Summary of International Economics by Pugel

What distincts international economics from the rest of economics? - Chapter 1

There is no overarching body that imposes laws, policy tools, currency, taxes and barriers on nations. Nations have their own policy and being sovereign makes them less likely to compromise and more likely to ignore foreign interests. On the other hand, regions have to obey nationwide rules and have less policy tools at their disposal than nations. This makes them more likely to compromise and distincts national economics from international eonomics. Four controversies will illustrate the special nature of international economics.

Which four controversies illustrate the special nature of international economics?

U.S. exports of natural gas

The example of the United States (U.S.) exporting natural gas clearly shows the influence of international trade. The U.S. has had a flat production of natural gas for several years while it faced increased consumption. At the same time, the production costs increased due to the exhaustion of available sources. U.S. imports increased to meet the increased demand. Just when it seemed they had to increase these high-cost imports of natural gas big time, technological developments enabled the U.S. to extract natural gas from newly accessible sources. U.S. firms increased production of natural gas for several years and could even look for new customers outside their own country. However, a U.S. law prohibited exporting unless it would be in the public interest. This raised the question how and whether the public interest would benefit from exporting natural gas. Some people were afraid that the U.S. would export all of its gas away or that it would be too costly. However, following the 2011 tsunami and its destructive aftermath, Japan shut down its nuclear facilities and increased its demand for natural gas to generate electricity. If the U.S. and Japan would open up to trade, the following would happen:

1. An equilibrium would result in the international natural gas market if the U.S. would export to Japan. Increased demand for natural gas would drive up its price, increasing U.S. production and decreasing U.S. consumption in turn. The price in Japan would actually fall, increasing consumption there.
2. Not everyone will benefit from trade. Due to an increased U.S. price, consumers will be harmed but producers and exporters will benefit.
3. Environmental effects aside, most people are better off. Despite a higher international price, the U.S. won't export all of its gas since transportation costs are significant.

Immigration

Immigration has some economic effects as well. Again, there is a net economic benefit. Job-seeking immigration benefits employers of immigrants and consumers who buy the products produced by them. However, since residents who compete with immigrants for jobs are usually worse off, there will always be fights over immigration.

China's exchange rate

The exchange rate is a key price in international economics. It is a powerful tool to influence flows of goods and services as well as financial flows. The Chinese government illustrated this by fixing the exchange rate between the yuan and the U.S. dollar. According to the U.S. and the European Union (EU), the yuan was valued too low. This increased demand for the yuan. Normally, the price of the yuan would increase but China chose to intervene to keep a competitive advantage and run a trade surplus. The Chinese government kept buying dollars with yuan and was pressured by the U.S. and the EU to end this 'unacceptable' currency manipulation. China kept resisting this pressure but started to experience the downside of the fixed exchange rate as well. The lower value of the yuan and its increased supply encouraged local borrowing and spending, putting upward pressure on its inflation rate. Therefore, in the end China could benefit from allowing the exchange rate of the yuan to increase.

This example illustrates that (international) trade usually results in an equilibrium. Deviations from this equilibrium tend to be temporary and result in shifts toward an equilibrium.

Euro crisis

The global financial and economic crisis and the Euro crisis clearly show the interrelatedness of nations' economies and the controversies that result from trade agreements. Loans in the U.S., especially mortgages, of low-risk borrowers were packaged with those of high-risk borrowers and sold with a good credit rating. This encouraged a credit boom that funded a housing bubble. The subprime mortgages of high-risk borrowers increasingly went into default and with them the packaged securities. All of a sudden, credit ratings were unreliable and the financial markets froze as financial institutions and investors became reluctant to lend to each other. Europe was involded in four ways:

1. Housing bubbles and credit booms were also present in Ireland, Spain and other European countries;
2. European banks also held subprime mortgages and (as it turned out) worthless packaged securities;
3. European banks in need of short-term funding were harmed since financial markets froze;
4. The U.S. financial crisis became a recession which spread to other countries when U.S. production and income, and hence, imports, declined.

The development of a monetary union was crucial in integrating financial markets across the euro area and has been really successful. Following the recession, however, the EU was under pressure to help several countries meet their financial obligations. Without intervention, severe losses would be made and the continuence of the union and its currency would be under pressure. Bailouts occured but institutions and investors were still reluctant to invest in certain government bonds, driving up their interest rates. The European Central Bank (ECB) had to intervene with a lot of money and show that it would do whatever it took to preserve the euro in order to restore trust and start recovery from the crisis.

How is international economics dependent on the nation-state?

The previous four examples illustrated the interplay of international economics and nations' sovereignity. Each country has policy tools to influence the international market. Among the most important are:

• Factor mobility: although workers and capital are more mobile within countries, they do move internationally.
• Different fiscal policies: each country can impose regulatory policies on flows of goods, services, financial assets and people like import taxes or export subsidies.
• Different moneys: each country can have its own currency and has policy tools to exert influence on the exchange rate. This means that the value of one currency can change relative to another on a daily basis.

Although there are international organizations like the World Trade Organization, the International Monetary Fund and the World Bank that try to exert some power over the global economy, in the end, countries are sovereign and control their own policies. This is what makes international economics a complex but interesting field of study.

How is basic trade theory shaped by demand and supply? - Chapter 2

What are the basics of demand and supply?

Every time a product is produced and bought, resources are used which cannot be used for other products. Therefore, producers and consumers have to allocate their resources and make trade-offs. So even when we seem to analyse a single product, we study this product relative to other goods and services in the economy.

Demand

Demand depends on a consumers' preferences, the price of the product, the prices of other products, and income. Demand curves usually slope downward, which indicates that an increase in price lowers demand. This is a movement along the demand curve. The impact of a certain demand characteristic can differ for different types of products. For example, a product is considered a normal good (e.g. clothing) if an increase in income increases demand. A product is considered an inferior good (e.g. pizza) if demand decreases when income increases. It is assumed that in the case of inferior goods, people prefere more expensive alternatives when they have more money to spend.

As a product's price is a determinant of its demand, the quantity demanded is responsive to a change in price. The level of responsiveness depends on the price elasticity of demand. This elasticity measure represents the percent change in quantity demanded when the price increases by 1 percent. Demand is said to be elastic if the absolute value of the elasticity measure is greater than 1. If the absolute value is less than 1, demand is said to be inelastic. This is represented by a steep slope of the demand curve as the quantity demanded does not respond that much to a price change.

When drawing the demand curve, the price of the product itself is included in the model. Therefore, a price change results in a movement along the demand curve. If any other demand characteristic changes - income, other prices, preferences - the entire demand curve shifts.

Consumer surplus

Demand for a product also depends on consumers' willingness to pay. At a given price, it is likely that there is a group of consumers which is willing to pay more. The area between the demand curve and the price of the product in the marketplace represents this higher willingness to pay and is called consumer surplus. This is the net gain that increases the economic well-being of consumers who are willing to pay a higher price but still pay the market price.

Supply

Important supply characteristics are the selling price and the cost of producing and selling the product. Supply curves usually slope upward. Suppliers usually offer extra products as long as the costs of producing and selling the extra units are covered by the selling price. For some products, marginal costs - the costs of producing an extra unit - rise. This means that a higher selling price is needed to cover these extra costs. An increase in a product's price increases the quantity supplied and indicates a movement along the supply curve. A change in any other supply characteristic - availability of inputs, technology - results in a shift of the entire supply curve.

The responsiveness of the quantity supplied to a change in the market price is measured by the price elasticity of supply. This elasticity measure represents the percent change in quantity supplied when the market price increases by 1 percent. Again, a price elasticity greater than 1 is said to be elastic and an elasticity less than 1 is said to be inelastic.

Producer surplus

Given the market price, it is likely that some producers are willing to offer their products at a lower price. The amount between the supply curve and the market price represents the net gain or the increase in the economic well-being of producers who receive the market price but would have settled for a lower price. This is called the producer surplus. Money spend on resources used in production of a given product cannot be spend in other production processes. The value of products not produced because resources are already in use, represents an opportunity cost for the economy as a whole. For an integration of supply, demand, and producer and consumer surplus, see figure 1.

A national market with no trade

If there is no international trade, there is one national price at which the domestic market clears. This is the equilibrium price at which demand equals supply. The amounts of consumer and producer surplus depend on the steepness of the demand and supply curves.

Why do countries trade?

If there is no trade, countries have their own domestic markets with equilibrium prices that are likely to differ. If they open up to trade, arbitrage opportunities arise. This would mean buying something at a lower price in one country and selling it for a higher price in another country to earn a profit.

How does trade affect production and consumption in each country?

Free-trade equilibrium

Arbitrage opportunities will be exploited until the prices in the two countries are comparable. If there are no transportation costs, a free-trade equilibrium price - called the international price or world price - will result. This price can be determined using demand for imports and supply of exports. When two countries have their own domestic equilibrium, the country with the highest equilibrium price will have demand for imports at a lower world price. Excess demand will arise since demand increases and supply decreases when the price drops. The country with the lowest equilibrium price will have supply of exports since the higher world price results in excess supply (decreased demand and increased supply). Eventually, demand for imports is expected to equal supply of exports at the world price. If not, excess supply on the world market would put downward pressure on the price of a trade product and excess demand would put upward pressure on the price.

Effects in the importing country

The importing country would have demand for imports as the foreign price is lower than the domestic price. Moving toward the free-trade equilibrium, consumers are better off at the world price and producers are worse off.

It is hard to say something about the net effect of trade because economic stakes are often dependent on subjective weights. Consumer surplus might increase more than producer surplus decreases but if it results in producers going out of business, is opening up to trade in the nation's best interest? Calculating net national gains means ruling out subjective weights and measuring the effect on aggregate well-being. A useful tool is the one-dollar, one-vote metric which values each dollar of gain or loss equally. If we ignore who experiences it, the net national gains from trade are equal to the difference between aggregate gains and losses.

Effects in the exporting country

The exporting country has supply of exports as the trade price is higher. Moving toward the free-trade equilibrium, producers are better off and consumers are worse off. The net effect can be calculated by comparing the gain in producer surplus with the loss in consumer surplus. To see the effects on the importing country, the exporting country and the world market, see figure 2.

Which country gains more from trade?

When countries open up to trade, the intersection of the demand curve for imports and the supply curve for exports shows the world price. Given this price, the net effects of trade are represented by the area up to the demand curve (for the importing country) and down to the supply curve (for the exporting country). The country with the steeper trade curve experiences a larger price change and thus gains more from trade.

Who are the gainers and losers from opening trade?

Consumers benefit from imported products but are hurt by exportable products. Producers benefit from exporting products but are hurt by imported products.

Every time a product is produced and bought, resources are used which cannot be used for other products. Therefore, producers and consumers have to allocate their resources and make trade-offs. So even when we seem to analyse a single product, we study this product relative to other goods and services in the economy.

How does comparative advantage foster trade? - Chapter 3

The previous chapter focused on trading one product but we would like international trade theory to consider the entire economy. However, since this is very complex, we start to examine a two-product economy in which the countries are a net exporter of one product and a net importer of another product.

What does Adam Smith's theory of absolute advantage teach us?

Simply put, Adam Smith's theory states that a country should focus on producing what is does best. If for example labor productivity - the number of units a worker produces in one hour - is higher, the country is said to have an absolute advantage in producing this product. If two countries devote their resources to the product in which they have an absolute advantage, total world production increases. Countries could trade (part of) their excess production and be better of than when each country produces every product themselves.

What does Ricardo's theory of comparative advantage teach us?

The principle of comparative advantage shows that countries can still gain from trade if one country has an absolute advantage in producing all products that another country has an absolute disadvantage in. Ricardo's theory states that countries should produce the product in which they have a relative advantage.

Suppose that country A requires 4 hours of labor to produce 2 units of wheat or 1 unit of cloth. The relative price of wheat is 0.5 units of cloth and the relative price of cloth is 2 units of wheat. Country B can produce 2/3 units of wheat or 1 unit of cloth which requires 1 hour of labor, so the relative price of wheat in country B is 1.5 cloth and the relative price of cloth is 0.67 units of wheat. Since country A requires so many labor hours to produce the products, it has an absolute disadvantage in producing both products. However, it has a relative advantage in producing wheat. This can be explained using opportunity costs. Country A has to give up half a unit of cloth to produce 1 unit of wheat whereas country B has to give up one and a half units of cloth to product 1 unit of wheat.

Opening up to trade will push the two separate national relative prices of the product toward a new equilibrium price. This world price will fall within the range of the two separate prices. Why? At a lower relative price both countries would want to import it and at a higher relative price both countries would want to export it. In this scenario no trade would result while both countries could be better of by trading.

As shown, countries could benefit from comparative advantage. It should be noted, however, that countries with an absolute disadvantage in all products are still less productive. These countries tend to be poor with low real wages.

What can we learn from the production-possibility curve?

A country can use all its available resources to produce one of the two products or a combination of both. If all resources are used at maximum productivity, we can draw a line representing all possible combinations. This is called the production-possibility curve (ppc). The slope of the ppc represents the relative price of one product in terms of the other or opportunity cost. The ppc is drawn as a straight line when we assume constant productivity because of constant marginal costs.

Assuming that arbitrage opportunities will be exploited when opening up to trade, a line can be drawn representing the world relative price for which the countries can trade their products. As illustrated before, this world relative price will fall within the range of the nation's domestic prices; hence trading along this trade line requires countries to specialize in producing the product in which it has a comparative advantage. This trade line also shows that opening up to trade enables countries to consume more of both products. Therefore, economic theory does not require one country to lose in order for another country to gain. To see how trade enables increased consumption, see figure 3.

The previous chapter focused on trading one product but we would like international trade theory to consider the entire economy. However, since this is very complex, we start to examine a two-product economy in which the countries are a net exporter of one product and a net importer of another product.

Why are factor availability and factor proportions key to international economics? - Chapter 4

In the previous chapter, constant marginal opportunity costs were assumed. Since resources are scarce, it is more realistic to incorporate increasing marginal costs of production. This will be the main focus of this chapter.

How do production possibilities change with increasing marginal costs?

The production-possibility curve is bowed out when we assume increasing marginal costs. As mentioned before, the slope of the ppc represents the relative price or opportunity cost of the two products. If we move along a bowed out curve toward full specialization, opportunity costs increase. Why? Usually, production requires different resources or factor inputs like land, labor and technology. Producing wheat requires relatively more land while producing cloth is labor-intensive. If a country would like to specialize in producing wheat and reduces cloth production, labor resources will become available. Adjusting wheat production so that these workers can be used in producing wheat will be costly; hence marginal costs increase.

Increased marginal costs can also be shown in an upward-sloping supply curve. This curve shows the relative cost of producing an extra unit of a given product and is therefore called the opportunity-cost curve or marginal-cost curve. Ignoring the fact that the slopes of the ppc are negative, this supply curve is basically the derivative of the ppc.

What production combination is chosen?

Competitive firms will produce a combination where the marginal costs equal the relative market price. If the opportunity cost of producing one product is lower than its relative market price, resources are reallocated and used to increase production of that product. When opportunity costs of a product are higher than its relative market price, it is profitable to decrease production of that product. Shifting resources like this will continue until the marginal or opportunity cost equals the relative price; hence when the slope of the ppc is equal to the relative price.

How do we depict the determinants of demand for two products simultaneously?

Consumers have various combinations of products they can consume that will give them the same level of well-being. These combinations can be graphically shown using indifference curves. Up and to the right of an indifference curve is better as it means consuming more of at least one product. While people can have infinite indifference curves, their actual consumption depends on their budget constraint or income:

Y = P₁ x Q₁ + P₂ x Q₂

For given income and prices, we can rearrange this formula to one that represents the quantity of a product that an individual is able to purchase:

Q₁ = (Y/P₁) - (P₂/P₁) x Q₂

The slope of this budget constraint equals the negative of the price ratio P₂/P₁ or the relative price of the second product. Therefore, we call this budget constraint the price line as well.

Consumption is likely to happen where the indifference curve (what highest feasible combinations do I want to buy?) is tangent to the price line (what highest feasible combinations can I buy?).

How do we bring production capabilities and consumption preferences together?

To analyze consumption in an international context, we need more than individual indifference curves. We will utilize community indifference curves which show how the consumption of a group determines its well-being. First, it should be noted that analyzing the group as a whole overlooks the different preferences individuals have (different shapes of indifference curves). Second, while the group as a whole might be better of, it is likely that certain individuals will be worse off. Subjective weights of these gains and losses are not incorporated.

Without trade, the best an economy can do is to move to the production point where the domestic community indifference curve touches the production-possibility curve.

With trade, consumption beyond the domestic production possibilities is possible (graphically up and/or to the right of the ppc). Differences in price ratios are crucial for trade to be benefical. Opening up to trade will change the following:

• Countries will have import demand for the product with the low relative foreign price and export supply of the product with the high relative foreign price.
• Resources are reallocated and production will move along the production-possibility curve to the point where import demand equals export supply.
• Trade results in an equilibrium world price that falls within the range of the domestic relative prices in both countries.
• Consumption will be at the point where the new price line (representing the relative price) touches the highest community indifference curve.

Note that without trade, the optimal point is where the production-possibility curve, the price line and the community indifference curve all touch each other. Simply put, production equals consumption. With trade, this will not be the case as trade allows for consumption above and beyond the domestic ppc. The slope of these curves will still be the same at the optimal point as the relative price determines both production and consumption! With trade, however, domestic production does not need to equal domestic consumption as there will be a free-trade equilibrium. Therefore, there are two separate optimal points, one for production and one for consumption, which both touch the (relative) price line. We can use these optimal points to show the quantities of export and import for that country, as follows:

• Draw a line between these optimal points (note that this will be part of the world relative price line)
• Draw a vertical line through the point where the world price line is tangent to the domestic ppc
• Draw a horizontal line through the point where the world price line is tangent to the highest indifference curve

The result is a trade triangle that can be drawn for each country. When these triangles are the same size, the countries agree on the amounts traded and international equilibrium is achieved.

The ppc and indifference curves can be used to derive demand and supply curves. Given two relative prices (it is best to use the domestic relative price and the world relative price), look where the (relative) price lines touch the ppc to derive two points of the supply curve and look where the price lines touch the highest indifference curves to derive two points of the demand curve. These curves will cross at the equilibrium domestic relative price. At the world relative price, the difference between demand and supply will represent the import demand (if demand exceeds supply) or export supply (if supply exceeds demand). To see how the production possibility and indifference curves relate to the supply and demand framework, see figure 4.

What are the gains from trade?

As stated before, we assumed that an overall increase in consumption is a good thing and that losses by certain individuals do not outweigh the gains of others. The gains from trade are derived from the terms of trade, which is the price of a country's export product relative to the price of its import product. Logically, a higher world relative price of your export product improves your terms of trade.

What are the effects on production and consumption?

Production shifts toward the product in which a country has a comparative advantage/is more productive. More efficient world production is the result. Consumption of the importable product increases as the relative price decreases. Real income rises due to the improved terms of trade. Initially, consumption of the exportable product decreases since its price goes up. However, higher income might offset this effect.

What determines the trade pattern?

Recall that a difference in relative product price is crucial for trade to be beneficial. Prices can differ due to:

• Different production conditions. A difference can exist in resource productivities, availability of factor resources and the use of factors of production.
• Different demand conditions. Consumers across the world are likely to have different preferences.
• A combination of different production and demand conditions.

What does the Heckscher-Ohlin (H-O) theory teach us?

According to the Heckscher-Ohlin theory, product prices differ between countries because they use different factor proportions in production. A country is considered relatively labor-abundant if it has a higher ratio of labor to other factors than other countries. A product is considered relatively labor-intensive if labor costs are a greater portion of a product relative to other products. Abundance of labor is likely to lower labor costs and boost production of labor-intensive products like cloth in terms of quantity and efficiency. Cloth is therefore likely to be the exportable product with international trade. Scarcity of labor indicates higher labor costs and production of cloth is likely to be lower and less efficient. Hence, cloth would likely to be imported. Remember that it is the relative abundance of the factor of production that matters.

In the previous chapter, constant marginal opportunity costs were assumed. Since resources are scarce, it is more realistic to incorporate increasing marginal costs of production. This will be the main focus of this chapter.

Who gains and who loses from trade? - Chapter 5

This chapter will extend the examination of the effects of trade with income distribution and a distinction between the short run and long run effects.

Who gains and who loses within a country?

Short-run effects of opening trade

In the short run, factors of production cannot be easily transferred across industries. Following the theories outlined in previous chapters, factors used in sectors that are expanding (due to foreign demand) are likely to be valued more. Rents and wages are expected to increase. Factors used in sectors that are contracting lose income because the reduction in demand lowers their value.

The long-run factor-price response

In the long run, opposite effects will occur when factors will move from the contracting to the expanding sector. However, these will not offset the effects in the short run. Why not? The intensively used factors in the contracting market that are laid off are of limited use in the expanding sector. At the same time, the availability of the factors that are widely used in the expanding sector (and which are highly demanded) is limited. Production processes in the expanding sector need to adjust to the available resources in order to stabilize rents and wages. Nevertheless, people initially involved in the expanding sector will be absolutely better off in the end while people initially involved in the contracting sector will be worse off.

For example, if a country opening trade starts to export wheat and import cloth, the following happens:

1. The price of wheat increases and the price of cloth decreases.
2. More wheat and less cloth is produced in response to changed product prices.
3. Excess supply of labor (laid off in the contracting labor-intensive cloth market) lowers wage rates as wheat production requires few workers.
4. Land rents rise as wheat production requires a lot of land but little land becomes available in the contracting cloth market.

What are the three implications of the Heckscher-Ohlin theory for factor incomes?

The Stolper-Samuelson theorem

As shown, opening to trade has specific gainers and losers. The Stolper-Samuelson theorem can be used to show how real factor returns change in the long run. Free trade changes product prices which have to be equal to their marginal cost under competition:

P_wheat = Marginal cost of wheat = ar + bw

P_cloth = Marginal cost of cloth = cr + dw

r is the rental rate of land, w is the wage rate of labor, and a, b, c and d are input/output ratios indicating how much of that factor is needed to produce one unit of that good. Suppose that the input/output ratios remain constant, that the price of wheat increases by 10% and that the price of cloth stays the same. As the production of wheat requires mostly land, the rental rate r is likely to increase. Considering the second equation above, if the price of cloth stays the same, the wage rate w should fall. This makes sense because the cloth market contracts. Considering the first equation, a fall in wage rate would mean that the rental rate should increase by more than 10% to equal the 10% rise in the price of wheat. What this shows is that the market reward (r in this case) for the factor used intensively in the expanding sector, rises faster than the product price does. Purchasing power for this factor increases for both products, raising the real return for this factor (land in this case) in the long run. Similarly, the real return for the factor used intensively in the contracting market falls.

The specialized-factor pattern

The specialized-factor pattern entails that a factor gains more when it is specialized more in the production of the exportable product. This applies to the short run where the product price rises as well as to the long run where it still benefits from being used in producing the exportable product. Similarly, a factor loses more when it is concentrated more in the production of the imported product.

The factor-price equalization theorem

The factor-price equalization theorem states that free trade equalizes individual factor prices between the two countries under the following assumptions:

• Free trade equalizes the product prices in the two countries (as shown before)
• Production technologies are the same
• Both countries produce both products
• The same factors of production are used (equally skilled workers and land of comparable quality)

The theorem basically stresses that the goods are products of its factor inputs. So even when factors cannot be transferred across countries, they are reflected in the product prices. Shipping land-intensive wheat and labor-intensive cloth moves product prices and factor prices toward an equilibrium price.

Does the Heckscher-Ohline theory apply to practice?

Testing the H-O theory using the simple two-factor trade model failed to confirm the theory. Leontief was able to test the theory by assuming that the U.S. economy was capital-abundant and labor-scarce relative to the rest of the world. Using U.S. data, he found that the U.S. was actually exporting relatively labor-intensive products and importing relatively capital-intensive products. This finding that the world's most capital-abundant country had a lower capital/labor export ratio than import ratio is called the Leontief Paradox.

Should we abandon the H-O theory? No. Follow-up studies have shown the importance of making a distinction within the factors of production. For example, labor could be highy skilled, medium skilled or unskilled. Studies have shown that the U.S., being abundant in highly skilled labor, was indeed a net exporter of products that use highly skilled labor intensively, as predicted by the H-O theory.

Several patterns arise when we examine the relative abundance and scarcity of factors of production. Industrialized countries tend to be abundant in highly skilled labor and nonhuman capital whereas unskilled labor is relatively scarce there. Developing countries show opposite patterns. The presence of these different factors of productions is what we call factor endowments.

Another way to validate the H-O theory is to examine the distribution of factors in the patterns of trade of specific products. It is expected that this distribition will be unequal in the sense that a country exports products merely produced using its abundant factors. International trade patterns are quite consistent with the H-O theory although there are some exceptions.

In addition, the H-O theory proposed that factor prices would equalize when countries open up to trade. This proposal is based on some strong assumptions which are not all valid in the real world. When we examine factor returns, we do see the tendency toward equalization but full factor-price equalization does not seem to exist in the real world.

This chapter will extend the examination of the effects of trade with income distribution and a distinction between the short run and long run effects.

How do scale economies and imperfect competition affect trade? - Chapter 6

The theory of comparative advantage suggests that countries that are similar should trade little and that countries export some products while importing others. However, industrialized countries do trade a lot with each other and they do so with very similar products as well. This chapter looks beyond the standard theory of comparative advantage and examines scale economies and deviations from perfect competition.

What are scale economies?

Scale economies are basically increasing returns te scale. Up to know, we assumed constant returns to scale which means that the total cost of input use rises in the same proportion as output quantity and average cost is constant. With scale economies, output increases more than total cost and average cost falls. It is assumed that all long-run adjustments of factor inputs can and will be made, and factor (input) prices are constant. Increasing returns to scale are not constant or it would be infinitely benefical to produce more and more. Therefore, the average cost curve is a bowed inward curve when cost per unit is compared to the output quantity.

What is the difference between internal and external scale economies?

When scale economies arise from a firm's own decisions, they are internal scale economies. Examples are fixed costs or investments that are spread over more units of output and more efficient use of equipment that can operate at high volume. These scale economies can enable firms to move away from perfect competition. When there are some scale economies but a large number of firms is able to compete, there is monopolistic competition where products are differentiated and offered at slightly different prices. Larger scale economies can result in few firms competing or an oligopoly. This is expected to be more profitable as firms have more control over product prices. External scale economies depend on the industry. Firms can benefit from clustering (knowledge exchange, spillover effects) as it might attract more business to the region.

What characterizes intra-industry trade?

There is inter-industry trade, exporting and importing different products, and intra-industry trade (IIT), exporting and importing similar (industry) products. The difference between export and import of a particular product is called net trade. Net trade and IIT are both components of total trade. The latter can be measured as twice the value of the smaller of exports or imports, or as the difference between total trade and net trade:

IIT = (X + M) - |X - M|

The relative importance of IIT as a share of total trade can then be calculated as:

IIT share = IIT / Total trade = [(X + M) - |X - M|] / (X + M) = 1 - |X - M| / (X + M)

Intra-industry trade tends to be more important for manufactured products than for primary products like agricultural products. To examine how important IIT actually is, the sector is divided into numerous different products for which the IIT share is calculated separately. The weighted average that can be calculated gives some insights. IIT is more prevalent without trade barriers or significant transportation costs and it is more important for high-income industrialized countries.

What drives intra-industry trade?

IIT is driven by:

• Comparative advantage: product categories used to calculate IIT might consist of different products produced by different methods.
• Seasonal differences: two-way trade of similar products can reflect seasonal circumstances.
• Product differentiation: similar products, especially from different countries, are not always considered perfect substitutes.

How does monopolistic competition change our analysis of international trade?

Since perfect competition assumes homogeneous products, with product differentiation and scale economies we move to imperfect competition. Monopolistic competition is characterized by differentiated products, some power for producers in determining prices, internal scale economies, and easy entry and exit of the market in the long run (which arrives rather quickly).

The market with no trade

Differentiated products mean more substitutes for consumers. The more products or models available in the market, the lower their price. The reverse is true for the unit costs of production. Offering more models forces each firm to produce at a smaller scale, driving scale economies in reverse and increasing average cost. The very competitive nature of the market should equal prices with unit or average cost. We say that zero economic profit will be made in the long run.

Opening to free trade

Since some consumers in both countries are likely to prefer the foreign models, opening up to trade (IIT) integrates both markets. Consumers can choose between more differentiated products and the world equilibrium price will be lower than each of the countries' domestic price without trade. Following the scale economies in reverse, unit costs are likely to increase.

Basis for trade

Products become exportable when foreign market consumers demand unique models that your country produces. Similarly, domestic consumers demand unique foreign models making these products importable. Therefore, the basis for trade is product differentiation. Scale economies only play a supporting role. Firms can compete by offering different models but the analysis of scale economies and average cost shows that scale economies actually encourage production specialization.

Gains from trade

Without an extensive analysis, a major gain is that consumers can choose from a much greater variety of products for a more competitive (lower) price. Consumer well-being increases. In addition, domestic distribution of factor income and total output do not change much. This is because the amount of exports and imports and their respective factor inputs are not that different (differing capabilities, same industry). This characterizes intra-industry trade. Even if annual income falls for some groups, they will be better off if the greater variety of products offsets these losses. Finally, trade could 'benefit' an economy as a whole when the increased competition drives firms with higher costs out of business.

How does oligopoly change our analysis of international trade?

An oligopoly is characterized as an industry with few firms competing and accounting for most of total production. If these firms can avoid aggressive competition amongst them, they can set their prices high. Market entry becomes very attractive but is usually prevented by the substantial internal scale economies of existing firms in the market. However, setting a high price enables a competing firm to take business away by setting a somewhat lower price. Aggressive competition on prices could result while all firms in an oligopoly would be better off by not competing aggressively (on prices). This is what is called the prisoners' dilemma. The firms can opt for cooperating but they would still have an incentive to cheat because substantial economic profits can be earned by doing so, especially in the short run. An oligopoly might not seem beneficial for an economy as a whole, countries are likely to welcome an oligopolistic firm. Why? Because high export prices improve the terms of trade and a countries' national income increases by amounts that would have been part of foreign consumers' surplus.

How do external scale economies change our analysis of international trade?

External scale economies result from knowledge spillovers enabled by clustering. Expansion of the industry can benefit all firms in that region as it lowers production costs (remember that scale economies lower average costs as output increases). Initially, opening up to trade increases demand (demand curve shifts to the right) and raises output in turn to meet the new demand. Prices are likely to increase. However, additional external economies raise productivity and shift the supply curve to the right. Output increases and average costs decline. The new long-run equilibrium has a lower market price which has positive welfare effects for consumers in all countries. Producers of the exportable product tend to gain from increased industry output but the decrease in price mitigates this effect. The positive welfare effects for consumers in all countries contrast the analysis of a market with constant returns to scale. The main difference is that the new equilibrium price is lower for all consumers instead of consumers of the importable product only.

The theory of comparative advantage suggests that countries that are similar should trade little and that countries export some products while importing others. However, industrialized countries do trade a lot with each other and they do so with very similar products as well. This chapter looks beyond the standard theory of comparative advantage and examines scale economies and deviations from perfect competition.

What are the implications of economic growth? - Chapter 7

The Heckscher-Ohlin theory looks at the international economy at one point in time. We have extended this view by shifting toward a free-trade situation. This chapter will focus on changes in productive capabilities or economic growth. Long-run economic growth can result from increases in the endowments of a country's production factors and from improvements in production technologies.

What is the difference between balanced growth and biased growth?

A country's production capabilities are reflected in its production-possibility curve (ppc). Economic growth shifts the ppc outward. When factor endowments increase proportionally or when technology improves by similar magnitude, we call it balanced growth. Expansion in favor of one of the products is called biased growth. If the relative product price stays the same, output changes disproportionately. It could be that economic growth enhances production of both products (continuing the two-product example) but this does not need to be the case. When the increased endowment or improved technology is not used in producing a product, its production will not increase. Its potential output given the ppc (the intersection with its axis) does not change and only the rest of the ppc shifts out.

Growth in only one factor is explained by the Rybczynski theorem which assumes constant product prices. Recall the two-product situation with wheat using land intensively and labor-intensive cloth production. If labor endowment grows, the ppc shifts outward with a bias toward cloth. Since labor is the more important factor in cloth production, cloth production increases. Wheat production could increase but won't. This is because cloth production also requires some land which has to be obtained from the wheat sector. The wheat sector will also lay off workers who can be reemployed to produce even more cloth. Therefore, the cloth sector will grow by more than the initial labor endowment growth and the wheat sector will decline. Output increases for the product using the growing factor intensively and decreases for the other product. To see how biased growth toward cloth changes production, see figure 5.

How does economic growth affect a country's willingness to trade?

Changes in a country's willingness to trade are reflected by a change in the size of the trade triangle. Remember that the trade triangle connects the point where the world price line is tangent to the domestic ppc (supply) and the point where the world price line is tangent to the highest indifference curve (demand). It summarizes how much a country wants to export and import.

Suppose that a proportionate expansion of production takes place. Again, we assume that the relative price remains constant. Given the proportionate expansion, the (relative) price line shifts outward. Income increases as well as consumption of both products. What happens to the willingness to trade? This depends on consumer preferences or the indifference curves as these determine the magnitude of the change in consumption. If consumption of the exportable product increases less than its production, the quantity available for exports increases. Hence, the willingness to trade increases. If consumption increases more than production, exports will decrease as shown by the smaller trade triangle and the willingness to trade decreases (try to picture this using the ppc, indifference curves and price lines). For the importable product, the willingness to trade increases when consumption increases more than production and decreases when consumption increases less than production.

If economic growth is sufficiently biased toward the importable product, production might rise by so much compared to consumption that it becomes an exportable product. In this case, the pattern of trade reverses itself as comparative advantage changes.

How does economic growth affect a country's terms of trade?

Recall that a country's terms of trade are the price of its exportable product(s) relative to the price of its importable product(s). A small country (in terms of its share in the world economy and its ability to influence the world price) has to take the world price as given but can benefit fom growth with increased consumption (reaching a higher community indifference curve). A large country is able to influence the world price and thus its terms of trade.

Consider the case where there is biased growth toward the importable product. Production of the importable product rises more than its consumption. Part of important demand will be met by domestic production, so fewer imports are demanded. Growth and higher income enable consumption of the exportable product to increase more than its production (if production rises at all; recall that this depends on the growth and use of particular factor inputs). Fewer exports will be supplied to meet domestic demand. These effects reduce a country's willingness to trade at any given price. So far, the relative price and the terms of trade are unchanged. However, the country could reduce import demand (lowering the relative price of the imported product) or reduce export supply (increasing the relative price of the exported product). This way, the country not only benefits from increase production possibilities but improves its terms of trade as the price of its exports relative to the price of its imports increases.

When growth increases the willingness to trade, increasing import demand increases the relative price of the imported product. Increasing export supply decreases the relative price of the exported product. These effects would hurt a country's terms of trade and it depends on the magnitude of change whether this offsets the initial growth in production.

Immiserizing growth

A very rare case is the one of immiserizing growth which means that increasing willingness to trade (by growth and expansion) makes a country worse off by reducing its terms of trade. How does this work? The following conditions need to be met:

1. Growth must be strongly biased toward the exported product increasing willingness to trade of a large country.
2. Foreign demand must be price inelastic to establish a large drop in the world price as a result of the country's increased export supply.
3. There have to be decent terms of trade to start with, so that the drop in terms of trade is large enough to offset the initial growth in production.

You might wonder why a country would increase export supply or import demand in this case of harmful trade. It's simply because these decisions are made by competitive firms of which some are likely to be better off in the end. This has some important implications for national policy though. A government might want to improve its country's terms of trade by favoring import-replacing industries over export industries.

Dutch disease

A second problem caused by developing a new exportable natural resource is called Dutch disease. The Netherlands started to use new natural gas fields what depressed the manufacturing industy. The Rybczynski theorem helps to illustrate this effect in two ways. First, the natural gas production drew resources away from manufacturing. Both labor and capital moved away from manufacturing, causing this sector to contract. Second, foreign money moved into the Netherlands to profit from the natural gas production, causing the Dutch currency to appreciate. Manufacturing firms had a hard time competing with foreign firms whose prices became relatively lower. The resulting drop in demand caused the manufacturing sector to contract.

How do improvements in production technologies affect trade?

A country tends to produce products in which it has the relatively better technology. This source of comparative advantage can influence the pattern of trade. This would offer an alternative explanation to the Heckscher-Ohlin theory which incorporates the relative abundance of factor inputs. However, we could argue that technological improvements result from the relative abundance of high-skilled labor and venture capital organized in research and development (R&D). It is not clear what happens to the country in which the technology is developed because technologies can be easily spread internationally. We call this diffusion.

To help us find a pattern in the development and diffusion of technologies, we use the product cycle hypothesis. Invention and development of a new technology requires R&D, (trial) production and marketing, all of which are likely to be present in advanced developed countries. Once the production technology becomes more standardized, factor intensity might shift to less-skilled labor. Production might move to countries that are relatively abundant in less-skilled labor. The product cycle hypothesis does seem to be applicable to practice despite some limitations. First, the length and progression of the phases of the cycle are unpredictable. Second, diffusion often occurs within multinational corporations causing the cycle to basically disappear.

How does openness to trade affect growth?

We have shown the impact of growth on international trade. Several explanations exist to prove that it works the other way around as well:

• Closing yourself to trade makes you lose out on adopting and using new technologies developed in other countries.
• Competitive pressure increases, enhancing the incentive to innovate.
• Firms might earn higher returns on innovation in foreign countries (again, enhancing the incentive to innovate).
• Absorbing new technologies enables developing additional innovations.

Testing these ideas in practice shows evidence of a positive relationship. However, proving the direction of causation and excluding other effects remains a challenge.

The Heckscher-Ohlin theory looks at the international economy at one point in time. We have extended this view by shifting toward a free-trade situation. This chapter will focus on changes in productive capabilities or economic growth. Long-run economic growth can result from increases in the endowments of a country's production factors and from improvements in production technologies.

What are the effects of tariffs on trade? - Chapter 8

Previous chapters have shown the economic benefits of opening up to trade. This chapter examines what is lost or gained by imposing trade barriers like a tariff. This tax on imported products can be a monetary amount per unit, called a specific tariff, or a percentage of the estimated market value of the product at the moment of arrival, called an ad valorem tariff.

Tariff rates are generally imposed to protect a country but have been declining over the years. A key role in this can be assigned to the General Agreement on Tariffs and Trade (GATT), now part of the World Trade Organization (WTO). The aim of the WTO is to establish lower, non-discriminating and fair tariffs. It has been successful mostly for developed countries. Developing countries were often left out of negotiations as they did not trade that much. Recently, developing countries have been included and tariffs have been reduced even more. However, tariffs are still very present today so it is important to explore their pros and cons in more detail.

What are the effects of a tariff on domestic producers and consumers?

It is very intuitive to say that an import tax benefits domestic producers as it raises the price of the imported product. Domestic producers can either expand production, raise their price, or do both. We can illustrate this by using the common demand and supply framework. Consider a small country where firms have to take the world market price as given. Recall that import demand results from a world price below the domestic equilibrium price. In addition, recall that there is less producer surplus in this free-trade situation and more consumer surplus compared to a no-trade situation. As we consider a small country, any tariff on imports is likely to be passed on directly to consumers (by an increase in price). Domestic producers can raise their prices by the same amount if their products are (close) substitutes. Domestic supply increases, domestic demand decreases, and import demand decreases as a result of the new domestic price with a tariff. Extra surplus on the products already sold and additional sales both increase producer surplus. Consumers are worse off. Less surplus on the products already bought and fewer purchases both decrease consumer surplus.

The net effect for the country seems clear. Since this tariff is imposed on an imported good, domestic demand outweighed domestic supply. Domestic producers gain on domestic output while domestic consumers lose on both domestic and foreign output. The tariff is a net loss in the market.

It is important, however, to take the government revenue from the tariff into account. This revenue is equal to the new amount of import times the monetary value of the tariff. The government could use this to compensate losses (by cutting taxes for example), spend it on other projects or consider it extra income.

What is the net national result from a tariff?

As illustrated in chapter 2, we can use the one-dollar, one-vote metric as a social value judgment. Every dollar of gain or loss is considered equal by this metric. The net result can be shown by deriving an import demand curve from the domestic supply and demand framework and its price lines. Starting with the domestic equilibrium price where import demand is zero, import demand (the difference between domestic demand and supply) increases for each price below the domestic equilibrium price. From this, a downward sloping import demand curve can be drawn. If we add both the world price line and the domestic price line with a tariff, and draw two vertical lines to the horizontal axis from the points where the price lines touch the import demand curve, two areas arise. The rectangle is the government revenue which can be calculated by the amount of imports times the monetary value of the tariff. The triangle is the net national loss from imposing the tariff. Part of this is called the consumption effect. It is the loss due to reduced consumption in response to the higher price. As it is a loss in consumption, neither producers nor the government gains here, so this is called a deadweight loss. The other part of the net national loss is called the production effect. Producers experience increasing marginal costs as they shift resources from importing to domestic production. These extra costs are paid for by consumers but neither the government nor the producers gain here, so this is a deadweight loss as well. To see the net net national loss from a tariff (or its equivalent quota), see figure 6.

What is the effective rate of protection?

The effect of a tariff can be expressed in terms of value added which is the amount used to pay for the primary production factors in an industry. It is common that many tariffs are imposed, not only on products. Tariffs on importable products usually help domestic producers. Tariffs on inputs generally hurt domestic producers. The net result is the effective rate of protection which measures by which a nation's full set of trade barriers raises the value added per unit of output. The nominal rate of protection is the tariff paid by consumers on the output. When this tariff rate on output is higher than the one on its inputs, the effective rate of protection will be greater then the nominal rate.

What about export taxes?

The effects of an export tax are very similar to the effects of an import tax. A large country with monopoly power in the world market could use tax exports to increase the world price and earn higher returns on its exports. Other reasons to impose export taxes are raising government revenue or favoring domestic consumers.

How can monopsony power be used to affect trade?

Individual firms might not be able to affect the price at which foreigners supply imports. If a nation collectively is able to do this, it is considered a large country that has monopsony power which it can use to improve its terms of trade (price of exports relative to price of imports). Since we consider a large country, the foreign export supply curve is upward sloping. In a small country case, it would have been flat. Foreign export supply would be infinitely elastic with the fixed world price, and the terms of trade could not be changed. A large country imposing a small tariff has the following effects:

• Import demand decreases as the domestic price increases.
• Foreigners can export fewer products and will produce less.
• Decreased production lowers foreigners marginal cost.
• Foreigners will compete by lowering their export prices.

Who gains and who loses? Domestic consumers pay a higher price with the tariff so their consumer surplus decreases. The special nature of this large country case is that foreign exporters also pay part of the tariff by lowering their export prices. The government receives revenue equal to the imported quantity times the tariff. The country imposing the tariff still experiences a deadweight loss. Part of this is due to decreased consumption; some consumers are willing to pay more than the foreigners export price but won't pay the higher domestic price including the tariff. The other part is the deadweight loss from the production effect as it is inefficient for domestic firms to move resources from importing to domestic production. Nevertheless, their producer surplus increases. The domestic deadweight loss will be outweighed by the part of the tariff that is absorbed by foreign exporters. The country imposing the small tariff is better off while the world as a whole is worse off. This will be the case for all tariffs up to a prohibitive tariff. Here, foreign exporters decide not to export at all to the country imposing the tariff and all gains from international trade are lost.

Assuming the world does not respond to the imposed tariff, there is a nationally optimal tariff where the country imposing the tariff has the largest net gain. For this country, it is best when the drop in foreigners supply is as small as possible (enabling more exploitation), so when their supply is more inelastic. This implies that the optimal tariff rate is equal to the reciprocal of the price elasticity of foreigners relevant export supply.

Previous chapters have shown the economic benefits of opening up to trade. This chapter examines what is lost or gained by imposing trade barriers like a tariff. This tax on imported products can be a monetary amount per unit, called a specific tariff, or a percentage of the estimated market value of the product at the moment of arrival, called an ad valorem tariff.

Tariff rates are generally imposed to protect a country but have been declining over the years. A key role in this can be assigned to the General Agreement on Tariffs and Trade (GATT), now part of the World Trade Organization (WTO). The aim of the WTO is to establish lower, non-discriminating and fair tariffs. It has been successful mostly for developed countries. Developing countries were often left out of negotiations as they did not trade that much. Recently, developing countries have been included and tariffs have been reduced even more. However, tariffs are still very present today so it is important to explore their pros and cons in more detail.

What are the effects of nontariff import barriers on trade? - Chapter 9

Next to imposing a tariff on imports, a government can use a nontariff barrier (NTB) to reduce imports. An NTB can limit the quantity of imports directly or indirectly by raising the costs of importing. This chapter will consider several NTBs of both types and their effects in the marketplace.

How does an import quota work?

An import quota or quota limits the imported quantity directly. Imports beyond a certain quantity are not allowed, so it has an impact if more products would be imported without the quota. A quota might be favored over a tariff as a tariff allows for imports to rise. It can be a powerful tool for government officials as well, as they might decide who gets the import licenses.

What differs a quota from a tariff for a small country?

Setting a quota limiting imports to a smaller quantity then with free trade leaves the domestic market with excess demand and a shortage of supply. The domestic price increases until import demand is equal to the quota. Recall that a small country does not affect the world price in this case. These effects are similar to imposing a tariff rate that reduces import demand to the same quantity as the quota here. Figure 6 shows how an equilavent quota shifts the domestic supply curve to the right and causes the same effects as the tariff. From the above reasoning, it is clear that:

• Domestic production and product price increase, so producers are better off.
• The fall in consumption and increased price lower consumers surplus.
• The country loses some income as producers face increased marginal costs (up to the new price) whereas it would be cheaper to import them from foreign exporters at the free-trade equilibrium price (the deadweight loss triangle with the production effect).
• Part of the fall in consumption and consumer surplus is not gained by anyone else (the deadweight loss triangle with the consumption effect).

A crucial exception is the area that would have been government revenue in case of a tariff. This area is the total of markups that result from imports at the world price and sales at the domestic price. What happens with these markups depends on the distribution of the import licenses. They can be allocated in different ways, each having their own implications:

• Fixed favoritism: licenses are allocated to importers without any resource costs. This way, domestic producers are better off by what domestic consumers are worse off. A political reason to allocate them proportionally to already existing importers is that they might lobby to block the entire quota otherwise. Their quantity of imports declines but average returns will be higher.
• Auction: an import license auction allocates the licenses to the highest bidders. Their offer is likely to be very close to the markup (or else they would be outbid) which directs nearly all revenues to the government. Corrupt government officials could take bribes to allocate the licenses differently but this would incur additional (social) costs beyond economic market inefficiency.
• Resource-using procedures; a resource-using application procedure encourages firms to invest heavily (up to the markup) in order to receive business. Since a lot of firms could be willing to invest under the assumption that it brings them business, a lot of resources could be wasted. This quota inefficiency makes the quota worse than the equivalent tariff when it comes to national well-being.

What differs a quota from a tariff for a large country?

A similar pattern arises compared to a small country. The effects of a quota are basically the same as for the equilavent tariff. The domestic price rises and the foreign export price declines until the difference is equal to the equivalent tariff and the import demand is equal to the quota. Again, the exception is the area that would have been government revenue in case of a tariff. Whether additional domestic gains can be made or whether the quota actually hurts the country depends on the resource costs associated with allocating the import quota licenses.

When the domestic industry is a monopoly, the difference between a quota and tariff can be quite substantial. The domestic producer would lose surplus if it sets its price higher than the foreign (world) price including the tariff. Consumers will demand more imports. In case of a quota, however, imports are limited and the monopolist can exert its monopoly pricing power. This way, or when the distribution of quota licenses wastes resources, the import quota is worse than the tariff for the country as a whole. Nevertheless, it is clear that the domestic monopoly prefers the quota.

How do voluntary export restraints work?

A voluntary export restraint (VER) is a trade barrier where an exporting country agrees to limit its exports to the importing country. It restricts sales and raises prices. Importing countries can do this to protect domestic firms that have trouble competing internationally. The exporting country's government might want to benefit from the VER by selling export licenses. However, it is in the best interest of exporting firms if they refrain from competition and charge the highest price that consumers are willing to pay. Here, the difference with an import quota becomes clear. The markups on the price are not 'for sale' in the domestic market but go to foreign exporters instead. Note that this is an extra loss for the country imposing the barrier but not for the whole world. Two additional effects of a VER might occur. First, foreign exporters might shift production toward varieties with higher returns because the limit on exports changes the optimal mix of varieties. Second, the import protection might incentivize foreign firms to directly invest in the country. Foreign direct investment will be discussed in another chapter.

Which other nontariff barriers are commonly used?

• Product standards: government regulation can restrict the import of products that do not meet certain requirements. Meeting these requirements or testing and certification can be costly for foreign exporters. Product standards usually do not bring in revenue from tariffs or taxes. It actually requires the government to use resources in regulating product standards. A country could be better off if there are health, safety, environmental or other benefits involved.
• A domestic content requirement requires imports to have a minimum of domestic production value in terms of components or parts for example. A similar barrier is a mixing requirement where a certain percentage of the product must be produced by domestic producers. Again, there is no government revenue in terms of tariffs or taxes. The price markups are likely to go to domestic producers. This does generate the deadweight losses we have seen in previous chapters.
• Government procurement: governments can choose to refrain from buying imports and buy domestic products instead.

What are the costs of protection?

Graphically, the costs of protection were shown by the deadweight losses in chapter 8. As described, the net national loss depends on the tariff and the reduction in import demand. To illustrate whether the costs of protection are large or small, we calculate its relative importance to a nation's gross domestic product (GDP) as follows:

(Net national loss from the tariff / GDP) = 0.5 x Tariff rate x Percent reduction in import quantity x (Import value / GDP)

This formula can be used for nontariff barriers as well as it adds up the losses of all products from import protection. If the tariff is rather small and a country does not heavily rely on imports, losses will be limited. However, the following events would increase the costs significantly:

• Foreign retaliation: foreign countries imposing barriers harms the domestic country.
• Enforcement costs: labor and other resources are used to enforce the barrier and represents a waste as these costs are not gained by others.
• Rent-seeking costs: producers might incur costs seeking protection (e.g. lobbying) wasting surplus that was gained on consumers.
• Rents to foreign producers: in the case of voluntary export restraints, foreign exporters raise their prices harming the importing country.
• Innovation: protection lowers competitive pressure and consequently the incentive to innovate.

In addition, protection is likely to reduce the number of varieties of products available in the market harming national well-being as well. From this, it is clear that creating protected income is likely to incur significant costs, even for a small level of protection.

What global efforts have been made to eliminate barriers to trade?

The GATT and the WTO were quite successful in eliminating import quotas but countries increasingly use other NTBs. The Kennedy Round and Tokyo Round are multilateral trade negotiations of the GATT that led to some agreements regarding NTBs but the Uruguay Round was more successful. Here, more NTB codes applying to all WTO members were negotiated and phasing out VERs on textiles and clothing was one of them. The most recent is the Doha Round which is very promising but hasn't been successful yet.

Countries fighting over trade barriers have had numerous international trade disputes. About half of them have been successfully negotiated by the GATT. The U.S. thought the GATT's settlement procedures were too weak and enacted Section 301 giving their president the right to eliminate unfair trade practices by threatening with retaliation. Many countries opposed section 301 and the U.S. has reduced its use since the WTO improved international dispute settlement procedures. Threatening retaliation by the WTO is usually successful but actual retaliation would be problematic because the WTO is supposed to liberalize trade.

Next to imposing a tariff on imports, a government can use a nontariff barrier (NTB) to reduce imports. An NTB can limit the quantity of imports directly or indirectly by raising the costs of importing. This chapter will consider several NTBs of both types and their effects in the marketplace.

When should a country opt for or refrain from protection? - Chapter 10

Previous chapters have shown that import barriers can increase domestic production (and employment), decrease domestic consumption, increase government revenue and change income distribution. There seem to be few situations in which a country is actually better off by imposing trade barriers. This chapter examines when import protection might be the best policy and what role politics play.

What characterizes an ideal world according to an economist?

In a first-best world the market is perfectly competitive. Free trade is economically efficient. Marginal costs to each group as well as to society as a whole are included and optimal at the equilibrium. This would mean that nobody could be better off without harming someone else more. Here, the market price not only equals the buyers' private marginal benefit (MB) and the sellers' private maginal cost (MC), but also social marginal benefit (SMB) and social marginal cost (SMC). Each deviation from this equilibrium would mobilize private producers or consumers to alter their level of production or consumption.

What characterizes a realistic world according to an economist?

In a second-best world the market has to deal with distortions. Private actions will not be efficient for society as a whole due to market failures or government intervention. Four market failures and their effects are:

• External costs: social marginal cost exceeds the price. An example of such an externality or spillover effect is pollution. Too much is supplied.
• External benefits: social marginal benefit exceeds the price. An example of such an externality is when too few workers are hired in the sector where knowledge from training or education spills over to people outside the sector. Not enough is demanded.
• Monopoly power: the price is set too high and supply is restricted. Not enough is demanded.
• Monopsony power: the price is too low; a firm dominating the labor market could set a low wage. Not enough is supplied.

In case none of these market failures exists, the government can distort the market by imposing a tax (e.g. a tariff where not enough is demanded) or subsidy. The latter is basically a negative tax lowering the price to buyers. In this case, too much is demanded.

How could government policy fix distortions caused by externalities?

Pigou developed the tax-or-subsidy approach whereas Ronald Coase developed the property-rights approach. The tax-or-subsidy approach is much more put into practice and will be discussed here. An externality where social marginal cost is too high should be fought by a tax that closes the gap between the social marginal cost and the private marginal cost. Similarly, when social marginal benefit is too high, a government subsidy would close the gap between the social marginal benefit and the private marginal benefit.

It should be noted that governments might fail to identify the problem or provide the solution. One of the causes could be that the analysis of a trade barrier is complicated when externalities or other distortions are involved. One way to deal with this is to apply the specificity rule. This rule states that a government intervention is usually more efficient if it directly tackles the source of the distortion.

How do a tariff and subsidy compare when domestic production is promoted?

Several reasons to protect domestic production or employment exist:

• Local production has positive effects that spillover to other groups;
• Additional employment requires new skills that benefit other areas of the economy when workers switch jobs;
• Additional production (at high cost) might enable producers to lower their costs over time;
• Without protection, extra costs arise when workers need to switch jobs to stay employed;
• Local production makes citizens proud;
• Local production is essential to national defense;
• Redistributing income can benefit the poor or disadvantaged groups in society.

The government can impose a tariff to promote domestic production. Previous analyses showed that the deadweight losses may or may not be compensated by government revenue. In this chapter, we include marginal external benefits in the analysis. Positive spillover effects from domestic production could be marginal external benefits. If these exceed the deadweight losses, the country is better off. Nevertheless, a subsidy seems to be better. Why? A subsidy equal to the tariff delivers the same amount of external social benefits and the production effect as a deadweight loss. However, the consumption effect as a deadweight loss is not present because consumption does not change. The subsidy only changes the price received by producers, not the price paid by consumers. This fits the specificity rule as it targets the objective of promoting domestic production more directly. It should be noted that the money spend on the subsidy is likely to be withdrawn somewhere else, so additional (social) costs might need to be included.

Which arguments are in favor of protection?

The infant industry argument

The infant industry argument supports a temporary tariff that enables domestic firms to learn how to produce at lower cost. This way, after some time they will be able to be competitive in the world market. Initially, domestic production is so expensive that there is no supply at the world price. Learning to produce at lower cost should lower the supply curve. By then, the producer surplus equals the benefit to the country. Its present value should outweigh the deadweight losses of the tariff to make the country better off in the end. Three important questions arise:

• Is government intervention really necessary? Becoming profitable is essentially every start-up's problem. Why should the government intervene? One reason could be that there are imperfections in the financial markets and that the government cannot eliminate these directly. Another reason could be that there is no other way to protect the infant firms against follower firms that can easily compete once the product is on the market.
• What government intervention is best? We just saw that a subsidy is better than a tariff or other similar import barriers. In addition, imperfections in financial markets could be fought by offering loans to infant firms. The specificity rule applies here as well.
• Will the infant firms really grow up? The infant firms should lower their costs significantly to become internationally competitive. If the tariff is not clearly tempory, the incentive to achieve this is not so big.

It is clear that government intervention can make sense. A tariff may or may not work out but other policies are likely to be better. Governments have a hard time deciding which industries to support because it is difficult to predict whether the required cost reductions to become internationally competitive will be made.

The dying industry argument and adjustment assistance

In a first-best world, the government should be reluctant to intervene as the market does its job. However, doing nothing might be worse than to intervene. It might be very costly to reallocate the resources of firms that go out of business. For example, workers that are laid off might need specialized skills to find employment elsewhere. The government might intervene to avoid the costs of unemployment. Again, the specificity rule applies and the government does not need to block imports. In this case, the government could subsidy the costs of training or education. Some governments have actually offered trade adjustment assistance to groups in import-threatened industries. While this form of protection might work, there are two reasons why it is opposed from a free-market perspective. First, people are reluctant to leave import-vulnerable industries (which might be better for the market as a whole) because they might be supported when things get worse. Second, people who receive unemployment compensation are reluctant to apply for a job. These negative behavioral effects (think of it as moral hazards) decrease the value of the assistance program.

The developing government argument

The developing government argument basically states that the whole world could be better off by a tariff imposed by a developing country as it becomes a crucial source of government revenue instead of industrial protection. Those countries often have a hard time measuring and monitoring regular taxes on production, consumption and income. Raising government revenue is easier and cheaper by charging taxes at key ports and border crossings. That is why customs duties tend to be a large portion of government revenue for developing countries. They can use the tariff revenues to benefit their country (or even the world when it fosters trade) but foreign trade is also taxed by corrupt governments.

Noneconomic arguments

The noneconomic arguments are not about achieving economic efficiency but consider well-being in a broader sense. Part of the specificity rule applies here as well. It is extended by stating that the noneconomic objective should be met by minimum economic cost.

National pride

Knowing that something is produced domestically can result in national pride. Government intervention might help if its about something collective or nationwide. If the government wants to intervene in domestic production, a subsidy is favored over an import barrier. If national pride arises from citizens' own efforts, an import barrier is favored.

National defense

Producers can use the national defense argument as a social excuse for protection. It can be tempting to block imports to increase domestic prodection. However, again it is in the nation's best interest when the government intervenes with a subsidy. A subsidy lowers the cost to the nation because the deadweight loss only consists of the production effect. Another argument against a tariff or other import barrier is that it increases the price paid. A nation could be better off if it bought in bulk at the free-trade price and stored the products inexpensively until they were needed.

Income redistribution

Import barriers are hard to justify when it comes to income redistribution. Inequity within a country or region can best be attacked through tax-and-tranfer programs. Nevertheless, tariffs are still used with the intention to equalize incomes.

What are the politics of protection?

Import barriers usually require a political process of decision-making. We have seen that protectionist measures can harm the nation's national well-being, so why would they be enacted? It is important to consider the following elements assuming a representative democracy:

• The size of the gains for the winners and the number of individual winners;
• The size of the losses for the losers and the number of individual losers;
• The reasons of these individuals for taking positions for or against protectionist measures;
• Type of political activities (e.g. elections, lobbying) and their costs;
• Political institutions and political processes like voting.

The producer-bias pattern

A tariff usually protects a smaller group than it hurts, so when individuals are allowed to vote it is unlikely that a tariff will be accepted. Consumers often face increased prices but if they are convinced that other consumer taxes are reduced or more money is spend on projects they value, they might support the tariff. Politicians could also be influenced by lobbying or contributions. From an economic perspective, since the total losses are greater than the gains, it is unlikely that the tariff will get through. In practice, however, it depends on the resources each group is willing to devote to political activity. The smaller group is likely to be more effective in its political activity. This is called the producer-bias pattern. Each individual in this smaller group has a larger individual gain. The difference can best be illustrated by introducing the free-rider problem. Each individual's effort benefits the group as a whole encouraging people to free-ride on the efforts of others. The bigger and more dispersed the group, the larger the free-rider problem.

Other trade-policy patterns

The tariff escalation pattern considers the number of individuals and concentration within a group crucial for lobbying. It assumes that tariff rates are higher on final consumer goods than on goods and raw materials used in production. The producer-bias pattern partly applies here. For intermediate goods, the situation is slightly different. Producers of intermediate goods have more bargaining power and might be able to prevent protection in favor of final good producers. Again, individual (household) consumers are considered a weak lobby.

Another pattern is that people take a position that is not in their own direct self-interest. Sympathy of others might help a particular interest group. Political sympathy tends to arise when a group suffers huge losses all at once, also called a sudden-damage effect. Sympathy can be driven by compassion for the people who lose income or by identification with that particular group. This usually happens when heavy import competition or a general recession takes place.

Why are import barriers not so high?

Despite all the benefits to groups that are powerful in collective bargaining, import barriers are generally not so high for the following reasons:

• There are powerful oppositions (among producers as well) that bargain against protectionist measures;
• Agreements reducing trade barriers have been made during multilateral trade negotiations like those of the GATT;
• Politicians considering economic ideology and the benefits of free markets are less likely to support protectionist measures.

Previous chapters have shown that import barriers can increase domestic production (and employment), decrease domestic consumption, increase government revenue and change income distribution. There seem to be few situations in which a country is actually better off by imposing trade barriers. This chapter examines when import protection might be the best policy and what role politics play.

What involves pushing exports? - Chapter 11

Where previous chapters focused on limiting trade with import barriers, this chapter focuses on pushing exports that promote trade.

Why do exporting firms engage in dumping?

Dumping is selling products for less than their normal value. The normal value of a product is either the price charged to comparable domestic buyers or the average cost of producing the product. This way, dumping favors buyers of exports. It seems counterintuitive when maximizing profits but there are several reasons why dumping occurs:

• Predatory dumping: driving foreign competitors out of business by charging a low price at first;
• Cyclical dumping: during a recession, a firm might choose to lower its price to prevent a large drop in sales. The recession lowers demand causing the market price to fall below full average cost. As long as the price exceeds average variable cost, the firm continues to produce and supply. Exporting at this lower price is considered dumping;
• Seasonal dumping: firms want to get rid of excess inventory. Lower production costs out of season enable firms to lower prices below full average cost. As long as the price is higher then marginal cost, this is economically sensible;
• Persistent dumping: a firm with market power can use price discrimination to increase its total profit if it faces more competition abroad and there is no arbitrage opportunity given the price difference. The firm maximizes profits in both markets separately.

Other reasons why dumping occurs is that it helps to promote new products (think of it as an introductory sale) and that it is driven by export subsidies.

How should a dumpee react to dumping?

Dumping harms the producers of the importing country but benefits its consumers. Generally, it is in a country's best interest to refrain from action for the following reasons:

• The lower import price improves the country's terms of trade. Any countermeasure is likely to worsen them;
• A tariff on the dumped imports could be prohibitive when the exporting country ceases its exports;
• The benefits to consumers tend to be larger than the losses to producers.

This is generally true for persistent, seasonal and introductory-price dumping. On the other hand, predatory dumping leads to high-priced imports in the long run when import-competing firms are out of business. Predatory dumping is not common in practice, however, because of uncertainty about its success and the likelyhood of new competition once it is successful.

Cyclical dumping is a special case. The decline in demand lowers prices and production worldwide. In case of a national recession, dumping could be seen as exporting unemployment. Cyclical dumping tends to be globally efficient though. This makes it hard to make a case for or against reacting to cyclical dumping. One approach, again, is to apply the specificity rule and deal with the imported unemployment directly instead of imposing a trade barrier.

What is known about actual antidumping policies?

If there is prove that a country's import-competing producers are injured by dumping, the WTO allows antidumping policies. An antidumping duty (a tariff) could make the 'unfair' dumping margin disappear. The number of antidumping measures has grown over the years but there are substantially more antidumping cases. This is because about a third of the cases is terminated due to successful negotiations. Studying antidumpung actions and reactions reveals some trends:

• Dumpers tend to increase prices when they see a case being made against them, probably to reduce the final dumping margin;
• The exported or trade quantity decreases;
• Once antidumping policies are present, exports decrease even more by an average of 70 percent (and sometimes they cease completely).

Actual antidumping policies tend to lower well-being of the importing country. It seems to be a good thing that threatening to make a case can do the job as well. However, while they started to fight unfair exports, antidumping policies have become a tool to protect against unwanted imports. Threatening to file a complaint this way is called the harassment effect.

Changing antidumping policies

Antidumping policies can be a good way to fight unfair trade. It should be noted that the large costs of deadweight losses, filing complaints, arguing cases and gathering prove are likely to hurt worldwide well-being after all. That is why voices are raised to reform the WTO rules in the following ways:

• Limit antidumping actions to fighting predatory dumping;
• Add consumers and users of the imported product to the equation in determining whether dumping actually hurts;
• Use temporary import protection to enable domestic producers to become competitive. The benefits of this safeguard policy are that no prove is needed (no associated costs), other interest beyond those of domestic producers are considered, and domestic producers are pressured to produce more efficiently.

What are the effects of an export subsidy?

Contrary to expectations, an export subsidy hurts the exporting country and benefits the importing country. The standard supply-and-demand framework can be used to illustrate the effects. We will examine competitive industries for both small and large countries.

The small exporting country case

Remember that a small country cannot influence the world market price. Exporting firms will receive the world price including the subsidy for their exports. They are not willing to sell their products for a lower price in their own country, so domestic consumers pay more as long as they are not better off abroad. The higher price enhances exports as supply increases and demand decreases. Producers gain, consumers lose and the government pays the subsidy. Again, using the one-dollar, one-vote metric, the nation suffers deadweight losses. Part of this is the consumer effect because some consumers are squeezed out of the market at this higher price. The other part is the production effect caused by production beyond the market efficient quantity (where the resource cost is higher than the world price).

The large exporting country case

A large country influences the world price when its export supply changes. Assuming that no arbitrage opportunities arise, the price difference for domestic and foreign consumers will be equal to the subsidy, just as in the small country case. The increase in exports drives the world price down. The domestic price will still rise, but not by as much as the subsidy. If the drop in the world price is large enough, the exporting country will suffer additional losses as its terms of trade deteriorate.

An export subsidy could be big enough to change import demand in export supply. This way, a net importer could become a net exporter of a subsidized product. Similar effects would occur. The main difference is that the production and consumption effects overlap graphically.

How does the WTO deal with export subsidies?

Subsidies directly linked to exports are prohibited. Other subsidies are actionable. If another country considers itself hurt by the subsidy, it can file a complaint to start a dispute settlement procedure or it can impose a countervailing duty (a tariff) to offset the effects of the subsidy. This is only allowed by the WTO if the subsidy and its negative consequences are demonstrable by the complaining country.

How should the importing country respond to subsidized exports?

An export subsidy imposed by a large country drives the world price down. Suppose that the whole subsidy is passed forward to foreign importers. Foreign importers are definitely better off at the lower world price but the foreign import-competing industry is hurt. There is a case for a countervailing duty following the WTO rules. If a countervailing duty is imposed that offsets the drop in the world price, world efficiency returns because the deadweight loss of excessive trade is eliminated. Remember that the export subsidy initially increased production beyond the market efficient quantity. In addition, the subsidy passed on to importers increased demand, so products were traded beyond the market efficient quantity. Despite world efficiency, the country imposing the countervailing duty is actually worse off. Remember that an export subsidy increases well-being for the importing country. A countervailing duty eliminated this effect. Note that it would still be better off than in the case of no export subsidy at all. Why? Because the export subsidy fully passed on to the importing industry is collected by the government when the countervailing duty is imposed. It turns out that the government paying the export subsidy actually pays for the countervailing duty in this case. Whether the duty is actually imposed depends on a lot of factors, among others the bargaining power of the import-competing industry. And just like with antidumping policies, countervailing duties can be misused as a protectionist measure.

How can strategic trade policy bring out the best in export subsidies?

An export subsidy in a perfectly competitive market did not seem to be good for world efficiency. In an imperfect market, the world as a whole can be better off. Suppose a two-firm rivalry (crossing borders) where both firms need to decide whether to produce a particular product or not. Since it requires a substantial investment for development, a lot is at stake. If both firms decide to produce, competitive pricing is likely to result (remember that cooperation in an oligopolistic market is better but incentives to cheat are very big). Both firms are unable to earn their investment back when the price is competitive. If only one of the firms decides to produce, huge profits could be made as this firm would be the only supplier. The other firm has no loss or gain in this case. Similarly, if none of the firms decides to produce, no gains or losses are made. Both firms face a dilemma. They are only willing to produce if they know that the other won't produce. A subsidy can be used as a strategic trade policy to solve this dilemma. If the government provides a start-up subsidy that offsets the initial investment, the firm's best choice is to produce. Given this, the other firm would be worse off if it starts to produce as well. Hence, only the subsidized firm will produce and the world is better off. However, if both firms are subsidized, the outcome is more difficult. The firms are likely to be better off but their governments have spended a lot. End consumers gain but they are likely to be spread all over the world. This lowers each government's incentive to provide the strategic subsidy. Clearly, too many conditions evolve around a strategic trade policy for it to be reliable.

Where previous chapters focused on limiting trade with import barriers, this chapter focuses on pushing exports that promote trade.

What are the effects of trade discrimination? - Chapter 12

Previous chapters on import barriers assumed that the barriers to trade applied to all imports. This chapter considers two forms of trade discrimination. The first is called a trade bloc where member countries do not face the trade barriers imposed on outside countries. The second is called a trade embargo (or trade block) where barriers are imposed on specific countries, usually as part of some sort of punishment.

What are the main types of economic blocs?

Discrimination in trade is common, not only between individual countries but countries group together as well. Four types of economic blocs will be discussed here, with increasing level of integration:

1. Free-trade areas: trade barriers are removed between members but kept toward the outside world.
2. Customs unions: in addition to removing barriers between them, members adopt the same barriers toward the outside world.
3. Common markets: not only products but factors of production like labor and capital are also allowed to flow freely between members.
4. Economic unions: in addition to a common market, members adopt the same policies toward trade, factor migration, and monetary and fiscal issues.

Is trade discrimination good or bad?

A free-trade area or customs union moves its members toward free trade which generally makes them better off. The downside is that the trade barriers with countries outside the area are maintained and as we know from previous analyses, barriers in general make the world worse off. Opposing the economic gains from a trade bloc, there are a several arguments against it:

• It encourages inefficient production as products produced at high cost within the area become more attractive;
• Trade discrimination has shown the destroy the gains from trade;
• Trade discrimination can easily lead to international conflicts.

The World Trade Organization (WTO) therefore opposes to trade discrimination toward countries with a most favored nation (MFN) status (all contracting partners of the WTO) but allows it when it favors developing countries and when it entails that industrialized countries decrease trade barriers on average.

What are the real gains and losses from a trade bloc?

The net effect of a trade bloc depends on two things. First, the partner costs relative to those of the outside world. Second, the elasticity of the import demand. Countries import the products that are produced most efficient because they are offered at the lowest price. Now suppose that products produced at higher cost become cheaper when they are not subject to an import tax anymore (in case of forming a trade bloc). If their price drops below the product price of the outside world, the increase in demand will foster trade creation; an increase in the net volume of new trade. These gains are greather (1) the lower the partner costs relative to those of the outside world and (2) the more elastic the import demand. We still have to take into account a loss though. If the products produced at higher cost become cheaper, the volume of trade shift to less efficient production and the country suffers from trade diversion. This loss also depends on the production costs and the elasticity of import demand. The net result of a trade bloc is the difference between the gains from trade creation and the loss from trade diversion.

Other possible gains from a trade bloc

Assuming that a trade bloc overcomes a lot of trade barriers, the larger (bloc-wide) market can provide several gains:

• Increased competition reduces prices;
• Increased competition reduces production costs;
• Scale economies can reduce costs;
• Increased availability of varieties increases consumer well-being;
• Increased profit opportunities increase business investments.

Of course, these positive effects are only likely to occur for a selection of products and members of the trade bloc.

What are the gains and losses for the European Union?

The European Union (EU) is the first modern trade bloc this big and so heavily integrated. From multiple studies about its economic effects, the following can be concluded:

• Trade creation from members' manufactured goods are considered small gains;
• Losses on unionwide agricultural policy outweigh other gains on manufactured goods;
• The gains from increased competition, scale economies, productivity and product variety are hard to measure.

Most gains from the EU result from trade created by the free flow of production factors. The EU's sugar policy is a good example of trade diversion as it requires members to purchase from (higher-cost) EU producers instead of from outside suppliers. Nevertheless, the gains seem to outweigh the losses and the EU has expanded several times. The deep integration of member countries implies a large set of requirements for new entrants. Further expansion is possible but it will take years for other countries to qualify and the EU could be concerned of its ability to integrate particular countries due to their wellfare, intentions or political issues.

What are the gains and losses for the North American Free Trade Area?

The North American Free Trade Area (NAFTA) evolved when Mexico got involved with the Canada-U.S. Free Trade Area. The NAFTA eliminated nearly all import barriers within the area and has its own dispute settlement procedures. There is, however, no free human migration within the area and Mexico got to keep its government oil monopoly. When the creation of the NAFTA became more and more likely, several arguments against it arose:

• Critics in Mexico were afraid that their domestic gap between rich and poor would become larger;
• They also warned for U.S. involvement in their national policies;
• American labor groups were afraid to lose their jobs to cheaper Mexican workers.

Proponents argued that:

• Mexico might be able to influence U.S. trade policies like antidumping;
• Mexico could face more foreign investments (from outside the trade area as well);
• The U.S. hoped to establish better economic and political relations with Mexico.

The real effects of the NAFTA

Trade expanded heavily between the Mexico, the U.S. and Canada. Substantial trade creation increased well-being across the trade area. However, trade diversion was also substantial. North American firms tend to be high-cost producers so shifting trade from the outside world to the trade area implied significant losses associated with inefficient production. The Canadian manufacturing industry benefited most from low-cost production and innovation as a result of increased competition. The case for scale economies is ambiguous because production did not really expand overall but fewer different products were produced. Benefits from specialization are likely. As expected, Mexico did face increased business investments, mostly because local production could serve the U.S. market. Cheap Mexican workers did cross the borders but did not deteriorate the U.S. labor market. Finally, Mexico exploited its comparative advantage in less-skilled labor and increased its consumption of U.S. services and manufactured goods.

An agreement like the NAFTA requires a lot of regulation. For the NAFTA, a lot of costs are associated with enforcing the rules of origin that determine whether goods can be traded freely within the area or not. They are established to avoid that producers modify only little to an imported product and then claim that it is produced within the NAFTA. The rules are sometimes so strict that they hinder trade between members of the NAFTA. In addition, they provide protection against foreign producers by applying local content requirements.

What are the effects of trade blocs among developing countries?

Following the infant industry argument, cooperation among developing countries could support several manufacturing producers to scale up and become internationally competitive. The number of firms that could be supported is very limited. This poses a problem because each member of the trade bloc wants to be the new industrial leader. Trade blocs like the Latin American Free Trade Area and the East African Community were relatively short-lived unions as they were unable to reach stable agreements. MERCOSUR (the Southern Common Market) is more outward focused and managed to survive. It is a free-trade area with the same set of external tariffs for most products. MERCOSUR has shown to have substantial positive effects in terms of trade creation. However, severe losses due to trade diversion seem to be present. The increase in trade is mostly accounted for by the products in which the area has a comparative disadvantage. The net effect for the members of MERCOSUR are not clear.

What are the effects of trade embargoes?

Trade embargoes are restrictions or complete bans on economic exchange. Countries use them as sanctions, usually to pressure a target country to change a particular policy. It is clear that an embargo hurts both sides because the gains of trade are lost. To illustrate the effect of an embargo on exports, we assume there are embargoing and nonembargoing countries. The following will happen:

• Part of the world export supply disappears, driving up the import price for the sanctioned country (which faces a steeper world export supply curve now).
• The sanctioned country is forced to purchase less at a higher price to reach a new equilibrium (recall that this is basically a loss in consumer surplus).
• Export supply to the rest of the world increases, driving down the world price.
• The countries enforcing the embargo lose some producer surplus here and lose exports to the sanctioned country.
• Nonembargoing countries are better of because the sanctioned country pays a higher price for their products.

The magnitude of these effects depends on the trade elasticities. When the sanctioned country's import demand is inelastic (a steep curve), it heavily depends on the trade with the embargoing countries. Similarly, embargoing countries having an inelastic export supply curve depend heavily on the sanctioned country. To illustrate this, a sanctioned country with an elastic (flat) import demand curve can do well without the embargoing countries' exports. A large drop in export supply will reduce its demand greatly but it will not be hurt that much because the price barely rises. If the embargoing countries have an inelastic export supply curve (dependence on sanctioned country is high), the embargo or drop in exports hurts them more than the sanctioned country. This kind of failure is called an economic failure of an embargo because most damage is done to the imposing countries instead of to the target country.

Now it is clear that embargoes apply stronger pressure when export supply is elastic and import demand is inelastic. Stronger pressure is most likely to occur when:

• Big countries impose embargoes on small countries. Their size is likely to reflect their dependence on the trade.
• The embargo is quick and unexpected. Import demand is more inelastic in the short run because the sanctioned country needs time to adjust to the new situation (importing from other countries). Of course, the embargoing countries are damaged more as well.
• The sanctioned government can be pressured by citizens or groups to comply.

Another type of failure is the political failure of an embargo. Political failure results if the country sticks with the policy despite the economic costs. This is more likely to happen in case of a dictatorship where individuals or groups are unable to apply pressure on the dictator.

Previous chapters on import barriers assumed that the barriers to trade applied to all imports. This chapter considers two forms of trade discrimination. The first is called a trade bloc where member countries do not face the trade barriers imposed on outside countries. The second is called a trade embargo (or trade block) where barriers are imposed on specific countries, usually as part of some sort of punishment.

How do trade and the environment affect each other? - Chapter 13

International trade has drawn attention in relation to environmental effects. This chapter considers environmental issues and policies that cross national borders.

Does free trade harm the environment?

In general, environmentalists are afraid that free trade shifts production to countries that lack environmental standards because it enables production at lower cost. However, research shows that the costs to meet environmental standards are generally low. Possible effects of the gains from trade on the environment were documented during the Uruguay Round of trade negotiations. It was stated that the composition of the products traded is important in determining environmental consequences. In addition, the gains from trade suggest that production and consumption increase which would probably lead to more pollution. Free trade also tends to increase income which can be used to support environmentally friendly policies. This combined size-income effect on the environment could follow one of three basic patterns:

• The rise in income lowers environmental damage. The demand for a better environment is larger than the size effect of the economy.
• The rise in income increases environmental damage. Demand for a better environment does not offset the environmental harm.
• The change in environmental damage depends on the income level. For low income levels, consumers choose their own well-being over environmental well-being. For high levels of income, environmental quality becomes more important than other potential benefits. The turning point is likely to be at an income level higher than those in developing countries and lower than those in developed countries.

Returning to the composition effect, we can use the Heckscher-Ohlin theory to illustrate this. Developed countries are relatively abundant in higher skilled labor which tends to be used in producing environmentally dirty products. Developing countries are relatively abundant in lower skilled labor which is often used in producing environmentally clean products. This way, the composition of pollution-intensive production changes but the net effect still depends on the size and income effects mentioned before.

Does the WTO care about the environment?

The main goal of the WTO is to liberalize international trade but WTO rules concern the environment as well. Environmental exceptions are made when:

• Consumption causes damage. Limiting imports is allowed when it is done to protect a country's health, safety or the environment. The policy should apply to all consumption though, not just to imports.
• Production in foreign countries causes damage. Countervailing measures (e.g. environmental standards) are allowed when its assistance in protecting the environment is demonstrable, when they are equally applied and when negotations are set to address the issue.
• The environmental problems are global and require multilateral environmental agreements. The WTO seems to support these kind of agreements but has not endorsed any of its rules.

It is clear that the WTO allows for environmental protection and encourages it when it limits trade as little as possible. In addition, it should not create disguised protectionism.

How can externalities be internalized?

Environmental effects like pollution are called negative externalities when they harm someone who is not involved in buying or selling the product. Remember from chapter 10 that this is the case when social marginal cost exceeds private marginal cost. Too much is produced and consumed when market decision-makers ignore social cost. The market is inefficient and calls for government policies to enhance market efficiency. Again, the specificity rule applies. The policy tool should tax the distortion directly instead of cutting down consumption or production completely. The government could use taxes and subsidies (the latter in case of promoting positive externalities) or change property rights. Taxing the distortion should make the market account for the social cost. In case of property rights, a firm could buy the right to pollute. The benefits can be used to offset the negative externality or the firm may refrain from pollution after all.

It can be hard to deal with the externality directly, especially when it crosses borders and nations have to cooperate to attack it. Following the specifity rule, when the pollution cannot be targeted directly, it is best to tax production or consumption instead of international trade. A nation might impose trade barriers when it has to act alone and foreign production or consumption damages the environment. The source of the externality can be domestic production, foreign production or world production. For each source, the challenges of dealing with these external costs will be discussed.

Trade and domestic pollution

When a country faces external costs that are not internalized, free trade can actually hurt a country. Additionally, it might be exporting a product that it should import. Imagine a situation without trade. Production and consumption levels are too high because there is no social cost; pollution is free. Opening up to free trade with a higher international price results in export supply. It is likely that the social cost of increased supply (production) exceeds the benefits from free trade. This negative externality from domestic production could be attacked by prohibiting exports but taxing the pollution itself would be better. A tax is an external factor in the regular demand and supply framework and initiates a shift of the supply curve. If the supply curve shifts up so far, that without trade the domestic equilibrium price would exceed the world price, import demand results. This shows that ignoring the social cost could cause a wrong trade pattern.

Domestic firms paying the pollution tax are worse off. If foreign firms are not taxed, domestic firms can complain about unfair or eco-dumping imports. However, as long as foreign firms' externalities do not impact the importing country, the importing country should not impose any more restrictions. It would make it worse off.

Transborder pollution

From the previous, it seems in the world's best interest if each country attacks its own pollution. Issues arise when pollution crosses national borders. Transborder pollution brings an external cost to a foreign country. The best solution would be to pollute the amount where the marginal benefits to the polluting country are equal to the marginal costs of the country that is hurt. However, given that there are no policies or restrictions, the polluting country maximizes its benefits by polluting more than the 'right' amount. The optimum amount could be achieved by imposing a tax but the polluting country has no incentive to do so. The foreign country would like to change this. One way to do this is to assign property rights so that the polluting country can buy the right to pollute up to the optimal amount. However, there is no world court that can assign or enforce property rights. The foreign country could opt for restricting imports, which is beneficial as long as the benefits outweigh the deadweight loss from restricting trade. If the country is also an exporter of the product, it could subsidize its exports to squeeze the polluting production out of the market. The main problem here is that the WTO is unlikely to allow for these kinds of import barriers or export subsidies, despite its exceptions to protect the environment. Agreements addressing the problem of transborder pollution are helpful but remain difficult. A country might not be willing or able to achieve enforcement.

Global environmental challenges

In the case of global problems, it is likely that one country is more affected than another. The domestic benefits are a good incentive to fight the problem but there won't be a solution if each country acts on its own. A global multilateral agreement is needed but it will be hard to negotiate and enforce the agreement. In addition, countries have an incentive to free-ride on the efforts of other countries. Four examples of global environmental problems will be discussed, of which two have been successfully adressed.

Extinction of species

A lot of species are threatened with extinction due to destruction of the environment, pollution, excessive hunting and excessive harvesting. It would be best to promote and protect these species directly but no international agreements have been made to preserve them in protective parks or wild areas. There is a global agreement to prevent excessive hunting and harvesting by controlling international trade of endangered species. Commercial trade is usually blocked. The Convention on International Trade in Endangered Species of Wild Fauna and Flora (CITES) has made this happen. CITES has had some success but faces quite a challenge. Restricting trade could actually harm species as it raises the world price and makes them more valuable. On the other hand, endangered species become valuable assets for tourism, creating an economic incentive for sustainability.

Overfishing

Oceans, fish and other marine life are not owned by anyone in particular. This makes it hard to protect them. Overfishing has been happening for years and led to declines in fish stocks. Some governments make matters even worse by subsidizing fishing. Global fishing is still inefficient as there are no successful global multilateral agreements.

Chlorofluorocarbon compounds (CFCs) and the ozone layer

CFCs have been widely used in producing industrial products for decades but proved to deplete the ozone. The Montreal Protocol is an international agreement by nearly all countries to ban its international trade. Most of them agreed to phase out production entirely. Normally a pollution tax would be preferred but the social-cost curve was assumed to be so steep that it would be challenging to establish a large cut in pollution. The Montreal Protocal is very successful. It achieves most if its economic and environmental goals and the free-rider incentive did not cause trouble. Several reasons for its success exist:

• The scientific evidence was hardly deniable;
• Relatively few products were involved, so substitutes could be offered with ease and limited cost;
• Production was concentrated in the U.S. and the EU, making it easier to establish the agreement;
• The countries involved expected to suffer the most from the environmental damage due to their geographic location (closer to the Poles).

Greenhouse gases and global warming

The most challenging problem is the one of greenhouse gas emissions and its effect on global warming. The first issue is that scientific evidence is limited. This shouldn't urge countries to do nothing because the stakes are high. There are, however, two more issues. The second one is that a few attractive policy changes do not provide a clear solution. Withdrawing subsidies on bad energy won't reduce emissions by more than 10 percent, growing new forests might cut the CO2 buildup by 25 percent but is negligible compared to reducing the burning of fossil fuels, and waiting for depletion of the earth's fossil fuels (along with the economic price and scarcity effects) would harm the environment for at least a couple more decades. The third issue is that implementing international trade policy regarding fossil fuels would not even comprise half of its emission and traded fuel would likely to be substituted by home fuel.

An effort that has been made is the Kyoto Protocol where industrialized countries agreed to reduce their emissions. Developing countries opposed it as they saw it as hampering their economic growth. Despite many countries meeting their targets, the Kyoto Protocol has had little effect worldwide. Greenhouse gas emissions rose because some industrialized countries missed their targets (by a mile), the U.S. (one of the largest polluters) did not participate, and because developing countries increased their emissions dramatically.

Attempts have been made to follow up on the Kyoto Protocol. The question is whether this will be effective or not, especially when large countries like Canada, the U.S. and China do not participate. It is clear that any solution requires all countries to be involved, using economic incentives (pricing) to reduce emission, and requires commitment for decades. How much should be given up? Scientific studies have shown that cutting emissions worldwide will do little damage to the global economy. The challenge remains to bring so many countries together and to negotiate and implement a global approach to global warming.

International trade has drawn attention in relation to environmental effects. This chapter considers environmental issues and policies that cross national borders.

How are developing countries shaped by trade policies? - Chapter 14

Because of their large share in world output, much attention in international trade has been devoted to industrialized countries. Since real growth rates (like average product per person) are higher for developing countries, we should consider them as well. There are also huge differences between developing countries. Some supergrowing newly industrializing countries (NICs) have left poor growing countries behind. This chapter examines what role trade policies play in establishing these differences.

Which trade policies can developing countries use?

Developing countries tend to have a comparative advantage in products where land, natural resources, and less-skilled labor are the abundant factors in production. These countries could reform their economies by focusing on manufacturing industries where these factors are widely used. This would require using infant industry policies. In general, developing countries have the following basic trade-policy choices:

• Exploiting comparative advantage in land and natural resources by encouraging exports of primary products. Industrial development should be discouraged which can be done by restricting imports or encouraging exports of manufactured products.
• Large countries can raise the world price of their primary products with an export tax to increase their gains. Small countries could form an international cartel to establish this goal.
• Protect and subsidize new (infant) industries serving the domestic market by imposing (temporary) import barriers. Its goal is to enable these industries to compete at world prices.
• Encourage development of new industries whose products can be exported. Again, the focus should be on exploiting comparative advantage, ideally in the most profitable sector where less-skilled labor is abundant (the manufacturing sector).

Barriers to trade and subsidies have similar effects for industralized and developing countries. The pros and cons from previous chapters are still applicable (including the specificity rule) but their are differences. Capital and labor markets do not work as efficient in developing countries as they do in industrialized countries. The cost of capital is higher and wage gaps keep labor from moving to its most productive use. Developing countries should carefully decide which sectors to focus on when developing policies.

What are the long-run price trends for primary products?

Primary products in developing countries are often called traditional exports. Some people argue that world income is distributed unfairly. They argue that primary products are less profitable than industrialized products and that the prices of primary products decline. The latter statement is supported by Engel's law and the presence of synthetic substitutes. Engel's law states that primary products like food have an income elasticity of demand less than 1. This means that developing countries with rising income face a fall in demand for their export product, lowering its price. Demand for luxury products increases. In addition, the development of synthetic substitutes replaces primary products and causes a similar drop in demand and price.

On the other hand there are two conditions that tend to raise the relative prices of primary products. First, primary products tend to use resources like land that are limitedly available. Nature's limits enhances scarcity and raises prices. Second, productivity growth in the manufacturing sector is higher than in the primary sector. Bigger investments lead to cost-cutting breakthroughs. The primary sector does not experience the same growth pace and primary products face a price increase relative to manufactured goods.

Research shows a small decline in the prices of primary products over the years, suggesting that the effects of Engel's law and synthetic substitutes are more powerful. It should be noted, however, that the downward trend in prices might be due to a fall in transport costs or a quality difference between primary and manufactured products. Technological advancements have lowered transport costs which are likely to be reflected in the price. Moreover, the difference in prices between primary and manufactured goods might not represent a difference in value. Manufactured goods might have increased in relative price due to a relative increase in product quality.

How can international cartels help raising primary-product prices?

Some countries see an opportunity to seize monopoly power when they work together in an international cartel. One such cartel that has been successful is the Organization of Petroleum Exporting Countries (OPEC). It succesfully quadrupled the price of oil without large changes in resource availability or extraction costs. World demand for oil was growing faster than the supply of non-OPEC countries. Countries' dependency on oil from the OPEC enabled the OPEC to set a higher price.

How much the OPEC could gain at the expense of the demand side depends on a number of factors. The cartel members should act together and align prices because oil cannot be differentiated. The cartel still faces a downward-sloping demand curve so there is a limit to the price increase. What is the cartel's optimal price? The cartel should set the price where its marginal revenue equals its marginal cost given the demand by foreign countries. Assuming the market was competitive at first, some world income is redistributed from buying countries to the OPEC and some income is lost due to the drop in quantity traded. The following factors determine how high the profit-maximizing price of the cartel can be:

• The marginal cost of production. The marginal-revenue curve slopes downward so a higher marginal cost of production would lead to a higher price;
• The elasticity of demand. When demand is inelastic, buyers cannot easily switch to other products and depend more on the suppliers. These suppliers have more power to set a higher price;
• The cartel's share of world production. A larger share of world production creates more (dependent) demand for the cartel's supplies, increasing the profit-maximizing price;
• The elasticity of supply. When supply is inelastic, raising the price will have little impact on sales. Hence, inelastic supply drives up the price.

So far, forming a cartel seems to be very profitable, especially when it is in place quickly (remember that elasticities tend to be larger in the long run). Several forces, however, including its own success, work against cartels over time:

• Sagging demand: buyers will look for alternatives which will likely decrease demand and damage the cartel's sales.
• New competing supply: the higher price and limited supply attracts new suppliers to the market. If they enter the market, the elasticity of demand increases.
• Declining market share: the cartel will face a drop in sales (which depends on the elasticity of supply) and non-cartel suppliers will try to increase their output and sales. The cartel will lose market share.
• Cheating: cartel members are usually able to produce more because the higher price reduced demand and supply. Lowering the price is likely to attract new and profitable business, so cartel members have an incentive to cheat on the cartel.

These forces are bad news for developing countries seeking to grow by joining a cartel. Their characteristic of mainly exporting primary products is associated with more elastic demand and is likely to make new competing supply easier.

What is the case for import-substituting industrialization (ISI)?

Previous cases have argued in favor of exploiting developing countries' comparative advantage in primary products. The decline in relative price of these products, despite the ability to increase it by forming a cartel, argues in favor of shifting toward developing new (manufacturing) industries. Many countries have successfully shifted toward import-substituting industrialization (ISI). The following arguments are in favor of ISI:

• The infant industry argument: gaining technological knowledge and worker skills might enable the country to become competitive worldwide in a new industry.
• The developing government argument: ISI might require to impose import barriers. An import tax could raise government revenue that can be used to support ISI in turn.
• Replacing imports with domestic production. Reducing import demand will lower the world price, so remaining imports will become cheaper.
• Replacing imports of manufactures. To determine which products would serve the home market, the developing country only needs to look at the import figures.

Despite these arguments, the evidence in favor of ISI is weak. Evidence against it is actually quite strong and consists of:

• The estimation of its static effects on national well-being: developing countries who put up trade barriers to promote industrialization experienced significant costs. One country experienced slight gains due to improved terms of trade. This proof is weak on its own because it only captures producer and consumer surplus, not potential cost reductions in production.
• Two cases showing that the infant industry argument can backfire: countries promoting exports of new manufacturing products saw early growth turn into a recession because the industrial production never became efficient.
• A comparison of growth rates of countries practicing ISI with countries supporting exports. The latter experienced higher growth rates. Note that this is about correlation and not causation.

In addition, the newly globalizing developing countries are characterized by a large increase in international trade and a drop in tariff rates. This points toward free trade instead of ISI. ISI could work but requires governments to collect the right information and be able to act on it, which is often not the case. Governments tends to be ill-informed, powerless or corrupt.

What is the case for switching from primary-product exports to manufactured exports?

Many developing countries have tried to switch to exporting manufactured products, probably backed by the theories on primary-product cartels and ISI. Its success has been hampered by industrialized countries who put up protectionist measures. Their nontariff import barriers discriminate against manufactured products from developing countries and their tariffs are generally higher for these products as well (though nondiscriminatory - the same for each country - in principle). Despite these shortcomings in promoting international trade, several developing countries succeeded in becoming exporters of manufactured products, for the following reasons:

• Technological progress has slowed down for some manufacturing products, enabling developing countries to break into the world market;
• Developing countries have become attractive locations for low-cost assembly of technological products (e.g. smartphones);
• Countries new to the market do not face the import barriers of industrialized countries (at first).

All together, switching to exports of manufactures seems to be the most promising strategy for most developing countries and statistics show that more and more countries pursue this strategy.

Because of their large share in world output, much attention in international trade has been devoted to industrialized countries. Since real growth rates (like average product per person) are higher for developing countries, we should consider them as well. There are also huge differences between developing countries. Some supergrowing newly industrializing countries (NICs) have left poor growing countries behind. This chapter examines what role trade policies play in establishing these differences.

How do multinational enterprises and migration shape the international context? - Chapter 15

Previous chapters have focused on the international trade of products and on policies that affect trade. This chapter focuses on the international movement of financial capital and labor as factors of production. It also reviews government policies aimed at international factor movements.

What is foreign direct investment (FDI)?

Foreign direct investment (FDI) is an investment in a foreign company that gives the investor an effective voice in the management of the company. Investments that are so small that the investor has no control or influence are called international portfolio investments. Most countries agree that an investor has some control when at least 10 percent ownership is possessed. The most common example of FDI is an investment to acquire at least 10 percent shares or ownership of a foreign firm. However, a loan to a foreign firm that is already 'owned' for at least 10 percent is also a form of FDI.

What are multinational enterprises?

Firms operating in more than one country are called multinational enterprises (MNEs). An MNE has a headquarter or parent firm located in the home country. Subsidiaries are foreign affiliates located in host countries. MNEs do not operate on foreign direct investments alone. FDI is usually a small part of an affiliates' total financing and the parent firm transfers a lot of intangible assets as well. Foreign affiliates are largely fund by outside lenders and investors because direct investments are exposed to exchange rate risk and political risk. The latter takes on the form of seizing investments or expropriation (taking over control) by the host government. MNEs use a lot of financial capital from the host country to reduce these risks.

How did FDI change over time?

Despite its limited share in the financing of MNEs, data on FDI is widely available over a long time period. FDI can be measures in flows, the investments and loans that are made, and in stocks, the total amount of direct investments at one point in time. Data on the flows of FDI provides the following insights into the movement of capital around the world:

• FDI has risen and fallen along with the economic cycle. Recessions have led to large drops in FDI but recovered largely as well.
• In de 1970s and 1980s, FDI moved away from developing countries due to resistance and expropriation.
• Around 1990, developing countries attracted FDI again by low production costs and reformed economic policies.
• The U.S. attracts the most FDI from the 1980s onward.
• Integration of international markets is positively related to FDI. Both the EU and Mexico (after joining the NAFTA) have attracted more FDI.

Data on the stocks of FDI provides some insights as well:

• Industrialized countries have the largest FDI outflows and inflows, the latter to a lesser extent.
• In the 1970s, about 25% of the world's FDI was in the primary sector, 50% in the manufacturing sector, and 25% in the services sector.
• The primary sector's share dropped to about 10%, the manufacturing sector's share fell to less than 30% and the services sector's share rose to over 60%.

Why do multinational enterprises exist?

Some might think that MNEs are mainly intended to transfer financial resources because of national differences in returns and risks. However, international portfolio investment would do this job and there would be no need to gain control over management decisions. Five conditions found more support in explaining the existence and magnitude of MNEs.

Inherent disadvantages

A firm trying to compete in a foreign country experiences inherent disadvantages of being foreign. First, it lacks knowledge about the market, laws and common practices. Second, operating at a distance is expensive when it comes to travel and (mis)communications. The firm is also likely to lack political connections and could even face hostility. A firm that is able to overcome these disadvantages still has several reasons to pursue FDI.

Firm-specific advantages

Firm-specific advantages like assets that provide an advantage over foreign competitors should help to overcome the inherent disadvantages. Such an advantage can be technological, marketing, managerial or other. For an MNE to exist, it should earn sufficient returns on these assets. The firm should carefully consider whether setting local production is more profitable (in the long run) than exporting from its home country or licensing local firms.

Location factors

Many countries differ to such an extent that locating their can be advantageous. In this case, FDI would be favored over exports. The most important location factors are:

• Comparative advantage: productions costs might be lower due to favorable resource availability.
• Scale economies: concentrating production in the serving country might entail scale economies.
• Overcoming governmental barriers: barriers to import are not relevant when a firm operates local.
• Trade blocs: if the host country is a member of a trade bloc (e.g. free-trade area) and the home country is not, barriers to trade can be overcome.
• Transportation cost is another important location factor but to a lessert extent. It depends much more on the type of product.

Internalization advantages

If a firm looks beyond exports, it might consider licensing. A license allows one firm to use another firm's asset(s). It usually avoids the inherent disadvantages but involves transaction (e.g. negotiation) costs and risks. Therefore, FDI could be favored as it provides internalization advantages; avantages of using the assets within the firm (e.g. control over the enterprise).

Oligopolistic rivalry

Firms that consider expansion abroad are generally large firms experiencing oligopolistic rivalry. They try to benefit from the first-mover advantage or they have to follow the leader if a competitor was first. If they don't, their international market position might be threatened.

What about taxation of multinational enterprises?

It would make sense to assume that the parent company is taxed in the home country and that the affiliates are taxed in the host countries, and this is usually the case. The home country's government might consider taxing the parent for foreign earnings but double taxation is usually avoided. Since each country can impose different tax rates, MNEs have two options to minimize their tax expenses. First, they can locate their affiliates in countries with lower taxes. Some countries are even known to be tax havens. Second, MNEs can use transfer pricing to redistribute some earnings. The price of units that transfer within a company can be set in such a way that it provides tax benefits. Governments tend to watch these transfers but are reluctant to intervene as long as they don't deviate to much from the market price.

How do multinational enterprises and foreign direct investment relate to trade?

We just posed some arguments why firms would either opt for exports or FDI. Following this reasoning, FDI would substitute trade. It turns out that about one-third of international trade is intrafirm trade between units of an MNE and that an additional one-third involves an MNE just as importer or exporter. How can we explain this? In the case where the parent and its affiliates are engaged in different production stages, FDI leads to more trade in order to assemble the final product. Trade in final products may decrease but trade in materials and components increases, so FDI and trade can be complements. However, most affiliates are rather duplicates of their parent firm. They can still complement the parent if production is centralized in a few locations to achieve scale economies. There is still a lot of trade needed to serve all markets. On the other hand, especially when transport costs and trade barriers are high, FDI is used to substitute international trade. Again, a countervailing effect might occur. When the local market expands due to better local marketing, it might expands trade in turn. So which effect is dominant? Most studies conclude that FDI is somewhat complementary to international trade.

How should the home country respond to FDI?

FDI transfers capital to a foreign country. This will happen at the expense of production and workers in the home country. Unemployment will be higher until the labor market adjusts and real wages will be lower. This way, FDI can be seen as exporting some business. The home government will be hurt by a decline in tax revenue. The owners of the multinational are the ones that gain. Whether the home country is better off in the end depends on whether the owners are domestic or foreign investors. Another effect of FDI could be that external technological benefits flow out of the country. If for example training of workers shifts to another country, the home country faces a loss. From this, it is not clear what the home country should do. Practice shows that there are barely any restrictions on FDI outflows.

How should the host country respond to FDI?

The effects on the host country are basically symmetrical to those on the home country. Employment makes workers better off and the host country can reap benefits from the inflow of technology, marketing capabilities and managerial skills. The government collects extra taxes. However, host countries have been quite reluctant to let FDI flow in freely and it is not just because earnings might flow to foreign owners. From the 1950s to the 1970s, host countries were very skeptical and suspicous. They thought MNEs would receive nearly all gains due to their size and power, that their capital-intensive production methods would not be suitable, and that local firms would be displaced. In addition, MNEs would extend the power of foreign governments and pressure the host country into corruption and plots. Many policies were aimed at restricting FDI but the economic arguments in favor of FDI won in the mid-1970s. Restrictions were liberalized and in some cases FDI is actually prioritized now.

What about migration?

After an extensive overview of financial capital, this chapter continues with labor as a factor that moves internationally. When people move from a sending country to a receiving country for a noticeable period of time, it is called international migration. Historic migration patterns show huge immigration flows into North America and Europe. Both areas have imposed restricting immigration policies for several times, especially in the aftermath of the first World War. Immigration policies were loosened after the second World War (favoring higher-skilled immigrants) but were tightened again due to cultural frictions and to protect jobs after the oil crisis in the 1970s.

How does migration affect labor markets?

We can think of the basis demand and supply framework to illustrate the effects. Without migration barriers, workers from the country with the low wage rate migrate to the country with the higher wage rate. In the case of labor markets, it is unlikely that the wage rates in both countries will equalize. Migrants do not only face transportation costs, but also lost wages while relocating, cultural and language differences and disconnection with friends and family. The wage rates will become more equal though. Workers in the country with the initial low wage will gain because the outflow of workers will increase the price of labor. Producers lose here. Migrants will be better off because their wage increase is likely to offset the expenses of migration. Their presence will lower the wages in their new country so workers there are worse off. Producers will gain here. The gain of producers in the receiving country outweighs the loss to workers because the labor market expands (making a case against restricting immigration). The loss of producers in the sending country outweighs the gain to workers because the market contracts. The world as a whole is better off because workers contribute more to world production. The effects on wages and workers in both countries are supported by empirical evidence. The difference in wage rate that remains is considered the cost of migration. In addition, research shows that world output increases and that immigrant's almost close the wage gap with native-born workers.

How should the sending country respond to emigration?

It seems obvious that the sending country should restrict out-migration because the loss of producers outweighs the gain to workers. We should, however, take into account some other effects. First, the government's tax revenues will decline but government spending will decline as well. Since part of government spending goes to public goods, the net effect on well-being is likely to be negative. This assumption is strengtened by the life-cycle pattern of migration. People tend to migrate when they finish (part of) their education. They are likely to receive funds from the government but won't pay taxes on their future earnings. This effect is largest and is called the brain drain for higher-skilled migrants. Second, a compensating effect occurs. Migrants who send money back to their friends and family bring monetary benefits into the sending country. The amount of these benefits largely determines the overall effect on the country's well-being. If this effect is negative, the government could restrict foreign travel (hurting not only migrants), tax emigration or encourage returning to the home country.

How should the receiving country respond to immigration?

The benefit to employers is likely to outweigh the cost to workers. The effect on government income seems to be symmetrical at first. Both tax income and public spending increase. We could make a case where public spending outweighs the change in tax income. This is because immigrants tend to use more government social services on average. Of course, this is likely to depend on the educational level if the immigrants. In addition, there are some external costs and benefits:

• Knowledge benefits: immigrants bring knowledge, benefiting the receiving country directly or indirectly through knowledge spill-overs.
• Congestion costs: the increase in population might lead to extra noise, conflict and crime.
• Social friction: cultural differences or the thought of immigrants as 'job stealers' could be an additional cost.

While there are several reasons why immigration could be restricted, a well-thought-out policy that admits immigrants gradually could make the receiving country definitely better off. Educational level and life-cycle pattern are important drivers of fiscal and other external benefits and costs. It should be noted that policies that limit migration will be under pressure because of social goals like family reunification and humanitarian assistance to refugees.

Previous chapters have focused on the international trade of products and on policies that affect trade. This chapter focuses on the international movement of financial capital and labor as factors of production. It also reviews government policies aimed at international factor movements.

What can we learn from the financial transactions among nations? - Chapter 16

Up to now, the main focus has been on the exchange of goods and services and some attention has been devoted to the movement of financial capital and labor. This chapter will focus on the monetary and financial aspects of international transactions. Many transactions involve financial assets and nearly all transactions involve the exchange of money. The balance of payments provides insides in these flows between nations and its characteristics provide important implications for economic growth, inflation and employment.

What are the accounting principles of the balance of payments?

The balance of payments consists of credit items, which represent monetary inflows (+), and debit items, which represent monetary outflows (-). Each transaction involves an in- and outflow (e.g. payment for exports) following the accounting principle of double-entry bookkeeping. This implies that the total will always be zero and that the total account 'balances'. The different categories on the balance of payments make it interesting because these can show a surplus or deficit for the given pattern of trade.

What constitutes the balance of payments?

The balance of payments consists of three broad categories:

• Current account: the current account includes all exports and imports of goods and services, income receipts and payments, and gifts. The debit and credit items of the goods and services constitute the goods and services balance. This balance measures the country's net exports and is often called the trade balance. A gift that is made does not directly involve a double entry. To meet the accounting principles, a unilateral transfer is recorded to represent the 'exchange' value of the gift. This applies to foreign aid as well as to money send home by migrants. The net value of the goods and services balance, income and unilateral transfers is called the current account balance.
• Financial account: the financial account includes all flows of financial assets except official international reserves. Only principal amounts are recorded in the financial account. Earnings on assets are recorded in the current account. What counts as a credit or debit item depends on where the payment goes. A resident decreasing a foreign holding receives a payment that counts as a credit. This is also called a capital import. Remember the difference between a direct investment and an international portfolio investment. The net value of all these flows constitutes the financial account balance.
• Official international reserves: official international reserves are not necessarily government reserves. This account on the balance of payments includes reserve assets that can be used to regulate currency values (by buying or selling currency). Most of these reserves are foreign exchange assets of foreign currencies. Gold reserves were important in the past but are now limitedly used.

Despite strict rules and principles, measurement errors arise. These errors could result from miscalculations or incorrect reporting (hiding) of transactions. To make the accounts balance, the net result of errors and omissions is compensated with the statistical discrepancy.

What is the macro meaning of the current account balance?

All items of the balance of payments that are not part of the current account represent international financial investments. Therefore, in order for the balance of payments to total zero, the current account balance (CA) must equal net foreign investment (I_f). A surplus or net inflow in the current account implies positive net foreign investments (outflow of capital). The country is a net lender. Similarly, a CA deficit means that the country is a net borrower because its net foreign investment is negative.

A country's CA is also equal to its national saving that is not invested domestically. Why? National saving can be used for domestic real investment (I_d) or net foreign investment (I_f), so I_d + I_f = S. We get I_f = S - I_d when we rearrange for net foreign investment. Note that we just established that I_f must equal CA, so CA = S - I_d or in words; the current account balance must equal the amount of national saving invested abroad.

We can also link national income to the CA. The following might be recognized from basic macroeconomics: Y = C + I_d + G + (X - M). Domestic production of goods and services (domestic product) equals all purchases made by the country, being consumption (C), domestic real investment (e.g. buildings and equipment, not investments in financial assets), government spending (G) and net exports. The first part, C + I_d + G, is domestic demand for a country's products, which we set equal to the country's total expenditures E. The second part (net exports) is foreign demand for its products. Combining these formulas gives Y = E + (X - M). Rearranging gives net exports (X - M) equal to Y - E. Since net exports take up such a large part of the CA, we can assume that the CA is roughly equal to (X - M). Combining these formulas gives CA = Y - E or in words; the current account balance is approximately equal to the difference between domestic product and the country's total expenditures.

From all this, we can derive some conclusions. A country with a current account surplus:

• Has positive net foreign investment, because CA = I_f
• Is saving more than it is investing domestically, because CA = S - I_d
• Is producing more (income) than it spends on goods and services, because CA = Y - E

To see why this is useful, suppose a country faces a current account deficit and wants to change this. What can it do? For instance, it could expand domestic production (Y) or limit national spending (E).

What is the macro meaning of the overall balance?

The official settlements balance (B) measures the sum of the current and the financial account balance, so B = CA + FA. For the balance of payments to total zero, the official reserve assets (OR) should make up for any imbalance in the official settlements balance: B + OR = 0. The official settlements balance (B) measures the net flows of all private (not official) transactions in goods, services, income, gifts and financial assets. If this balance deviates from zero, the official reserve assets (OR) should counterbalance. This happens when a country's monetary authorities officially intervene in the foreign exchange markets. A positive official settlements balance implies a net inflow of payments. Buying foreign currency (by offering domestic currency) will be a counterbalancing act.

What is the international investment position?

The international investment position reflects the amount of a nation's international assets and foreign liabilities at a point in time. As we have seen, a current account surplus indicates a positive net foreign investment. The accumulation of foreign financial assets or decline in foreign liabilities will increase the value of a country's international investment position. It is important to note that the current account reflects a flow over time. The previous reasoning establishes a relationship between the current account and the investment position but it does not mean that a current account surplus indicates a positive investment position. It will, however, increase the investment position. As shown before, a country with a CA surplus is a lender and a country with a CA deficit is a borrower. A nation with a positive stock of foreign assets (a positive investment position) is a creditor and a nation with a negative stock is a debtor. If a country is a debtor and has a current account surplus, it could become a creditor but not necessarily. It will increase its investment position but its position could still remain negative. This link between these two accounts makes that the international investment position (basically a balance sheet) complements the balance of payments accounts.

Up to now, the main focus has been on the exchange of goods and services and some attention has been devoted to the movement of financial capital and labor. This chapter will focus on the monetary and financial aspects of international transactions. Many transactions involve financial assets and nearly all transactions involve the exchange of money. The balance of payments provides insides in these flows between nations and its characteristics provide important implications for economic growth, inflation and employment.

How does the foreign exchange market work? - Chapter 17

This chapter introduces the basic dynamics of currency trading and its price; the exchange rate. It will show that the foreign exchange market and the balance of payments are very much interrelated. While there are some exceptions in case of markets with direct investment activities and cartels, most markets are competitive and can be analyzed using the ordinary demand and supply framework.

What are the basics of currency trading?

Foreign exchange takes place when the money of one nation is traded for the money of another nation at the exchange rate. The spot exchange rate is the price for immediate (within 48 hours) exchange and the forward exchange rate is the price for an exchange at some point in the future (usually 30, 90 or 180 days from now). This chapter focuses on the spot exchange rate. Part of foreign exchange is done with customers; the retail part of the market. Some trading is done with individuals but most of it is done by nonfinancial companies and financial institutions. Foreign exchange between banks is called the interbank part of the market. You might expect traders to trade currencies directly. Most foreign exchange trade, however, involves the dollar as a vehicle currency; one foreign currency is exchanged for dollars and these dollars are traded for another currency.

Foreign exchange takes place for all items included in the balance of payments. Goods being exchanged for money requires foreign exchange as well. Companies want to receive their own currency and the foreigner has to exchange currencies in order to be able to purchase the product. Banks hold accounts for each currency. They need to be able to receive and offer a particular currency in order to serve its customers. A bank might hold a speculative position (usually for a short time) to speculate on exchange-rate movements. For the biggest part, this is done by brokers who are actually paid to 'shop' in exchange markets.

How do demand and supply determine the exchange rate?

Assuming that exporters prefer to receive their own currency for their products, exports create supply of a foreign currency and demand for the domestic currency. Similarly, imports require demand of foreign currency and supply of the domestic currency. The same applies to capital flows. Capital outflows create demand for foreign currency and supply of the domestic currency, and capital inflows create demand for domestic currency and supply of foreign currency. In what way demand and supply determine the exchange rate depends on the foreign exchange system.

Floating exchange rates

In case of a floating exchange-rate system, the exchange rate can float freely within the market. The demand curve slopes downward. A lower exchange rate makes a currency and the goods denoted in that currency more attractive, increasing demand for it. If demand for those goods increased because of some other reason, the demand curve shifts to the right and, assuming a stable supply curve, the exchange rate increases. Similarly, if the willingness to invest in a country increases, the demand for its currency increases and the exchange rate rises as well. This is called an appreciation whereas a decrease in a floating exchange rate would be called a depreciation.

Fixed exchange rates

A fixed exchange-rate system requires market intervention. Usually, the exchange rate is kept in a narrow band that allows it to float just a bit. When it deviates too much from the desired rate, officials must intervene. The most common denotation of an exchange rate is as follows: the price or exchange rate of the euro (in terms of pounds) equals £1.11/€. If the exchange rate hits the lower boundary, say £1.05/€ is the market-clearing rate, the euro is considered too cheap. At the higher desired price, there would be excess supply which needs to be absorped by the intervention. Therefore, euros need to be bought with foreign currency. If the desired fixed par value is increased, it is called a revaluation (more pounds are needed for the same euro). A decrease in the fixed par value is called a devaluation.

How does arbitrage shape the exchange-rate market?

If there is a gap in exchange rates between different locations and the currencies can be traded freely, arbitrage opportunities arise. Traders can buy the currency in one location, sell it somewhere else, and earn a riskless profit. This usually happens at a large scale and ensures that rates in different locations are essentially the same. Extra demand drives up the price where the currency is sold at a lower price and extra supply lowers the price where the currency is sold at a higher price. Arbitraging through three rates is called triangular arbitrage. Suppose the cross-rate between the pound and euro is £1,60/€, £0.50 for each Swiss franc and 3 Swiss francs for each euro. 150 pounds will buy you 300 Swiss francs. 300 Swiss francs will buy you 100 euros. 100 euros will buy you 160 pounds, providing a profit if 10 pounds. While such large arbitrage opportunities are rare, trading fast can provide significant profits in the spot exchange market. Nevertheless, increased globalization and integration of markets have absorped most arbitrage opportunities.

This chapter introduces the basic dynamics of currency trading and its price; the exchange rate. It will show that the foreign exchange market and the balance of payments are very much interrelated. While there are some exceptions in case of markets with direct investment activities and cartels, most markets are competitive and can be analyzed using the ordinary demand and supply framework.

How can we hedge foreign exchange-rate risk? - Chapter 18

Many international activities require transactions in the future. The challenge with money exchanges in the future is that the future spot exchange rate is unknown. This chapter focuses on the risks involved with future exchanges and how these risks can be hedged.

What is the exchange-rate risk?

Floating exchange rates can change quickly when demand or supply changes. Fixed exchange rates are subject to changes as well. Usually, there is a small band around the par value where it can float. Even when the fixed-rate system is very tight, a currency devaluation or revaluation can still change the value of exchanges. People are said to be exposed to exchange-rate risk. An investment in a foreign country (with a different currency) will lose value if that currency depreciates. Many people try to hedge this risk by eliminating their position subject to exchange-rate risk. Others try to speculate on possible changes in the exchange rate, which is basically the opposit; they take a position in a foreign currency.

How can we use the market of forward foreign exchange?

Parties can agree on a future price for exchanging currencies and disclose a forward exchange rate as part of a forward foreign exchange contract. The forward exchange rate can differ from the future spot rate which is vulnerable to changes over the course of the forward contract. The forward exchange rate is a fixed price so changes in the spot rate will not affect the net value of the contract. People can hedge by taking a long position (an agreement to buy) or a short position (an agreement to sell). Forward contracts can be easily used for speculation. Suppose you expect a currency to depreciate. You could take a short position at the given forward rate if you expect the future spot rate to be lower. This way, once the contract expires, you can buy the currency 'cheap' in the market and sell it at the fixed forward rate, making an instant profit. Of course, if many people in the market expect the currency to depreciate and speculate on it, the forward exchange rate will adjust. Speculators apply pressure on the forward rate until it equals the average expected value of the future spot exchange rate.

There are more ways to hedge exchange rate risk. Three well-known types of contracts are:

• Currency futures: similar to a forward contract, a fixed price can be agreed on. There are some differences though. A futures contract is standard and thus tradable whereas a forward contract is customized. Furthermore, a futures contract requires a money deposit as a margin and profit and losses on the contract are settled daily. If you suffer too much losses you might need to add to your margin account. Profits and losses are usually not taken until the maturity date of the contract. Finally, currency futures are accessible to anyone who can pay the margin. Forward contracts are only disclosed with creditworthy customers.
• Currency options: as opposed to the previous contracts, an option gives you the right and not the obligation to exchange the currency at some point in the future at a price set today. You have the right to buy (in case op a call option) or sell (in case of a put option) your currency at this disclosed exercise price or strike price. Of course, since you can benefit from a positive outcome while avoiding losses, options require you to pay a premium when acquiring them.
• Currency swap: a currency swap includes future exchanges of different currencies between two parties. The parties agree on the period of time and the price (or amounts). The parties can benefit from lower transaction costs and risk reduction because multiple exchanges can be included in one contract.

People wishing to hedge or speculate can choose from different types of contracts tailored to their needs and risk aversion.

What about international financial investments?

Investors usually want to exchange their returns on foreign investments back to their own currency. These returns (and possibly their initial investment) are subject to exchange-rate risk. A foreign exchange contract can be used which hedges this exposure. This is called a covered international investment. The investor can also accept the risk that the future spot exchange rate lowers the value of the returns. This unhedged investment is somewhat speculative and is called an uncovered international investment. We will have a closer look at each of these types of investments.

Covered international investments

The difference between an investment abroad and at home when hedging for exchange-rate risk is called the covered interest differential. The first part consists of the investment abroad, which requires you to exchange your money at the current spot price, invest it abroad at the current (foreign) interest rate and convert it back at the forward exchange rate. The second part is just your money invested at the current (home) interest rate. The difference (when substracting one from the other) clearly shows whether is it more profitable to investment abroad or at home. The term covered indicates that the investor is fully hedged against exchange-rate risk.

To have a closer look at this, we define the forward premium (as the name suggests) as the proportionate difference between the current forward exchange-rate value and the current spot value. It is basically the difference between these rates divided by the current spot value. If this value is negative, it means that you would lose on your investment. The currency you would invest in is at a forward discount. If we add the interest rate differential to this forward premium, we approach the covered interest differential. Why does this makes sense? Because it shows that the covered interest differential positively depends on the forward premium and the interest rate differential.

Traders can use this covered differential to make arbitrage profits. This covered interest arbitrage involves buying a country's currency at the spot exchange rate and selling it at the forward rate. The forward premium and the difference in interest rates combined could make a net profit. Suppose there is no forward premium and the foreign interest rate is higher than the domestic interest rate. Arbitrageurs take this opportunity and shift their funds abroad. This requires selling domestic currency and buying foreign currency in the spot market, increasing the spot exchange rate. It also requires buying domestic currency and selling foreign currency in the forward market, decreasing the forward exchange rate. Domestic borrowing increases and arbitrageurs invest their money abroad, increasing the domestic interest rate and decreasing the foreign interest rate. What is the pattern here? Arbitrage opportunities are self-eliminating; any real forward premium or real interest differential is likely to be absorped by the market. John Maynard Keynes referred to this as the covered interest parity where the covered interest differential equals zero. Covered interest parity explains the difference between a currency's current spot and current forward exchange rate.

Uncovered international investments

The difference with covered investments is that uncovered international investments are not backed by a forward contract. The calculation of its return depends in the expected future spot rate. The expected uncovered interest differential is a comparison of an exhange at the spot rate that is invested abroad (receiving foreign interest) and exchanged back at the expected future spot rate, with the same initial amount invested domestically at the home interest rate. The difference with the covered interest differential is the decision not to cover (hedge) the exchange rate risk. Why would anyone choose not to cover his or her investment? First, the expected overall return may be higher (even when taking into account the risk). Second, the investment can actually reduce the risk of a portfolio investment because of diversification benefits. If the exchange-rate risk is offset or investors are indifferent to the risk (they are risk neutral), investors are likely to profit from a positive uncovered interest differential. Again, this will place pressure on the current spot exchange rate and the interest rates, driving the uncovered interest parity to zero. This parity is also called the international Fisher effect and implies that any difference in interest rates will lead to an offsetting appreciation of the currency (in case the interest rate is lower) or depreciation (in case the interest rate is higher).

Does interest parity hold in practice?

Evidence on the covered interest parity seems quite strong and consistent. Large deviations might be explained by an exogenous factor. In the past, governments have threatened to or imposed actual capital controls on financial markets. These controls limit the ability of investors to transfer money and cause market imperfections. Political risk is known to distort financial markets more often. In a free financial market, spot and forward exchange rates are tightly linked to interest rates.

Evidence on the uncovered interest parity is weaker. First, it is hard to measure people's actual expectations of future exchange rates. To overcome this problem, one could look at actual returns to derive expectations about returns and exchange rates. If covered interest parity applies, uncovered interest parity can be tested by examining whether the forward rate predicted the future spot rate (of course, a year after they were stated). Results show that uncovered interest parity applies roughly. Market participants seem to be wrong about future spot exchange rates. Consistent errors could point toward market inefficiency but it could well be that their forecasts are biased due to lack of market knowledge.

Many international activities require transactions in the future. The challenge with money exchanges in the future is that the future spot exchange rate is unknown. This chapter focuses on the risks involved with future exchanges and how these risks can be hedged.

What are the determinants of exchange rates? - Chapter 19

Where previous chapters highlighted the importance of exchange rates, this chapter revolves around understanding them. Long-term trends, medium-term trends, shirt-term variability and their interrelatedness are discussed.

Providing a short overview of the path to understanding exchange rates:

• First, short-run effects are discussed. The perceptions and actions of investors are important. Most currency exchanges are related to the currency composition of investment portfolios instead of to trading goods and services. This is why the asset market approach to exchange rates is introduced, showing that a currency's exchange rate positively depends on its (relative) interest rate and the expected future spot exchange rate.
• Second, long-term effects are considered. Purchasing power parity is used to understand the relationship between inflation of product prices and exchange rates.
• Third, the effect of money on product prices and inflation rates is discussed. The monetary approach to exchange rates shows that the spot exchange rate of a currency positively depends on its money supply and its real domestic product.
• Fourth, we turn to the relationship between short-, medium-, and long-term rates. Exchange rates tend to overshoot in the short run when important economic or political news is announced.
• Finally, the chapter finishes with the usefulness of these theories in practice and how exchange rates can be forecasted and measured.

What determines exchange rates in the short run?

Recall from chapter 18 that uncovered interest parity assumes the expected uncovered differential to equal zero. This means that the expected appreciation and interest rate differential should offset each other. Any change in one of the four variables domestic interest rate, foreign interest rate, current sport exchange rate or expected future spot exchange rate will lead to adjustments in at least one of the other variables.

The role of interest rates

If the domestic interest rate increases relative to the other variables, investors shift their financial resources toward domestic-currency assets and cause the domestic currency to appreciate. Similarly, a lower domestic interest rate shifts these resources toward foreign-currency assets and causes a depreciation of the domestic currency. In reverse, a higher foreign interest rate depreciates the domestic currency and a lower foreign interest rate appreciates the domestic currency. The interest rate determines the attractiveness of financial assets denominated in that currency. It changes demand and supply for that currency and causes its price to increase (appreciate) or decrease (depreciate).

The role of the expected future spot exchange rate

An increase in the expected future spot rate makes foreign-currency assets more attractive. To see why, market participants expect to need more of the domestic currency in the future in exchange for one unit of foreign currency. Investing abroad would yield returns on foreign currency which can be exchanged back for more of the domestic currency. Investors shifting their funds need to buy the foreign currency and sell the domestic currency, causing the domestic currency to depreciate. Similarly, a decrease in the expected future spot rate causes investors to reposition their funds toward domestic-currency assets and leads to domestic currency appreciation. Basically, expectation becomes reality and this can happen very quickly. This effect is sometimes called a self-confirming expectation.

What determines exchange-rate expectations? Some investors expect recent trends to continue in the future. Extrapolating such a trend into the future leads to a bandwagon. This lack of economic reasoning can be destabilizing when it keeps the exchange rate from reaching a long-term equilibrium. In contrast, some investors expect the exchange rate to fluctuate along with basis economic conditions. These expectations can be stabilizing as they are consistent with economic fundamentals (e.g. product price levels). Expectations tend to be generally important when they build on unexpected information about government policies or the economy for example.

What determines exchange rates in the long run?

Understanding exchange rates relies heavily on the relationship between product price levels and exchange rates. The law of one price states that a product should have the same price everywhere (when denoted in the same currency) as long as it can be traded easily and freely in perfect competition. This would be the equilibrium world price. Of course, deviations are likely due to transport costs, trade barriers and imperfect competition. For many products the law of one price does not hold closely.

Purchasing power parity

Absolute purchasing power parity (absolute PPP) is very similar to the law of one price. The only difference is that absolute PPP considers a bundle of products instead of just one product. Absolute PPP can be useful if differences average out within the bundle, but evidence shows that divergences from absolute PPP can be quite large. In addition, countries sometimes work with different bundles of products. Nevertheless, the prices of (easily) traded products seem to approach absolute PPP over time.

Where absolute PPP focuses on one point in time, relative purchasing power parity focuses on differences over time. Relative PPP states that the difference between changes in product prices over time will be offset by the change in the exchange rate over time. This does not mean that the prices have to be equal, but it does mean that any difference in inflation rates between two countries will be offset by a change in the exchange rate. This way, relative product prices are assumed to remain equal. In other words, relative PPP predicts that countries with relatively low inflation rates will face appreciation of their currency and countries with relatively high inflation rates will face depreciation of their currency. Evidence of relative PPP is weak for the short run but quite strong for the long run. It should be noted that it could take years for exchange rates to adjust only partly to offset deviations from PPP.

The monetary approach

We just established a relationship between the inflation rate and the exchange rate. Many economists believe that the inflation rate depends on the money supply. This suggests a relationship with the exchange rate as well. It is not surprising that the price of money (the exchange rate) depends on the availability of money. Hyperinflation is a good example that the supply of money affects its value.

Again, supply and demand are important. The demand for money stems from the need and desire to use it as a medium of exchange. People want to carry out transactions that require the availability of money. This establishes a link with domestic product. Higher domestic product involves more transactions and economic activity that make people want to hold more money. This forms basically the quantity theory equation which states that money supply equals money demand determined by gross domestic product (GDP).

Combining the quantity theory and absolute PPP in one model, we can predict the exchange rate based on the money supply in two countries and their national products. Recall from absolute PPP that the exchange rate (e) equals the price ratio (P/P_f). We add the money supplies to the model as M and M_f, the real production as Y and Y_f and k and k_f as the extra demanded amount for money. The formula for the exchange rate looks like this:

e = P/P_f = (M/M_f) * (k_f/k) * (Y_f/Y)

Pay attention to the position of the foreign variables denoted with subscript 'f'. The equation predicts that the exchange rate between the foreign and home currency increases (or that the foreign currency appreciates) if the foreign nation experiences a combination of slower money supply growth, faster real output growth and increased demand for money (increased transactions). Suppose the ratio k_f/k stays the same, then every percent change in one of the other variables will lead to an equal percentage change in the exchange rate. This implies that the exchange rate elasticities are equal to 1. In addition, it implies that balanced growth in two countries will not affect their currency's exchange rate. Note that a change in real income does not necessarily influence the exchange rate in the short run. It might add to inflation instead if the government increases its spending. Such a demand shift is dominant in the short run whereas the quantity theory applies to the long run where the supply shifts are dominant.

What is exchange-rate overshooting?

Suppose that the money supply suddenly increases by 10 percent without affecting its expected rate of growth. Investors would expect the exchange rate to increase (the price of foreign exchange rises) by 10 percent as well. The same goes for the domestic price level. However, as we just saw, the quantity theory assumes these effects to happen in the long run. If this is true, what happens in the short run? Because product prices are sticky, the increase in money supply puts downward pressure on the domestic interest rate. The lower real interest rate (compared to the foreign interest rate) and the expected appreciation of the foreign currency enhances an outflow of financial capital. Foreign-currency assets become more attractive. The expected appreciation of 10 percent will lead to an immediate appreciation of 10 percent (recall that this is the self-confirming expectation). The decrease in the domestic interest rate puts additional upward pressure on the current spot exchange rate. The combined appreciation of the foreign currency will be more than 10 percent, so it is said to be overshooting. After a while, product prices adjust (they increase in this case) and the exchange-rate value decreases to its long-run equilibrium. While the exchange rate overshoots, investors still expect the long-run appreciation to be 10 percent. Due to the overshooting, the foreign currency is expected to depreciate from its high value. This adjustment would reestablish uncovered interest parity. Note that overshooting does not necessarily imply market failure. It is the result of rational decisions made by investors.

How well can we predict exchange rates?

Exhange-rate predictions for the short run are not good. They barely beat random walks or the assumption that the future spot rate will be the same as the current one. Economic models like PPP and the monetary approach are of more use in the long run. However, accurate predictions are still difficult for two reasons. First, exchange rates are volatile to new information. Unexpected changes in policy or economic variables are not absorped by the market and its predictions. In addition, short-run overshooting can disturb a long-run trend that was actually 'on track'. Second, exchange-rate expectations do not only stem from economic fundamentals. And since exchange rates can be self-confirming, exchange-rate developments might not make sense from an economic point of view. If changes appear to be inconsistent with economic fundamentals, it is called a (speculative) bubble. Bubbles tend to occur quite often, making a case for market inefficiency in foreign exchange markets.

How can we measure the exchange rate?

The regular market rate between two currencies is called the nominal bilateral exchange rate. If we want to know how a country's exchange rate is doing compared to other countries, we use the nominal effective exchange rate. This is a weighted average of the exchange rates with multiple currencies and can be used to analyze the effect on a country's exports and imports.

Incorporating the price ratio enables us to measure deviations from PPP. The exchange rate between two countries that incorporates both the market rate and the price ratio is called the real bilateral exchange rate. The weighted average across multiple foreign countries is called the real effective exchange rate. The real exchange rate is not only an indicator for deviations from PPP, but also an indicator of a country's international price competitiveness.

Where previous chapters highlighted the importance of exchange rates, this chapter revolves around understanding them. Long-term trends, medium-term trends, shirt-term variability and their interrelatedness are discussed.

How do governments intervene in the foreign exchange market? - Chapter 20

Previous chapters have paid attention to the ins and outs of exchange rates in free markets. In the real world, many governments intervene in the foreign exchange market. One objective can be to reduce the fluctuations in exchange rates. Additionally, some governments prefer to keep a relatively high exchange rate, favoring buyers of imports and reducing inflation pressure, or a relatively low exchange rate, favoring the export and import-competing sectors. This chapter focuses on why governments intervene, how they do this and how they have done this in the past.

What kind of policies do governments use?

Of course, imposing no restrictions at all is also a policy choice. This means that a country's currency is fully convertible for every type of transaction. Any active policy can either be directly applied to the exchange rate or regulates who may use the foreign exchange market (exchange control). This distinction is similar to the one between tariffs and quotas. One impacts the price and the other the quantity. They are very much related because any change in price is likely to alter the quantity traded and vice versa. Exchange control can be 100% which means that all transactions have to be approved by the monetary authority. Most policies require partial exchange control. One common example is allowing current account transactions (for exports and imports) and restricting financial transactions (through capital controls).

What characterizes a floating exchange rate?

A market equilibrium solely determined by private supply and demand enables a clean float. Governments who are reluctant to allow complete flexibility use official intervention to impact the exchange rate. As long as the rate is generally floating, such an intervention establishes a managed float (a positive view of government intervention) or a dirty float (a negative view). The government hopes to change the currency's value by altering its supply.

What characterizes a fixed exchange rate?

Recall that a little flexibility is allowed when a government sets a band around a chosen fixed rate; the par value or central value. When a government decides to fix its exchange rate, it needs a reference point. In the past, gold has been a popular commodity standard. Nowadays, countries often use a basket of currencies. This basket can consist of the four major currencies in the world, the special drawing right (SDR), or some other combination, for example of currencies most important to a country's trade.

A permanent fixed exchange rate is hard to maintain. Speculators can give a government a hard time when they expect the government to give in to market forces. Their actions will require additional government intervention. Besides, a permanent fixed rate is likely to distort PPP and create international opposition. The likelihood of a permanent fixed rate is negligible, so we often call it a pegged exchange rate. Any changes make it an adjustable peg. Even then, market forces are likely to increase the government's flexibility. A pegged exchange rate is hard to maintain when a country's inflation rate is relatively high. It will violate PPP and make the country less competitive. This is why some countries choose for a crawling peg; changing the peg value regularly. The government can use the inflation difference as an indicator for government intervention. The difference between a floating and pegged rate is not so obvious in practice. A pegged rate can be quite flexible when it is adjusted frequently and a floating rate can be quite stable if market forces allow it. In case the government wants to defend a fixed exchange rate, it has four basic options:

• Buy or sell foreign currency in exchange for domestic currency;
• Impose exchange controls;
• Alter domestic interest rates;
• Adjust the domestic macroeconomic position by using fiscal or monetary policy.

Notice that all these options are intended to change the supply-demand position in the foreign exchange market. They can be exercised at the same time and tend to be closely related. Another option would be to not defend the fixed rate anymore. The government might call for a devaluation or revaluation of the currency, or switch to a floating rate.

How does official intervention work?

Suppose a country (which we consider to be domestic) choses to peg its currency to the dollar (the foreign currency). The spot exchange rate equals the amount of domestic currency for each dollar. Official intervention to direct the currency depends on the situation at hand.

Defending against depreciation

An increase in the exchange rate indicates that more domestic currency is needed for each dollar. The domestic currency decreases in value and is said to depreciate. This could be the result of nonofficial supply and demand. The monetary authority can defend the exchange rate if it enters the foreign exchange market in its official role. It must buy domestic currency with dollars to counteract the depreciation. This intervention is reflected in the balance of payments. First, the initial depreciation indicates relatively weak demand for the domestic currency which is likely to result from weaker demand for its products and financial assets (reflected respectively in the current account and financial account balances). Second, the intervention finances a deficit in the official settlement balance.

The monetary authority needs dollars to buy its domestic currency. In case the dollar is not held as a reserve currency, the authority can either use its own official international reserve assets to obtain dollars or borrow dollars. The international reserve assets could stem from holdings of foreign currencies, special drawing rights, gold or a position with the International Monetary Fund (IMF). On average, two-thirds of these holdings are in dollars and about one-forth in euros. Dollars can also be borrowed. Some countries hold swap lines which each other enabling them to exchange their currencies easily. They can also be borrowed from private sources. If the country's currency is hold as a reserve currency by a foreign authority, it can issue and sell assets. This way, a foreign authority buys the domestic currency.

In buying domestic currency, the currency is removed from the market. The monetary authority might not want this decrease in money supply and could exercise a sterilized intervention; preventing the money supply from changing. The sterilization act should let domestic money flow back into the economy. Without sterilization, the change in money supply alters domestic interest rates and macroeconomic factors in turn, as shown before.

Defending against appreciation

An exchange rate approaching or hitting the lower band requires less domestic currency for each dollar. The domestic currency becomes more valuable and appreciates. This relatively strong demand for the currency is reflected in the current and financial account of the balance of payments as well (try to picture this). A surplus in the official settlement balance is financed. Defending against appreciation requires buying dollars with domestic currency. The country increases its holdings of official (dollar-denominated) reserves assets. The domestic money supply will increase unless the monetary authority decides to sterilize the intervention. Again, no or partial steriliziation will affect domestic interest rates and the entire macroeconomy.

Temporary disequilibrium

If the 'imbalance' can be temporary, intervention makes sense. Financing temporary deficits and surpluses is better than a floating exchange rate. For example, the exchange rate can be subject to seasonal differences. Seasonal patterns can cause large differences in exchange rate pricing. During harvest season, the higher exports earn more foreign currency, lowering the exchange rate. During off-season, the opposite happens. Stabilizing the exchange rate brings a net social gain to the world. First, during off-season, the home currency is sold for a lower exchange rate than some people are willing to pay. Second, during harvest season, the home currency is bought for a higher exchange rate than some people are willing to sell it for. In order for this intervention to be successful, private speculators should not jump in. Their actions would stabilize the exchange rate already, making official intervention unnecessary. In addition, the intervention should be based on accurate forecasts or else the distortion or imbalance will be maintained.

Disequilibrium that is not temporary

If official intervention finances a deficit in the official settlements balance (when defending against depreciation), official reserves are lost. The monetary authority will be reluctant to intervene continuously. In case of an ongoing deficit, it can run out of official reserves. Speculators might expect the defense strategy to be given up and the currency to be devalued. Exercising a one-way speculative gamble puts even more pressure on the reserves. Another defense strategy could be adopted (e.g. exchange control, altering domestic interest rates or changing fiscal or monetary policy) but in most cases the monetary authority is forced to devalue its currency. Rebuilding official reserves will be expensive as a result of devaluation.

Defending against appreciation entails accumulating reserves and financing a surplus in the official settlements balance. Monetary authorities are reluctant to build up reserves for several reasons:

• Returns on official reserves are rather low;
• If a country chooses to revalue its currency after building up a lot of reserves, these reserves lose their value (because their respective currency depreciates);
• Other countries are running deficits and are likely to oppose to the large build-up of reserves.

From this, it is clear that financing a fundamental disequilibrium is not the solution. Then what is? A strong case is made for temporary adjustments but a fundamental disequilibrium cannot be identified until the monetary authority already took a strong position.

What impact do exchange controls have?

Exchange controls have similar effects as quotas on imports. The government could require exporters to exchange their export revenues with the government at a fixed rate that is lower than the market rate. At this rate, a limited amount of money is available for exchange. The government could also ration the right to buy foreign exchange. One could derive a demand curve for foreign exchange that has a downward slope and indicates that some people are willing to pay more for foreign exchanges. The difference between this willingness and the fixed rate, multiplied by the amount of money that is exchanged, equals the government revenue. Excluding likely administrative costs; even when the government would return this revenue to society, the exchange control imposes a loss of well-being on society as a whole. Because the amount of money available for exchange is limited, some mutually profitable exchanges are prohibited (think of the deadweight losses). In addition, exchange controls are likely to lead to additional costs. First, the government faces transaction or administrative costs in allocating the right to buy foreign currency. Dealing with exchange controls leads to private resource costs. Ignoring the one-dollar, one-vote metric, losses could be higher valued than the gains because the government is not necessarily serving the demanders toward the top of the demand curve. Second, since people are willing to pay more than the fixed rate, they look for an alternative way to exchange what they want. One such way is to bribe the people in charge. Another is to offer the recipients of foreign exchange rights more money. If this happens on a large scale, a second foreign exchange market - a parallel market - is likely to be created. These 'black' markets exist a lot in practice although some governments impose strict penalties.

Returning to one of the main goals of regulating the exchange rate; reducing uncertainty about its value. Whether there is a good chance that this is achieved, exchange controls increase uncertainty about exchanges in general. People start to wonder whether they will be allowed to exchange foreign currencies whenever they want to. Another reason for controls to exist is that they are used for increasing power over the allocation of resources. This power can be used to achieve social goals but can also be lucrative to certain government individuals or groups. And of course the existence of parallel markets questions the effectiveness of exchange controls.

What is the historical experience of actual government policies?

The gold standard era

From the late 17th century on, Britain tied its pound sterling more to gold than to silver because its gold-silver ratio was more valuable. Britain's industrialization, world trade and the absence of being in a war made Britain very prestigious. Another important development was the discovery of more gold in small enough quantities to remain valuable. The international gold standard emerged for these reasons by 1870 and was successful until it ended with World War I. During the gold standard, countries fixed their currencies to a specific amount of gold, linking it to their macroeconomies as well. Arbitrageurs made sure that the exchange rates did not fluctuate too much.

At first, the gold standard seems very successful because international markets were so stable during that time. However, several fundamental criticisms should be addressed:

• Most countries were able to run payment surpluses without pressure to adjust;
• Britain (and Germany to a lesser extent) ran payment deficits by building up liquid liabilities. Again, without pressure to adjust;
• Britain was able to call in large volumes of short-term capital, even when other countries adjusted to changes in for example interest rates. This is likely to be linked to London being the financial center for the world's money markets;
• The world economy was not subject to large shocks like a world war during the time of the gold standard;
• Central bankers were not pressured to fight unemployment or stabilize prices. They could focus solely on defending the exchange rate.

Some of these criticisms support the notion that the fixed-rate gold standard mostly pressured countries with payment deficits. In line with this, studying fixed and flexible exchange rates reveals that most countries that abandoned fixed exchange rates, actually experienced growing payment deficits and reserve outflows. During the period of the gold standard, flexible exchange rates were, with some exceptions, quite stable as well.

Interwar instability

In the aftermath of World War I and leading up to the Great Depression, countries' payment balances and exchange rates were chaotic. High inflation and political instability were the rule rather than the exception. Most policies that were imposed turned out to be unsuccessful. Domestic unemployment became one of the most urgent issues. Countries used devaluations, tariffs and other trade barriers to boost domestic employment. Such policies at the expense of other countries are called beggar-thy-neighbor policies. The interwar experience showed the importance of flexible exchange rates to cope with any kind of international shock. In fact, holding on to a fixed rate is rather destructive, despite its benefits during more stable periods. Moreover, during the interwar era, domestic monetary and fiscal policies turned to be destabilizing whereas speculation seemed to have a more stabilizing effect. Exchange-rate flexibility might lead to uncertainty but they at least reflect the health of national economies more accurately.

The Bretton Woods era

Many countries wanted a reformation that would lead to a stable fixed exchange-rate situation. Countries needed to have enough reserves to overcome temporary disequilibriums. What the world needed was a new central bank. This central bank could provide the needed reserves to overcome temporary deficits. Automatic pressure on governments running surpluses or deficits to change their policies should have been included as well. However, the U.S., at that time dominating the world economy, gold reserves and the Bretton Woods conference, was not prepared to provide so much dollars for international reserves and to let inflation stabilize the world economy. The negotiations resulted in the Bretton Woods system, featuring an adjustable peg. To overlook international monetary stability and to lend reserves to countries in need of financing temporary deficits, the International Monetary Fund (IMF) was created. Monetary stability was not a sure thing, partly because the IMF had limited resources. When looking at countries' growth and unemployment rates, the Bretton Woods system seemed to be successful for almost two decades though. Nevertheless, the system caused some trouble. The adjustable-peg system encouraged private speculators to exercise one-way speculative gambles. Speculative attacks might be called destabilizing when they make the official defense of a currency to surrender. However, it can be considered stabilizing in the sense that it forces shifting toward a new equilibrium rate.

Under the Bretton Woods system, the dollar became the most important reserve currency and many countries pegged their currency to the dollar. When these countries increased their official reserves, the U.S. started to run large official settlements balance deficits. The official price of the dollar (for reserves exchanges) was set at 35 dollars per ounce as the gold-exchange standard. Exchange controls restricting mobility of capital was not popular and a devaluation of the dollar in terms of gold would have benefited the Soviet Union and South Africa as the two major gold producers. Therefore, the U.S. chose to change the rules with a two-tier gold price system. The private price was allowed to fluctuate while the official price remained at 35 dollars per ounce of gold. The U.S. kept running deficits and started to impose controls and restrictions, threatening the existence of the Bretton Woods system. It caused many countries to drop their pegged rate against the dollar and shift to a floating rate. The Bretton Woods system effectively ended in 1971 and was officially abandoned in 1973.

The current system: limited anarchy

Under the current system most countries choose their own policy with regard to the exchange rate. Most countries turned to floating exchange rates but members of the European Union (EU) are the most notable exception. Over the years, they adopted a pegged rate with a band, a fixed rate and currently the euro is the common currency for 19 countries of the EU. The euro is still very successful as a common currency but it limits countries' ability to exert monetary policy within the euro area. There is a large group of currencies pegged to the euro and another bloc of currencies pegged to the U.S. dollar. Many countries have pegged or heavily managed floating rates because of skepticism toward floating rates. However, multiple exchange-rate crises have shown that defending such rates is very difficult (think of the one-way speculative gamble). Every system, including a nonsystem, has proven to be associated with many uncertainties and difficulties. There is no consensus among governments about what works best.

Previous chapters have paid attention to the ins and outs of exchange rates in free markets. In the real world, many governments intervene in the foreign exchange market. One objective can be to reduce the fluctuations in exchange rates. Additionally, some governments prefer to keep a relatively high exchange rate, favoring buyers of imports and reducing inflation pressure, or a relatively low exchange rate, favoring the export and import-competing sectors. This chapter focuses on why governments intervene, how they do this and how they have done this in the past.

What is the role of international lending in financial crises? - Chapter 21

Chapter 15 has been largely devoted to foreign direct investment (FDI). This chapter will focus more on portfolio investment and international lending. Private and official international flows will be discussed as well as their role in financial crises.

What are the gains and losses from international lending?

International financial flows are characterized by the type of lender or investor (private versus official), type of borrower (private or government), maturity (long-term versus short-term) and existence of control (direct versus portfolio). Many combinations can be made, each of them used for different reasons. In general, international lending brings two major benefits. First, as intertemporal trade, it reallocates resources from lenders who are willing to give them up for a premium in the future to borrowers in need of them today. Second, international lending can be used for diversification of investments.

As long as borrowers honor their commitments, the world can be better off. To illustrate how this works, lets assume there are two countries; country A with relatively few investment resources but abundant domestic investment opportunities and country B with abundant resources but limited profitable opportunities. Both countries face a downward-sloping marginal-product-of-capital curve because investment opportunities have different returns and the most profitable ones will be exercised first. Without international financial transactions, country A can exercise few of its profitable investment opportunities while country B ends up investing in opportunities with a (relatively) low return. Without barriers to international finance, country B can earn higher returns if it lends to country A. Country A will be able to borrow at a lower rate. Assuming that the riskiness is the same, the countries will reach an equilibrium rate which lies between their former domestic rates. Capital formation increases in country A and decreases in country B. While both countries are better off in the end, not all groups benefit from these international flows. Borrowers in country B will face a higher rate and lenders in country A will face a lower rate. There is one more effect that is less straightforward. The increased capital formation in country A raises the productivity and earnings of other resources (like labor and land) while the decreased capital formation in country B lowers the productivity and earnings of these resources.

How can taxes influence international lending?

Both countries from the previous example are said to have some market power. Country A because of its large demand for foreign resources and country B because of its large foreign supply of resources. If country B restricts its lending by imposing a tax, it drives up the interest rate for the remaining resources that are borrowed by country A. Country B loses some profitable lending but its tax revenue will outweigh this loss. The largest gap (net benefit) to country B represents its nationally optimal tax. Of course, this could happen only if country A does not impose a tax. Similarly, country A could restrict its borrowing by imposing a tax on the same financial flows. Country B experiences the same losses but the tax revenue goes to country A. Here, as long as country B does not impose a tax, country A gains at the expense of country B. Both countries imposing a tax will decline international lending and borrowing and is likely to make both countries worse off. At the most, one of the countries might gain compared to the situation with free financial flows.

What is different about lending to developing countries?

Mutual benefits as discussed in the two-country example are common among industrialized countries. International lending involving developing countries often provides different results. Developing countries have more difficulties in making debt payments, especially when struck by a financial crisis. Defaults on such loans in the past have made industrialized countries reluctant to lend any more money. Several financial crises will be discussed along with the capital flows of countries involved.

The surge in international lending, 1974-1982

The Great Depression from the 1930s caused many developing countries to default on their loans. Lending to developing countries deteriorated until the oil shocks of the 1970s. These shocks caused recessions and high inflation in industrialized countries but international lending increased rapidly for the following four reasons:

• The oil-exporting nations stocked their funds at banks and other financial centers who needed to find other borrowers;
• Profitable investment opportunities in industrialized countries were limited because real interest rates were low and energy-saving equipment as promising investment opportunity took time to develop;
• Developing countries restricted FDI, causing industrialized countries to search for other ways to earn the higher returns in developing countries;
• Banks started to compete for lending opportunities and demonstrated herding behavior.

The debit crisis of 1982

The U.S. adopted a tighter monetary policy to fight its increasing interest rates and inflation. This resulted in recessions among industrialized countries, causing developing countries' exports to deteriorate in terms of price and quantity. Real interest rates remained high and developing countries, starting with Mexico in 1982, declared they had to default on previous loans. Smaller banks eliminated their exposure by getting rid of these loans but larger banks were afraid to make matters even worse. They rescheduled loan payments and lent new money to help the debtors. Of course, this could not last forever and the low economic growth and lack of access to international finance kept the crisis going. By 1989, the U.S. came up with the Brady Plan offering each debtor country the chance to reduce its debt and repackage the remaining debt as Brady bonds. The debt crisis came to an end.

The resurgence of capital flows in the 1990s

Developing countries gained more excess to international funds for four reasons:

• The scope of the Brady Plan made lenders willing to provide lending again;
• Lenders were encouraged to seek higher returns in developing countries due to low U.S. interest rates;
• Developing countries reformed their policies (e.g. new investment opportunities through deregulation) and became more attractive to lend money to;
• Investors managing portfolios and seeking higher returns and risk diversification found them in developing countries.

Different from the lending wave in the late 1970s, stocks and bonds became much more popular whereas bank lending became relatively less important.

The Mexican crisis, 1994-1995

During the resurgence of capital flows in de 1990s, Mexico experienced a lot of capital inflows because of economic reform and joining the NAFTA. Its inflation rate was relatively high compared to the U.S. and the Mexican government decided to fight the resulting depreciation. Its increasing current account deficit was financed by the capital inflows but defending the exchange-rate value absorped a lot of international reserves. The government lacking adequate supervision and regulation decided to replace peso-denominated government debt with tesobonos; short-term dollar-indexed government debt. Investors were afraid that the Mexican government had to default on these loans and withdrew a lot of capital from Mexico, putting even more pressure on the peso. Investors withdrew not only capital from Mexico, but also from other developing countries. The U.S. arranged a rescue package with help of the IMF that Mexico needed to pay off the tesobonos. The IMF imposed conditionality, which means that it required certain policy changes by the borrowing country. While most of the crisis came to an end, Mexico did suffer from a severe recession with depreciation and financial turmoil. The (now fully allowed) exchange-rate adjustment absorped the current account deficit as imports decreased and exports increased.

The Asian crisis, 1997

Despite solid macroeconomic policies in Southeast and East Asia, Thailand and South Korea in particular lacked adequate government supervision and regulation. Borrowed funds were exposed to severe exchange-rate risk. In addition, the real exchange rate seemed to be overvalued. The current account deficits had been financed by strong capital inflows, but the overvaluation caused exports to slow. The crisis started in Thailand where stock and real estate prices declined because of the expectation of declining exports. The government could only defend the downward pressure on the exchange rate for a short amount of time. After being forced to allow its currency to depreciate, the borrowed funds (exposed to severe exchange-rate risk) became the new problem. Foreign investors lost confidence in local bank borrowers and stock markets and the crisis spread to other countries in the region. The IMF issues large rescue packages with similar effects as with the Mexican crisis. The currency depreciations restored the current account deficits, mainly through decreased imports, and countries like Thailand, Indonesia, South Korea, Malaysia and the Philippines experienced severe recessions.

The Russian crisis, 1998

Despite its large fiscal budget deficit, Russia was not caught in the Asian crisis. Its rapid increases in government debt did, however, call for an IMF lending package. The Russian government did not meet the policy requirements imposed by the IMF. It did restructure its debt and tried to protect Russian banks. The IMF did not provide the next installment on the loan because the required fiscal reforms were not carried out. Foreign lenders did not expect this and had to adjust their risk assessments. They reduced their investments, causing stock and bond prices to fall and troubling Russia even more.

Argentina's crisis, 2001-2002

In the early 1990s, Argentina recovered from hyperinflation and severe depreciation by fixing its peso to the U.S. dollar and imposing adequate supervision and regulation. A strengtening of the dollar and a depreciation of Brazil's currency caused the peso to appreciate relative to other currencies. Exports declined and the current account deficit increased. Argentina also faced an increasing fiscal deficit and a recession was born by 1998. Official loans, partly from the IMF, did not help and the fiscal problem still existed. The situation got even worse due to rising interest rates. The IMF provided additional funds one more time but pulled back when Argentina did not meet the imposed conditionality. Eventually, Argentina's government surrendered the fixed exchange rate in 2002, resulting in defaults on loans, severe depreciation and huge losses to banks. After a few months Uruguay was hit by Argentina's huge recession because it relied on its tourism and banking business. Uruguay could not defend its pegged rate for a long time, switched to a floating rate and relied on IMF funds to stabilize its financial situation. Nevertheless, a recession was inevitable.

What are the major forces that lead to financial crises?

The previous examples of financial crises illustrate that international lending can cause a lot of damage as well. The following five forces help to explain the frequency and scope of financial crises:

• Waves of overlending and overborrowing: countries seeking expansion tend to borrow funds beyond those needed to finance deficits. When the government borrowed to much, it is likely to default and cause a financial crisis. Too much private borrowing can cause trouble as well. Stock and real estate prices might rise but if lenders fear that too much has been lent, funds are withdrawn and a financial crisis can result. In an extreme case it could be a price bubble that bursts. Excessive borrowing is sometimes denoted as a debt overhang, which is the amount by which debt obligations exceed the present value of future debt payments.
• Exogenous international shocks: when the price of a key export product plummets, a country will have a difficult time servicing its debt and is more likely to default. Changes in real interest rates can cause similar problems.
• Exchange-rate risk: private borrowers might choose not to hedge exchange-rate risk because they expect their government to defend the fixed or pegged rate continuously. If the government runs out of reserves and the likelihood of surrender increases, additional pressure on the exchange rate results. Surrender will be detrimental to the uncovered foreign borrowing.
• Fickle international short-term lending: countries often think that a recession is temporary and that short-term lending can be sufficient to stabilize the economy. If economic problems persist, lenders are likely to be reluctant to refinance the short-term debt and demand repayment immediately.
• Global contagion: recessions or crises can spillover to countries that have close trade links for example. A more indirect effect takes place when a crisis in one country functions as a wake-up call. Lenders might expect things to get bad in other countries as well. If they act on it (e.g. withdraw funds or demand repayment) things actually turn bad. This could be seen as a self fullfilling prophecy.

What are international efforts to resolve financial crises?

Since financial crises can cause global damage through trade, integrated financial systems and contagion effects, international efforts have been made to resolve financial crises. Two approaches will be discussed.

Rescue packages

The IMF, the World Bank and national governments have offered rescue packages to countries for several purposes:

• Compensate the decline in economic activity. Private lending, foreign exchange, domestic investments, aggregate demand and domestic production tend to decline during a crisis;
• Restore investor confidence. An increase in official reserve holdings or just the signal of international support can change capital flows;
• Limit contagion effects;
• Gain financial stability and economic benefits in the future. Parties offering rescue packages often require some policy, supervision or regulation changes.

The question arises whether these rescue packages are effective or not. Most of them have been at least moderately successful. Some argue that they provide an incentive to lend and borrow too much. This moral hazard problem is likely to be limited because borrowers are worse off, even with rescue packages. In addition, the IMF has discontinued rescue packages for Russia and Argentina because they did not meet the conditionality, so they do not always provide a bailout.

Debt restructuring

Debt restructuring can take the form of pushing repayments into the future (debt rescheduling) or lowering the amount of debt (debt reduction). Debt restructuring poses a problem. Lenders have an incentive to free-ride on the efforts of other lenders. If other lenders restructure their agreements, the free rider could be repaid faster or fully. If this free-rider problem prevents a restructuring deal, everyone is worse off. In addition, some issued bonds can only be restructured with the consent of all bondholders. Collective action clauses can overcome these problems and are often characterized by requiring:

• Only a qualified majority (like 75%) instead of all bondholders to agree on restructuring;
• Equal payments and recoveries from the issuer among the bondholders;
• A minimum portion (like 25%) of bondholders to start legal action against the issuer.

Collective actions clauses were not present before 2003 but are widely used nowadays. Issuers will benefit from streamlined restructuring (if necessary) and bondholders will receive better partial repayments.

How can we prevent financial crises?

Proposals to improve international financial stability are widespread. The following four reforms enjoy a lot of support and are widely applied in practice:

• Overborrowing or loss of confidence in developing countries should be prevented by sound macroeconomic policies;
• Economic and financial data should be more accurate and publicly available;
• Developing countries should avoid short-term borrrowing denominated in foreign currency;
• Adequate supervision and regulation of banks in developing countries.

Some proposals are more controversial and suggest opposite policies. One such proposal is about the exchange rate. Some argue that developing countries should adopt a floating exchange rate. This would provide a better assessment of exchange-rate risk and lowers unhedged (or uncovered) liabilities in foreign currency. Others defend the case for a fixed or heavily managed rate (using currency boards and dollarization) because it encourages consistent macroeconomic policies. Similarly, there is some debate about the role of the IMF. Some people want it to disappear or to limit its activities to acting as a lender of last resort (to prevent moral hazard and overlending). Others want the IMF to offer large rescue packages and expand its activities. IMF's recent expansion suggests that proponents have made a stronger case.

Bank regulation and supervision

One of the proposals that is not controversial is striving for adequate supervision and regulation by banks. Developing countries tend to have underdeveloped stock and bond markets which makes them rely heavily on bank lending for financing local businesses. Poor regulation and supervision encourages riskier activities, corruption and crony capitalism (politics and business are intertwined). Regulators should reduce risk exposure, recognize bad loans and weak banks, and intervene. Allowing foreign banks to operate locally could help as well when they bring better management and techniques for controlling risk.

While there is consensus about the need for sound supervision and regulation, its implementation is still a challenge. Powerful politicians, banks and certain borrowers are likely to resist the reforms. In addition, there is often lack of expertise to regulate banks effectively.

Capital controls

One of the proposals that is controversial is imposing capital controls. These controls like quotas or taxes are known for the following benefits:

• They prevent capital inflows that would result in overborrowing;
• They discourage short-term borrowing;
• They reduce the risk of contagion because the funds that lenders can pull out of the country are smaller.

Despite these benefits, capital controls are criticised for losing the gains from international borrowing. Remember that capital controls are not in accordance with the specificity rule and are considered a second-best policy. In addition, they are likely to lose their effectiveness over time because people find a way to circumvent the controls. They might be used during the time that is needed to implement effective bank supervision and regulation.

What characterizes the global financial and economic crisis?

The global financial and economic crisis from 2007 onward, the worst since the Great Depression, originated in the industrialized countries. The euro crisis followed in 2010. A housing price bubble was created because it was relatively easy to borrow money. Banks and other institutions were eager to lend money, even to people with low credit ratings. This was because their sub-prime mortgages were packaged with much less riskier loans. These packages received a higher credit rating than they should have and encouraged overlending and overborrowing. When the house price bubble bursted, things got bad. The failure of Lehman Brothers (LB) in 2008, an investment bank that was assumed to be 'too big to fail', made matters even worse. Through contagion the crisis became a global financial and economic crisis. Many European financial institutions had invested in these sub-prime mortgages as well and a euro crisis was inevitable. A lot of effects discussed in this chapter were present. Each shock (e.g. the burst of the bubble and the failure of LB) let to short-term lending, contagion effects, a drop in confidence, fewer lending possibilities, declining imports and changes in regulation and supervision. Central banks intervened a lot to recover from the crisis.

Chapter 15 has been largely devoted to foreign direct investment (FDI). This chapter will focus more on portfolio investment and international lending. Private and official international flows will be discussed as well as their role in financial crises.

How does the open macroeconomy work? - Chapter 22

The main focus of previous chapters has been on understanding the product markets, money markets and foreign exchange markets separately and examining how well they perform in terms of efficiency. This chapter integrates these markets and provides a framework for analyzing the macroeconomic performance of a nation open to international transactions.

What determines the performance of a national economy?

A nation's performance is often measured in terms of price level stability, employment and the balance of payments. Domestically oriented goals such as full employment and growth of production are aimed at achieving internal balance. Establishing a reasonable and sustainable balance of payments is the goal to achieve external balance. Recall that this does not require a zero balance in the current account. A current account surplus or deficit is not a problem as long as it is compensated in the financial account and when the imbalance is not too large. Similarly, the official settlements balance does not need to balance. It is, however, important that imbalances are not piling up in one direction because this would mean that a country keeps losing or building up official reserves.

The main focus of this chapter will be on the short run determinants of macroeconomic performance. Remember that the price level is considered to be sticky. Over time, the inflation rate depends on the growth of the money supply and the economy moves toward full employment.

What are the determinants of real GDP?

In the short run, domestic production is determined by aggregate demand (AD) for a country's products. The potential for production depends on the factor endowments of labor, capital, land and natural resources, and on the intangibles such as technology that determine the productivity of the resources. We measure their values through the income they create. Recall that real GDP (Y) is decomposed into household consumption (C), domestic investment (I_d), goverment spending (G) and net exports (X - M). Equilibrium occurs when domestic production equals demand for domestic products, so when Y = AD = C + I_d + G + (X - M). An increase of production relative to its potential decreases unemployment.

The domestic spending components add up to national expenditures (E), so E = C + I_d + G. Household consumption is determined by disposable income, which in turn depends on the difference between total income and taxes. Since taxes are closely related to income (e.g. taxes on income and sales), consumption can be stated as a function of income (taxes included): C = C(Y). Of course, consumption of for example cars depends on the interest rate. This and other influences like household wealth and consumer sentiment are treated as shocks to keep the analysis simple.

Domestic investment depends on the interest rate: I_d = I_d(i). A higher interest rate increases financing costs and lowers real domestic investment. Again, other influences like business sentiment are treated as shocks.

Government spending (G) is treated as a political decision. Together with taxes, it constitutes the fiscal policy of a country.

What is the relationship between income and trade?

From empirical studies, imports are expected to be determined by real national income or production, so M = M(Y). This implies that imports are often used in domestic production and that imports also depend on real expenditures (E). The increase in imports for each dollar increase in income is called the marginal propensity to import (m). On the other hand, income or production could influence exports. An increase in national income could shifts resources from export production to domestically oriented production. However, this relationship suffers from poor empirical evidence. Exports depend on the income of foreign countries.

What can we learn from equilibrium GDP?

For the analysis, we assume that prices and pricelike variables like the interest rate are constant. In addition, the relationship between foreign income and exports are ignored for now. The equilibrium equation including the variables' determinants looks like this: Y = AD(Y) = E(Y) + X - M(Y). This indicates that the value of aggregate demand (AD) depends on national income. To see why, suppose that AD exceeds income or production. Firms will respond by expanding their production. The resulting increase in employment and income restores the equilibrium. Similarly, insufficient demand will lead to cutbacks in production and will achieve full employment in the long run as well.

Now we will introduce the foreign sector. We can say that national saving (S) equals the difference between national income (Y) and national expenditures on noninvestment items, so S = Y - C - G (remember that national expenditure E equals C + I_d + G). Rewriting the equilibrium equation gives Y = E + X - M. If we subtract consumption and government spending from both sides of this equation, we can establish an equilibrium between national saving, domestic investment and net exports:

Y - C - G = E - C - G + (X - M)

S = I_d + (X - M)

Because net exports are (approximately) equal to the current account balance and net foreign investment (this is discussed in chapter 16), we can go back to S = I_d + I_f. This implies that when a country's domestic investment outweighs its savings, these investments are financed through foreign borrowing.

What happens when a small country that is open to trade increases its national spending? Because the country is small, there is no effect on foreign demand for the country's exports. There are, however, effects on national savings and demand for both domestic and foreign products. The rise in national spending leads to expansion of domestic production and income, which increases spending in turn. The size of this spending multiplier depends on the marginal propensities. The larger the propensity to consume domestic products (and the lower the propensities to save and to import), the larger the multiplier.

If, instead, the country is large, foreign-income repercussions become part of the process in two ways. First, domestic production and income effects will have spillover effects on foreign production and income through import demand. Second, the changes in foreign income will affect their import demand (and hence, the first countries' exports). This is why the spending multiplier is potentially larger for large countries. The larger the first countries' effect on foreign incomes, and the larger the foreigners' propensity to import, the larger the multiplier. This multiplier helps explain why business cycles across the world are so parallel.

How does integrating the three markets change the equilibrium?

The discussion of the domestic product market and the multplier is useful, but to provide insides into macroeconomic performance we need to add supply and demand for money (the money market) and the overall balance of payments (the foreign exchange market). We drop the assumption that interest rates are constant and consider it, just like domestic product, an endogenous variable that is determined by the system. The system evolves around the three markets, each subject to their own exogenous forces as discussed in previous chapters. These three markets determine domestic product (Y) and the home country interest rate (i), which in turn impact the balance of payments and the foreign exchange market. In bring the three markets together, we develop a new framework.

The domestic product market

Income and the real interest rate both determine aggregate demand. We can draw a line for each point where the domestic product market is in equilibrium. The IS (investment-saving) curve shows al these equilibrium combinations of domestic product levels and interest rates. We established an equilibrium equation for national saving, domestic investment and net exports before. Including the variables' determinants gives us the following equation: S(Y) = I_d(i) + X - M(Y). National income positively influences national savings and imports, and the interest rate negatively impacts domestic investment. A lower interest rate encourages investments in domestic real capital, increasing aggregate demand and domestic product. Recall what the IS curve shows and you will understand why it is downward sloping.

A change in the interest rate affects aggregate demand and indicates a movement along the IS curve. Any other change is considered exogenous and indicates a shift of the IS curve. For example, an increase in government spending or in consumer sentiment toward domestic products increases aggregate demand and shifts the IS curve to the right.

The money market

The supply of money is determined by monetary policy. The demand for money depends on GDP. Real GDP (Y) should be multiplied with the price level P to establish nominal GDP. Money is held for carrying out transactions, so the larger the domestic product, the greater the amount of money kept on hand for carrying out transactions. However, there is an opportunity cost for holding money, equal to the interest rate that could have been earned by investing the money. Therefore, the demand for (nominal) money (L) is positively related to nominal GDP and negatively related to the interest rate: L = L(PY, i). The equilibrium equation is M^s = L(PY, i).

Drawing a line for each point where the money market is in equilibrium gives us the LM (liquidity-money) curve. Similar to the IS curve, it shows all combinations of production levels and interest rates. The LM curve represents the money market equilibrium given the money supply, the price level and the demand for money. With a higher interest rate, people are encouraged to hold less money and earn interest on it. An equilibrium only results if there is a reason for money demand to meet money supply. As we saw, money demand comes from the need to carry out transactions, so higher domestic product and income will do the job. That is why the LM curve slopes upward.

Changes in the interest rate or domestic product indicate shifts along the LM curve. Any exogenous force shifts the entire curve. For example, an increase in the money supply shifts the LM curve to the right. Given the sticky price level in the short run, the increase in money supply lowers the interest rates, supporting a higher level of domestic product and transactions (and hence, an outward shift of the LM curve).

The IS and LM curves can be combined in one scheme because they both show combinations of production levels and interest rates. The intersection of these curves shows the levels of production (Y) and interest rates (i) where the product and money market are in equilibrium.

The foreign exchange market

Adding the foreign exchange market to the model is easiest using the balance of payments. Of course, we have to understand its interaction with the key variables of our model; real product/income and the interest rate. An increase in domestic product has a negative impact on the current account of the balance of payments through demand for imports. For the short run (which we still consider!), we can assume that a higher domestic interest rate leads to a capital inflow. In the long run, this effect fades out as portfolios are adjusted and could even be offset when those higher interest rates on bonds and loans have to be repaid (causing an outflow of capital). From this, we can derive an equation for the official settlements balance: B = CA(Y) + FA(i). If we draw a line that represents all interest-and-production combinations for which the official settlements balance equals zero, we have an FE (foreign-exchange) curve that we can add to the model.

The FE curve slopes upward. Everything else being equal, a higher interest rate causes a financial account and official settlements balance surplus. For the official settlements balance to equal zero, the current account should offset the financial account surplus. Higher domestic product and income will create more import demand and the resulting negative effect on the current account will do the job.

Whether the LM curve or the FE curve is steeper depends on their elasticities or responsiveness to changes in the interest rate and domestic product. Perfect capital mobility is an extreme case in which capital flows are extremely sensitive to changes in the interest rate. The FE curve would be flat in this case.

Again, changes in other variables than the interest rate or domestic product are exogenous and cause a shift of the FE curve. For example, an increase in foreign income improves the balance of payments (through higher exports) and shifts the curve to the right. An increase in foreign interest rates causing an outflow of capital has the opposite effect.

Integrating the three markets

Integrating the three markets generates the following conclusions:

• If the IS-LM intersection is to the left of the FE curve, the official settlements balance is in surplus.
• If the IS-LM intersection is to the right of the FE curve, the official settlements balance is in deficit.
• If the IS-LM intersection is on the FE curve (triple intersection), the official settlements balance is zero.

To see why, recall that an improvement of the balance of payments shifts the FE curve to the right. If the IS-LM intersection is to the right of the FE curve, an improvement in the balance of payments is needed to achieve a triple intersection. Hence, the official settlements balance is in deficit. If a country has adopted a fixed exchange rate and there is no triple intersection, official intervention is required. To see what the IS-LM-FE framework looks like when the official settlements balance is zero, see figure 7.

What if the price level does change?

Beyond the short run, the price level changes because:

• Countries tend to experience ongoing inflation, related to a growth in nominal GDP and money supply.
• A change in aggregate demand puts pressure on the price level. Strong demand overheats supply capabilities and puts upward pressure whereas weak demand puts downward pressure.
• Shocks can cause large changes in the price level, even in the short run. They usually occur on the supply side, as was the case with the oil price shock, but an abrupt change in the exchange rate will have a large effect as well through imports.

Price level changes can affect international price competiveness, changing the current account. One notable effect that will not be thoroughly examined is the effect of the price level on money demand [recall that we determined demand for money as L = L(PY, i)].

What is the role of international price competitiveness?

The demand for imports not only depends on domestic product and income but also on the relative price of imports. The exchange rate is an important variable here as well. Net exports increase when the price competitiveness improves. The price competitiveness changes with relative changes in product prices, exchange rates and inflation rates. A change in international price competitiveness is an exogenous change to the model described in this chapter. An improved price competitiveness increases net exports, aggregate demand for domestic products and shifts the IS curve to the right. The increase in net exports improves the current account and shifts the FE curve to the right. There is no exogenous force that affects the LM curve in this case.

The main focus of previous chapters has been on understanding the product markets, money markets and foreign exchange markets separately and examining how well they perform in terms of efficiency. This chapter integrates these markets and provides a framework for analyzing the macroeconomic performance of a nation open to international transactions.

What are the macroeconomics of achieving internal and external balance with fixed exchange rates? - Chapter 23

We touched upon internal and external balance briefly before. Achieving internal balance (actual production equal to potential production or full employment) and external balance (balanced international payments) simultaneously is hard, especially for governments who adopted a fixed exchange rate. Tidying up the balance of payments might change inflation and employment. In addition, controlling domestic production may create or widen external imbalance. In dealing with these challenges, this chapter looks at a mixture of policies and considers giving up the fixed rate.

What is the relationship between the balance of payments and the money supply?

From the balance of payments to the money supply

An official intervention involving the buying and selling of currency to defend a fixed rate changes the holdings of official reserves and could change the country's money supply as well. A country's central bank has a balance with assets and liabilities. Its assets consist of domestic assets and international reserve assets. The difference is the denomination of the assets in either domestic or foreign currency. The central bank's liabilities consist of issued domestic currency and deposits of the regular domestic banks. These two central-bank liabilities form the monetary base. The currency and regular bank deposits held by the public constitute the country's money supply. The central bank requires domestic banks to hold a certain amount of reserves to back up these deposit liabilities. Some of these reserves are likely to be deposits at the central bank. This system is called fractional reserve banking. Note that the central bank can expand the money supply by increasing the amount of currency held by the public directly, or indirectly through lowering the reserve requirement fraction. The latter enables multiple expansion of the money supply (because each reserve backs up more deposits) and is called the money multiplier process.

Remember that an official settlements balance surplus can result from positive net exports or a net inflow of capital and is characterized by upward pressure on the exchange rate. Given this information, an official intervention used to defend the fixed rate requires buying foreign currency and selling domestic currency. This will increase the official international reserve holdings and increase the central bank's liabilities because it adds domestic currency to the economy. The money supply will increase, whether the central bank's transactions increase actual currency outstanding or bring deposits to a regular bank. The regular bank faces an increase in domestic currency holdings and is likely to increase its reserves to back these up. This way, the money supply can increase by more than the size of the initial intervention.

Similary, an official settlements balance deficit requires selling foreign currency and buying domestic currency to fight the downward pressure on the exchange rate. Official international reserve holdings and the central bank's liabilities will decrease. Domestic currency is removed from the economy and the money supply decreases (by a multiple in case of fractional reserve banking). This effect on the money supply will occur unless the central bank performs a counteraction.

From the money supply back to the balance of payments

In case of an official settlements balance surplus, the central bank increases bank reserves. Banks want to use these funds to expand their business and are willing to make more loans. Competition is likely to lower interest rates, causing capital to flow out of the country (seeking higher returns) and worsening the financial account. As discussed before, this is a short-run effect until portfolios are adjusted and the reverse could happen when bonds mature or loans come due. The lower interest rate also makes it attractive to finance investment projects. Real domestic product and income will increase, causing increased imports and worsening of the current account. Additionally, extra spending puts upward pressure on the price level. The magnitude of the income and price level effects depends on the state of the economy. If there are unemployed resources, the change in real income is likely to dominate. If the economy is already close to full employment, pushing against the supply capabilities is likely to make the price-level effect dominant. The rise in prices will worsen the international price competitiveness and the current account.

These conditions and changes can be pictured using the IS-LM-FE framework. Recall that an official settlements balance surplus means that the IS-LM intersection is to the left of the FE curve. The increase in money supply shifts the LM curve to the right. As just described, the interest rate decreases and domestic product and income increase. These changes cause a downward shift (to the right) along the IS curve toward the new intersection of the LM and FE curves. Full adjustment occurs when the LM curve shifts to the triple intersection (and the interest rate and domestic product/income adjust accordingly).

Full adjustment results in external balance, which is good. However, the problem with the effects just described is twofold. First, the acquisition of international reserves (or loss in case of an official settlements balance deficit) might not be desirable. One way the central bank can limit this effect is by using an open market operation. It can buy domestic government securities, adding to its domestic assets and liabilities directly. This intervention would speeden the process and does not require the acquisition of official reserve assets as described before. Second, adjustment toward external balance puts upward pressure on the price level which can cause internal imbalance through an increase in the inflation rate. In the deficit situation, a recession with lower real production and higher unemployment may be the problem.

How can a change in the money supply be prevented by sterilization?

The central bank can avoid internal imbalance if it takes an offsetting domestic action. If it defends the fixed rate in case of a payments surplus, it increases the money supply through acquiring international reserves and increasing liabilities. The latter increases the monetary base. An open market operation where the central bank sells domestic government bonds has a sterilizing effect because it reduces its holding of domestic assets and central bank liabilities. It takes money from the general public out of circulation and the net effect is basically a change in the composition of central bank assets. However, since the money supply does not change, the LM curve does not shift and there is no adjustment toward external balance. If nothing else shifts the FE curve toward the IS-LM intersection or vice versa, the country keeps running a payments imbalance and the sterilized intervention is basically a wait-and-see or wait-and-hope strategy.

What are the implications of a fixed exchange rate for monetary policy?

From the previous analysis, it is clear that adopting and maintaining a fixed exchange rate severely limits a country's ability to choose its monetary policy. Achieving external balance can put pressure on price or unemployment levels. If the country chooses to implement expansionary monetary policy to fight unemployment, domestic product increases but the current account and financial account will worsen. To defend the fixed rate, the countermeasure is to sell foreign currency and buy domestic currency. This reduces the money supply and deteriorates the expansionary monetary policy. Independent monetary policy is basically given up for a fixed exchange rate. If the country keeps running an official settlements balance surplus, it builds up foreign reserves. Similarly, a country fighting a deficit runs out of reserves. There is a lot of pressure to revaluate (in case of a surplus) or devaluate the country's currency. Defending a fixed exchange rate is not as straighforward as it may sound.

What are the implications of a fixed exchange rate for fiscal policy?

Suppose the government decides to increase spending and runs a budget deficit. Financing the deficit requires borrowing more, which drives up the interest rate. As discussed before, this attracts foreign capital until portfolios are adjusted and payments are returned, improving the financial account at first. Another effect of increased government spending is the rise in aggregate demand and real domestic product (if there are resources available). This results in extra import demand, worsening the current account balance. In addition, the extra demand can put upward pressure on the price level over time, worsening the current account balance as well. The overall effect on the current account balance depends on the magnitude of the financial account and current account effects. If international capital flows are very sensitive to interest rate changes, the capital inflows will be large and the overall balance will go into surplus. Insensitive capital flows will have little positive effect on the financial account and the negative effect(s) on the current account will put the overall balance into deficit.

Again, the IS-LM-FE framework can be used to picture these effects. Expansionary fiscal policy shifts the IS curve to the right. Moving along the LM curve increases the interest rate and domestic product. As just described, it is likely that an overall imbalance results. This will put pressure on the exchange rate and official intervention is needed to defend the fixed exchange rate. Without sterilization, the money supply has additional effects on the interest rate and domestic product. Highly mobile capital will lead to an overall payments surplus, requiring the central bank to buy foreign currency and sell domestic currency. Expansion of the domestic money supply (if no offsetting policy is imposed) shifts the LM curve to the right. Moving along the IS curve, interest rates decrease and domestic product is expanded even more. This way, expansionary fiscal policy is strengtened by an additional increase in real GDP. On the other hand, low mobility of capital will lead to an overall payments deficit, requiring sales of foreign currency and purchases of domestic currency. Without sterilization, the domestic money supply decreases (LM curve shifts to the left), the interest rate rises and the domestic output declines. Here, expansionary fiscal policy loses some of its power as real GDP decreases again.

What if there is perfect capital mobility?

Perfect capital mobility implies that every teeny-tiny change in the interest rate results in an unlimited flow of capital. This is more likely the more open capital markets are and when the political and economic situation is considered stable. A small country's interest rate must be equal to the interest rate in the global capital market. The money supply is determined by international capital flows that respond to changes in the interest rate. Suppose a reduction in the money supply increases the interest rate. Large capital inflows result. To defend the fixed exchange rate, domestic currency has to be sold. However, this increases the money supply again. Furthermore, sterilization is nearly impossible because the capital inflows are so large. The domestic economy will not be influenced because the capital flows will absorb any change in monetary policy. The money supply is basically ruled by the balance of payments.

In contrast, fiscal policy is enhanced by perfect capital mobility. Because of the immediate (compensating) inflow of capital, expansionary fiscal policy does not raise the interest rate. It is no use for domestic borrowers to seek lower returns abroad, so the economy can enjoy the full spending multiplier effects. This applies to small countries that maintain a fixed rate and have open capital markets. Considering the IS-LM-FE framework, perfect capital mobility implies a flat FE curve. In addition, because of the given interest rate and the fixed rate, the money supply must be whatever is necessary to be in line with the interest rate (or capital movements will absorb the difference immediately). This implies that the LM curve can also be considered flat and the same as FE. The countries' monetary policy fully depends on the interest rate but its fiscal policy is extra powerful. Expansionary policy shifting the IS curve to the right does not change the interest rate but its effect is fully captured by an increase in domestic product.

What are the effects of shocks?

We still consider an economy with a fixed exchange rate and now we will assume that it has achieved external balance before the shock occurred. A domestic monetary shock changes money supply or money demand and shifts the LM curve. A change in money demand can be caused by a financial innovation like the spread of credit cards. Remember from the monetary-policy section with a fixed exchange rate that defending the fixed exchange rate requires central bank intervention that reverses the shift in the LM curve. So, the shock does not affect interest rates and domestic product that much but it does alter the country's holdings of official reserve assets. A domestic spending shock alters real expenditure (E) through one of its components. For example, a change in fiscal policy could alter real domestic investment or government spending and a change in consumer sentiment could alter consumption. Such a shock tends to have a whole chain of effects as changes in import demand alter foreign economies, affecting the domestic economy in turn.

An international capital-flow shock can be caused by foreign policy or political changes. Capital outflow as result of an expected devaluation is called a capital flight. In case of external balance, the outflow of capital will shift the overall balance into deficit. This payments deficit shifts the FE curve to the left. The central bank must intervene to deal with this downward pressure on the exchange rate. Buying domestic and selling foreign currency shrinks the domestic money supply (shifting the LM curve to the left) if the central bank does not sterilize its intervention. The interest rate increases and real domestic product decreases. The drop in aggregate demand and employment is likely to cause internal imbalance. The increased interest rate is part of the defense when investors shift their capital into the country again. That is why a common policy tool is to increase short-term interest rates dramatically. A different approach would be to sterilize the central bank intervention. If the payments deficit is temporary because investors change their expectations about the devaluation of the currency, the economy will be back at its initial equilibrium. This is not so likely, however, and defending the fixed rate in case of a capital-flow shock can have a strong impact on internal balance.

An international trade shock shifts a country's exports or imports through any cause (e.g. product quality expectations) other than a change in real income. A shift toward imports (away from domestic products) worsens the current account. The IS and FE curves shift to the left. In moving toward the new IS-LM equilibrium, the domestic interest rate and real domestic product decline. The gap with the FE curve represents the payments deficit. Unsteralized intervention to defend the fixed exchange rate will reduce the money supply (buying domestic currency) and shift the LM curve to the left. In moving toward the new triple intersection, the interest rate rises again but real domestic product will decline even further. Defending the fixed rate in case of a trade shock can have a strong impact on internal balance. It even magnifies its effect on domestic production.

What are the best policy responses in case of imbalances?

Internal imbalance can be characterized by high unemployment or rapid inflation whereas external imbalance can be characterized by a payments surplus or deficit. Countries often experience a combination of internal and external imbalance. The two combinations with straightforward best policies wil be described first. First, high unemployment and a payments surplus requires expansionary policies to achieve balance. An increase in the money supply increases aggregate demand and lowers unemployment. This worsens the payments balance through an increase in import demand and the domestic price level. In addition, the increased money supply lowers the interest rate. The resulting capital outflow worsens the payments balance as well. Second, high inflation and a payments deficit requires contractionary policies to achieve balance. Decreasing the money supply will have the exact opposit effects as just described for expansionary policies. The other two combinations result in a dilemma because fighting unemployment or rapid inflation will increase the payments imbalance. A country facing these dilemmas could abandon its goals of external (e.g. fixed rate) or internal balance. When the latter is given up, a country basically follows the rules of the game of a fixed-rate system. The country's government could also try to find more policy tools or creative ways to use them. In case of high unemployment and a payments deficit, it should improve its productivity. National income, production and employment increase while international competitiveness increases net exports and reduces the payments deficit. Of course, there is no simple or low-cost way of improving supply capabilities because production factors (whether its technology or labor) respond sluggishly to government manipulation.

In the short run, a monetary-fiscal mix of policies can solve the dilemmas. Earlier in this chapter, we saw that expansionary fiscal policy can improve the payments balance at first. This brings an opportunity in case of high unemployment and a payments deficit. A large fiscal expansion along with a small monetary contraction should do the job. Similarly, expansionary (easier) monetary policy along with some tighter fiscal policy will fight inflation and still reduce the payments surplus in the short run. These policy mixes are in line with the assignment rule which states that monetary policy should be devoted to achieving external balance (stabilizing international payments) whereas fiscal policy should focus on internal balance through stabilizing the domestic economy. The many interrelated factors make it hard to predict whether such a policy mix will work in practice or not.

What happens if a country surrenders and the exchange rate changes?

In case of fundamental disequilibrium, changing domestic policies may not be enough to restore balance. In case of surrendering with a payments deficit and high unemployent, a devaluation is necessary. The devaluation should improve the country's international price competitiveness, increasing exports and decreasing imports. The current account improves. The financial account may improve if the devaluation ends a capital flight that was based on the expected devaluation. The payments balance improves. The increase in net exports increases aggregate demand and domestic production, and lowers unemployment. The rise in foreign import demand puts upward pressure on export prices. The increase in aggregate demand might increase inflation as well, but this effect is likely to be small as the economy moves toward full employment. Picture this using the IS-LM-FE framework. Recall that the payments deficit implies that the IS-LM intersection lies to the right of the FE curve. The devaluation and improved payments balance shift the FE curve to the right. The increase in net exports shifts the IS curve to the right. Moving toward the triple intersection, the interest rate and real domestic product increase. Note that this lowers unemployment while the payments balance is improved. There are, however, several reasons why this stablizing outcome would not be achieved;

• The change in aggregate demand is different. The devaluation hurts firms that have substantial liabilities denoted in foreign currency. If these firms are forced to cut back on spending, the IS curve may actually shift to the left.
• External balance is not achieved. Exports and imports might not be that responsive to the exchange rate or the government pursues policies that actually expand the payments deficit.
• The change in capital flows is different. Investors may expect that the devaluation does not restore external balance (for one of the aforementioned reasons) and expect another devaluation. This will cause a capital flight that worsens the payments deficit.

Of course, monetary policy can be used to limit the expansion effects of fiscal policy like inflation, prevent a capital flight and restore external balance, making the devaluation successful.

How responsive is the trade balance to an exchange-rate change?

We just discussed that a devaluation improves price competitiveness and increases net exports. This effect may not be as straightforward as it seems. Imports are indeed likely to decline. Not just quantitively, but any change in its pricing will likely to be negative as well. However, in case of exports, the quantity is likely to increase but the price might actually fall. Exporters can receive the same domestic price as before while lowering the export price (the domestic currency's devaluation makes foreign currency worth more). This way, the effect could be ambiguous as it depends on the price elasticities of demand and supply for exports and imports.

In case of perfectly inelastic demand for exports and imports, import quantities and prices do not change, the export quantity does not change but the export price still declines in terms of foreign currency. Net exports decline in this case and the devaluation backfires completely. In practice, export and import demand elasticities tend to be sufficiently high (especially in the long run) to improve the payments balance. Remember that the smaller the country, the higher its elasticity.

The increases in these elasticities over time is related to trade quantities being contractually arranged. Price changes are likely to occur faster. The change in quantities traded changes over time and causes a pattern called a J curve that shows the current account's (and payments balance's) response to the devaluation. Initially, the payments deficit increases but the payments balance should improve once quantities are adjusted. The FE curve shifts to the left at first before it shifts to the right. The economy could need a year to achieve this turning point and several more years to establish the intended effects of the devaluation.

We touched upon internal and external balance briefly before. Achieving internal balance (actual production equal to potential production or full employment) and external balance (balanced international payments) simultaneously is hard, especially for governments who adopted a fixed exchange rate. Tidying up the balance of payments might change inflation and employment. In addition, controlling domestic production may create or widen external imbalance. In dealing with these challenges, this chapter looks at a mixture of policies and considers giving up the fixed rate.

What are the macroeconomics of achieving internal balance with floating exchange rates? - Chapter 24

Chapter 23 examined the macroeconomics with a fixed exchange rate. This chapter considers floating exchange rates that automatically adjust to achieve external balance. Macroeconomic policy, both monetary and fiscal, can be directed toward achieving internal balance. The exchange rate should change until no further transactions in official reserves are made, or when the official settlements balance equals zero. The chapter explores how this works and what impact various shocks can have.

What are the implications of a floating exchange rate for monetary policy?

Under floating exchange rates, monetary policy can have a strong impact on internal balance. To see why, consider an expansion of the money supply. Banks willingness to lend money increases, causing the interest rate to fall. Depending on capital mobility, capital flows out in the short run and causes the currency to depreciate. Overshooting, discussed in chapter 19, is a form of perfect capital mobility that could magnify this effect. Similarly, the increase in borrowing and spending (due to the lower interest rate) worsens the current account balance and depreciates the currency as well. This effect is strengthened (beyond the short run) through a price level increase. The currency depreciation has a balancing effect in the external market; the improved international price competitiveness improves the current account balance (in the latter stage of the J curve). The impact on the economy is so strong because the depreciation increases the effect of the money supply. The resulting extra demand increases real product and income even more. Of course, this puts more upward pressure on the price level as well.

Picturing the expansion using the IS-LM-FE framework gives the following results: expansion of the money suplly shifts the LM to the right. The resulting payments deficit is illustrated by the new IS-LM intersection to the right of the FE curve. The currency depreciation and improved current account balance shift the FE and IS curves to the right, establishing a triple intersection at a (much) higher level of real GDP.

An important side note is that there is a limit to expansionary monetary policy; interest rates cannot fall below zero. So if interest rates are close to zero, monetary expansion will not expand real GDP and the economy is caught in a liquidity trap. Fiscal policy or unconventional monetary policy like quantitative easing (QE) might offer a solution. The central bank performing QE basically buys and holds massive amounts of securities. It could buy long-term bonds hoping to decrease the long-term interest rates. In addition, but this effect is rather small, banks holding even more excess reserves might be encouraged to make more loans. Finally, the increase in liquidity might flow into the foreign exchange market, depreciating the currency and causing the effects described in this section.

What are the implications of a floating exchange rate for fiscal policy?

Similar to the analysis in chapter 22, fiscal policy causes differential effects. Government borrowing increases interest rates and attracts foreign capital. The currency would appreciate. On the other hand, the rise in spending and production worsens the current account balance (through imports). Again, this effect is strengthened in the medium and long run through a price level increase. This would cause the currency to depreciate. The overall effect largely depends on the mobility of capital. If capital flows in quickly, the currency is likely to appreciate first. Eventually, the aggregate-demand effect of the fiscal expansion will depreciate the currency. In case of an initial appreciation, the loss in price competitiveness reduces the expansionary effects.

Fiscal expansion shifts the IS curve to the right. In case of an appreciation and a worsening of the current account balance, the FE curve shifts to the left and the IS curve shifts a bit to the left as well. The capital flows reduce the expansion. In case of a depreciation and an improved current account balance, the FE and IS curves shift to the right, increasing domestic product and the expansion even further. The LM curve does not need to shift because the central bank can keep the money supply steady.

What are the effects of shocks?

This section will discuss the same shocks as discussed in the previous chapter with fixed rates. A domestic monetary shock changes the relationship between money supply and money demand, shifting the LM curve. A change in monetary policy is such a shock, and as we just saw, this has a lot of impact on a country's economy. Expansion leads to currency depreciation, further increasing domestic product. Contraction leads to currency appreciation, further decreasing domestic product. A domestic spending shock changes domestic expenditure and shifts the IS curve. A change in fiscal policy is such a shock, and as we just saw, its effect depends on whether international capital flows or the country's current account changes more.

Foreign policy or political changes can cause international capital-flow shocks. A higher foreign interest rate causes an outflow of capital. The FE curve shifts to the left and the currency depreciates. Improved price competiveness improves the current account and the aggregate-demand effect increases domestic product, shifting the IS and the FE curves to the right. This analysis seems to imply that an adverse shock can make the domestic country better off. It should be noted, however, that an economy can also contract if the capital outflow is caused by political or economic problems. In addition, large capital outflows can disturb financial markets in a way that goes beyond this simple analysis. Such a disruption is likely to contract the domestic market as well.

An international trade shock changes the current account balance. An adverse shock reduces the current account and domestic product/income. While the latter effect lowers demand for imports (and could improve the CA), this effect is assumed not to offset the deterioration of the current account. The payments deficit causes a depreciation, improving the price competitiveness. The current account improves again along with an increase in domestic product and income. If international capital flows do not change, the depreciation should put the payments balance back to zero. This illustrates the mitigating effect of the exchange rate on internal balance in case of an international trade shock. Reversing all the directions of change applies to a positive trade shock.

What are the best policy responses in case of internal imbalance?

Internal balance could either be high unemployment or high inflation. Expansionary macroeconomic policy is useful to fight unemployment (through depreciation) but remember that monetary policy is more powerful than fiscal policy. Similarly, contractionary policies are best to fight high inflation.

Is there a case for international macroeconomic policy coordination?

Floating exchange rates and policy changes cause spillover effects. For example, changes in import demand and price competitiveness have foreign income repercussions. Policies benefiting the domestic economy but harming foreign economies appear to be beggar-thy-neighbor policies. It could also be that foreign countries actually reap the benefits of the policy change. The question is whether all countries would be better off with international coordination. International policy cooperation includes sharing economic data and information about policies and problems. This is quite common and popular among organizations like the International Monetary Fund.

International macroeconomic policy coordination goes beyond mere cooperation and includes joint determination of macroeconomic policies. It has been successful following the stock market crash in 1987. Financial activity plummeted and financial markets were in need of liquidity. Individual central banks were reluctant to provide this (as other countries could reap the benefits of it), so several central banks coordinated their actions. The boost in liquidity stabilized the financial markets. Nevertheless, coordination is somewhat more controversial than cooperation for several reasons. First, countries tend to have goals that are not compatible. For example, the European Central Bank is focused on preventing inflation, making it reluctant to agree on heavy expansionary policies. Second, the benefits of coordination may be small, especially when comparing it to what each country could have achieved on its own. However, the value of international coordination arises from two things. First, commitment to international coordination makes it easier to support policy changes domestically. Second, the visibility of coordinated actions can stabilize economies by changing expectations (remember what kind of impact expectations about a currency's value can have). Despite these benefits, international policy coordination is limited.

Chapter 23 examined the macroeconomics with a fixed exchange rate. This chapter considers floating exchange rates that automatically adjust to achieve external balance. Macroeconomic policy, both monetary and fiscal, can be directed toward achieving internal balance. The exchange rate should change until no further transactions in official reserves are made, or when the official settlements balance equals zero. The chapter explores how this works and what impact various shocks can have.

How do national and global choices shape the global exchange-rate system? - Chapter 25

This chapter brings the insights from chapters 16 through 24 together and discusses the key issues in considering floating rates and the alternatives. Global choices have let to the gold standard and the Bretton Woods system in the past. Nowadays, there is a wide range of different exchange-rate policies. Most countries have a floating exchange rate but their is a trend toward fixed exchange rates. Their strengths and weaknesses will be key points in this concluding chapter.

What are the key issues in choosing exchange-rate policy?

Five major issues are key to choosing exchange-rate policies. Each will be discussed in turn.

Effects of macroeconomic shocks

As described in chapter 23, a domestic monetary shock is not so disruptive with a fixed exchange rate. Defending the fixed rate reverses the shock and its effects. Not much but the country's holdings of official reserve assets has changed. On the other hand, a monetary shock with a floating exchange rate has a lot of impact because its effects are magnified. For example, a monetary expansion leads to currency depreciation, further increasing domestic product. The effects of a domestic spending shock depend on capital mobility. In case of low capital mobility with a fixed rate, the current account worsens and macroeconomic policy can stabilize the economy. If capital mobility would be high, the payments balance may move in one direction first, and in the other direction eventually. Defending the fixed rate immediately would magnify the long-run disrupting effects, but doing nothing would disrupt the economy as well. In case of a floating rate, suppose domestic spending declines. If capital is highly mobile, it will flow out of the country due to the lower interest rate (because fewer loans are made). This will cause a depreciation that will offset some of the contractionary effects on the economy. If capital is not mobile, the current account effect will dominate. Real production and income decline, improving the current account through lower import demand (strengtened by the price level decrease beyond the short run) and the currency appreciates. This will magnify the effects of the domestic spending shock. In general, the impact of these internal shocks is larger for a floating-rate system than for a fixed-rate system.

In contrast, external shocks disrupt the economy more in case of a fixed-rate system. To see why, suppose there is a drop in demand for a country's exports; an international trade shock. Both the current account and the payments balance tend to worsen. The central bank must fight this downward pressure by buying domestic currency. This implies a contraction of the money supply that adds to the recession already taking place by a further decline in domestic product. In case of a floating rate, the currency would depreciate and the resulting improved competitiveness counters the recession. Such a kind of international trade shock is most relevant for small developing countries that are more vulnerable to changes in world prices.

International capital-flow shocks can have substantial effects under fixed exchange rates. A capital outflow causing a payments deficit puts downward pressure on the exchange rate. Unsterilized intervention by buying domestic currency reduces the money supply. While this increases the interest rate and might attract capital, the reduction in spending has an adverse effect on the economy. Under a floating exchange rate, the currency would have depreciated. This is less disruptive because the resulting improved competitiveness increases production.

The differential effects under the different exchange-rate systems have some implications. Countries that tend to suffer most from internal shocks will favor a fixed exchange rate. Countries suffering most from external shocks will favor a floating exchange rate. One important side not should be made. The previous examples assumed no sterilization. If a country chooses to sterilize its intervention under a fixed-rate system, the domestic money supply does not change. This implies that a country loses the stabilizing effect of the money supply when it is hit by an internal shock. At the same time, it prevents the disruptive effects of a money supply change during an external shock. Note that this might not be feasible in the long run as the country could keep running a payments imbalance (as discussed in chapter 23).

The effectiveness of government policies

The effectiveness of monetary policy depends on the exchange-rate system. Independent monetary policy that pursues domestic goals is given up when a country wants to maintain a fixed rate, as discussed in chapter 23. Furthermore, recall that monetary policy loses its power in case of perfect capital mobility. This implies that a country that wants to pursue domestic objectives with monetary policy, cannot permit free capital flows and maintain a fixed exchange rate at the same time. Only two of these three policies can be pursued simultaneously. This is called the inconsistent trinity or (policy) trilemma. In contrast, under floating exchange rates, monetary policy effects are reinforced through the exchange-rate effect.

The effectiveness of fiscal policy depends on the exchange-rate system and on the mobility of capital. If capital is highly mobile under a fixed rate, fiscal expansion does not increase the interest rate (absorped by immediate flows of capital) and the economy can enjoy the full spending multiplier effects. Under a floating exchange rate, the exchange-rate change offsets the fiscal-policy effects. When capital is not mobile under a fixed exchange rate, defending the fixed rate requires imposing an offsetting monetary policy. Under a floating rate when capital does not flow easily, the effect of fiscal policy is magnified (as discussed in chapter 24).

Differences in macroeconomic goals, priorities, and policies

Government policies can differ across countries. Even if they pursue the same goals, they can prioritize them in a different way. Maintaining a fixed rate requires some consistency or coordination. If this does not happen, large payments imbalances are likely to develop and defending the fixed rate becomes troublesome. One best practice is to refrain from policy changes that cause large capital flows or to coordinate them. For example, if a country suddenly reduces its taxes on financial investments, capital will flow into the country. A foreign country with a fixed rate has to defend it against depreciation by buying its own currency. It will lose international reserves by doing so. This could only work in the long run if the foreign country has enough reserves or if it raises its interest rates. Hence, it requires some consistency or coordination. Another example considers inflation versus unemployment. A fixed rate between one country prioritizing a low inflation rate and the other prioritizing growth and employment is hard to maintain. Growth and increased employment will put upward pressure on the inflation rate, changing the real interest rate. Again, large capital flows could result and a change in the (nominal) interest rates could have a stabilizing effect.

In contrast, floating exchange rates allow for large and long-term divergences in government goals, priorities and policies. However, this tolerance might lead to a very strong or weak currency that conflicts with domestic goals.

Controlling inflation

Touched upon briefly in the previous section, inflation is hard to control in case of fixed exchange rates. This follows from purchasing power parity. A difference in inflation rates would likely alter the exchange rate, but if this rate is kept fixed, the inflation rates should adjust accordingly. Countries with a fixed rate are committed to have similar inflation rates over the long run. Any gap should be filled by money flows that respond to a difference in price competitiveness. An interesting implication is that a country seeking to pursue a low inflation rate could fix its exchange rate to a country that already has one. Credibility is important here because expectations of a lower inflation rate in the future could be selffulfilling. Another implication is that a fixed-rate system imposes price discipline on participating countries in that it lowers the average global rate of price inflation. A country running a deficit intervenes by buying domestic currency. The contraction of the money supply might be prevented by sterilization but it should tighten up its money supplies anyway to defend the fixed rate. The resulting lower money growth will already lower inflation. In addition, a country running a surplus defends the fixed rate by acquiring reserves. Sterilization is needed to stabilize the monetary base, preventing an increase in money growth. Overall, less money growth in all countries adopting a fixed-rate system will lower average price inflation. A third implication is that countries that want to have an even lower inflation rate, cannot sustain this in the long run because they 'import' inflation from the other fixed-rate countries.

In contrast, floating exchange rates allow for different inflation rates. Some people are afraid that this will increase inflation worldwide. Higher inflation tends to depreciate a currency, reinforcing the inflation rate by increasing the domestic currency price of imports. Some trends of the past might be in accordance with this fear, but recent experience indicates that this does not need to be the problem. As long as national monetary authorities have some discipline in pursuing goals and policies, inflation rates tend to remain low.

Real effects of exchange-rate variability

For some people, the variability of a floating exchange rate is a big concern. Despite its ability to reduce the effects of shocks in the long run, people are concerned that international activities like trade and FDI are discouraged. Hedging exchange-rate risk is easier in the short run because the size of the money flows is more certain and many contracts with short maturities and low transaction costs exist. This is especially useful in case of overshooting but there is still some concern about the real effects of exchange-rate variability. Large short-run changes (overshooting or not) can cause changes in price competitiveness and resource reallocations. These turn out to be excessive if the overshooting reverses itself. Nevertheless, empirical evidence shows that exchange-rate variability has little effect on trade volumes. Proponents of floating rates consider the changes as seeking economic efficiency based on changes in market conditions. According to them, a fixed rate is inefficient because it is basically a form of price control. The price often tends to be too high (overvalued currency) or too low (undervalued). In addition, it is quite common that fixed rates are adjusted through a devaluation or revaluation. Such a shock tends to be quite disruptive. Investments that did not need to be hedged because of the fixed rate could face a drop in value in case of a sudden exchange-rate change. In general, any disruptions that do occur within a floating exchange-rate system can be assigned to the rationale of the people who make the transactions. Of course, a more stable exchange rate serves its transaction function best.

What determines a nation's choice for an exchange-rate system?

A floating rate is preferred because it allows for pursuing internal and external balance; control over monetary policy allows for pursuing domestic goals. In addition, no defense is needed against speculative attacks. Fixed rates are preferred because they reduce or even eliminate exchange-rate risk, encouraging international activities. It reduces variability as long as it can be defended. Many countries adopted some sort of managed float. This allows for independent policy and enables countries to reduce exchange-rate variability. Another 'compromise choice' is a soft peg that offers leeway to change the fixed rate. Because this encourages speculative attacks, some countries adopted a hard peg.

What characterizes extreme forms of fixed rates?

Despite the trend toward more flexibile exchange-rate policies, some countries moved toward fixed rates. Two extreme forms, the currency board and dollarization, will be discussed.

Currency board

A currency board acts as a monetary authority but focuses solely on maintaining the fixed rate. It holds foreign-currency assets and domestic-currency liabilities. Since it does not hold domestic-currency assets, it cannot sterilize its actions. This increases the credibility of the commitment to the fixed rate because every intervention will change the money supply. It has several disadvantages however. First, the vulnerability to adverse external shocks increases. A change in capital flows changes the money supply and puts pressure on the currency board. Second, the board can be threatened by speculative attacks and any exit strategy (giving up the fixed rate) will be disruptive. Third, maintaining the fixed rate might require imposing unpopular fiscal policies. If there is lack of discipline, the countries' economy is likely to suffer even more in the end (whether the fixed rate is given up or not).

Dollarization

The switch to using another country's currency (usually the U.S. dollar) is called dollarization. Still, this fix is not permanent because a country could reintroduce its local currency again. The major advantage, however, is the elimination of exchange-rate risk. It is likely to prevent speculative attacks and the risk premium (to compensate for this risk) is eliminated. This tends to lower interest rates. In addition, transaction costs of currency exchanges are eliminated. On the downside, the country loses income on international reserve assets. It has to use its U.S. holdings to obtain dollars and the central bank loses its seigniorage profit. This is a markup for issuing currency and bringing it into circulation. Another drawback might be that the country's monetary policy is tight to the U.S policy decisions. However, a smooth transition to dollarization requires a stable fixed rate, so independent monetary policy was given up already.

What characterizes the ultimate fixed exchange-rate arrangement?

After the Bretton-Woods fixed rate system ended, the countries of the European Union have taken steps towards fixed rates. The Exchange Rate Mechanism (ERM) established fixed exchange rates. Further steps towards unification were taken with the use of a single currency (the euro) and the monetary union, a single monetary policy for all participating European countries.

Exchange Rate Mechanism

In the early years, the Exchange Rate Mechanism seemed to be working well. More countries joined, fixed rates with adjustable pegs were used, most capital controls were removed and there was free movement of goods and services. Inflation rates declined as they moved toward the inflation rate of Germany, the country which was seen as the lead country due to its economic size and central bank prestige. Exchange rates were steadier then before. But after 1992, worries of international investors about inflation led to large capital flows and the need for strong defense by the central banks. Italy and Britain surrendered. Following speculative attacks, several countries devalued their currencies and the ERM widened its allowable band for exchange-rate fluctuations. Altogether, the ERM can be seen as a classic example of the strengths and weaknesses of a fixed exchange-rate system.

European Monetary Union

Following the Maastricht Treaty in 1991, the European Monetary Union was established. Participating required a country to meet five criteria:

• Inflation no higher than 1.5 percentage points above the average inflation of the three EU countries with the lowest inflation;
• Two years of exchange rates within the ERM bands and without realignment should precede the application;
• Long-term government bond interest rate no higher than 2 percentage points above the average interest rate in the three EU countries with the lowest inflation;
• Budget deficit not larger than 3% of GDP;
• Gross government debt not larger than 60% of GDP.

All these rules were relative to how the other European countries were doing. In 1998, The European Central Bank (ECB) was established to maintain price stability and reduce inflation. Initial weakness of the euro was due to ECB officials who made confusing statements. The risks and gains from the European Monetary Union can be seen as an example of fixed rates in general. The union eliminated exchange-rate concerns (no variability or risk), speculation and transactions costs. Trade increased and financial markets integrated more, allowing greater gains from intertemporal trade. On the downside, the countries gave up independent monetary policy and the ability to use the exchange rate as a policy tool. Given this, there are still three mechanisms that can reduce national imbalances within the union:

• Cross-national resource movements: high labor mobility allows workers to adjust to internal imbalances. However, regional migration is low in practice.
• National price-level adjustments: a change in price competitiveness changes national real exchange rates. This can boost exports relative to imports and reduce unemployment. This is a difficult and slow process, especially in case of fundamental disequilibrium. Forcing internal devaluation by reducing wages and other costs is difficult and painful. This stresses the drawback of unification; the inability to devalue.
• Fiscal policies: with the near absence of unionwide fiscal policy and almost no automatic stabilizers, countries rely on national fiscal policy. As described in chapter 23, fiscal policy is enhanced by high capital mobility, which is likely to be the case in a monetary union. However, countries are more willing to build up fiscal deficits if they believe that union members will rescue them if the deficit becomes unmanageable. This risk had to be reduced by the Stability and Growth Pact that mandates that government deficits should be no higher than 3% of GDP, with monetary sanctions in case of violation. Temporary exceptions in case of shocks or recessions were allowed. This puts a lot of pressure on a nation and the union of a recession kicks in while the budget deficit is already around 3%. Following the mandate, contractionary policy should be imposed but this would worsen the recession. Therefore, the EU decided not to penalize Germany and France in the early 2000s and revised the pact, allowing more exceptions.

Some years later, a more troublesome situation occured. The large fiscal deficit and the recession in Greece spread to other countries. Other countries and the International Monetary Fund provided rescue loans that required a lot of effort and leeway from union members. What the EU crisis has made clear, is that there is tension between national fiscal policy as a tool for correcting economic shocks on a national level, and national fiscal policy as a risk of instability for the union. Outside of the EU, more countries have been moving towards floating exchange rates. Given how things went down in the EU, countries might even be less likely to establish another monetary union.

This chapter brings the insights from chapters 16 through 24 together and discusses the key issues in considering floating rates and the alternatives. Global choices have let to the gold standard and the Bretton Woods system in the past. Nowadays, there is a wide range of different exchange-rate policies. Most countries have a floating exchange rate but their is a trend toward fixed exchange rates. Their strengths and weaknesses will be key points in this concluding chapter.

Year of summary

• summary of 16th edition