters who stand to gain and lose from a particular trade policy. It predicts the candidate who proposes policies that favour slightly more than half of the voters, regardless of the size of the gains or losses involved, will win the election. What it doesn’t predict, however, is that the policymaker who wins the election will necessarily maximize total welfare.  
 
The uninformed voter model suggests that trade policies will reflect the interests of those who stand to gain or lose a lot from policy choices but ignore the interests of individuals who stand to gain or lose just a little. In other words, it suggests that smaIl special interest groups will have a disproportionately large influence on government policies because most voters have little information on most issues that they feel do not directly affect them.  
 
The endogenous tariff model predicts a positive level of endogenous tariffs because policy makers will 'sell' their policy choices to special interests in order to raise campaign funds to sway uninformed or partially informed voters. A trade-off exists between this need to raise campaign funds and the need to minimize the politically-unpopular welfare losses from trade restrictions enacted to satisfy campaign contributors seeking protection. The trade restriction level settles at the point where the votes gained because of the special interest campaign financing equals the marginal votes lost because people become aware of the cost of trade restrictions. This suggests that the political process leads to some protection despite the welfare loss.  
 
The adding machine model relates trade policy to the number of people directly
employed by and closely associated with the specific industries affected by the policy, implying that large industries are more likely to gain protection than small ones. Policymakers will therefore opt to deal with issues that are important to many people than those that are important to few people. The adding machine model, therefore, contradicts the uninformed voter model and the endogenous tariff model. 

Chapter H: Trade Policy

International trade policy has changed directions often over the course of history. There have been periods of increasing globalisation as well as periods of increasing isolation. The Mediterranean region experienced free trade in the time of the Roman Empire, yet after the Roman Empire fell, the Europe fragmented into isolated and separate nations and embraced feudalism. Yet the Middle East remained open to free trade. The Renaissance led to the opening up of Europe. The Middle East, however, stopped its trade technological progress around the year 1000 in fear of outside ideas. The seventeenth and eighteenth centuries were therefore characterized by protectionist trade policies; China and Japan in the Far East also completely isolated their economies from the rest of the world and the major nations of Europe generally followed mercantilist policies of protecting domestic industry.
 
Mercantilism originated around the year 1500. It is the belief that international trade is a beneficial activity provided that it was regulated by government so that it enhanced the immediate interests of domestic merchants, manufacturers, and the Crown. Exports were seen as beneficial, while imports were seen as harmful. Mercantilism in France was known as colbertism. It was wrong in the eyes of most economists. It depicts the international economy as a zero sum game. This means that what the winners win equals what the losers lose (total sum of zero). During the Enlightenment, however, the policies of mercantilism were increasingly scrutinized, most notably by Adam Smith. He reasoned that the protection advocated for by mercantilists reduces the long-run growth of human welfare since the only true sources of economic growth and improved human welfare were trade and specialization. Adam Smith demonstrated that mercantilism doesn’t make you rich, you are just piling up money, which in the golden days didn’t even give you interest. He depicts the international economy as a positive sum game (every country gains).
 
In the nineteenth century, with England taking the lead, European nations moved toward true free trade. Trade expanded rapidly in the late 1800s due to improved transport. Yet trade was hindered by the economic slowdown in the 1870s. Only England, Denmark and Holland were able to maintain open markets and resist pressures from special interest. England used diplomacy to open borders to trade in Europe, such as the Cobden-Chevalier Treaty (1860), which reduced many tariffs on trade between England and France. Most bi-lateral agreements had a most favoured nations (MFN) clause. The MFN principle is a key principle that must be satisfied if a nation is to maximize its static gains from trade. It simply says that all nations should not discriminate in the way they treat their trade partners, so if they enact a bi-lateral agreement with one trade partner, it becomes a multi-lateral agreement for every one of their trade partners.  
 
The United States did not follow in the footpaths of England and instead catered to the interests of its nascent industries by maintaining fairly high tariff protection throughout the nineteenth century. Although the predominantly agricultural Southern states favoured free trade, the northern states, with their new industries, favoured high tariffs.  Around the middle of the nineteenth century, Japan and China opened their economies to trade in response to outside pressure and, in the case of Japan, domestic interests seeking modernization.
 
After World War I, the world again took a protectionist turn that culminated with a sharp downturn in international trade during the Great Depression of the 1930s. In 1922, the U.S. implemented the Fordney-McCumber Tariff, which doubled average tariff rates when Europe was still struggling to recover from World War I. According to the Treaty of Versailles (1919), Germany had to compensate to the Allies for their war losses, and the Allies had to repay their lender the U.S. Yet neither the United States nor the European Allies would liberalize trade enough to allow the necessary trade deficits.
 
Pressure for protection increased after the stock market crash in 1929. In 1930 the U.S. Smoot-Hawley tariff set off a trade war that helped spread economic depression throughout the world. Four years later, however, in 1933, when world trade volume had decreased by 70% since 1929 and the world was still spiralling deeper into a trade war, the U.S. started to propose negotiations to reduce tariffs, realizing the negative consequences of the U.S. Smoot-Hawley tariff. In 1934, the U.S. trade policy reversed direction with the Reciprocal Trade Agreements Act. The authority for trade negotiations was no longer in the hands of the entire legislative body, but it was now the “fast-track” authority of the president. Fast-track authority is the commitment by the legislature to quickly vote 'yes' or 'no' on the ratification of a treaty brought to it by the country's negotiators without altering the treaty in any way. The full results of the Act
were not realized until the end of World War II.  
 
The details of the United States' post—World War II trade policy suggests that the United States' commitment to free trade was not always strong. Even as major agreements to reduce trade barriers were successfully negotiated, the United States has increasingly used non-tariff barriers to protect politically sensitive industries and interest groups. Special interests in most other countries have also found other ways of achieving protection against foreign competition, and the proliferation of antidumping tariffs, sanctions,  bureaucratic barriers, and other ways to restrict trade has become the
dominant characteristic of recent trade policies worldwide.
 
Overall, the world has steadily reduced trade restrictions since World War II, and today the world's economies are more closely linked through trade than they have ever been.
 
GATT
The General Agreement on Tariffs and Trade (GATT) is the agreement reached by the major Western economies after World War II (1947) which set the legal framework within which international trade policy was to be set and trade negotiations were to be conducted. It farms the fundamental rules that govern the World Trade Organization today. The World Trade Organization (WTO) is the permanent organization which succeeded the General Agreement on Trade and Tariffs (GATT), to administer the rules established under the GATT and its successive negotiating rounds, and to administer formal trade dispute settlement procedures agreed on during the Uruguay Round.  
 
The World Trade Organization was established in 1994, and its dispute settlement procedures have worked fairly well, rendering predictable decisions according to generally acknowledged legal principles
Unfortunately, GATT itself produced only modest reductions in tariffs and other trade barriers. The “no injury” clause in the president’s fast-track authority severely restricted the U.S. negotiators. Yet in 1962 the Trade Assistance program was established to replace the “no injury” clause, which was for the better.
 
The eight rounds of trade negotiations under the auspices of the GATT have successfully reduced tariffs on most industrial goods; average tariffs are less than 10 percent of what they were at the end of World War II. The rounds, acts and agreements included: The Dillon Round, which was less successful than the rest.
 
The 1962 Congress, which agreed to give President Kennedy authority to offer tariff reductions in exchange for similar tariff reductions, without being burdened by the “no-injury” clause.
 
The 1962 Act, which provided new ways to deal with “injury”, The Kennedy Round (early 1960’s), which proved successful in reducing tariffs and dealt mainly with manufactured goods,
 
The Tokyo Round, which was also dealt primarily with manufactured goods, and was also successful in reducing tariffs,
 
The Multi-Fiber agreement, which actually wasn’t even covered by negotiations and was sanctioned by the GATT,
 
The Uruguay Round (1985), in which nearly 120 countries participated (will be covered more extensively in a moment)
 
The Doha Round (2001), which we will also cover more extensively later on.
 
The Uruguay Round, concluded in 1994, addressed some of the more difficult trade issues, such as trade in agricultural products, services, and intellectual property rights, and a formal world organization to oversee and enforce international trade rules. Intellectual property rights are the legal rights of ownership to ideas, knowledge, writing, art, and other creations; patents and copyrights are common forms of intellectual property rights. There is still no universal acceptance of the idea of intellectual property rights, even though from an economic perspective there is no difference, for example, between a physical piece of machinery, over which property rights can be established in most societies, and the design and software that controls the machine, for which many countries have been reluctant to grant property rights. This issue is extremely important in the modern economy, where ideas are as valuable as private property. Examples of intellectual property rights include patents and
copyrights. A patent is a right of ownership granted to the inventor or creator of a product, process, or idea that excludes all others from producing or marketing the product, process, or idea for some limited period of time without the explicit permission of the inventor. A copyright is a legal instrument that assigns the ownership of authors of original works, such as novels, movies, plays, textbooks, etc., to the creators of the works and protects them against unauthorized copying and use for some defined period of time.  
 
The major accomplishments of the Uruguay Round were that:

• A reduction in tariffs by nearly 40 percent,
• A consensus was reached to phase out the Multi-Fiber Agreement by 2005,
• An agreement by most countries was reached to establish compatible patent and copyright laws by 2000 (2006 for less developed countries),
• The World Trade Organization was established.

The major failures of the Uruguay Round were that:

• Little progress was made to eliminate the barriers to trade and services,
• Transportation services also remained protected in most countries,
• There were few reductions in the protection of agricultural products by more developed economies of Europe, Japan, and elsewhere,
• The MFA (Multi-Fiber Agreement) will be replaced by equivalent tariffs, which may be preferable to quotas, but trade in clothing and textiles will still be highly taxed after 2005.

In 2001 in Doha, Qatar, the 142 members of the WTO agreed to launch a new round of trade negotiations, with an agenda that includes further tariff reductions on industrial goods, the liberalization of agricultural trade, the setting of rules for antidumping tariffs, and liberalization of services trade. Tariff escalation implies increasing tariffs on a product more the higher the value added. 

Chapter I: Discriminatory Trade Policies

A group of countries that agrees to reduce or eliminate trade barriers between them while maintaining barriers to trade with countries outside the group is referred to as a regional trade area. Such groups of countries that liberalize free trade among themselves are also popularly called trade blocs. Regional free trade areas have become an established part of the world's trade regime. The act of forming a regional free trade area is also popularly called economic integration. There are many types of economic integration. The following list mentions all the types of economic integration. As you move down the list, the degree of economic integration increases.
 
A preferential trade area (PTA) is a regional trade area in which the member countries agree to lower trade barriers within the group to levels below those erected against outside economies but they do not establish complete free trade within their area. PTAs are illegal under GATT/WTO rules, although developing countries have been permitted to form PTAs.
 
A free trade area (FTA) is a trade bloc within which member states completely
liberalize trade among themselves but maintain their own trade barriers against outside countries.  
 
A customs union (CU) is a trade bloc in which the member countries agree to not only allow the free trade of goods between their economies, but also maintains a set of common tariffs and other trade restrictions against non-member countries.
 
A common market (CM) is a trade bloc that establishes completely free trade among member countries, sets common tariffs and other trade restrictions against outside countries, and permits the free movement of factors of production such as capital and labour.
 
An economic union (EU) is a regional trade area that has all the characteristics of a common market plus the members agree to a uniform set of macroeconomic and microeconomic policies. This is the highest form of regional economic integration.  
 
Trade creation is the increase in trade that results from a shift in trade policy and is, all other things equal, welfare enhancing. Trade diversion is the redirection of a country's foreign trade away from the world’s lowest-cost producers and highest-priced markets as in the case of a discriminatory regional trade agreement, which, all other things equal, reduces the welfare gains from trade. Some costly trade diversion is not just a possibility, but a certainty, under any form of regional economic integration. Trade diversion occurs because free trade induces importers to buy from a higher cost
producer in a free trade area country rather than from the world’s true lowest-cost suppliers.  
 
In a case of some trade and some trade restrictions, the formation of a trade bloc has uncertain welfare effects. A trade bloc reduces the domestic prices, dead-weight losses and government tariff revenue caused by a tariff, but increases the prices paid to foreigners due to higher production costs in that country.
   
When trade diversion exceeds trade creation, a regional free trade area reduces
national welfare, which implies that regional free trade is not a substitute for non-discriminatory multilateral free trade. Multilateral free trade can be reached in two different ways:

• Directly through multilateral negotiations,
• Indirectly through the two-step procedure of regional integration followed by negotiations among the regional groups.

If regional FTAs are easier to negotiate, the latter indirect route might be more
productive than the direct route. Yet once the FTAs have been established and trade diversion has occurred, those who gain from trade diversion will resist multilateral free trade because then they will lose their regional advantage.
 
Active regional trade blocs include the following:

• The European Union (EU) is currently a common market and is in the process of becoming a complete economic union. This trade bloc consists of Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden, and the United Kingdom. In 2002 ten more European countries were invited to join. The European Union is set to expand with the admission of several Eastern European economies; President George W. Bush has called for extending NAFTA to the Caribbean and even the rest of Latin America; and some Asian economies appear to be seriously considering their own free trade area.
• The Southern Common Market (MERCOSUR) is expected to first become a tariff union, and later a common market.
• The Association of Southeast Asian Nations (ASEAN) is trying to establish a free trade area.
• The Central American Common Market (CACM) became a common market in 1965. It is now trying to revive after years of civil war and strife in some of its member countries.
• The Caribbean Community (CARICOM), though behind schedule, is moving towards a full common market.
• The Common Market of Eastern and Southern Africa (COMESA) became a free trade area in 2000 and was scheduled to become a customs union in 2004.
• The North American Free Trade Area (NAFTA) is a free trade area consisting of Canada, Mexico, and the United States, and has no intentions of further integration. The agreement calls for the harmonization of policies on fair competition, trade in services, government procurement, and intellectual property rights.

Article I of the General Agreement on Tariffs and Trade (GATT) contains the most
favoured nation (MFN) clause, which requires each country to grant to every country the same access to its market that it grants to any other signatory of the GATT. The MFN effectively prohibits countries from discriminating among trade partners. Standard models of trade show that only in a system of unbiased free trade can the potential gains from trade, and hence world welfare, be maximized. The GATT's prohibition of discrimination among trading partners has been routinely ignored throughout the post—World War II period. The GATT itself has permitted some specific exceptions to the most favoured nation clause.
 
Dumping
Dumping is most primitively defined as selling below cost. In foreign trade, it is defined as selling at a lower price in a foreign market than the identical good sells for in the producer’s home market. The GATT/WTO rules define dumping as occurring when a foreign supplier sets a lower price in a foreign market than it sets in its home market. The GATT/WTO rules also provide an alternative definition of dumping, which is when the export price is less than the cost of production plus a reasonable margin for selling costs and profit.  
 
If either definition of dumping is satisfied, a country can impose antidumping duties that exactly compensate for the margin of dumping. An anti-dumping duty is a tariff that is imposed by an importing country that allegedly is the target of foreign dumping in order to offset the margin of dumping and raise the domestic price to where it would fall if the foreign supplier charged a price that reflected true costs and a 'fair' profit. The margin of dumping is defined as:

• The difference between the selling price and in the foreign market and the average production cost plus transport, selling cost, and “reasonable” profit, or
• The difference between the foreign price and a home price or third-country market price.

The GATT/WTO permits governments to restrict trade when dumping occurs, but since the definition of dumping is so broad that countries use dumping claims to justify discriminatory protectionist measures that have nothing to do with economically harmful predatory dumping.  
 
Dumping harms a country's economic welfare only if it is predatory and reduces
competition, as is the case where selling below cost drives competitors out of business and permits the predator firm to reap monopoly profits after its competitors' demise.  
 
The WTO requires countries to formally prove dumping, and most countries have set up procedures that appear to objectively determine the degree of dumping and apply accurate antidumping measures. Under the Sherman Antitrust Act, the United Sates requires proof that:

• The alleged predator had the intent to drive out the competition in order to monopolize the market,
• The predator has a reasonable chance of succeeding in its attempt to drive out the competition,
• The loss of competition would cause actual damage to the economy.

These criteria are much tougher than those of the GATT/WTO. The three step procedure that is valid in the U.S. is as follows:
 
The U.S. producer must first petition the U.S. Department of Commerce for a ruling on whether or not there is a case of dumping.
 
If the U.S. Department of Commerce agrees that dumping is indeed occurring, the International Trade Commission (ITC) decides whether or not the dumping has a “material” effect on the U.S. industry.
 
If the ITC confirms that the dumping has “material effects” on the economy, the
President must decide whether or not to impose protectionist anti-dumping duties.
 
In practice the antidumping procedures are easily, and often, corrupted because the procedures are completely controlled by the government of the importing country—the home of the firms seeking protection from imports.
 
Price differences across different markets are driven by different demands in each market.  Suppliers decrease their profit-maximizing price as the demand curve becomes more elastic and the market becomes more competitive. Foreign suppliers would not even be able to enter a more competitive market if they set the same price in the foreign market that they set in their less competitive home market.
 
Price discrimination does not imply dumping. The best solution to price discrimination is more market integration, which requires more trade, not protectionist policies.

Chapter J: International Investment Models

International investment refers to the purchase of financial and real assets by
individuals, firms, financial organizations, or government agencies in one country from a people, firms, financial organizations, or government agencies in other countries. An inter-temporal transaction is a transaction that involves payments or the delivery of goods today for goods or payments in the future. Inter-temporal markets are problematic because they must deal with the risk of default and the lack of perfect information about transactors and future economic conditions.  
 
The two-period inter-temporal exchange model shows how different inter-temporal preferences and different investment opportunities across countries create opportunities for welfare-enhancing inter-temporal trades. In other words, two economies with different time preferences gain from being able to borrow and lend. These inter-temporal preferences are represented by inter-temporal difference curves. If people acquire foreign assets or sell assets to foreigners, they can reach a higher indifference curve, representing a higher level of welfare.
 
The ICPF is an abbreviation for the inter-temporal consumption-possibilities frontier. The fact that the ICPF is bowed out (concave to the origin) reveals that the returns to investment are diminishing. The fact that consumers can reach inter-temporal combinations which lie outside the ICPF confirms that international investment increases welfare.
The assumptions of the two-period model are:
 
Output Y is produced using capital, K, and labour, L, according to the production
function Y = F(K,L).
 
Output Y can be used for consumption C or as a productive capital good K.  
If the labour force, L, remains constant, investment in new capital is subject to
diminishing returns.

• Technology doesn’t change.
• The economy begins period 1 with a certain endowment of labour and capital.
• Suppose, finally, that capital goods last just one period, after which point they must be replaced by newly-produced capital inputs.

The two-period inter-temporal exchange model also shows that international trade and international investment are closely related. To be able to take advantage of the international investment opportunities, a small country must engage in international trade.  
 
Trade deficits and surpluses in the short run are also essential ingredients for gaining from inter-temporal trade, thus they may even be desirable and are not necessarily ‘problems’ that need to be corrected. According to the models, a trade surplus or deficit reflects welfare-maximizing behaviour by consumers and firms in countries with different inter-temporal opportunity costs. The country with the higher-return investments and greatest growth potential will attract foreign savings, be a net borrower, and run a trade deficit (all other things equal). This country will also have an inter-temporal comparative advantage due to its high return investments. The country with the greater desire to consume today rather than save for the future will also attract foreign savings and run a trade deficit (all other things equal). Prudent countries will lend to foreigners in the short run and run trade surpluses.
 
Determinants of inter-temporal comparative advantage include differences in interest rates, inter-temporal preferences, and in returns to investment. 

• Differences in interest rates between countries are the result of:
• Different indifference curves (consumer preferences),
• Different ICPF’s (different rates of return to investment).
• Differences in inter-temporal preferences reflect differences in people’s tastes, age, household responsibilities, present and expected future income, and willingness to bear risk.
• Differences in returns to investment are the result of differences in:
• The availability of other factors to combine with capital,
• Technology,
• The efficiency of the financial system in allocating savings to investors,
• Institutions such as the protection of property, the rule of law, contract enforcement, and sound monetary policy.

The flaw of the two-period, two-country inter-temporal model of investment and tradev examined above doesn’t tell us how the gains from international investment are distributed. Therefore we use the partial equilibrium model of international investment, which is also referred to as the loanable funds market model. It is ‘partial’ because it only extends for one period. It shows that international borrowing and lending has distributional effects, with lenders gaining at the expense of borrowers in the country that sends its savings overseas, and borrowers gaining at the expense of domestic lenders in the country that imports foreign savings.  
 
We now extend the partial equilibrium model of international investment to two
countries, India and Pakistan, who have different interest rates. Provided that there are no barriers, savings will move from Pakistan to India, which causes India to purchase assets and Pakistan to save assets. This causes India’s supply curve to move to the left and Pakistan’s supply curve to the right, which causes the interest rates to equalize in both countries.
 
Indian savers lose the area a to the Indian borrowers, who also gain the area b, which results in a net gain for India of area b. India experiences an increase in total investment equal to fg. This increases its total assets. Pakistani borrowers lose the area c to the Pakistani savers, who also gain the area d, which results in a net gain for Pakistan of area d. Pakistan experiences a decrease of total investment equal to ij. Pakistan, however, still gains because the total Pakistani income rises and the Pakistani savers enjoy higher returns. The partial equilibrium model of international investment therefore shows that in each country, the gainers gain more than the losers lose, which means that there are net gains to international investment in each country, just as in the general equilibrium model.
 
Traditional analysis of the gains from the free exchange of assets points to three
sources of potential welfare gains:  

• Efficiently allocating consumption over time,  
• Efficiently allocating savings to investment opportunities,  
• Using international diversification to reduce risk.

These three gains directly motivate individuals, firms, governments, and financial institutions to lend, borrow, and exchange many different types of assets across borders. The three motives for international investment are as follows: 

• Inter-temporal consumption smoothing,
• Efficient allocation of savings,
• Risk diversification.

Risk diversification is the spreading of one's wealth among a variety of assets in order to reduce the overall risk of the asset portfolio. Asset risk is the uncertainty surrounding an asset's future returns and residual value. The two goals of asset holders (maximization of returns and minimization of risk) often seem to conflict. Successful risk reduction requires that asset earnings are not perfectly correlated. International asset prices and returns are less likely to be correlated. International investment therefore provides opportunities for risk-reducing asset diversification. It lets savers reach a more advantageous compromise between returns and risk by expanding the possibilities for diversifying their portfolios of assets; two-way exchanges of assets are
likely to occur as wealth holders in all countries seek to diversify their asset portfolios across borders.  
 
Overall country performance is the result of individual actions, and countries exchange assets because individuals, firms, and government entities find it advantageous for their long-term welfare to do so.
 
International investment may increase economic growth in addition to creating static gains from improved allocation of savings and diversification. The Solow growth model permits the gains from international investment to generate only medium-term growth. The return to investment is the slope of the production function Y = f(K). If the slope is steep, this implies a high return to investment since each increase in K results in a large increase in output Y. The slope of f(K) depends on:

• The stock of capital: the slope is greater with a low stock of capital (K) than with a high stock of capital (diminishing returns to capital).
• The stock of other substitute factors of production: an increase in, for example, the amount of labour (L) raises the production function, which increases the slope and causes the marginal rate of return to investment (capital) to increase as well.
• The level of technology: technological progress also raises the production function, which increases the slope and causes the marginal rate of return to investment (capital) to increase along with it.

The Schumpeterian model of technological progress, in contrast to the Solow growth model, points to several channels through which international investment can lead to permanently higher rates of economic growth, most notably as a facilitator of international transfers of technology. The formula for the Schumpeterian model of technological progress is as follows:

 
The effects of international investment are that it:
Increases the profits of innovation) because it contributes to globalisation and affects technological progress, decreases the cost of innovation because it facilitates the information flow of ideas and technology transfers between economies (due to FDI). Possibly increases q because FDI may also stimulate innovation by increasing competition.
 
International production is financed by FDI. According to the OLI-paradigm, FDI should be executed when there are ownership-specific advantages of firms, location advantages of regions or countries, and internationalisation advantages of firms. When there are only ownership-specific advantages of firms and internationalisation advantages (of firms), a country should export. When there are solely ownership-specific advantages of firms and location advantages of regions or countries, a country should look to license.
 
The actual amount of international investment today is much smaller than the models of international investment suggest should be the case; this result is often referred to as the 'home bias puzzle.'
 
Some possible reasons explaining why international investment is too small are that:

• Governments still impose many restrictions in capital flows,  
• Exchange rate uncertainty makes foreign investment more risky relative to domestic investment,  
• Inter-temporal transactions are inherently difficult to carry out,

With inter-temporal transactions, one party agrees to accept payment(s) at some future date, where they may not be fully comfortable with. There are also some perverse incentives which make it more likely that future payments will fall short of agreed-to levels.
 
The institutions that can minimize the inherent risks of inter-temporal exchange are often missing.
 
International investment experiences more difficulties in foreseeing the future and countering perverse incentives.
 
Compared to domestic asset purchases, international investors face more severe
problems of asymmetric information, moral hazard, and adverse selection. Asymmetric information is the situation where those on one side of a transaction (lenders) have a different information set than those on the other side of the transaction (borrowers). Often the lenders know less than the borrowers about the eventual payout of assets. Asymmetric information can result in moral hazard and adverse selection, both of which lead financial markets to fail to efficiently allocate savings to investment projects.  
 
Moral hazard is the likelihood that a borrower will engage in more risky or less
productive behaviour than he or she would if only his or her own money was at stake, thereby reducing the eventual earnings from an asset.
 
Adverse selection is a potential market failure caused by the price's influence on who seeks to transact in a market; a higher price to cover risk may cause only the riskiest customers from demanding the product. For example, a high rate of interest may lead only the riskiest borrowers to seek loans, or a high price of insurance may result in only those with very high probabilities of experiencing the insured event purchasing insurance. Because buyers have difficulty verifying the assets, a disproportionate amount of “bad” assets are likely to be offered for sale.

Chapter K: Forms of International Investment

There are similarities between all international investment flows in that each involves an inter-temporal transaction with payments and receipts occurring at different points in time, but there are also differences among them; each type of flow exploits its particular advantages in overcoming some of the difficulties inherent to inter-temporal transactions.  
 
Today's international investment is deeper than ever before, and the variety of assets traded across borders continues to expand. Intra-firm trade refers to the trading of goods and services between domestic and foreign affiliates of the same MNE.
 
Foreign direct investment (FDI) is investment by private firms in foreign countries, whereby the investor maintains some degree of direct control of the investment project. The rule of thumb used most often is that the foreign firm own at least 10 percent of the foreign project or enterprise. Foreign direct investment has in recent years become one of the two largest categories of international investments, surpassing $1 trillion in 2000. During much of the 1990s FDI grew about three times as fast as overall investment worldwide. FDI is the international investment which is most likely to facilitate technology transfers. It is essentially the only way to introduce cutting-edge technology
into a country since firms do not easily part with their own technology. International investment has been linked to transfers of technology because FDI includes such things as operating foreign factories, introducing new products, upgrading acquired foreign firms and facilities, and building marketing and distribution organizations in foreign markets, all activities that involve the introduction of new ideas and knowledge. It is interesting to note that the technological leaders in each industry are the more active foreign investors.  
 
There are two types of FDI:

• Vertical FDI, which implies that an MNE owns facilities that fit into different stages of the supply chain,
• Horizontal FDI, which consists of MNE investments that duplicate facilities and operation in several countries.

By definition, multinational firms carry out all of the world's direct foreign investment, which is the purchase of controlling interest in foreign firms or foreign real assets. Multinational enterprises (MNEs) are also referred to as multinational corporations (MNCs). They operate or control business activities in more than one country. MNEs use FDI to establish their methods and proprietary techniques in foreign countries. They also transfer people, designs, business philosophies, and management techniques across borders. MNEs are involved in more than 75% of all international trade.  
 
MNEs essentially do what could, theoretically, be accomplished through other
channels, which means their existence must be due to some special advantages.  Among the advantages that MNEs enjoy over arm's-length transactions between firms of different countries is that they can:

• Apply proprietary know-how that could not otherwise be used in foreign markets (best exploited in-house),  
• Internalise transaction costs,  
• FDI may be possible when financial markets do not exist to otherwise channel funds to profitable projects,
• Make up for missing international financial markets,  
• Exploit economies of scale across borders,  
• A local presence can help firms anticipating favourable local business opportunities,
• Jump over trade restrictions by producing overseas behind trade walls,  
• Avoid some taxes and regulations,  
• Make use of their reputations,  
• Reduce exchange rate risk by spreading expenses and earnings across borders.

Portfolio investment is the acquisition of financial assets or securities (bonds and stocks) in quantities too small to give the owners any controlling interest in the firms and enterprises who issued the securities. Portfolio investment has recently become one of the largest categories of international investment (next to FDI). Its development has been stimulated by the widespread establishment of stock and bond markets throughout the world. It is now widely used for the additional purpose of spreading risk and raising overall returns to savings.  
 
An interesting characteristic of modern international banking is the emergence of the Eurocurrency markets, which are essentially an offshore banking market controlled only indirectly by the various national banking authorities. They are largely unregulated worldwide markets for lending and borrowing Eurocurrencies, which are time deposits of money in an international bank located in a country other than the country that issues the money.  
 
International bank lending has not grown as fast as FDI and portfolio flows, although banking has become increasingly international in scope.
 
Foreign aid refers to direct government-to-government transfers and aid provided by government-funded development banks and other international agencies that are usually intended to deal with short-run emergencies and long-run programs to promote economic growth and development. Foreign aid flows to developing countries have not grown for 20 years, having been replaced by private portfolio investment, FDI, and bank lending in the more successful developing economies. The decline in foreign aid flows as a percentage of all international capital flows from developed to developing countries reflects, among other things:

• The tremendous growth of private flows in the 1990s,  
• The end of the cold war,  
• A growing dissatisfaction with the results of direct aid flows.

Capital flows measured as a proportion of GDP were much larger in the 1800s than they are now. Yet international investment is much more diverse today. In the past it was always subject to occasional defaults and renegotiation. International capital movements prior to World War I consisted mostly of bond sales, often through the London financial markets. The returns on the foreign assets were as least as high as they were on the domestic British assets.  
 
International investment virtually ceased entirely during the de-globalisation in the 1930s, when widespread defaults discouraged both lenders and borrowers, and it recovered only slowly and non-uniformly after World War II. Foreign aid dominated. MNEs began to spread across borders and the Eurocurrency market was born in the 1950s. Bank-lending to the developing countries grew rapidly from the 1970s until the 1980s due to the 1982 debt crisis. Bank-lending was surpassed by FDI and portfolio investment in the 1990s.
 
It is impossible to forecast the precise future scope of international investment, but it will play a prominent role in the continued globalisation of the world economy both as a complement to international trade and as a source of economic volatility.

Chapter L: Foreign Exchange Markets

The monetary system has been evolving over time. The foreign exchange markets have been an integral part of the global economy ever since countries began trading. Foreign exchange markets refer to the worldwide set of markets where the many different national currencies are exchanged. Foreign exchange risk is inherent to all assets denominated in foreign currencies, which is that changing foreign exchange rates will change the domestic currency value of foreign currency assets.  
 
Milton Friedman’s “Free to Choose” theory said that the market will automatically solve all problems. So if we leave the supply and demand markets free, why don’t we leave exchange markets free to be driven by supply and demand? Friedman wrote against the Bretton Woods idea of a fixed exchange market. He said that leaving a currency to float won’t cause major fluctuations (while in effect, it did do so in both the short and long term). China has for a long time fixed its currencies, often by selling or buying currencies in foreign exchange markets to neutralize shifts in supply and demand. The foreign exchange rate reflects supply and demand in the foreign exchange market,
which depend on the demand and supply of goods, services, and assets, plus any other flows listed in the balance of payments.
 
Financial trade has been growing out of proportions, with more than one trillion dollars of trade per day world-wide. This greatly exceeds the volume of any other financial market in the world. Most of the currencies are traded in the over-the-counter (OTC) market, a trading market that is not physically located in a single place but rather consists of numerous buyers and sellers that are connected electronically or by telephone. Traditionally London has been the major trading centre of the world in precious metals and currencies, and it somewhat still is. Modern banking (last 300 years) has used exchange of bills rather than coins. The currency exchange market is almost a perfect/ ideal market because:

• Information is almost simultaneous and open to everyone,
• There are no transport costs.

Seigniorage refers to the gains to the government from its monopoly on creating
money, which are equal to the difference between the real purchasing power of newly-created money and the cost of creating the new money. For example, a 20 dollar bill may actually only cost 2 cents to produce, but it is worth a thousand times more.
 
Since the 1980s, analysts have been collecting information on the relative size of the individual currency exchange markets.
 
The United Kingdom and the United States were the largest exchange markets in 2001. The fast-growing market of Japan lags not far behind. Data is for an average day in April since in that month, many things usually do not change exchange data (whereas in October, exchange data varies widely). In countries where the domestic currency is weak, the circulation of American dollars tends to be high (‘dollarization’). Examples include Argentina and Russia.  
 
In 2001, the average daily world trade in international currencies has more than doubled its average in 1989. Most trade is spot exchange trade. The spot exchange rate is the price set in the spot market for foreign exchange, and it represents the current price for foreign exchange. The spot market for foreign exchange is the segment of the foreign exchange market where currencies are traded for immediate delivery.  
 
The forward exchange rate is the price of one currency in terms of another currency far an exchange that is contractually agreed on today but will not be carried out until a specific future date. The forward exchange market is the market where currencies are currently traded for future delivery or receipt. Forward transactions constitute over half of all transactions in the foreign exchange market. The same dealers who operate the spot markets operate the forward markets. The forward exchange rate is not a good predictor of the expected spot rate.  
 
You need a lot of information to make decisions and predictions. Exchange rates
change simultaneously if expectations change. New information on a rational basis changes every second. News is unpredictable and causes the spot exchange rate to deviate from its long-run path. Exchange rates actually fluctuate much more than interest rate differences across countries suggest. Rational expectations are based on the following information set of data:
The model of exchange rate determination, Information that helps valuate the variables in the model of exchange rate determination.
 
Arbitrage
Arbitrage is the process that effectively combines distinct markets into a single
integrated market by means of profit-seeking arbitrageurs who buy goods or assets in those segments of the market where prices are low and sell where prices are high.  
 
Most of the activity on the foreign exchange markets is related to arbitrage, but
arbitrage does not drive the long-term values of currencies; it mostly serves to keep the exchange rates compatible across geographic markets, across different currencies, and over time.
 
If demand for Mexican pesos rises, the American exchange rate rises and the
American dollar depreciates. (The equilibrium rate from an American perspective is the amount of dollars to be paid for a peso). The supply of Mexican pesos hereby decreases, which causes the Mexican exchange rate to fall and the Mexican exchange rate to appreciate. (The equilibrium rate from a Mexican perspective is the amount of pesos to be paid for a dollar).
 
Arbitrage will shift supply and demand curves until trading currencies will no longer offer any profit possibilities. (Of course, due to transaction costs, trading costs, and non-availability costs, there are discrepancies in the real world which deviate from a perfect model).  
 
The foreign exchange markets for most currencies are characterized by three types of arbitrage: geographic arbitrage, triangular arbitrage, and inter-temporal arbitrage.
 
Geographic arbitrage, enhanced by modern communications, ensures that the relative prices of any two specific currencies will be essentially the same anywhere in the world where the free exchange of currencies is permitted.
 
Triangular arbitrage is arbitrage consisting of at least two exchanges of currency to exploit inconsistencies across different bilateral exchange rates. For example, with the first currency you buy a second currency, and with the second currency you buy a third currency, and with the third currency you buy back the first currency (all in the attempt to make profit). Triangular arbitrage means that if any one exchange rate changes, then all other exchange rates will also change.
 
Triangular arbitrage ensures that all exchange rates are compatible and that for n different currencies, you need to know only the n-1 exchange rates for one currency to determine the world's [n(n-1)]/2 bilateral exchange rates. So for n currencies, there are [n(n-1)]/2 different foreign exchange markets. In a world with 216 different currencies, there are 216(215)/2 = 23,220 foreign exchange rates. You have to subtract the diagonals since they are the currencies in terms of that same currency (Note that a/b = amount of a to be paid for a unit of b currency).  
 
Inter-temporal arbitrage links the spot exchange rate to expectations of future exchange rates in general and, when they exist, the forward markets. It is usually stated as the interest parity condition. The interest parity condition implies that the spot exchange rate is largely a function of expectations about the future international trade and investment flows that will determine future exchange rates. The free exchange of assets across borders means that the interest parity condition is likely to be approximately satisfied. The covered and uncovered interest rate parity conditions will be dealt with next. They give an estimated configuration of what expected interest and exchange rates could be. Actual prices also depend on expected prices. We assume that the foreign and domestic assets are perfect substitutes; in other words, there is no risk difference between the two.  
 
The covered interest parity condition
In the covered interest parity condition, the forward exchange rate is used in place of the expected future exchange rate, in effect 'covering' the exchange risk of the inter-temporal arbitrage. This hedging instrument eliminates risk.  The covered interest parity condition is therefore also sometimes called the hedged, closed, or absent interest parity condition.
 
In the U.S., dollar-denominated assets earning a rate of return r, over a period of one year, would give a wealth of w($)_t+1 = $100(1+r). In Britain, with a foreign rate of return r* and a contracted current foreign exchange rate f^t _t+1  (foreign exchange rate at period t relevant for period t+1), wealth would grow to w(£)_t+1 = ($100/e_t)(1+r*) f^t _t+1.  Wealth obtained by investment in British assets will not equal wealth obtained by  investment in American assets, unless you have unrestricted international asset trade. This allow for international investment arbitrage to occur until the inequality becomes an equality, namely: $100(1+r) = ($100/e_t)(1+r*) f^t _t+1.
 
From the previous equality, we derive the following equation: e_t = [(1+r*)/(1+r)](f^t _t+1), which denotes the covered interest parity condition.  Alternatively we will let e_t be denoted by S and  f^t _t+1 be denoted by F. If S- F / S is  negative, we have a forward premium, and if S- F / S is positive, we have a forward  discount. A forward premium is the amount by which a country’s forward exchange rate exceeds its spot rate. A forward discount, then, is the amount by which a country’s forward exchange rate falls short of its spot rate. We denote the forward premium or discount by P; if P > 0, we have a forward premium, and if P < 0, we have a forward discount. So P =  S- F / S. We rearrange this equation as follows:

r-r* = P+ Pr*, where Pr* cancels out of the equation for simplistic purposes and
because it is a small percentage, and thus:
 
r-r* ≈ P, or: r ≈ r*+P.
 
The interest rate differential is equal to (r-r*). The forward premium (P) therefore
depends on the interest rate differential. The forward premium, in turn, tends to equal the expected exchange rate change.  
 
The uncovered interest parity condition
The uncovered interest parity condition may also be referred to as the un-hedged or open interest parity condition. There is no forward exchange rate; instead we compare returns across countries using the expected spot rate one year from now, denoted by E_te_t+1. Note that the forward exchange rates cannot be used to predict future spot exchange rates.
 
In the U.S., dollar-denominated assets earning a rate of return r, over a period of one year, would give a wealth of w($)_t+1 = $100(1+r). In Britain, with a foreign rate of return r* and an expected future spot exchange rate Etet+1, wealth would grow to w(£)_t+1 = ($100/e_t)(1+r*)(E_te_t+1). Wealth obtained by investment in British assets will not equal wealth obtained by investment in American assets, unless you have unrestricted international asset trade. This allow for international investment arbitrage to occur until the inequality becomes an equality, namely: $100(1+r) = ($100/e_t)(1+r*)(E_te_t+1).
 
From the previous equality, we derive the following equation: e_t = [(1+r*)/(1+r)]( E_te_t+1), which denotes the uncovered interest parity condition. This means that the spot exchange rate is directly related to the expected future exchange rate. If we rearrange the formula slightly, we derive: (r-r*)/(1+r*) = E_t(e_f – e_t)/e_t. Because of the fact that (1+r*) is very close to one, we take for granted that it does, and therefore we can cancel it out of the equation. We therefore derive the following equation: (r-r*)= E_t(e_f – e_t)/e_t. The expected change in the exchange rate equals (e_f – e_t) and approximately equals the international interest rate differential. The international interest rate differential is exactly offset by the expected percentage exchange rate change over the investment period when overall returns for domestic and foreign assets are equalized via arbitrage.  
 
In general, the spot rate is a function of the expected exchange rate for n periods into the future. This is denoted by the following formula:
et = E_te_t+n[(1+r*)/(1+r)]ⁿ.
 
If the interest rate differential is negative (r* > r), the domestic currency is depreciating in the long term, and if the interest rate differential is positive (r* < r), the domestic currency is appreciating in the long term.
 
In a perfect world, the forward premium or discount (FP) is equal to the expected
change in the future spot exchange rate compared to the present spot exchange rate ( m ). Thus, FP =  m . In a non-perfect world, one has to take into account the risk premium (p ). Thus, r_t = r_ft +  m  +  p .  
 
The more developed the levels of interest parity are, the better integrated the international markets are (yet the less they are supported by empirical research). If expectations about the future performance of the world's economies change, all exchange rates will tend to change in line with those changes in expectations; hence exchange rates will remain stable over time only if expectations about economic policies and economic performance remain stable. When expectations are rationally set and the interest parity condition holds (meaning trade is not restricted), future changes in the exchange rates are unpredictable.
 
The fundamental forces that drive exchange rates in the long run are:
International trade (determined by comparative and competitive advantage),
International investment (related to long-term shifts in savings and investment
opportunities).
 
The effective exchange rate is a weighted average of a set of bilateral exchange rates that provides a better indication of the overall value of a currency in the global economy. An effective exchange rate is a better indicator of a country's
competitiveness in world markets because it provides information on a country's price level relative to many of its trading partners.  
When asked the question: “Is the euro doing well?”, you have to ask “Against which currency?”, because it could be appreciating against one currency and depreciating against yet another currency. The effective exchange rates compiled by the U.S. Federal Reserve Bank are as follows:

• The Broad Dollar Index,
• The Major Currencies Dollar Index,
• The Other Important Trading Partners Dollar Index

These above three mentioned exchange rates behaved very differently over the past 25 years.

Chapter M: Economic Policy

If there is unrestricted international investment and the interest parity condition holds, then exchange rates can remain fixed only if: 

• Expectations about future exchange rates (E_te_t+n) do not change,  
• Rates of return on assets are the same at home and abroad (r = r*),  
• Policy makers immediately adjust domestic policies when expectations or interest rates change to shift exchange rate expectations back to where they were, to change domestic returns so that they again equal foreign returns, or to change some variables to offset changes in others.

Floating exchange rates are determined exclusively by the unhindered forces of supply and demand, which tends to change as demand and supply change. Floating regimes do not necessarily have to mean that there are always very wide fluctuations, however.  
 
Fixed exchange rates (also called pegged exchange rates), on the other hand, are intentionally prevented from changing by means of specific government policies that intervene in the foreign exchange markets. Foreign exchange market intervention is the buying and selling of foreign exchange by a government agency, usually the central bank, to keep the intersection of supply and demand from deviating from the targeted exchange rate. There are advantages and disadvantages to both fixed and floating exchange rate regimes, and both continue to operate in the world economy, as they have in the past.
 
Several exchange rate arrangements after World War II were designed to maintain fixed exchange rates by means of central bank intervention in the foreign exchange markets. In order to increase the supply of pesos and thereby reduce the exchange rate from the U.S. perspective ($/ peso), for example, the Mexican bank can create pesos and sell them on the foreign exchange market, or the U.S. Federal Reserves Bank could sell reserves of pesos. In order to achieve the same reduction of the exchange rate from the Mexican perspective (peso/ $), the central banks would have to issue more dollars instead of pesos.
 
In a global economy where international investment is large and there are few restrictions on people's freedom to shift their wealth among assets of different countries, central bank intervention is not viable for fixing the exchange rate for long periods of time because sooner or later other policy goals will conflict with the actions necessary to keep exchange rates fixed. An additional problem arises when foreign exchange markets alter countries’ money supplies, and such de facto monetary policy may conflict with other macroeconomic goals.
 
In the long run, exchange rates reflect purchasing power parity (PPP), which means that the nominal exchange rate e = P/P*, where P is the domestic price index and P* is the foreign price index. The PPP theory is based on the idea that trade, as a process of arbitrage, will cause the prices of goods to be the same everywhere.
 
The evidence on purchasing power parity suggests that in the short run, there is
virtually no correlation between price movements and exchange rate movements, but in the long run exchange rates do clearly reflect purchasing power parity. Countries’ relative inflation rates are useful for explaining long-run but not short-run exchange rate movements. The adjustment of exchange rates toward their purchasing power parities is very slow, however.
 
The AD/AS model
Since the exchange rate is determined, in the long run, by relative price levels, the fundamental determinants of the exchange rate must be those things that determine price levels.
 
The aggregate demand/aggregate supply (AD/AS) model from macroeconomics
highlights the determinants of price levels and, therefore, serves as part of a general theory of exchange rates.
 
The aggregate demand (AD) curve depicts the economy's total demand for output, including consumption, investment, government, and net foreign demand, as a function of the overall price level. The aggregate demand (AD) curve therefore reflects all of the determinants of the variables in the relationship Y = C + I + G + X – IM.
 
We will now elaborate on defining each of the determinants of Y:
 
Consumer spending (C) is negatively related to the value of taxes (T) and positively related to the value of income (Y) and transfers (Tr). The function is therefore: C = f(Y, T, Tr).
Investment (I) is negatively related to the foreign return on investment (r*), and is positively related to the value of income (Y), the domestic return on investment (r), the domestic real money supply (M/ P), and the real foreign money supply (M* / P*). The function is therefore: I = f(Y, r, r*, M /P, M* / P*).
 
Government spending (G) is negatively related to the value of taxes (T) and transfers (Tr), and is positively related to the value of political forces (POL), income (Y), domestic real money supply (M/P) and foreign real money supply (M*/ P*). The function is therefore: G = f(POL, Y, T, Tr, M/ P, M*/ P*).
 
The trade balance (X-M) is a function of all the variables in the C, I, and G equations:
X-M = f(C, C*, I, I*, G, G*, P/P*, e). The trade balance is negatively related to C, I, G, and P/P*, and it is positively related to C*, I*, G*, and e.
 
If we put substitute the above functions for the equation Y = C + I + G + X – M, we derive:
 
f(Y, Y*, T, T*, Tr, Tr*, r, r*, M/ P, M*/P*, POL, POL*, P/P*, e). The relation to T, T*, Tr, Tr*, r, r*, POL, and POL* are unknown. The function is negatively related to Y, M/P, and P/P*. It is positively related to Y*, M*/P8, and e.
 
The aggregate supply (AS) curve depicts the economy's total supply of output as a function of the overall price level.  
 
The long-run AS curve is usually drawn as a vertical line under the assumption that supply in the long run is purely a real phenomenon related to the economy's total resources. The long-run aggregate supply (AS) curve depends on economic growth, which in turn depends on the saving rate (s ), investment, and the determinants of technological progress (q), such as the rate of interest (r), the cost of innovation ( b ), the payoff or profit to innovation ( p ), and the availability of resources necessary for creating new ideas and knowledge (R). Technological progress (according to the Schumpeterian innovation model) is therefore defined by the following function: q = f(p , r, R,  b ). It is positively related to the payoff of innovation ( p ), and the availability of resources necessary for creating new ideas and knowledge (R). It is negatively related to the rate of interest (r) and the cost of innovation ( b ).
 
The entire function for AS, including both the short-run variables of the Solow growth model and the long-term variables of the Schumpterian growth model, is as follows:
 
  AS = g (K, L,  d , s ,  p ,  b , i, R), where:  K is the rate of capital,  
            L is the rate of labour,
d  is the depreciation rate,
p  is the payoff of innovation,        
s  is the saving rate
b  is the cost of innovation,
i is the interest rate,
R is the availability of resources necessary for creating new ideas and knowledge.
The AS curve is positively related to K, L, s ,  p , and R, and it is negatively related to d ,  b , and i.  
 
If the AD curve shifts slower than the AS curve, the price level will fall, output will increase and the income will increase as well. If the AD curve shifts faster than the AS curve, the price level will rise, output will decrease and the income will decrease as well.  
 
It is likely that the models that people implicitly use in setting their long-run expectations about exchange rates follow the logic of the AD/AS macroeconomic model, the purchasing power parity theory, and the interest parity condition.  The interest parity condition relates the spot exchange rate to the expected future exchange rate.  
 
PPP relates the exchange rate to the countries' relative price levels; spot exchange rate depends on the expected future price levels across all nations. If expectations about any one nation’s price level changes, all exchange rates tend to change through triangular arbitrage.  
 
The AD/AS macroeconomic model details the variables that determine an economy's price level and, therefore, relates the expected future exchange rate to the variables that determine future aggregate demand and aggregate supply.
 
The Trilemma
The trilemma states that no country can simultaneously fix its exchange rate, set economic policies with only domestic goals in mind, and permit the free flow of goods and assets across national borders.  A country may choose any two of the three options simultaneously:
The trilemma explains the failures of most fixed exchange rate systems, particularly the exchange rate collapses that precipitated the financial crises in Mexico (1994), East Asia (1997), and Argentina (2001), of which the Asian crisis was the most severe (but is pretty much over by now). There are many obvious parallels between the 1994 Mexican crisis, 1997 Asian crisis, and the 2001 Argentinean crisis:  
 

• All of the countries concerned had shifted their economic policies toward greater globalisation,  
• All of the countries had liberalized financial account transactions, and foreign loans and investment had grown rapidly,  
• All the governments were openly committed to maintaining tightly controlled exchange rates.  
• All the governments picked globalisation (capital mobility and free trade) and fixed exchange rates from the trilemma menu.  

Then, when domestic policy or international economic conditions changed, the fixed exchange rate could not be maintained and the currencies' values fell sharply. The central banks were not able to intervene to extend the exchange rates constant, and so the fixed exchange rates were eventually abandoned and replaced by floating rates.  
 
The exchange rate crisis implied a sudden fall in the international price of the countries’ currencies which caused widespread bankruptcies and deep recession as those countries’ debtors were unable to service their foreign currency debt. The economic slowdowns in Mexico, Southeast Asia, and Argentina were severe because the exchange rate crises triggered financial crises since foreign debt was contracted in terms of dollars. This slowed down investment and stopped economic growth and the countries were forced to endure severe recessions and long adjustment periods.

Chapter N: The Creation of International Financial Systems

An international financial or monetary order is a framework of laws, conventions, and regulations that motivates the behaviour by individuals, firms, financial institutions, and policy makers which results in a particular international financial system. An international monetary order refers to the “the rules of the game” (according to Keynes) and other formal and informal incentives under which a financial system operates. According to Mundell, “an international financial order is to a monetary system what a constitution is to a political system.”  
 
In ancient times the international monetary system consisted of an informal web of money changers serving mostly merchants who traded goods between areas where different coins circulated.
 
The eventual control of the Mediterranean by the Romans created a large free trade area with a single currency over a large region. The Roman Empire is an early example of an economic union.
 
When changing economic, social, and political conditions cause policy-makers to address the trilemma differently, financial order tends to change.
A more detailed summary of the post-ancient times period is given below:

• The International Gold Standard (1870 - 1913)
• The Bretton Woods Agreement in 1945: The Spirit of the Treaty,
• The Fixed-Rate Dollar Standard (1950-1970),
• The Floating-Rate Dollar Standard (1973-1984),
• The Plaze-Lauvre Intervention Accords for the Dollar Exchange Rate (1985-1992),
• The European Monetary System in 1979: The Spirit of the Treaty,
• The European Monetary System as a Greater Deutsche Mark Area (1979 -1992) 

The Gold Standard (1870-1913)
The (international) gold standard was the international monetary order that prevailed over the period 1880-1913, under which countries made their currencies fully convert-ible to gold at fixed parties so that all exchange rates were effectively fixed. The system worked for as long as it did because governments engaged in relatively little economic policy making that could have undermined confidence in the permanence of the fixed exchange rates.  
 
The gold standard arose as a direct result of the relationship between national
monetary policies and the value of national currencies in the foreign exchange markets. In 1817 the British parliament sought to rein in the Bank of England's power to print money by mandating that each pound note be convertible into a fixed amount of gold upon demand.
 
Bimetallism was pursued by the United States in the early 1800’s. It refers to the
simultaneous circulation of coins made of silver and gold as well as paper money convertible to both silver and gold. It was supported by a large amount of heavily indebted American farmers who wanted to increase the monetary base and subsequent money supply. Supporters of an exclusive gold standard, however, sought a tighter money supply.
 
When, by 1879, most currencies were freely convertible into gold at specific gold
parities, the world in effect had gained a unique world monetary system that came to be known as the international gold standard.
 
The gold standard was an order built on the faith that paper money and bank accounts could always be converted to pure gold at any time without restrictions, and this required that the order, or the 'rules of the game,' be respected by governments to maintain credibility in the financial system. Several other “rules of the game” had to additionally be respected by the government to enhance faith in the system, namely: Domestic coins and currency had to be backed fully with gold reserves and growth of domestic money had to be linked to the availability of the reserves,
 
The domestic price level must be determined by the worldwide supply and demand for gold, The central bank had to be the lender of last resort.
An essential rule of the game was that restrictions on imports and exports of gold were completely eliminated; foreign exchange transactions were free. Exchange rates remained fixed due to fixed gold parities (prices), free convertibility, and credible economic policies.
 
The specie flow mechanism was described back in 1752 by David Hume and was used later as an argument that the gold standard was self-correcting. The specie flow mechanism was believed to anchor the gold standard because it implied gold movements would automatically cause price level adjustments that would restore the trade balance; that is, because the specie flow mechanism made the gold standard self-adjusting, it was assumed to be the reason for the system's stability. When a country exports more than it imports, it accumulates gold and silver, which increases the money supply and raises prices, causing exports to decline, imports to rise, and the trade surplus to shrink. A trade deficit similarly disappears because gold outflows reduce the money supply and lower prices, thus increasing exports and reducing imports.  
 
Under the gold standard, in the long run, prices did roughly respond to the supply of gold despite the variability in money supplies from one year to the next.  
 
The gold standard was a qualified success because it permitted economic growth and technological progress to accelerate.
 
Regarding the trilemma, the Gold Standard chose for a fixed exchange rate and for capital mobility and free trade.
 
To see how Gold Standard scored on the scorecard of the following seven criteria, consult the chart below:
 
Scorecard for the Gold Standard
Economic Growth  Yes
Globalization  Yes
Price Stability   Yes
Output Stability   No
Policy Flexibility  No
Mutually Beneficial  Maybe
Self-Regulating  Maybe
 
As you can see, the gold standard did not satisfy the fourth through the seventh criteria of success for financial orders nearly as well because the rigid rules of the game often caused financial panics and severe ups and downs in economic activity in many countries.  
 
An additional weakness of the Gold Standard system was therefore that revenue-hungry governments were tempted to issue more paper currency than they can back with the gold stored in their vaults. Suspicious holders of paper money could panic and start a gold “run”. This led governments to suspend the convertibility of paper money and eventually leave the gold standard.
 
The Inter-War Period
Given the economic difficulties faced by many countries at the close of World War I, it is not surprising that the return to the order of the gold standard would take a long time and would ultimately fail. Due to inflation during the war years, countries had to deflate in order to return to the gold standard under the old gold parities. These deflationary policies, however, led to the Great Depression. The demands placed on Germany to repay the losses of the allies were impossible to fulfil and caused the political upheavals of the 1920’s and 1930’s. Keynes had warned against this because he found these deflationary policies too costly in terms of unemployment, falling investment, and lost output. Keynes instead advised countries to implement new parities and seek price stability at higher price levels. Mundell also said in the year 2000 that if the price of gold had been raised in the late 1920’s (as Keynes advised), or the central bank had sought price stability instead of blindly adhering to the gold standard, “there would have been no Great Depression, no Nazi revolution, and no World War II.”
 
In 1936, in the middle of the Great Depression, the United States, Great Britain, and France negotiated the Tripartite Accord, which was an attempt to restore some stability to the world financial system; under this agreement the three countries agreed to fix exchange rates between their currencies.
 
The score card for the inter-war period tells it all:
 
Scorecard for the Inter-War Period
 
Economic Growth  No
Globalization  No
Price Stability   No
Output Stability   No
Policy Flexibility  No
Mutually Beneficial  No
Self-Regulating  No
 
Bretton Woods (1944-1971)
 
In July 1944, policymakers of the allied countries met in the United States to establish an international order proceeding World War II. They wanted to reverse the trend toward economic isolation and growth-haltering economic policies during the inter-war years.
 
The major purposes of the Bretton Woods Conference were to: 

• Design a world economic order that would minimize economic conflict,  
• Encourage sound macroeconomic policies to generate growth and employment in all economies,  
• Restore the flow of goods and investment between countries to at least the minimum levels that prevailed before the 1930s.  

 
The Bretton Woods Conference resulted in the creation of the GATT, IMF
(International Monetary Fund), and the World Bank.
 
The early Bretton Woods order lasted from 1944-1958 and focused on a fixed
exchange rate and policy interdependence. The latter duration of the Bretton Woods order (1959-1971) chose for a fixed exchange rate and capital mobility and free trade.  Exchange rates under the Bretton Woods system were pegged but adjustable. This was the most distinctive features of the Bretton Woods system; fixed exchange rates were not to be treated as if they were etched in stone. Keynes had already argued that exchange rates should be alterable in the case of a fundamental disequilibrium, which occurred when an exchange rate was not compatible with the monetary and fiscal policies necessary to maintain full employment, promote economic growth, or satisfy other important domestic policy objectives.  
 
The Bretton Woods system worked reasonably well, and world trade grew twice as fast as the world economy as a whole, which also grew at a very healthy rate; the countries that had been destroyed by the war recovered impressively.
 
The Bretton Woods system of pegged exchange rates eventually ran afoul of the
trilemma, however, and when major economies did not follow similar economic
policies, it had to be abandoned for floating exchange rates.
 
How the Bretton Woods order scored according to the seven financial order criteria can be seen below:
 
Bretton Woods Scorecard
Economic Growth  Yes
Globalization  Yes
Price Stability   Maybe
Output Stability   Maybe
Policy Flexibility  No
Mutually Beneficial  Maybe
Self-Regulating  No
 
Note the difference between depreciation or appreciation and devaluation or
revaluation.  
 
Devaluation refers to a change in the fixed exchange rate that causes the national currency to de cline in value relative to other currencies. Depreciation refers to the wearing out or using up of the stock of capital. The proportion of capital that 'wears out' in each period of time is the rate of depreciation.
 
Revaluation refers to a change in a currency peg that increases its value relative to other currencies. Appreciation is the process that effectively combines distinct markets into a single integrated market by means of profit-seeking arbitrageurs who buy goods or assets in those segments of the market where prices are low and sell where prices are high.  
 
Post Bretton Woods (1973 - present)
 
Because European countries are closely linked in trade, fluctuating exchange rates were especially costly to them, and they established the European Monetary System (EMS) in 1979 to keep exchange rates fixed.
 
Economic policies and the fixed exchange rates became incompatible in 1990 with the fall of the Berlin Wall and the unification of Germany in 1990, and in 1992 the EMS became the third major fixed exchange rate system to be discontinued during the twentieth century.
 
The scorecard for the Post Bretton Woods floating era can be viewed below:
 
Scorecard for Post Bretton Woods  
 
Economic Growth  Maybe
Globalization  Yes
Price Stability   No
Output Stability   No
Policy Flexibility  Yes
Mutually Beneficial  Maybe
Self-Regulating  Yes
The post Bretton Woods order chose for capital mobility and free trade and for policy interdependence (since rates can fluctuate).
 
In 1995, the European Union, which had just been extended to include 15 members, reconfirmed its intent to create a single currency. In 2002, the euro became the currency of most EU member countries. The five criteria for joining the euro were as follows:

• The currency’s exchange rate must remain stable for two years,
• Inflation must be less than 1.5% above the average inflation rate of the three European countries with the lowest inflation rate,
• The interest rates on openly-traded government bonds must be less than  2% above the average rate of the three European countries with the lowest rates,
• The government budget deficit must be less than 3% of its GDP,
• The government debt must be less than 60% of its GDP.

The European Union chose for capital mobility and free trade as well as fixed exchange rates.

Chapter O: International Migration

Immigration is one of the three types of international economic activity that are usually included among the economic activities that constitute globalisation.
 
In the beginning, there were no political boundaries. One spoke therefore of migration, not of international migration, which requires a change in allegiance and citizenship. The establishment of permanent settlements was initiated in the Fertile Crescent in the Middle East. People developed a sense of nationality and political boundaries were created. Movement from one nation to another then became known as international migration.
 
Immigrants fall into different categories reflecting different motivations and
permanence, such as settlers, contract labourers, professionals, asylum seekers and refugees, illegal immigrants, and involuntary immigrants. Settlers remain in another country as permanent residents. Contract labourers go to another country for some limited period of time to perform a specific job. Illegal immigrants immigrate without following the required formal legal procedures to gain entry to another country.
 
In general, immigrants move from one country to another because they expect to improve their well-being, whether they are escaping an unbearable situation at home or pursuing a more attractive situation abroad. The idea that people seek to improve their welfare motivated each of the models of immigration which will be presented.  
 
Economic incentives are most frequently the driving force behind international
migration.
 
The labour supply model of immigration, which holds labour demand constant, shows that immigration causes wages to rise in the source country and fall in the destination country. The labour demand curve (D_L) is the value of the marginal product of labour curve (VMP_L), which equals the product of the marginal physical product of labour, dY/dL  or MP_L, and the price of the output (P). The MPL is the differentiation of the macroeconomics production function Y = f(K, L). The VMP_L curve has a negative slope since MPL declines as more labour is hired. Supply of labour is modelled with a vertical line since the effects of higher wages on labour supply is uncertain; on the one hand, higher wages motivate people to work more and sacrifice leisure for work, but on the other hand, higher wages result in higher income which reduces the need to work more.  
 
 GDP is calculated as the sum of area B (which equals total labour income (w*L)) and area A (which equals the income of the remaining productive factors such as capital, human capital, and land). Note that GDP is not the same thing as GNP (Gross National Product). GDP includes all income earned by citizens or foreigners within the physical borders of the nation. GNP includes all income produced by citizens of the respective nation earned domestically or abroad.
 
The labour supply model of immigration shows that in the destination country
immigration reduces wages for native workers who are similar to the immigrants, and increases the returns to factors that complement immigrant labour.  
 
The labour supply model of immigration additionally shows that economically motivated immigration causes the overall welfare of the destination country and total world income to rise, but immigration may cause net welfare losses in the source country. If 25 million workers migrate from Morocco to France, the labour supply curve shifts to the left in Morocco, causing an increase in the wage rate, a decrease in GDP, and an increase in GNP. The labour supply curve shifts to the left in France, causing a decrease in the wage rate, an increase in GDP, and an increase in GNP. However, the net world GDP increases. We also see that immigration's positive effect on total world output is the result of economically motivated labour moving from a country where its marginal contribution to increasing real output is low to a country where its marginal contribution to increasing output is higher.
 
The VMP_L curve does not remain constant when immigrants arrive because immigrants add to demand as well as labour supply in the destination country, and they reduce demand as well as labour supply in the source country.
 
The labour supply and demand model gives a more accurate picture of the immediate effects of immigration because it shows both the demand and supply effects of immigration on the labour markets in the source and destination countries. In the destination country, the supply curve and the demand curve increase and shift to the right. This causes a decrease in the wage rate (smaller than in the supply-only model). In the source country, the supply curve and the demand curve decrease and shift to the left. This causes an increase in the wage rate (smaller than in the supply-only model).
 
The gains and losses from immigration are also influenced by the propensity for
immigrants to send some of their income to family and relatives back in their native countries. If remittances are large enough, then even if the immigrants are permanent and their welfare is counted as part of the destination country's welfare, the source country also gains welfare. Remittances to less developed countries have increased from 1988 to 1999.
 
Some positive externalities to immigration include:

• Enhanced efficiency due to increased competition,
• An increase in the overall level of technology due to the introduction of new products and production methods,
• Greater exploitation of economies of scale due to the larger population and economy.  

Some negative externalities to immigration include:

• Immigrants require more government services,  
• Immigrants commit crimes,  
• Immigrants congest the country's facilities or burden existing infrastructure.

If negative externalities to immigration exist, then the welfare of natives could decline with immigration.
 
According to immigration research of Rachel Friedberg and Jennifer Hunt, “the effect of immigration on the labour market outcomes of natives is small. There is no evidence of economically significant reductions in native employment. On the contrary, immigrants may affect the rate of economic growth in the source and destination countries because they may have human capital that is especially important for R&D activity or because they are especially entrepreneurial. Immigrants frequently have the talents and personalities which are appropriate for innovation. According to William Petty, “it is more likely that one ingenious curious man may rather be found among 4 million than among 400 persons.” According to Joseph Schumpeter, immigrants were good candidates to be entrepreneurs because they are less attached to the traditions of society and, therefore, more willing to “be different.” Immigration indeed tends to reduce the aptitude of vested interests to take protectionist measures that slow the process of creative destruction. Additionally, immigration also increases technology transfer.   
 
The immigration by educated people from developing economies, where education is scarce, is referred to as the brain drain. This is often seen as enhancing growth in the richer destination countries while limiting potential growth in the poorer source countries. There are few easy solutions to the brain drain, and given the incentives for such immigrants and the countries receiving the educated immigrants, the brain drain will most likely accelerate until technology transfers and capital flows enable the developing economies to provide their own citizens with greater rewards for using their education at home. The negative effects of the brain drain effect, however, may possibly be offset by the remittances from abroad and the eventual return of migrants
after gaining foreign experience.

Chapter P: Immigration Policies

Little more than 100 million people live in countries where they were not born, which is a large number of people but still accounts for about 2 percent of the world's population.
 
There are numerous push, stay, pull, and stay-away factors which explain why people do or do not migrate. Attractive factors of countries are ‘stay’ and ‘pull’ factors.  
 
Unattractive factors of countries are ‘push’ and ‘stay away’ factors.
 
Without diminishing any of the other reasons why people stay at home, or stay away from other countries, it is safe to say that one of the main reasons so few people migrate is the fact that most countries intentionally limit immigration.
 
The United States and its changing immigration policy over the past 200 years provide a valuable case study.
 
Throughout the 1800s immigration was largely unrestricted in the United States, as it was in most other countries. The first legislation strictly limiting immigration was enforced in 1882 in China and was called the Chinese Exclusion Act. It was also racist because it only banned Chinese immigrants.  
 
The U.S. quickly followed in the footsteps of China. In 1891, the Office of Immigration was created (known today as the INS (Immigration and Naturalization Service)). In 1892, moral and health criteria were enforced in immigration law in New York, and in 1913 a law was enforced requiring that immigrants be literate.  However, immigration to the United States gradually grew throughout the nineteenth century, and it reached nearly 1 million people per year between 1900 and 1910. Yet during World War I and the Great Depression, more people left the United States than entered it.
 
Although there was increased political support for curbs on immigration in the late 1800s and early 1900s in the United States, it took until the 1920s before legislation was passed to sharply limit immigration by means of a quota system aimed at keeping the ethnic composition of the U.S. population from changing. The 1921 Emergency Quota Act set strict limits for the first time, followed by an even more specific Immigration Act in 1924 which was intended to preserve the traditional ethic makeup of the U.S. The Japanese Exclusion Act of 1924 banned Japanese immigrants.  
 
The 1965 Immigration and Nationality Act Amendments abolished the U.S quota system for new criteria permitting essentially unlimited immigrant visas for relatives of people already living in the United States and to people with special skills; this caused immigration to grow.
 
Illegal immigration was especially growing rapidly in the 1980’s, which led to the subsequent implementation of the Immigration Reform and Control Act (IRCA) of 1986, which strengthened the border patrol and initiated punishment procedures on those people who helped illegal immigrants enter the country. Employers had to check the status of their employees to ensure it was legal. Yet the IRCA also gave 2.7 million illegal immigrants a legal status, which gave illegal immigrants more motivation to enter the country (in the hope for later legal status grants). Forged documents were also the result of the obligatory citizenship identification. Increased border controls had little effect on the rate of illegal immigration.  
The Immigration Act of 1990 caused a reduction of visas granted to non-skilled workers and an increase of visa grants to skilled workers. The Illegal Immigration Reform and Immigrant Responsibility Act of 1996 established a telephone clearing house for the verification of immigrant status. The Personal Responsibility and Work Opportunity Act led to the exclusion of non-citizens in numerous public aid programs. In 2000, Congress allowed for the issuance of temporary work visas.
 
By the year 2000 close to one million people were immigrating legally to the United States each year. In the year 2001, the U.S. accepted more than one million immigrants (of which two-thirds were admitted because they already had relatives in the U.S.). Of all the source countries, Mexico delivered the most immigrants to the U.S., and of all the American states, California accepted the most immigrants. The share of females in international migration has increased from the year 1970 to 2000. Today the majority of U.S. immigrants are females. Half of the American immigrants are between the ages of 25 and 45.
 
Illegal Immigration
Despite the increase in legal immigration, many more people wanted to live and work in the United States, and illegal immigration also grew throughout the latter half of the twentieth century. Illegal immigration occurs not only in developed countries, but it occurs between all nations where there are substantial differences in economic opportunities. As income differences between developed and developing countries have grown and developed countries increased restrictions on immigration, illegal immigration has increased sharply.
 
Illegal immigration may constitute a form of market segmentation since native workers are paid higher wages than illegal immigrants and since illegal immigrants are often limited to participating in only certain sectors of the destination country's economy. (Yet these illegal immigrants still earn more in their destination country than in their source country). Because the illegal immigrants end up in a lower-paying market segment, they do not directly compete with native workers. This de facto labour market segmentation therefore minimizes welfare losses to native workers while maintaining
most of the gains to consumers and employers. Because employers and consumers in developed economies often enjoy the benefits of immigration, illegal immigrants are tolerated in many countries.
 
As you can see in figure 16.10 copied underneath, if illegal immigrants earn w2 and native workers earn w1, this will cause an employers surplus equal to area G. If the VMPL curve does not change, the native workers’ wages will remain unaffected (their income is equal to areas E+F with or without illegal immigration). If, however, the VMPL curve shifts to the left, the native workers will experience an increase in wages from w1 to w3 and their income will increase from areas E and F to also include area J. Employers also enjoy a larger employer surplus equal to the enlarged area G.
 
The same forces that pushed U.S. immigration policy in the direction of greater
government control in the early twentieth century and toward liberalization at the end of the century also affected immigration policies in other high-immigration countries such as Australia, Canada, and New Zealand. Australia and Canada revised their immigration laws more recently to stimulate immigration by people with special skills and high levels of education.
 
After playing the role of source countries for the massive immigrations to North
America, South America, and Australia in the nineteenth and much of the twentieth centuries, most European countries have become destination countries for immigrants from southern Europe, Africa, and Asia.  
 
Immigration laws and procedures are notoriously complex in the United States and many other countries, although efforts have been made to simplify the process for highly skilled people and business executives. As business becomes more global, business managers will more often have to work with immigrants and they are more likely to become immigrants themselves.

Chapter Q: Globalisation in the Future

As globalisation began at the end of the 19th century, people enjoyed increasing
standards of living, although they still had a lot to complain about. Globalisation was stopped in 1914 as World War I broke out. After this war, policymakers were not willing or unable to return to globalisation policies. They even reversed the direction by turning to economic and political isolation. International trade, immigration, and foreign investment all decreased. After World War II, however, most Western countries learned from the brutal lessons of recent history and returned onto the path of globalisation.  
 
The example of the Nebraska automobile industry showed us that protection of one sector of the economy injured other economic sectors, and so it does not favour national interests over foreign interests, but a national interest over other national interests. The circular flow diagram showed us that performance in one economy is linked to performance in the other economies in multi-dimensional ways.
 
The Lerner symmetry theorem showed us that protectionism is costly because it favours higher-cost industries over lower-cost industries. Protecting the import industry hurts the export industry. Protectionism that fully eliminates trade reduces the economy back to self-sufficiency and a lower welfare level; protectionism can therefore not raise welfare.
 
The two-country models of trade show that the effects of protectionism do not only pertain to the domestic country itself; instead, it also has economic effects abroad.
 
The power of compounding shows that long-run growth is more beneficial for human welfare than short-term growth. Long-term growth requires continued technological process, which is reduced by protectionism. Protectionism not only involves short-term opportunity costs, but also negative long-term effects on economic growth.
 
According to Robert Isaak, “ethnocentrism – the belief in the primacy of one’s own people or way of life – is the ultimate motive behind protectionism.” Antiglobalist protestors argue that globalisation clashes with the concept of “nation.” They resist globalisation because they fear that repeated contacts with foreign products and businesses will cause them to lose their national identity and undermine society.  
 
In the past, foreigners have often been perceived as more of a threat than as the
source of welfare which they could be through specialization and exchange. During the previous 1000 years, China and Japan have isolated themselves from the world for long periods, alleging the evils of foreign cultural and moral influences that accompany trade. During the Bretton Woods Conference, however, delegates finally saw the light and sought to create institutions that would promote the growth of economic transactions.  
 
Globalisation can also be seen as a route to world peace. The future of globalisation ultimately depends on people’s views of foreigners and their nation’s relationships with them.  
 
Another common implication of globalisation is the so-called “loss of political
autonomy.” This may be partially true because governments have increasingly less freedom to set all kinds of economic policies as products are increasingly moving across the border. The international mobility of trade also affects the government’s ability to tax because investment will flee from countries that tax investment highly to countries that tax it lightly. There is increasing competition among countries to reduce taxes since countries often use tax reductions to attract foreign investment.  
 
Some people fear that globalisation will cause a backlash due to possible increased taxation of labour and lower taxation of investment. Yet in the long run, everyone gains from growth due to globalisation, including labour as well as capital. Globalisation does not bring about a long-term decrease in wages. Neither does it cause desirable government programs to go without funding. Globalisation actually enhances the government’s ability to fund and carry out economic policies, programs, and transfers.  
 
A rather ambiguous matter is whether or not international competition weakens or strengthens economic institutions. It is therefore not easy to choose between international institutions and national sovereignty. Both are additionally shaped by political pressures and interest group lobbying.  
 
Globalisation is frequently said to create a “race to the bottom.” The increased
competition is though to decrease taxes, relax regulations and standards, and bow down to foreign business interests. There is little evidence available for this theory however. On the contrary, studies more often show a race to the top.  
 
Yet the “race to the bottom” argument is still frequently used by environmentalists to argue that globalisation is detrimental to the environment. They claim that companies will locate where pollution controls are the weakest, which increases overall world pollution. People will also flock to these locations due to increased labour supply, which enhances the pollution problem even more. Yet globalisation and economic growth only if there is no technological progress.  
 
Technological progress fuels long-term growth (according to the Solow growth model) and it is additionally essential for understanding scarcity. Productivity of natural resources can be increased through a technical innovation that increases the amount of output that can be produced from a given amount of natural resources. Technological progress also increases the effective stock of resources remaining for the future. By increasing technological transfers and stimulating research aimed at large world markets, globalisation permits humanity to increase its standards of living more quickly without destroying the environment.  
 
Environmental taxes and elimination of environmentally un-friendly subsidies can relieve costly tax burdens elsewhere in the economy and provide the multiple benefits of improved resource allocation, more resource-saving technological progress, and reducing the costs of other welfare-enhancing activities.  
 
Therefore, to argue that globalisation is bad for the environment means to argue that; Technological progress would be less in a competitive global economy than in closed economies,
Governments in small, isolated economies adjust prices and taxes more accurately to reflect opportunity costs than governments do in integrated economies. These are undoubtedly very questionable assumptions.
 
The fact that globalisation and income divergence have gone in hand throughout
history has been a basis for many to believe that reversing globalisation is the best solution for solving inequality. Lindert and Williamson found that “virtually all of the observed rise in world income inequality has been driven by widening gaps between nations, while almost none of it has been driven by widening gaps within nations.” Globalisation is known to reduce welfare for some people in the short-term and medium-run (in the long-run, everyone benefits).
 
Differences in per-capita income have also been increasing throughout the past 200 years. Yet per-capita income has increased everywhere in the world, although the problem is that they have done so faster in some countries.  
 
From 1820 onwards, when the middleclass emerged, there has been an enormous spurt in population growth. (Before that, basically everyone was poor). Absolute poverty has naturally increased along with the population growth. Relative poverty, however, has decreased. Today, however, poverty is declining in both absolute and relative terms. This is mostly due to the major decline of poverty in China and India.
 
Wage policies don’t work in poor countries, and tax policies are limited because the tax structure is very different in poor countries. Taxes are mostly collected on an indirect basis, via import duties and sales taxes. (In the Netherlands, most taxes are collected on a direct basis via income tax). The focus should be on equalizing access to inputs rather than trying to redistribute outputs. The methods for reducing inequality include removing trade barriers in developed countries, enhancing effective aid, and improving access to transport and communication, agricultural inputs, micro credit, property rights, and lastly, but most importantly, education and health.   
 
Inequality between countries is more important and larger than inequality within
countries. Inequality would be reduced if lower-income countries grew faster than high-income countries, which is unfortunately very difficult for them. Jeffrey Sachs thought that more, not less, globalisation was needed to enable rapid economic growth in the developing countries to occur. This requires better education, more open societies, greater social mobility, and the opening of borders to more economic transactions.  
 
The adoption of technology is possible via three main channels:

• Importing technology,
• Licensing technology from patent holders,
• Attracting FDI.

In order for the effects on globalisation to be advantageous, trade should be voluntary. This provides net gains to both parties. Plunder and conquest are merely the transfer of resources from one person to another (theft: one loses, another gains) and equals a net gain of zero. They are referred to as the “invasion” of foreign products, the “destruction” of local culture, and the “conquest” of foreign markets. Changes should also remain voluntary, not forced. Entrenched interests always resist change. Vested interests that want to prevent competition and resist change are working very hard to shape international institutions in their favour. This negatively effects the formation of
“good” international institutions that effectively determine technological progress and economic growth.
 
There are several requirements for the various components of globalisation, namely:

• International rules of conduct are required for international trade,
• Uniform property protection is required for efficient international investment,
• Uniform protection of intellectual property is required for dissemination of technology,
• Uniform protection of individual rights is required for international migration.

Today’s antiglobalists are wrong in predicting globalisation to cause conformity. The global economy will actually give people more choices. As Thomas Barlow said, “the unpredictable is not the same as the uncontrollable. We will see that man does not conform to technology but to a perception of opportunity.”