International EconomicsTheory and Policy ppt

International
Economics
Theory and Policy
SIXTH EDITION
Paul R. Krugman
Princeton University
Maurice Obstfeld
University
of
California, Berkeley
Boston San Francisco New York
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Frete Universal Berlin
Wlrtschaftswissenschatilicte
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International Economics: Theory and Policy
Copyright © 2003 by Paul R. Krugman and Maurice Obstfeld
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03 02
BRIEF CONTENTS

Contents
vii
Preface xxii
1 Introduction
1
Part
I
International Trade Theory
9
2 Labor Productivity and Comparative Advantage:
The Ricardian Model 10
3 Specific Factors and Income Distribution 38
4 Resources and Trade: The Heckscher-Ohlin Model 67
5 The Standard Trade Model 93
6 Economies of Scale, Imperfect Competition,
and International Trade 120
7 International Factor Movements 160
Part
2
International Trade Policy
185
8 The Instruments of Trade Policy 186
9 The Political Economy of Trade Policy 218
10 Trade Policy in Developing Countries 255
11 Controversies in Trade Policy 276
Part
3
Exchange Rates
and
Open-Economy

Macroeconomics
293
12 National Income Accounting and the Balance of Payments 294
13 Exchange Rates and the Foreign Exchange Market:
An Asset Approach 324
14 Money, Interest Rates, and Exchange Rates 357
15 Price Levels and the Exchange Rate in the Long Run 388
16 Output and the Exchange Rate in the Short Run 433
17 Fixed Exchange Rates and Foreign Exchange Intervention 481
Part
4
International Macroeconomic Policy
53 I
18 The International Monetary System, 1870-1973 532
19 Macroeconomic Policy and Coordination under Floating
Exchange Rates 568
20 Optimum Currency Areas and the European Experience 604
21 The Global Capital Market: Performance
and Policy Problems 636
22 Developing Countries: Growth, Crisis, and Reform 665
vi Brief Contents
Mathematical Postscripts 707
Postscript to Chapter 3: The Specific Factors Model 708
Postscript to Chapter 4: The Factor Proportions Model 714
Postscript to Chapter 5: The Trading World Economy 717
Postscript to Chapter 6: The Monopolistic
Competition Model 726
Postscript to Chapter 21: Risk Aversion and
International Portfolio Diversification 728
Index 737

CONTENTS
Preface xxii
1 Introduction I
What
Is
International Economics About?
3
The Gains from Trade
3
The Pattern
of
Trade
4
How Much Trade?
5
The Balance
of
Payments
6
Exchange Rate Determination
6
International Policy Coordination
7
The International Capital Market
7
International Economics: Trade
and
Money
8
Part

I
International Trade Theory
9
2 Labor Productivity and Comparative Advantage:
The Ricardian Model
10
The Concept
of
Comparative Advantage
10
A One-Factor Economy
12
Production Possibilities
12
Relative Prices
and
Supply
14
Trade
in a
One-Factor World
14
Box: Comparative Advantage
in
Practice:
The
Case
of
Babe Ruth
16

Determining
the
Relative Price after Trade
16
The Gains From Trade
19
A Numerical Example
20
Relative Wages
22
Misconceptions about Comparative Advantage
23
Productivity
and
Competitiveness
23
The Pauper Labor Argument
24
Exploitation
24
Box:
Do
Wages Reflect Productivity?
25
Comparative Advantage with Many Goods
26
Setting
Up the
Model
26

Relative Wages
and
Specialization
27
Determining
the
Relative Wage
in the
Multigood Model
28
Adding Transport Costs
and
Nontraded Goods
30
Empirical Evidence
on the
Ricardian Model
31
Summary
34
VII
viii Contents
3 Specific Factors and Income Distribution 38
The Specific Factors Model 39
Assumptions of the Model 39
Box: What Is a Specific Factor? 40
Production Possibilities 40
Prices, Wages, and Labor Allocation 44
Relative Prices and the Distribution of Income 49
International Trade in the Specific Factors Model 50

Resources and Relative Supply 51
Trade and Relative Prices 52
The Pattern of Trade 53
Income Distribution and the Gains From Trade 54
The Political Economy of Trade: A Preliminary View 57
Optimal Trade Policy 57
Income Distribution and Trade Politics 58
Box: Specific Factors and the Beginnings of Trade Theory 59
Summary 60
Appendix: Further Details on Specific Factors 63
Marginal and Total Product 63
Relative Prices and the Distribution of Income 64
4 Resources and Trade: The Heckscher-Ohlin Model 67
A Model of a Two-Factor Economy 68
Assumptions of the Model 68
Factor Prices and Goods Prices 69
Resources and Output 72
Effects of International Trade Between Two-Factor Economies 75
Relative Prices and the Pattern of Trade 76
Trade and the Distribution of Income 76
Factor Price Equalization 78
Case Study: North-South Trade and Income Inequality 80
Empirical Evidence on the Heckscher-Ohlin Model 82
Testing the Heckscher-Ohlin Model , 82
Implications of the Tests 85
Summary 86
Appendix: Factor Prices, Goods Prices, and Input Choices 89
Choice of Technique 89
Goods Prices and Factor Prices 91
5 The Standard Trade Model 93

A Standard Model of a Trading Economy 94
Production Possibilities and Relative Supply 94
Relative Prices and Demand 95
The Welfare Effect of Changes in the Terms of Trade 98
Contents ix
Determining Relative Prices 98
Economic Growth: A Shift of the RS Curve 99
Growth and the Production Possibility Frontier 100
Relative Supply and the Terms of Trade . 101
International Effects of Growth 101
Case Study: Has the Growth of Newly Industrializing
Countries Hurt Advanced Nations? 103
International Transfers of Income: Shifting the RD Curve 104
The Transfer Problem 105
Effects of a Transfer on the Terms of Trade 105
Presumptions about the Terms of Trade Effects of Transfers 107
Case Study: The Transfer Problem and the Asian Crisis 108
Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD 109
Relative Demand and Supply Effects of a Tariff 109
Effects of an Export Subsidy 110
Implications of Terms of Trade Effects: Who Gains and Who Loses? 111
Summary 113
Appendix: Representing International Equilibrium
with Offer Curves 117
Deriving a Country's Offer Curve 117
International Equilibrium 118
6 Economies of Scale, Imperfect Competition,
and International Trade 120
Economies of Scale and International Trade: An Overview 120
Economies of Scale and Market Structure 122

The Theory of Imperfect Competition 123
Monopoly: A Brief Review 123
Monopolistic Competition 126
Limitations of the Monopolistic Competition Model 131
Monopolistic Competition and Trade 132
The Effects of Increased Market Size 132
Gains from an Integrated Market: A Numerical Example 133
Economies of Scale and Comparative Advantage 136
The Significance of Intraindustry Trade 139
Why Intraindustry Trade Matters 140
Case Study: Intraindustry Trade in Action: The North
American Auto Pact of 1964 141
Dumping 142
The Economics of Dumping 142
Case Study: Antidumping as Protectionism 145
Reciprocal Dumping 146
The Theory of External Economies 147
Specialized Suppliers 147
Labor Market Pooling 148
Knowledge Spillovers 149
Contents
External Economies and Increasing Returns 150
External Economies and International Trade 150
External Economies and the Pattern of Trade 150
Trade and Welfare with External Economies 151
Dynamic Increasing Returns 152
Box: Tinseltown Economics 153
Summary 155
Appendix: Determining Marginal Revenue 158
7 International Factor Movements 160

International Labor Mobility 161
A One-Good Model Without Factor Mobility 161
International Labor Movement 162
Extending the Analysis 163
Case Study: Wage Convergence in the Age of Mass Migration 165
Case Study: Immigration and the U.S. Economy 166
International Borrowing and Lending 167
Intertemporal Production Possibilities and Trade 167
The Real Interest Rate 168
Intertemporal Comparative Advantage 169
Direct Foreign Investment and Multinational Firms 169
Box: Does Capital Movement to Developing Countries Hurt
Workers in High-Wage Countries? 170
The Theory of Multinational Enterprise 172
Multinational Firms in Practice 173
Case Study: Foreign Direct Investment in the United States 175
Box: Taken for a Ride? 177
Summary 177
Appendix: More on Intertemporal Trade 181
Part 2
International Trade Policy 185
8 The Instruments of Trade Policy 186
Basic Tariff Analysis 186
Supply, Demand, and Trade in a Single Industry 187
Effects of a Tariff 189
Measuring the Amount of Protection 190
Costs and Benefits of a Tariff 192
Consumer and Producer Surplus 192
Measuring the Costs and Benefits 195
Other Instruments of Trade Policy 196

Export Subsidies: Theory 197
Case Study: Europe's Common Agricultural Policy 198
Contents xi
Import Quotas: Theory 200
Case Study: An Import Quota in Practice: U.S. Sugar 200
Voluntary Export Restraints 202
Case Study: A Voluntary Export Restraint in Practice:
Japanese Autos 203
Local Content Requirements 203
Box: American Buses, Made in Hungary 204
Other Trade Policy Instruments 205
The Effects of Trade Policy: A Summary 206
Summary 206
Appendix I: Tariff Analysis in General Equilibrium 210
A Tariff in a Small Country 210
A Tariff in a Large Country 212
Appendix II: Tariffs and Import Quotas in the Presence
of Monopoly 214
The Model with Free Trade
M
214
The Model with a Tariff 215
The Model with an Import Quota 216
Comparing a Tariff and a Quota 216
9 The Political Economy of Trade Policy 218
The Case for Free Trade 218
Free Trade and Efficiency 219
Additional Gains from Free Trade 219
Political Argument for Free Trade 221
Case Study: The Gains from 1992 221

National Welfare Arguments Against Free Trade 223
The Terms of Trade Argument for a Tariff 223
The Domestic Market Failure Argument Against Free Trade 224
How Convincing Is the Market Failure Argument? 226
Box: Market Failures Cut Both Ways: The Case of California 227
Income Distribution and Trade Policy 229
Electoral Competition 229
Collective Action 230
Modeling the Political Process 231
Who Gets Protected? 232
Box: Politicians for Sale: Evidence from the 1990s 233
International Negotiations and Trade Policy 234
The Advantages of Negotiation 235
International Trade Agreements: A Brief History 237
The Uruguay Round 239
Trade Liberalization 239
From the GATT to the WTO 240
Benefits and Costs 241
Box: Settling a Dispute—and Creating One 242
Preferential Trading Agreements 243
xii Contents
Box: Free Trade Area versus Customs Union 244
Box: Do Trade Preferences Have Appeal? 245
Case Study: Trade Diversion in South America 246
Summary 247
Appendix: Proving that the Optimum Tariff
Is Positive 252
Demand
and
Supply

252
The Tariff
and
Prices
252
The Tariff
and
Domestic Welfare
253
10 Trade Policy in Developing Countries 255
Import-Substituting Industrialization
256
The Infant Industry Argument
256
Promoting Manufacturing Through Protection
258
Case Study:
The End of
Import Substitution
in
Chile
260
Results
of
Favoring Manufacturing: Problems
of Import-Substituting Industrialization
261
Problems
of the
Dual Economy

263
The Symptoms
of
Dualism
263
Case Study: Economic Dualism
in
India
264
Dual Labor Markets
and
Trade Policy
264
Trade Policy
as a
Cause
of
Economic Dualism
267
Export-Oriented Industrialization:
The
East Asian
Miracle
267
The Facts
of
Asian Growth
268
Trade Policy
in the

HPAEs
269
Box: China's Boom
270
Industrial Policy
in the
HPAEs
270
Other Factors
in
Growth
271
Summary
272
I I Controversies in Trade Policy 276
Sophisticated Arguments
for
Activist Trade Policy
276
Technology
and
Externalities
277
Imperfect Competition
and
Strategic Trade Policy
278
Case Study: When
the
Chips Were

Up 282
Globalization
and
Low-Wage Labor
283
The Anti-Globalization Movement
284
Trade
and
Wages Revisited
285
Labor Standards
and
Trade Negotiations
287
Environmental
and
Cultural Issues
288
The
WTO
and
National Independence
288
Case Study:
The
Shipbreakers
of
Alang
289

Summary 290
Contents xiii
Part
3
Exchange Rates and Open-Economy
Macroeconomics
293
I 2 National Income Accounting and the Balance
of Payments 294
The National Income Accounts
295
National Product and National Income
296
Capital Depreciation, International Transfers, and Indirect
Business Taxes
297
Gross Domestic Product
298
National Income Accounting
for an
Open Economy
299
Consumption
299
Investment
t
299
Government Purchases
299
The National Income Identity

for an
Open Economy
300
An Imaginary Open Economy
300
The Current Account and Foreign Indebtedness
301
Saving and the Current Account
303
Private and Government Saving
305
Case Study: Government Deficit Reduction May Not Increase
the Current Account Surplus
306
The Balance
of
Payment Accounts
307
Examples
of
Paired Transactions
309
The Fundamental Balance
of
Payments Identity
310
The Current Account, Once Again
310
The Capital Account
312

The Financial Account
312
The Statistical Discrepancy
313
Official Reserve Transactions
313
Box: The Mystery
of
the Missing Surplus
314
Case Study:
Is the
United States the World's Biggest Debtor?
316
Summary
320
I 3 Exchange Rates and the Foreign Exchange Market:
An Asset Approach 324
Exchange Rates and International Transactions
325
Domestic and Foreign Prices
325
Exchange Rates and Relative Prices
327
The Foreign Exchange Market
328
The Actors
328
Box:
A

Tale
of
Two Dollars
329
Characteristics
of
the Market
330
Spot Rates and Forward Rates
331
xiv Contents
Foreign Exchange Swaps
332
Future
and
Options
333
The Demand
for
Foreign Currency Assets
334
Assets
and
Asset Returns
334
Risk
and
Liquidity
335
Interest Rates

336
Exchange Rates
and
Asset Returns
' 337
A Simple Rule
338
Return, Risk,
and
Liquidity
in the
Foreign Exchange Market
340
Equilibrium
in the
Foreign Exchange Market
341
Interest Parity:
The
Basic Equilibrium Condition
341
How Changes
in the
Current Exchange Rate Affect Expected Returns
342
The Equilibrium Exchange Rate
344
Interest Rates, Expectations,
and
Equilibrium

346
The Effect
of
Changing Interest Rates
on the
Current Exchange Rate
347
The Effect
of
Changing Expectations
on the
Current Exchange Rate
347
Box:
The
Perils
of
Forecasting Exchange Rates
349
Summary
350
Appendix: Forward Exchange Rates and Covered
Interest Parity 354
I
4
Money, Interest Rates,
and
Exchange Rates
357
Money Defined:

A
Brief Review
358
Money
as a
Medium
of
Exchange
358
Money
as a
Unit
of
Account
358
Money
as a
Store
of
Value
358
What
Is
Money?
359
How
the
Money Supply
Is
Determined

-359
The Demand
for
Money
by
Individuals
359
Expected Return
360
Risk
360
Liquidity
361
Aggregate Money Demand
361
The Equilibrium Interest Rate:
The
Interaction
of
Money
Supply
and
Demand
362
Equilibrium
in the
Money Market
362
Interest Rates
and the

Money Supply
365
Output
and the
Interest Rate
366
The Money Supply
and the
Exchange Rate
in the
Short
Run 366
Linking Money,
the
Interest Rate,
and the
Exchange Rate
367
U.S.
Money Supply
and the
Dollar/Euro Exchange Rate
369
Europe's Money Supply
and the
Dollar/Euro Exchange Rate
370
Money,
the
Price Level,

and the
Exchange Rate
in the
Long
Run 373
Money
and
Money Prices
373
The Long-Run Effects
of
Money Supply Changes
374
Empirical Evidence
on
Money Supplies
and
Price Levels
375
r
Contents
XV
Money
and the
Exchange Rate
in the
Long
Run 376
Box: Inflation and Money-Supply Growth in Latin America 377
Inflation and Exchange Rate Dynamics 378

j:
Short-Run Price Rigidity versus Long-Run Price Flexibility 378
Box: Money Supply Growth and Hyperinflation in Bolivia 380
Permanent Money Supply Changes and the Exchange Rate 381
Exchange Rate Overshooting 383
| Summary 384
t I 5 Price Levels and the Exchange Rate in the Long Run 388
The Law of One Price 389
Purchasing Power Parity 389
The Relationship between PPP and the Law of One Price 390
• Absolute PPP and Relative PPP 391
\ A Long-Run Exchange Rate Model Based on PPP , 392
; The Fundamental Equation of the Monetary Approach 392
Ongoing Inflation, Interest Parity, and PPP 394
[ The Fisher Effect 396
; Empirical Evidence on PPP and the Law of One Price 400
! Box: Some Meaty Evidence on the Law of One Price 402
Explaining the Problems with PPP 404
' Trade Barriers and Nontradables 404
: Departures from Free Competition 405
• Box: Hong Kong's Surprisingly High Inflation 406
International Differences in Price Level Measurement 408
PPP in the Short Run and in the Long Run 408
Case Study: Why Price Levels Are Lower in Poorer Countries 409
Beyond Purchasing Power Parity: A General Model
of Long-Run Exchange Rates 411
The Real Exchange Rate 411
Box: Sticky Prices and the Law of One Price: Evidence
from Scandinavian Duty-Free Shops 412
Demand, Supply, and the Long-Run Real Exchange Rate 415

Nominal and Real Exchange Rates in Long-Run Equilibrium 416
Case Study: Why Has the Yen Kept Rising? 419
International Interest Rate Differences and the Real
Exchange Rate 421
Real Interest Parity 423
Summary 424
Appendix: The Fisher Effect, the Interest Rate,
and the Exchange Rate under the Flexible-Price
Monetary Approach 430
16 Output and the Exchange Rate in the Short Run 433
Determinants of Aggregate Demand in an Open Economy 434
xvi Contents
Determinants of Consumption Demand 434
Determinants of the Current Account 435
How Real Exchange Rate Changes Affect the Current Account 436
How Disposable Income Changes Affect the Current Account 437
The Equation of Aggregate Demand 437
The Real Exchange Rate and Aggregate Demand 437
Real Income and Aggregate Demand 438
How Output Is Determined in the Short Run 438
Output Market Equilibrium in the Short Run:
The DD Schedule 440
Output, the Exchange Rate, and Output Market Equilibrium 440
Deriving the DD Schedule 441
Factors that Shift the DD Schedule 443
Asset Market Equilibrium in the Short Run: The AA Schedule 445
Output, the Exchange Rate, and Asset Market Equilibrium 445
Deriving the AA Schedule 446
Factors that Shift the AA Schedule 446
Short-Run Equilibrium for an Open Economy: Putting

the DD and AA Schedules Together 448
Temporary Changes in Monetary and Fiscal Policy 450
Monetary Policy 451
Fiscal Policy 451
Policies to Maintain Full Employment 452
Inflation Bias and Other Problems of Policy Formulation 455
Permanent Shifts in Monetary and Fiscal Policy 456
A Permanent Increase in the Money Supply 456
Adjustment to a Permanent Increase in the Money Supply 456
A Permanent Fiscal Expansion 458
Macroeconomic Policies and the Current Account 460
Box: The Dollar Exchange Rate and the U.S. Economic
Slowdown of 2000-2001 461
Gradual Trade Flow Adjustment and Current
Account Dynamics 463
The J-Curve 464
Exchange Rate Pass-Through and Inflation 465
Summary 466
Appendix I: The IS-LM Model and the DD-AA Model 470
Appendix II: Intertemporal Trade and Consumption
Demand 475
Appendix III: The Marshall-Lerner Condition and
Empirical Estimates of Trade Elasticities 477
17 Fixed Exchange Rates and Foreign Exchange
Intervention 481
Why Study Fixed Exchange Rates? 481
Contents xvii
Central Bank Intervention and the Money Supply 482
The Central Bank Balance Sheet and the Money Supply 486
Foreign Exchange Intervention and the Money Supply 487

Sterilization 488
The Balance of Payments and the Money Supply 489
How the Central Bank Fixes the Exchange Rate 490
Foreign Exchange Market Equilibrium under a Fixed
Exchange Rate 491
Money Market Equilibrium under a Fixed Exchange Rate 491
A Diagrammatic Analysis 492
Stabilization Policies with a Fixed Exchange Rate 494
Monetary Policy 494
Fiscal Policy 495
Changes in the Exchange Rate 496
Adjustment to Fiscal Policy and Exchange Rate Changes 498
Case Study: Fixing the Exchange Rate to Escape
from a Liquidity Trap 499
Balance of Payments Crises and Capital Flight 502
Managed Floating and Sterilized Intervention 505
Perfect Asset Substitutability and the Ineffectiveness
of Sterilized Intervention 505
Box: Mexico's 1994 Balance of Payments Crisis 506
Foreign Exchange Market Equilibrium under Imperfect
Asset Substitutability 507
The Effects of Sterilized Intervention with Imperfect
Asset Substitutability 508
Evidence on the Effects of Sterilized Intervention 510
The Signaling Effect of Intervention 510
Reserve Currencies in the World Monetary System 511
The Mechanics of a Reserve Currency Standard 512
The Asymmetric Position of the Reserve Center 512
The Gold Standard 513
The Mechanics of a Gold Standard 513

Symmetric Monetary Adjustment under a Gold Standard 514
Benefits and Drawbacks of the Gold Standard 515
The Bimetallic Standard 516
The Gold Exchange Standard 516
Summary 517
Appendix I: Equilibrium in the Foreign Exchange
Market with Imperfect Asset Substitutability 522
Demand 522
Supply 523
Equilibrium 523
Appendix II: The Monetary Approach to the Balance
of Payments 525
Appendix III: The Timing of Balance of Payments Crises 527
xviii Contents
Part 4
International Macroeconomic Policy 53 I
I 8 The International Monetary System, 1870-1973 532
Macroeconomic Policy Goals in an Open Economy 533
Internal Balance: Full Employment and Price-Level Stability 533
External Balance: The Optimal Level of the Current Account 534
International Macroeconomic Policy under the Gold Standard,
1870-1914 537
Origins of the Gold Standard 537
External Balance under the Gold Standard 537
The Price-Specie-Flow Mechanism 538
The Gold Standard "Rules of the Game": Myth and Reality 539
Box: Hume versus the Mercantilists 540
Internal Balance under the Gold Standard 541
Case Study: The Political Economy of Exchange Rate Regimes:
Conflict over America's Monetary Standard During the 1890s 541

The Interwar Years, 1918-1939 542
The German Hyperinflation 543
The Fleeting Return to Gold 543
International Economic Disintegration 544
Case Study: The International Gold Standard
and the Great Depression 545
The Bretton Woods System and the Internationa]
Monetary Fund 546
Goals and Structure of the IMF 547
Convertibility 548
Internal and External Balance under the Bretton Woods System 549
The Changing Meaning of External Balance 550
Speculative Capital Flows and Crises 550
Analyzing Policy Options under the Bretton Woods System 551
Maintaining Internal Balance 552
Maintaining External Balance 553
Expenditure-Changing and Expenditure-Switching Policies 554
The External Balance Problem of the United States 556
Case Study: The Decline and Fall of the Bretton Woods System 557
Worldwide Inflation and the Transition to Floating Rates 561
Summary 564
I 9 Macroeconomic Policy and Coordination under
Floating Exchange Rates 568
The Case for Floating Exchange Rates 568
Monetary Policy Autonomy 569
Symmetry 570
Contents xix
Exchange Rates as Automatic Stabilizers 571
The Case Against Floating Exchange Rates 573
Discipline 573

Destabilizing Speculation and Money Market Disturbances 574
Injury to International Trade and Investment 575
Uncoordinated Economic Policies 576
The Illusion of Greater Autonomy 576
Case Study: Exchange Rate Experience Between the Oil
Shocks, 1973-1980 577
Macroeconomic Interdependence under a Floating Rate 582
I Case Study: Disinflation, Growth, Crisis, and
I Recession, 1980-2002 586
I What Has Been Learned Since 1973? 590
I Monetary Policy Autonomy 590
I Symmetry 592
[,• The Exchange Rate as an Automatic Stabilizer
t
592
[• Discipline 593
i Destabilizing Speculation 594
• International Trade and Investment 594
» Policy Coordination 595
Are Fixed Exchange Rates Even an Option
for Most Countries? 596
Directions for Reform 596
Summary 597
Appendix: International Policy Coordination Failures 601
20 Optimum Currency Areas and
the European Experience 604
How the European Single Currency Evolved 604
European Currency Reform Initiatives, 1969-1978 605
The European Monetary System, 1979-1998 607
German Monetary Dominance and the Credibility Theory

of the EMS 609
The EU "1992" Initiative 610
European Economic and Monetary Union 612
The Euro and Economic Policy in the Euro Zone 613
The Maastricht Convergence Criteria and the Stability
and Growth Pact 613
The European System of Central Banks 615
Box: Designing and Naming a New Currency 616
The Revised Exchange Rate Mechanism 616
The Theory of Optimum Currency Areas 617
Economic Integration and the Benefits of a Fixed
Exchange Rate Area: The GG Schedule 618
Economic Integration and the Costs of a Fixed
Exchange Rate Area: The LL Schedule 620
XX Contents
The Decision
to
Join
a
Currency Area: Putting
the GG and
LL Schedules Together
622
What
Is an
Optimum Currency Area?
624
Case Study: Is Europe an Optimum Currency Area? 625
Box: How Much Trade Do Currency Unions Create? 628
The Future of EMU 630

Summary 632
2
I The
Global Capital Market: Performance
and Policy Problems
636
The International Capital Market and the Gains from Trade 637
Three Types
of
Gain from Trade
637
Risk Aversion
638
Portfolio Diversification
as a
Motive
for
International Asset Trade
639
The Menu
of
International Assets: Debt Versus Equity
640
International Banking and the International Capital Market 640
The Structure
of the
International Capital Market
641
Growth
of the

International Capital Market
643
Offshore Banking
and
Offshore Currency Trading
643
The Growth
of
Eurocurrency Trading
644
Regulating International Banking 647
The Problem
of
Bank Fai lure
647
Difficulties
in
Regulating International Banking
649
International Regulatory Cooperation
650
Box: The Banco Ambrosiano Collapse 651
Case Study: The Day the World Almost Ended 653
How Well Has the International Capital Market Performed? 655
The Extent
of
International Portfolio Diversification
655
The Extent
of

Intertemporal Trade
656
Onshore-Offshore Interest Differentials
657
The Efficiency
of the
Foreign Exchange Market
658
Summary 662
22 Developing Countries: Growth, Crisis,
and
Reform
665
Income, Wealth, and Growth in the World Economy 665
The
Gap
Between Rich
and
Poor
666
Has
the
World Income
Gap
Narrowed over Time?
666
Structural Features of Developing Countries 668
Developing Country Borrowing and Debt 671
The Economics
of

Capital Inflows
to
Developing Countries
672
The Problem
of
Default
672
Alternative Forms
of
Capital Inflow
675
Latin America: From Crisis to Uneven Reform 676
Inflation
and the
1980s Debt Crisis
in
Latin America
678
Box: The Simple Algebra of Moral Hazard 679
Contents
XXI
Case Study: Argentina's Economic Stagnation
681
Reforms, Capital Inflows, and the Return
of
Crisis
684
East Asia: Success and Crisis
687

The East Asian Economic Miracle
687
Box: What Did Asia
Do
Right?
689
Asian Weaknesses
689
The Asian Financial Crisis
691
Crises
in
Other Developing Regions
692
Case Study: Can Currency Boards Make Fixed Exchange
Rates Credible?
695
Lessons
of
Developing Country Crises
697
Reforming
the
World's Financial "Architecture"
698
Capital Mobility
and
the Trilemma
of
the Exchange Rate Regime

699
"Prophylactic" Measures
701
Coping with Crisis
702
A Confused Future
702
Summary
702
Mathematical Postscripts 707
Postscript
to
Chapter 3: The Specific Factors Model
708
Factor Prices, Costs, and Factor Demands
708
Factor Price Determination
in the
Specific Factors Model
710
Effects
of a
Change
in
Relative Prices
712
Postscript
to
Chapter
4:

The Factor Proportions Model
714
The Basic Equations
in the
Factor Proportions Model
714
Goods Prices
and
Factor Prices
715
Factor Supplies
and
Outputs
715
Postscript
to
Chapter
5:
The Trading World Economy
717
Supply, Demand,
and
Equilibrium
717
World Equilibrium
717
Production and Income
717
Income, Prices,
and

Utility
718
Supply, Demand,
and the
Stability
of
Equilibrium
719
Effects
of
Changes
in
Supply
and
Demand
721
The Method
of
Comparative Statics
721
Economic Growth
722
The Transfer Problem
723
A Tariff
724
Postscript
to
Chapter
6:

The Monopolistic Competition Model
726
Postscript
to
Chapter 21: Risk Aversion and International
Portfolio Diversification
728
An Analytical Derivation
of
the Optimal Portfolio
728
A Diagrammatic Derivation
of
the Optimal Portfolio
729
The Effects
of
Changing Rates
of
Return
732
Index
737
PREFACE
At the start of the twenty-first century, international aspects of economics remain as
important and controversial as ever. In the last decade alone, major currency and Financial
crises have rocked industrializing countries from East Asia to Latin America; countries in
Europe have given up their national currencies in favor of a common currency, the euro;
and growing trade and financial linkages between industrial and developing countries
have sparked debate and even open protest inspired by claims that economic "globaliza-

tion" has worsened worldwide ills ranging from poverty to pollution. Although the United
States is more self-sufficient than nations with smaller economies, problems of interna-
tional economic policy have assumed primacy and now occupy a prominent place on
newspapers' front pages.
Recent general developments in the world economy raise concerns that have preoc-
cupied international economists for more than two centuries, such as the nature of the
international adjustment mechanism and the merits of free trade compared with protec-
tion. As always in international economics, however, the interplay of events and ideas has
led to new modes of analysis. Three notable examples of recent progress are the asset
market approach to exchange rates; new theories of foreign trade based on increasing
returns and market structure rather than comparative advantage; and the intertemporal
analysis of international capital flows, which has been central both in refining the concept
of "external balance" and in examining the determinants of developing country borrow-
ing and default.
The idea of writing this book came out of our experience in teaching international eco-
nomics to undergraduates and business students since the late 1970s. We perceived two
main challenges in teaching. The first was to communicate to students the exciting intel-
lectual advances in this dynamic field. The second was to show how the development of
international economic theory has traditionally been shaped by the need to understand the
changing world economy and analyze actual problems in international economic policy.
We found that published textbooks did not adequately meet these challenges. Too often,
international economics textbooks confront students with a bewildering array of special
models and assumptions from which basic lessons are difficult to extract. Because many of
these special models are outmoded, students are left puzzled about the real-world rele-
vance of the analysis. As a result, many textbooks often leave a gap between the somewhat
antiquated material to be covered in class and the exciting issues that dominate current
research and policy debates. That gap has widened dramatically as the importance of
international economic problems—and enrollments in international economics courses—
have grown.
This book is our attempt to provide an up-to-date and understandable analytical frame-

work for illuminating current events and bringing the excitement of international econom-
ics into the classroom. In analyzing both the real and monetary sides of the subject, our
approach has been to build up, step by step, a simple, unified framework for communicat-
ing the grand traditional insights as well as the newest findings and approaches. To help the
student grasp and retain the underlying logic of international economics, we motivate the
theoretical development at each stage by pertinent data or policy questions.
xxii
Preface xxiii
The Place of This Book in the Economics Curriculum
Students assimilate international economics most readily when it is presented as a method of
analysis vitally linked to events in the world economy, rather than as a body of abstract theo-
rems about abstract models. Our goal has therefore been to stress concepts and their applica-
tion rather than theoretical formalism. Accordingly, the book does not presuppose an extensive
background in economics. Students who have had a course in economic principles will find
the book accessible, but students who have taken further courses in microeconomics or
macroeconomics will find an abundant supply of new material. Specialized appendices and
mathematical postscripts have been included to challenge the most advanced students.
We follow the standard practice of dividing the book into two halves, devoted to trade
and to monetary questions. Although the trade and monetary portions of international eco-
nomics are often treated as unrelated subjects, even within one textbook, similar themes and
methods recur in both subfields. One example is the idea of gains from trade, which is
important in understanding the effects of free trade in assets as well as free trade in goods.
International borrowing and lending provide another example. The process by which coun-
tries trade present for future consumption is best understood in terms of comparative advan-
tage (which is why we introduce it in the book's first half), but the resulting insights deepen
understanding of the external macroeconomic problems of developing and developed
economies alike. We have made it a point to illuminate connections between the trade and
monetary areas when they arise.
At the same time, we have made sure that the book's two halves are completely
self-

contained. Thus, a one-semester course on trade theory can be based on Chapters 2 through
11,
and a one-semester course on international monetary economics can be based on Chap-
ters 12 through 22. If you adopt the book for a full-year course covering both subjects, how-
ever, you will find a treatment that does not leave students wondering why the principles
underlying their work on trade theory have been discarded over the winter break.
Some Distinctive Features of International
Economics:
Theory and Policy
This book covers the most important recent developments in international economics with-
out shortchanging the enduring theoretical and historical insights that have traditionally
formed the core of the subject. We have achieved this comprehensiveness by stressing how
recent theories have evolved from earlier findings in response to an evolving world econo-
my. Both the real trade portion of the book (Chapters 2 through 11) and the monetary portion
(Chapters 12 through 22) are divided into a core of chapters focused on theory, followed by
chapters applying the theory to major policy questions, past and current.
In Chapter 1 we describe in some detail how this book addresses the major themes of
international economics. Here we emphasize several of the newer topics that previous
authors failed to treat in a systematic way.
Asset Market Approach to Exchange Rate Determination
The modern foreign exchange market and the determination of exchange rates by nation-
al interest rates and expectations are at the center of our account of open-economy
xxiv Preface
macroeconomics. The main ingredient of the macroeconomic model we develop is the
interest parity relation (augmented later by risk premiums). Among the topics we address
using the model are exchange rate "overshooting"; behavior of real exchange rates; balance-
of-payments crises under fixed exchange rates; and the causes and effects of central bank
intervention in the foreign exchange market.
Increasing Returns and Market Structure
After discussing the role of comparative advantage in promoting trade and gains from

trade, we move to the frontier of research (in Chapter 6) by explaining how increasing
returns and product differentiation affect trade and welfare. The models explored in this dis-
cussion capture significant aspects of reality, such as intraindustry trade and shifts in trade
patterns due to dynamic scale economies. The models show, too, that mutually beneficial
trade need not be based on comparative advantage.
Politics and Theory of Trade Policy
Starting in Chapter 3, we stress the effect of trade on income distribution as the key politi-
cal factor behind restrictions on free trade. This emphasis makes it clear to students why the
prescriptions of the standard welfare analysis of trade policy seldom prevail in practice.
Chapter 11 explores the popular notion that governments should adopt activist trade policies
aimed at encouraging sectors of the economy seen as crucial. The chapter includes a theo-
retical discussion of such trade policy based on simple ideas from game theory.
International Macroeconomic Policy Coordination
Our discussion of international monetary experience (Chapters 18, 19, 20, and 22) stresses
the theme that different exchange rate systems have led to different policy coordination
problems for their members. Just as the competitive gold scramble of the interwar years
showed how beggar-thy-neighbor policies can be self-defeating, the current float chal-
lenges national policymakers to recognize their interdependence and formulate policies
cooperatively. Chapter 19 presents a detailed discussion of this very topical problem of the
current system.
The World Capital Market and Developing Countries
A broad discussion of the world capital market is given in Chapter 21, which takes up the
welfare implications of international portfolio diversification as well as problems of pru-
dential supervision of offshore financial institutions. Chapter 22 is devoted to the long-term
growth prospects and to the specific macroeconomic stabilization and liberalization prob-
lems of industrializing and newly industrialized countries. The chapter reviews emerging
market crises and places in historical perspective the interactions among developing coun-
try borrowers, developed country lenders, and official financial institutions such as the
International Monetary Fund.
International Factor Movements

In Chapter 7 we emphasize the potential substitutability of international trade and interna-
tional movements of factors of production. A feature in the chapter is our analysis of inter-
national borrowing and lending as intertemporal trade, that is, the exchange of present con-
Preface
xxv
sumption
for
future consumption.
We
draw
on the
results
of
this analysis
in the
book's
second half
to
throw light
on the
macroeconomic implications
of the
current account.
New
to the
Sixth Edition
For this sixth edition
of
International Economics: Theory
and

Policy,
we
have extensively
redesigned several chapters. These changes respond both
to
users' suggestions
and to
some
important developments
on the
theoretical
and
practical sides
of
international economics.
The most far-reaching changes
are the
following:
Chapter 9, The Political Economy of Trade Policy This chapter now includes
the role
of
special-interest payments
in
influencing political decisions over trade policy.
Coverage
of the
World Trade Organization
is
brought
up to

date.
Chapter I I, Controversies in Trade Policy A new title signals that this chapter
expands
its
coverage beyond
its
predecessor's focus
on
strategic trade policy.
In
addition,
Chapter
11 now
covers
the
recent globalization debate—including
the
effects
of
trade
on
income distribution
and the
environment,
as
well
as the
role
of
international labor standards.

Chapter 12, National Income Accounting and the Balance of Payments
The revised Chapter
12
reflects
the new
balance
of
payments accounting conventions
adopted
by the
United States
and
other countries.
Chapter 18, The International Monetary System, 1870-1973 This chapter
now pays more attention
to the
political economy
of
exchange rate regimes, using
as an
example
the
battle over
the
gold standard that dominated American politics
in the
late
nineteenth century.
Chapter 19, Macroeconomic Policy and Coordination under Floating
Exchange Rates

We
have replaced
the
detailed two-country model
of
earlier editions
with
a
brief intuitive discussion
of the
major results
on
international policy repercussions.
That change allows
the
instructor
to
focus more
on
important policy issues
and
less
on dry
technical details.
Chapter 20, Optimum Currency Areas and the European Experience As
recently
as the
mid-1990s, Europe's vision
of a
single currency looked like

a
distant
and
possibly unreachable goal.
As of
2002, however, twelve European countries
had
replaced
their national currencies with
the
euro,
and
others
are
poised
to
follow. Chapter
20 has
been
revised
to
cover
the
first years
of
experience with
the
euro.
Chapter 21,The Global Capital Market: Performance and Policy Problems
To make room

for
more topical material elsewhere
in the
book,
we
have streamlined this
chapter
by
removing
the
detailed exposition
of
Eurocurrency creation contained
in
earlier
editions.
xxv
i
Preface
In addition to these structural changes, we have updated the book in other ways to main-
tain current relevance. Thus we extend our coverage of the welfare effect of newly industri-
alizing countries' exports on more advanced economies (Chapter 5); we update the discus-
sion of Japanese policy toward the semiconductor industry (Chapter 11); we discuss Japan's
liquidity trap (Chapter 17) and evidence on the effect of currency unions on trade volume
(Chapter 20); and we recount the collapse of Argentina's currency in 2002 (Chapter 22).
Learning Features
This book incorporates a number of special learning features that will maintain students'
interest in the presentation and help them master its lessons.
Case Studies
Theoretical discussions are often accompanied by case studies that perform the threefold

role of reinforcing material covered earlier, illustrating its applicability in the real world,
and providing important historical information.
Special Boxes
Less central topics that nonetheless offer particularly vivid illustrations of points made in
the text are treated in boxes. Among these are the political backdrops of Ricardo's and
Hume's theories (pp. 59 and 540); the surprising potential importance of NAFTA's effect on
California's demand for water (p. 227); the astonishing ability of disputes over banana
trade to generate acrimony among countries far too cold to grow any of their own bananas
(p.
245); the story of the Bolivian hyperinflation (p. 380); and the 1994 speculative attack
on the Mexican peso (p. 506).
Captioned Diagrams
More than 200 diagrams are accompanied by descriptive captions that reinforce the dis-
cussion in the text and help the student in reviewing the material.
Summary and Key Terms
Each chapter closes with a summary recapitulating the major points. Key terms and phrases
appear in boldface type when they are introduced in the chapter and are listed at the end of
each chapter. To further aid student review of the material, key terms are italicized when
they appear in the chapter summary.
Problems
Each chapter is followed by problems intended to test and solidify students' comprehension.
The problems range from routine computational drills to "big picture" questions suitable for
classroom discussion. In many problems we ask students to apply what they have learned to
real-world data or policy questions.
Further Reading
For instructors who prefer to supplement the textbook with outside readings, and for stu-
dents who wish to probe more deeply on their own, each chapter has an annotated bibliog-
raphy that includes established classics as well as up-to-date examinations of recent issues.
Preface xxvii
Study Guide, Instructor's Manual, and Web Site

International Economics: Theory and Policy is accompanied by a Study Guide written by
Linda S. Goldberg of the Federal Reserve Bank of New York, Michael W. Klein of Tufts
University, and Jay C. Shambaugh of Dartmouth College. The Study Guide aids students by
providing a review of central concepts from the text, further illustrative examples, and
additional practice problems. An Instructor's Manual, also by Linda S. Goldberg, Michael
W. Klein, and Jay C. Shambaugh, includes chapter overviews, answers to the end-of-chap-
ter problems, and suggestions for classroom presentation of the book's contents. The Study
Guide and Instructor's Manual have been updated to reflect the changes in the sixth edition.
We are also pleased to recommend the companion Web site to accompany International
Economics, Sixth Edition, at www.aw.com/krugman_obstfeld. The site offers students
self-check quizzes for each chapter, links to sites of interest, and occasional updates on late-
breaking developments. All new to the site for this edition is an animated PowerPoint pro-
gram of the text's figures and tables, prepared by Iordanis Petsas of the University of
Florida under the direction of Professor Elias Dinopoulos. And also featured on the Web site
is a brand-new, comprehensive Test Bank for the instructor, prepared by Yochanan Shach-
murove of the City College of the City University of New York and the University of Penn-
sylvania, and Mitchell H. Kellman of the City College of the City University of New York
and the Graduate Center of the City University of New York. The Test Bank offers a rich
array of multiple-choice and essay questions, plus mathematical and graphical problems, for
each textbook chapter.
For those interested in course management, a Course Compass Web site is also available.
Contact your Addison-Wesley sales representative for details.
Acknowledgments
Our primary debts are to Jane E. Tufts, the development editor, and to Sylvia Mallory and
Denise Clinton, the economics editors in charge of the project. Jane's judgment and skill
have been reflected in all six editions of this book; we cannot thank her enough for her con-
tributions. Heather Johnson's efforts as project editor are greatly appreciated. We thank the
other editors who helped make the first five editions as good as they were.
We owe a debt of gratitude to Galina Hale, who painstakingly updated data, checked
proofs, and critiqued chapters. Annie Wai-Kuen Shun provided sterling assistance. For

constructive suggestions we thank Syed M. Ahsan, Daniel Borer, Petra Geraats, Alan M.
Taylor, Hans Visser, and Mickey Wu.
We thank the following reviewers for their recommendations and insights:
Michael Arghyrou, Brunei University, U.K.
Debajyoti Chakrabarty, Rutgers University
Adhip Chaudhuri, Georgetown University
Barbara Craig, Oberlin College
Robert Driskill, Vanderbilt University
Hugh Kelley, Indiana University
Michael Kevane, Santa Clara University