International economics 3rd by taylor

omy is kept as a stabilization tool. In a monetary union, where states have
also relinquished monetary policy to the ECB, the pain of hard fiscal rules
is likely to be intolerable.

2  Preface
■

Once countries joined the euro, the main “carrot” enticing them to follow the
SGP’s budget rules (or to pretend to follow them) disappeared. Hence, surveillance, punishment, and commitment all quite predictably weakened once the
euro was up and running.

These failures of the SGP came to light only gradually, but by 2003 the pact was
in ruins, once it became clear that France and (ironically) Germany would be in
breach of the pact and that no serious action would be taken against them. As we
see next, fiscal problems in the Eurozone have only gotten worse, although whether
the principles of the SGP can, or should, be reinstated is the subject of ongoing
disagreement.

A MODERN BOOK FOR
A MODERN AUDIENCE

Feenstra and Taylor’s text incorporates
fresh perspectives, current topics, and
4 The Eurozone in Crisis, 2008–2013
up-to-date empirical research. It expands
For almost 10 years, Eurozone policy making focused on two main macroeconomicthe study of international economics to
goals: the ECB’s monetary policy credibility and inflation target, seen as a broad
success given low and stable inflation outcomes; and the Eurozone governments’encompass the latest theories and world
fiscal responsibility, seen as a failure given the general disregard for the SGP rules.events.
However, policy makers (like their counterparts all over the world) failed to spot key

macroeconomic and financial developments that were to plunge the Eurozone into
crisis in 2008 and beyond.

Boom and Bust: Causes and Consequences of an Asymmetrical Crisis With
a fanatical devotion to inflation targeting, the ECB (and its constituent central banks)
paid insufficient attention to what was historically a primary responsibility of central
banks, namely, financial stability. Within some parts of the Eurozone (as elsewhere)
borrowers in the private sector were engaged in a credit-fueled boom. In other parts
of the Eurozone, savers and banks funneled ever more loans toward those borrowers. The creditors were core Northern European countries like Germany and the
Netherlands; the debtors were fast-growing peripheral nations such as Greece, Ireland,
Portugal, and Spain (so called because they are located geographically on the periphery of Europe).
In Greece, much of the borrowing was by a fiscally irresponsible government that
was later found to be falsifying its accounts. In the other peripheral nations, however, the flow of loans funded rapid investment and consumption surges, including a
residential construction boom that in places (e.g., Dublin and Barcelona) rivaled the
property bubble in parts of the United States. In Ireland and Spain, even as this boom
took place, the governments had maintained a fiscal position close to balance, or even
surplus; the asymmetric boom helped them
at that time. The trouble was to come
222 Part 3 ■ New Explanations for International Trade
when the boom gave way to a severe asymmetric bust.

The chapter on the euro covers
the dramatic developments
since 2010, including the Greek
debt restructuring; assistance
programs in Spain, Ireland and
Portugal; and the Cyprus banking crisis.

page 843

Feenstra_IntEcon_3e_Ch21.indd 843

FIGURE 7-14
Trade surplus 140
(US$ billion)
120

1/10/14 2:03 PM

100
United States

80

United Kingdom

60
40
20

India

0
–20
1970

THEORY TESTED AND REFINED
Feenstra and Taylor’s text covers many
empirical studies that prove or refute existing theories, revealing important new
lessons about the determinants of trade,

factor flows, exchange rates, and crises.

1975

1980

Trade Surplus in Business Services This figure
shows the combined trade surplus in computer and
information services, insurance, and financial services
for the United States, the United Kingdom, and India
from 1970 to 2010. The U.S. surplus in these categories
of services has been growing since about 1985, with an
occasional dip, and exceeded the trade surplus of the

1985

1990

1995

2000

2005

2010

United Kingdom, its chief competitor, up until about
2000. Since then the surpluses of the United Kingdom
and of the United States have been similar. India’s
surplus began growing around 2000 and is based

entirely on its exports of computer and information
services.
Source: World Bank World Development Indicators.

3 The Politics and Future of Offshoring

page 222

Offshoring is controversial and is often the topic of political debate. In
February 2004 the first quote at the beginning of this chapter appeared in the
Economic Report of the President. The writer of that sentence, Harvard economist
N. Gregory Mankiw, who was chairman of the Council of Economic Advisors,
also said that “outsourcing is just a new way of doing international trade. More
things are tradable than were tradable in the past, and that’s a good thing.” Those
comments were widely criticized by the Democrats and Republicans alike, and
Professor Mankiw later apologized in a letter to the House of Representatives,
writing, “My lack of clarity left the wrong impression that I praised the loss of
U.S. jobs.”
In the Democratic primary elections of 2007 and in the presidential campaign


Chapter 10

■

Export Policies in Resource and High-Technology Industries 351

MODERN TOPICS
Feenstra and Taylor’s text shows why trade
and capital flows have been liberalized

and allowed to grow. The text focuses
more attention on emerging markets and
developing countries—regions that now
carry substantial weight in the global
economy.

TIM WIMBORNE/Reuters/Corbis

In March 2012, the United States, the European Union, and Japan filed another
WTO case against China charging that it applied unfair export restrictions on its rare
earth minerals, as well as tungsten and molybdenum. The first step in such a case is
for the parties involved (the United States, Europe, and Japan on one side; China
on the other) to see whether the charges can be resolved through consultations at
the WTO. Those consultations failed to satisfy either side, and in September 2012,
the case went to a dispute settlement panel at the WTO. The Chinese government
appealed to Article XX of the GATT, which allows for an exception to GATT rules
in cases “relating to the conservation of exhaustible natural resources.” But the WTO
ruled against China, who is expected to appeal.
Regardless of the ultimate outcome of that case, it appears that China has already
changed its policies on rare earth minerals. By the end of 2012, China realized that
its policy of export quotas for rare earth minerals was not having the desired effect
of maintaining high world prices. It therefore shifted away from a strict reliance on
export quotas, and introduced subsidies to help producers who were losing money.
These new policies are described in Headlines: China Signals Support for Rare
Earths. The new subsidy policy might also lead to objections from the United States,
the European Union, and Japan. But as we have seen earlier in this chapter, it is more
difficult for the WTO to control subsidies (which are commonly used in agriculture)
than to control export quotas.
A final feature of international trade in rare earth minerals is important to recognize: the mining and processing of these minerals poses an environmental risk,
because rare earth minerals are frequently found with radioactive ores like thorium or uranium. Processing these minerals therefore leads to low-grade radioactive

waste as a by-product. That aspect of rare earth minerals leads to protests against
the establishment of new mines. The Lynas Corporation mine
in Australia, mentioned in the Headlines article, processes the
minerals obtained there in Malaysia. That processing facility was
targeted by protesters in Malaysia, led by a retired math teacher
named Tan Bun Teet. Although Mr. Tan and the other protestors
did not succeed in preventing the processing facility from being
opened, they did delay it and also put pressure on the company to
ensure that the radioactive waste would be exported from Malaysia,
in accordance with that country’s laws. But where will this waste
go? This environmental dilemma arises because of the exploding
worldwide demand for high-tech products (including your own
cell phone), whose manufacturing involves environmental risks.
This case illustrates the potential interaction between international
trade and the environment, a topic we examine in more detail in
the next chapter. ■

Protesters from the Save
Malaysia Stop Lynas group
demonstrating outside a
hotel in Sydney, Australia.

7 High-Technology Export Subsidies
We turn now to consider high-technology final products. This sector of an economy
also receives substantial assistance from government, with examples including subsidies to the aircraft industries in both the United States and Europe. In the United
States, subsidies take the form of low-interest loans provided by the Export-Import

page 351
Feenstra_IntEcon_3e_Ch10.indd 351

1/8/14 10:07 AM


Chapter 12

■

The Global Macroeconomy 417

HEADLINES
Chapter 8

■

Import Tariffs and Quotas Under Perfect Competition 269

Economic Crisis in Iceland

International macroeconomics can often seem like a dry and abstract
subject, but it must be remembered that societies and individuals can be
profoundly shaken by the issues we will study. This article was written
China and the Multifibre Arrangement
just after the start of the severe economic crisis that engulfed Iceland in
One of the founding principles of GATT2008,
was that
countries
should of
not
quotasrate, a financial crisis, and a
following

the collapse
itsuse
exchange
Applications illuminate real-world
to restrict imports (see Article XI of Side Bar:
Key Provisions
theoutput
GATT).
government
fiscal crisis.ofReal
per The
person shrank by more than 10%,
Multifibre Arrangement (MFA), organizedand
under
the auspicesrose
of the
policies,
events,
and empirical evidence.
unemployment
fromGATT
1% to in
9%.1974,
Five years
later a recovery
was just
was a major exception to that principle andbeginning
allowed the
industrial
to take

shape.countries to restrict
imports of textile and apparel products from the developing countries. Importing
“The 550 families we welcome here
small, formerly fishing-based economy
Reykjavik—The
crisis that
brought
countries could join the MFA and arrange
quotas bilaterally
(i.e.,
afterdown
negotiating
represent about 2,700 people, and the
with fast cash.
Iceland’s
economy in
2008 quotas
threw estabwith exporters) or unilaterally (on their own).
In practice,
thelate
import
number keeps going up. And we think
Back then, the biggest worry for many
of ed
formerly
well-off families
lished under the MFA were very detailedthousands
and specifi
the amount
of each textile

it will keep growing until next year, at
poverty, forcing people like Iris to Icelanders was who had the nicest SUV,
and apparel product that each developinginto
country
could sell to countries including
least,” said Asgerdur Jona Flosadottir,
or the most opulent flat.
turn to charity to survive.
Canada, Europe, and the United States.
who manages the Reykjavik food bank.
But today visible signs of poverty
Each week, up to 550 families queue
Although the amount of the quotas was occasionally
revised
upward,
it
did
not
keep
For Iris, the fall came quickly.
up at a small white brick warehouse in are quickly multiplying in the Nordic isup
with
the
increasing
ability
of
new
supplying
countries
to

sell.
Under
the
Uruguay
She is struggling to keep up with payReykjavik to receive free food from the land nation, despite its generous welfare
page 269
Round of WTO negotiations held from 1986
to
1994,
developing
countries
were
able
12 ■ The Global
Macroeconomy
ments on two car loans, which she took out
state, as the
middle class is increasingly
Icelandic Aid to Chapter
Families organisation,
417
to negotiate an end to this system of import
quotas.
expired
January
in foreign currencies on what proved to be
hit 1,
by unemployment, which is up from
three
times The

more MFA
than before
the on
crisis.
2005. The biggest potential supplier of textileRutur
and Jonsson,
apparel products
was retired
China, soone
the
disastrous advice from her bank, and which
to nine per cent in about a year, and
a 65-year-old
have tripled since the kronur’s collapse.
a large number of defaults on mortgages.
mechanical
fellowto other
expiration of the MFA meant that China could
exportengineer,
as muchand
as ithis
wanted
HEADLINES
Threatened in November with eviction
Icelanders who lose their job are initheirindays
distributcountries—or so it thought. The potentialvolunteers
for a hugespend
increase
exports
from China

Headlines
boxes
insights
into
theofglobal
from her
home in the
village
Vogar,
ts worth 70
per offer
milk,developing
bread, eggs countries
and cannedexpected
food tially
posed a problem for many other countries.ing
Some
that entitled to benefi
some 40 kilometres (25 miles) southcent
the amount
by own
businesses
rising exports Crisis
from China
compete donated
with their
exportand
of individuals
apparel items,
onof their wages—but

economy
from
international
media
sources.
Economic
in would
Iceland
west of Reykjavik, she managed to
dwindles fast the longer they are withor bought The
in bulk
at the
supermarket.
which many workers depended for their livelihood.
large
producers
in importing
negotiate a year’s respite with her bank.
“I have
time toabstract
spend on others and out work. Coupled with growing debt,
International
macroeconomics
canwith
oftenthe
seem
like
a dry
countries were
also concerned

potential
riseand
in Chinese exports because it
“I feel very bad and I am very worthat’s and
the best thing I can
thinkbeI can do,” the spike in long-term unemployment is
subject,
butto
it the
mustloss
be of
remembered
that own
societies
could lead
jobs for their
workers individuals
in textiles and apparel.
ried,” she said, running her fingers
heThis
saidarticle
as he was
pre-packed
profoundly shaken by the issues we will study.
writtengrocery bags taking a heavy toll.
full of produce.
Growth
in start
Exports
Immediately

after January
just
after the
of thefrom
severeChina
economic
crisis that engulfed
Iceland1,in2005, exports of
In a small,
close-knit
country
of just
textilesfollowing
and apparel
from China
rapidly.
exports
2008,
the collapse
of its grew
exchange
rate,For
a fiexample,
nancial crisis,
and of
a Chinese tights
317,000by
people,
where
everyone and

knows
and pantyhose
tocrisis.
the European
Union
increased
2,000%
in January
February,
government
fiscal
Real output
per person
shrank
by
more
than
10%,
the stigma of accepting a
as compared
with arose
year
earlier;
ofeveryone,
pullovers
and
jerseyswas
from
China jumped
and

unemployment
from
1% toimports
9%. Five
years
later
a
recovery
just
hand-out is hard to live down and of
nearly 1,000%;
imports of trousers more than tripled. Overall in 2005, China’s
beginning
to takeand
shape.
the dozens of people waiting outside
textile and apparel imports to the United States
rose by more than 40% as compared
the food bank in the snow on a dreary
“The 550 families we welcome here
small,8-12,
formerly
fishing-based
economy
Reykjavik—The
thatas
brought
with the year crisis
before,
showndown

in Figure
where
we include
theonly
top one
20 exportMarch
afternoon,
Iris is the
withwefast
cash.the change in the value represent
Iceland’s
economy
in late 16
2008
page
In threw
panel (a),
show
of textileabout 2,700 people, and the
ers417
to the
U.S. market.
willing
to talk.
number keeps going up. And we think
then,
the biggest
worryfrom
for many
thousands

of formerly
families
and apparel
importswell-off
from each
country.Back
The
of imports
China
“Itsurge
was very
difficult for
me to
come came at
it will keep growing until next year, at
into poverty, forcing people like Iris to Icelanders was who had the nicest SUV,
the expense of some higher-cost exporters,
such
as South
Korea,
and
here
in the
beginning.
But Hong
now I Kong,
try
least,” said Asgerdur Jona Flosadottir,
or the most opulent flat.
turn to charity to survive.

notdeclined
to care so
Taiwan, whose exports to the United States
bymuch
10%anymore,”
to 20%. said the
who manages the Reykjavik food bank.
But today visible signs of poverty
Each week, up to 550 families queue
weary-looking
41-year-old,
whoprices
lost her textiles
In apanel
of Figure
8-12, weinshow
percentage
change
the
Iris, the fall came quickly.
arethe
quickly
multiplying
in theinNordic
is- of For
up at
small(b)
white
brick warehouse
job

in a pharmacy
last summer,
as she
and apparel
products
fromfrom
eachthecountry,
depending
the products
Shewere
is struggling to keep up with payland nation,
despiteon
itswhether
generous welfare
Reykjavik
to receive
free food
wrung
her
hands
nervously.
“constrained
to the MFA
quota
1, 2005. China
hason
the
ments
two car loans, which she took out
state,

as thebefore
middleJanuary
class is increasingly
Icelandic
Aid togoods,”
Familiessubject
organisation,
The
contrast
is
brutal
with
the
oslargest
drop
in prices
fromthe
2004
to 2005,
38%
in the “constrained
in foreign currencies on what proved to be
hit by
unemployment,
which is upgoods”
from categories.
three
times
more
than before

crisis.
tentatious wealth that was on display
Many
countries
also experienced
in their
prices
to theadvice from her bank, and which
disastrous
nine per centfall
in about
a year,
and due
Rutur other
Jonsson,
a 65-year-old
retired one atosubstantial
across the island just two years ago, as Protesters outside the Icelandic parliament in Reykjavik demand that the government do more
have
a large
number
defaults on and
mortgages.
mechanical
engineer,
and18%
his for
fellow
end of the MFA
quota:

Pakistan;
16%
for of
Cambodia;
8% to 9%
fortripled
the since the kronur’s collapse.
a hyperactive banking sector flooded the to improve conditions for the recently poor.
Icelanders
lose their
job are
ini- dueThreatened
volunteers
spend
their days India,
distributPhilippines,
Bangladesh,
Indonesia,
and Sriwho
Lanka.
A drop
in price
to the in November with eviction
Continued on next page
her home in the village of Vogar,
to benefi
ts worth
70 per as from
ing
milk, bread,

and quota
cannedisfood
removal
of the eggs
import
exactlytially
whatentitled
we predict
from
the theory,
we move

APPLICATION

APPLICATIONS

HALLDOR KOLBEINS/AFP/Getty Images

HEADLINES

11/8/13 10:13 AM

9:27 AM

HALLDOR KOLBEINS/AFP/Getty Images

some 40 kilometres (25 miles) southdonated by businesses and individuals cent of their wages—but the amount
west of Reykjavik, she managed to
dwindles fast the longer they are withor bought in bulk at the supermarket.
16 “I have time to spend on others and

negotiate
out work.
Coupled are
with
growing
debt, and
Figure 8-12 and the welfare estimates in the following
paragraphs
from
James Harrigan
Geoffreya year’s respite with her bank.
Barrows,
the Theory
of
Trade the
Policy:
from the
Abrupt End is
of the Multifi
brevery bad and I am very wor“I feel
spikeEvidence
in long-term
unemployment
that’s
the2009,
best “Testing
thing I think
I can
do,”
Available

now:
Arrangement,” The Review of Economics
and Statistics,
vol. 91(2), pp. 282–294.
ried,” she said, running her fingers
he said as he pre-packed grocery bags taking a heavy toll.
full of produce.
International Economics
417
In a small, close-knit country ofFeenstra_IntEcon_3e_Ch12.indd
just
International
Trade
317,000 people, where everyone knows
International
Macroeconomics
everyone, the stigma of accepting
a
hand-out is hard to live downEssentials
and of
of International Economics
the dozens of people waiting outside
the food bank
dreary
For
more information, go to www.worthpublishers.com/economics
Feenstra_IntEcon_3e_Ch08.indd
269 in the snow on a
12/18/13
March afternoon, Iris is the only one

willing to talk.
“It was very difficult for me to come
here in the beginning. But now I try
not to care so much anymore,” said the
weary-looking 41-year-old, who lost her
job in a pharmacy last summer, as she
wrung her hands nervously.
The contrast is brutal with the ostentatious wealth that was on display
across the island just two years ago, as Protesters outside the Icelandic parliament in Reykjavik demand that the government do more
a hyperactive banking sector flooded the to improve conditions for the recently poor.
Continued on next page

Feenstra_IntEcon_3e_Ch12.indd 417

11/8/13 10:13 AM


This page intentionally left blank.


third edition

international
economics


This page intentionally left blank.


third edition

international
economics
ROBERT C. FEENSTRA

ALAN M. TAYLOR

University of California, Davis

University of California, Davis

Worth Publishers
A Macmillan Higher Education Company


Senior Vice President, Editorial and Production: Catherine Woods
Publisher: Charles Linsmeier
Associate Director of Digital Marketing: Scott Guile
Marketing Manager: Tom Digiano
Marketing Assistant: Tess Sanders
Senior Acquisitions Editor: Sarah Dorger
Development Editors: Jane Tufts and Bruce Kaplan
Associate Development Editor: Mary Walsh
Associate Media Editor: Lukia Kliossis
Director of Digital and Print Development: Tracey Kuehn
Associate Managing Editor: Lisa Kinne
Project Editor and Supplements Project Editor: Edgar Bonilla
Senior Designer, Cover and Interior Design: Kevin Kall
Photo Editor: Cecilia Varas
Photo Researchers: Ramon Rivera Moret and Eileen Liang

Production Manager: Barbara Anne Seixas
Supplements Production Manager: Stacey Alexander
Composition, Layout Designer, and Graphics: TSI Graphics
Printing and Binding: RR Donnelley
Cover Photo Credits: © Ocean/Corbis
Library of Congress Control Number: 2013957830
ISBN-13: 978-1-4292-7842-3
ISBN-10: 1-4292-7842-0
© 2014, 2008, 2012 by Worth Publishers
All rights reserved.
Printed in the United States of America
First printing
Worth Publishers
41 Madison Avenue
New York, NY 10010
www.worthpublishers.com


Bud Harmon

About the Authors

Robert C. Feenstra

and Alan M. Taylor
are Professors of Economics at the University of
California, Davis. They each began their studies
abroad: Feenstra received his B.A. in 1977 from
the University of British Columbia, Canada, and
Taylor received his B.A. in 1987 from King’s College,

Cambridge, U.K. They trained as professional economists in the United States, where Feenstra earned his
Ph.D. in economics from the Massachusetts Institute
of Technology in 1981 and Taylor earned his Ph.D. in
economics from Harvard University in 1992. Feenstra
has been teaching international trade at the undergraduate and graduate levels at UC Davis since 1986,
where he holds the C. Bryan Cameron Distinguished
Chair in International Economics. Taylor teaches
international macroeconomics, growth, and economic
history at UC Davis, where he also holds appointments as Director of the Center for the Evolution of
the Global Economy and Professor of Finance in the
Graduate School of Management.
Both Feenstra and Taylor are active in research and
policy discussions in international economics. They are

research associates of the National Bureau of Economic
Research, where Feenstra directs the International
Trade and Investment research program. They have
both published graduate level books in international
economics: Offshoring in the Global Economy and Product
Variety and the Gains from Trade (MIT Press, 2010),
by Robert C. Feenstra, and Global Capital Markets:
Integration, Crisis and Growth (Cambridge University
Press, 2004), by Maurice Obstfeld and Alan M. Taylor.
Feenstra received the Bernhard Harms Prize from
the Institute for World Economics, Kiel, Germany,
in 2006, and delivered the Ohlin Lectures at the
Stockholm School of Economics in 2008. Taylor was
awarded a Guggenheim Fellowship in 2004 and was
awarded a Houblon-Norman/George Fellowship by
the Bank of England in 2009–10.

Feenstra lives in Davis, California, with his wife,
Gail, and has two grown children: Heather, who is
a genetics counselor; and Evan, who is a musician
and entrepreneur. Taylor also lives in Davis, with his
wife, Claire, and has two young children, Olivia and
Sebastian.
v

�


To our parents


Brief Contents
PART 1 Introduction to International Trade
Chapter 1 Trade in the Global Economy  1

PART 2 Patterns of International Trade
Chapter 2 Trade and Technology: The Ricardian

Model 27

PART 5 Introduction to International
Macroeconomics
Chapter 12 The Global Macroeconomy  411

PART 6 Exchange Rates
Chapter 13 Introduction to Exchange Rates and

the Foreign Exchange Market  435

Chapter 3 Gains and Losses from Trade in the

Specific-Factors Model  59

Chapter 14 Exchange Rates I: The Monetary

Approach in the Long Run  473

Chapter 4 Trade and Resources: The

Heckscher-Ohlin Model  87

Chapter 15 Exchange Rates II: The Asset

Approach in the Short Run  521

Chapter 5 Movement of Labor and Capital

between Countries  123

PART 3New Explanations for International
Trade

PART 7 The Balance of Payments
Chapter 16 National and International Accounts:

Income, Wealth, and the Balance of
Payments 567

Chapter 6 Increasing Returns to Scale and

Monopolistic Competition  165

Chapter 17 Balance of Payments I: The Gains

from Financial Globalization  609

Chapter 7 Offshoring of Goods and

Services 197

Chapter 18 Balance of Payments II: Output,

Exchange Rates, and Macroeconomic
Policies in the Short Run  663

PART 4 International Trade Policies
Chapter 8 Import Tariffs and Quotas Under

Perfect Competition  233
Chapter 9 Import Tariffs and Quotas Under

PART 8 Applications and Policy Issues
Chapter 19 Fixed Versus Floating: International

Monetary Experience  715

Imperfect Competition  279

Chapter 10 Export Subsidies in Agriculture and

Chapter 20 Exchange Rate Crises: How Pegs

Work and How They Break  757

High-Technology Industries  327
Chapter 11 International Agreements: Trade,

Labor, and the Environment  367

Chapter 21 The Euro  811
Chapter 22 Topics in International

Macroeconomics 859


IndexI-1

vii

�


Contents
Preface xxvi

PART 1

Introduction to

International Trade

CHAPTER 1Trade in the Global Economy  1
1 International Trade  3
The Basics of World Trade  3
HEADLINES Sum of iPhone Parts: Trade Distortion  5
APPLICATION  Is Trade Today Different from the Past?  5
Map of World Trade  7
Trade Compared with GDP  11
Barriers to Trade  12
“First Golden Age” of Trade  12
“Second Golden Age” of Trade  14
HEADLINES A Sea Change in Shipping 50 Years Ago  15

2 Migration and Foreign Direct Investment  16
Map of Migration  16
Map of Foreign Direct Investment  19

3Conclusions 23
Key Points, Key Terms, and Problems

PART 2

Patterns of
International Trade

CHAPTER 2Trade and Technology: The Ricardian Model  27
1 Reasons for Trade  29
Proximity 29
Resources 30

Absolute Advantage  30
SIDE BAR  Can Comparative Advantage Be Created? The Case
of “Icewine”  31
Comparative Advantage  32
SIDE BAR  David Ricardo and Mercantilism  32

2 Ricardian Model  33
The Home Country  33
The Foreign Country  37

�

viii


CONTENTS  ix

APPLICATION Comparative Advantage in Apparel, Textiles, and
Wheat 38

3 Determining the Pattern of International Trade  40
International Trade Equilibrium  41
APPLICATION  Labor Productivity and Wages  46

4 Solving for International Prices  47
Home Export Supply Curve  47
International Trade Equilibrium  51
APPLICATION  The Terms of Trade for Primary Commodities  52

5Conclusions 53

Key Points, Key Terms, and Problems

CHAPTER 3Gains and Losses from Trade in the Specific-Factors
Model 59
1 Specific-Factors Model  61
The Home Country  61
The Foreign Country  64
Overall Gains from Trade  64
APPLICATION  How Large Are the Gains from Trade?  65

2 Earnings of Labor  66
Determination of Wages  66
Change in Relative Price of Manufactures  68
APPLICATION  Manufacturing and Services in the United States:
Employment and Wages across Sectors  71
APPLICATION  Trade Adjustment Assistance Programs: Financing the
Adjustment Costs of Trade  73

3 Earnings of Capital and Land  74
Determining the Payments to Capital and Land  74
HEADLINES Services Workers Are Now Eligible for Trade
Adjustment Assistance  75
Numerical Example  77
What It All Means  80
APPLICATION  Prices in Agriculture  80

4Conclusions 82
HEADLINES Rise in Coffee Prices—Great for Farmers,
Tough on Co-ops  83
Key Points, Key Terms, and Problems

x CONTENTS

CHAPTER 4Trade and Resources: The Heckscher-Ohlin
Model 87
1 Heckscher-Ohlin Model  88
Assumptions of the Heckscher-Ohlin Model  89
APPLICATION  Are Factor Intensities the Same Across Countries?  91
No-Trade Equilibrium  92
Free-Trade Equilibrium  94

2 Testing the Heckscher-Ohlin Model  98
Leontief’s Paradox  99
Factor Endowments in 2010  100
Differing Productivities across Countries  102
HEADLINES China Drawing High-Tech Research from
U.S. 105
Leontief’s Paradox Once Again  107

3 Effects of Trade on Factor Prices  110
Effect of Trade on the Wage and Rental of Home  110
Determination of the Real Wage and Real Rental  113
Changes in the Real Wage and Rental: A Numerical Example  115
APPLICATION  Opinions toward Free Trade  117

4Conclusions 119
Key Points, Key Terms, and Problems

CHAPTER 5Movement of Labor and Capital Between

Countries 123
1 Movement of Labor between Countries: Migration  125
Effects of Immigration in the Short Run: Specific-Factors
Model 125
APPLICATION  Immigration to the New World  128
APPLICATION  Immigration to the United States and Europe
Today 129
HEADLINES Call for Return of Border Controls in Europe  130
HEADLINES The Economic Windfall of Immigration
Reform 131
Other Effects of Immigration in the Short Run  133
Effects of Immigration in the Long Run  134
Rybczynski Theorem  139
Factor Price Insensitivity Theorem  140
APPLICATION  The Effects of the Mariel Boat Lift on Industry
Output in Miami  140
APPLICATION  Immigration and U.S. Wages, 1990–2006  142


CONTENTS  xi

2Movement of Capital between Countries: Foreign Direct
Investment 144
Greenfield Investment  145
FDI in the Short Run: Specific-Factors Model  145
FDI in the Long Run  147
APPLICATION  The Effect of FDI on Rentals and Wages in
Singapore 149

3 Gains from Labor and Capital Flows  151

HEADLINES The Myth of Asia’s Miracle  151
Gains from Immigration  152
SIDE BAR  Immigrants and Their Remittances  155
APPLICATION  Gains from Migration  156
Gains from Foreign Direct Investment  159

4Conclusions 160
Key Points, Key Terms, and Problems

CHAPTER 6Increasing Returns to Scale and Monopolistic
Competition 165
1 Basics of Imperfect Competition  168
Monopoly Equilibrium  168
Demand with Duopoly  169

2 Trade Under Monopolistic Competition  170
Equilibrium without Trade  172
Equilibrium with Free Trade  174

3 The North American Free Trade Agreement  178
Gains and Adjustment Costs for Canada Under NAFTA  178
HEADLINES The Long and the Short of the Canada-U.S. Free
Trade Agreement  179
Gains and Adjustment Costs for Mexico Under NAFTA  179
HEADLINES NAFTA Turns 15, Bravo!  180
HEADLINES Nearly 20 Years After NAFTA, First Mexican Truck
Arrives In U.S. Interior  181
Gains and Adjustment Costs for the United States Under NAFTA  184

4 Intra-Industry Trade and the Gravity Equation  187

Index of Intra-Industry Trade  188
The Gravity Equation  189
APPLICATION  The Gravity Equation for Canada and the United
States 190

5Conclusions 193
Key Points, Key Terms, and Problems

PART 3 

New Explanations
for International
Trade


xii CONTENTS

CHAPTER 7Offshoring of Goods and Services  197
SIDE BAR  ”Foreign Outsourcing” Versus “Offshoring”  199

1 A Model of Offshoring  200
Value Chain of Activities  200
Changing the Costs of Trade  203
APPLICATION  Change in Relative Wages Across Countries  205
Change in Relative Wages in the United States  206
Change in Relative Wages in Mexico  211

2 The Gains from Offshoring  212
Simplified Offshoring Model  213
Production in the Absence of Offshoring  213

Terms of Trade  216
APPLICATION  U.S. Terms of Trade and Service Exports  219

3 The Politics and Future of Offshoring  222
HEADLINES How to Destroy American Jobs  224
HEADLINES Caterpillar Joins “Onshoring” Trend  225
The Future of U.S. Comparative Advantage  225

4Conclusions 226
Key Points, Key Terms, and Problems

­­­­PART 4

International Trade
Policies

CHAPTER 8Import Tariffs and Quotas Under Perfect
Competition 233
1 A Brief History of the World Trade Organization  235
2 The Gains from Trade  236
Consumer and Producer Surplus  236
SIDE BAR  Key Provisions of the GATT  237
Home Welfare  239
Home Import Demand Curve  241

3 Import Tariffs for a Small Country  242
Free Trade for a Small Country  242
Effect of the Tariff  242
Why and How Are Tariffs Applied?  246
SIDE BAR Safeguard Tariffs 247

APPLICATION  U.S. Tariffs on Steel and Tires  248

4 Import Tariffs for a Large Country  256
Foreign Export Supply  256
Effect of the Tariff  257


CONTENTS  xiii

APPLICATION  U.S. Tariffs on Steel Once Again  261

5 Import Quotas  263
Import Quota in a Small Country  263
HEADLINES Banana Wars  265
HEADLINES Sugar Could Sweeten U.S. Australia Trans-Pacific
Trade Talks  266
APPLICATION  China and the Multifibre Arrangement  269

6Conclusions  272
Key Points, Key Terms, and Problems

CHAPTER 9Import Tariffs and Quotas Under Imperfect
Competition 279
1 Tariffs and Quotas with Home Monopoly  281
No-Trade Equilibrium  282
Free-Trade Equilibrium  283
Effect of a Home Tariff  284
Effect of a Home Quota  286
APPLICATION  U.S. Imports of Japanese Automobiles  288

2 Tariffs with Foreign Monopoly  291
Foreign Monopoly  291
APPLICATION  Import Tariffs on Japanese Trucks  293
HEADLINES The Chickens Have Come Home to Roost  295

3Dumping  296
Numerical Example of Dumping  298

4 Policy Response to Dumping  298
Antidumping Duties  299
APPLICATION  United States Imports of Solar Panels from
China 299
APPLICATION  Antidumping Duties Versus Safeguard Tariffs  302

5 Infant Industry Protection  304
Free-Trade Equilibrium  306
Tariff Equilibrium  306
APPLICATION  Examples of Infant Industry Protection  308
Government Policies in the Solar Panel Industry  308
U.S. Tariff on Heavyweight Motorcycles  310
HEADLINES Solar Flares  310
Computers in Brazil  314
Protecting the Automobile Industry in China  316


xiv CONTENTS

HEADLINES Milestone for China Car Output  316
HEADLINES Shanghai Tie-Up Drives Profits for GM  318

6Conclusions  320
Key Points, Key Terms, and Problems

CHAPTER 10Export Subsidies in Agriculture and HighTechnology Industries  327
1 WTO Goals on Agricultural Export Subsidies  329
Agricultural Export Subsidies  329
Other Matters from the Hong Kong WTO Meeting  330

2 Export Subsidies in a Small Home Country  331
Impact of an Export Subsidy  332

3 Export Subsidies in a Large Home Country  334
Effect of the Subsidy  334
APPLICATION  Who Gains and Who Loses?  336
HEADLINES G8 Shifts Focus from Food Aid to
Farming 339
HEADLINES Hunger and Food Security Back on Political
Agenda 340

4 Production Subsidies  340
Effect of a Production Subsidy in a Small Home Country  341
Effect of the Production Subsidy in a Large Home Country  343

5 Export Tariffs  343
Impact of an Export Tariff in a Small Country  344
Impact of an Export Tariff in a Large Country  345

6 Export Quotas  347
APPLICATION  Chinese Export Policies in Mineral Products  349

7 High-Technology Export Subsidies  351
HEADLINES China Signals Support for Rare Earths  352
“Strategic” Use of High-Tech Export Subsidies  352
Effect of a Subsidy to Airbus  355
Subsidy with Cost Advantage for Boeing  357
APPLICATION Subsidies to Commercial Aircraft  358

8Conclusions 361
HEADLINES EU Seeks $12 billion from US over Boeing
Aid 362
Key Points, Key Terms, and Problems


CONTENTS  xv

CHAPTER 11International Agreements: Trade, Labor,
and the Environment  367
1 International Trade Agreements  370
The Logic of Multilateral Trade Agreements  370
Regional Trade Agreements  373
Trade Creation and Trade Diversion  375
Numerical Example of Trade Creation and Diversion  375
HEADLINES China-ASEAN Treaty Threatens Indian
Exporters 376
Trade Diversion in a Graph  377
APPLICATION  Trade Creation and Diversion for Canada  380

2 International Agreements on Labor Issues  380
Labor Side Agreement Under NAFTA  381
Other Labor Agreements  382

HEADLINES Wal-Mart Orders Chinese Suppliers to Lift
Standards 384
HEADLINES American Tariffs, Bangladeshi Deaths  386
HEADLINES U.S. Suspends Bangladesh’s Preferential Trade
Status 387

3 International Agreements on the Environment  388
Environmental Issues in the GATT and WTO  388
Does Trade Help or Harm the Environment?  391
Examples of the Environmental Impact of Trade  394
The Tragedy of the Commons  396
International Agreements on Pollution  400
APPLICATION The Kyoto Protocol and the Copenhagen Accord  402

4 Conclusions 404
HEADLINES Dismal Outcome at Copenhagen Fiasco  405
Key Points, Key Terms, and Problems

CHAPTER 12The Global Macroeconomy  411
1 Foreign Exchange: Currencies and Crises  412
How Exchange Rates Behave  413
Why Exchange Rates Matter  414
When Exchange Rates Misbehave  415
Summary and Plan of Study  416
HEADLINES Economic Crisis in Iceland  417

2 Globalization of Finance: Debts and Deficits  418
Deficits and Surpluses: The Balance of Payments  418
Debtors and Creditors: External Wealth  421

PART 5 

Introduction to
International
Macroeconomics


xvi CONTENTS

Darlings and Deadbeats: Defaults and Other Risks  422
Summary and Plan of Study  423

3 Government and Institutions: Policies and Performance  424
Integration and Capital Controls: The Regulation of International
Finance 424
Independence and Monetary Policy: The Choice of Exchange Rate
Regimes 426
Institutions and Economic Performance: The Quality of Governance  427
Summary and Plan of Study  429
HEADLINES The Wealth of Nations  429

4 Conclusions 431
Key Points, Key Terms, and Problems

PART 6

Exchange Rates

CHAPTER 13Introduction to Exchange Rates and the Foreign
Exchange Market  435

1 Exchange Rate Essentials  436
Defining the Exchange Rate  436
Appreciations and Depreciations  438
Multilateral Exchange Rates  440
Example: Using Exchange Rates to Compare Prices in a Common
Currency 441

2 Exchange Rates in Practice  443
Exchange Rate Regimes: Fixed Versus Floating  443
APPLICATION  Recent Exchange Rate Experiences  444

3 The Market for Foreign Exchange  449
The Spot Contract  449
Transaction Costs  450
Derivatives 450
APPLICATION  Foreign Exchange Derivatives  451
Private Actors  452
Government Actions  452

4 Arbitrage and Spot Exchange Rates  453
Arbitrage with Two Currencies  454
Arbitrage with Three Currencies  455
Cross Rates and Vehicle Currencies  456

5 Arbitrage and Interest Rates  457
Riskless Arbitrage: Covered Interest Parity  457
APPLICATION  Evidence on Covered Interest Parity  459
Risky Arbitrage: Uncovered Interest Parity  460

CONTENTS  xvii

SIDE BAR  Assets and Their Attributes  461
APPLICATION  Evidence on Uncovered Interest Parity  463
Uncovered Interest Parity: A Useful Approximation  464
Summary 466

6 Conclusions 466
Key Points, Key Terms, and Problems

CHAPTER 14 Exchange Rates I: The Monetary Approach in
the Long Run  473
1 Exchange Rates and Prices in the Long Run: Purchasing Power
Parity and Goods Market Equilibrium  474
The Law of One Price  475
Purchasing Power Parity  476
The Real Exchange Rate  477
Absolute PPP and the Real Exchange Rate  477
Absolute PPP, Prices, and the Nominal Exchange Rate  478
Relative PPP, Inflation, and Exchange Rate Depreciation  478
Summary 480
APPLICATION  Evidence for PPP in the Long Run and
Short Run  480
How Slow Is Convergence to PPP?  481
What Explains Deviations from PPP?  482
SIDE BAR  Forecasting When the Real Exchange Rate Is
Undervalued or Overvalued  483
HEADLINES The Big Mac Index  484

2 Money, Prices, and Exchange Rates in the Long Run: Money

Market Equilibrium in a Simple Model  486
What Is Money?  486
The Measurement of Money  486
The Supply of Money  487
The Demand for Money: A Simple Model  488
Equilibrium in the Money Market  489
A Simple Monetary Model of Prices  489
A Simple Monetary Model of the Exchange Rate  490
Money Growth, Inflation, and Depreciation  491

3 The Monetary Approach: Implications and Evidence  492
Exchange Rate Forecasts Using the Simple Model  492
APPLICATION  Evidence for the Monetary Approach  495
APPLICATION Hyperinflations 496
SIDE BAR Currency Reform 497


xviii CONTENTS

4 Money, Interest Rates, and Prices in the Long Run:
A General Model  499
HEADLINES The First Hyperinflation of the Twenty-First
Century 500
The Demand for Money: The General Model  500
Long-Run Equilibrium in the Money Market  501
Inflation and Interest Rates in the Long Run  502
The Fisher Effect  503
Real Interest Parity  504
APPLICATION  Evidence on the Fisher Effect  505
The Fundamental Equation Under the General Model  506

Exchange Rate Forecasts Using the General Model  507

5 Monetary Regimes and Exchange Rate Regimes  509
The Long Run: The Nominal Anchor 510
APPLICATION  Nominal Anchors in Theory and Practice 512

6 Conclusions 514
Key Points, Key Terms, and Problems

CHAPTER 15 Exchange Rates II: The Asset Approach in the
Short Run 521
1 Exchange Rates and Interest Rates in the Short Run:
UIP and FX Market Equilibrium  522
Risky Arbitrage  522
Equilibrium in the FX Market: An Example  524
Adjustment to Forex Market Equilibrium  525
Changes in Domestic and Foreign Returns and FX Market Equilibrium  526
Summary 528

2 Interest Rates in the Short Run: Money Market Equilibrium  528
Money Market Equilibrium in the Short Run: How Nominal Interest Rates
Are Determined  528
Money Market Equilibrium in the Short Run: Graphical Solution  530
Adjustment to Money Market Equilibrium in the Short Run  530
Another Building Block: Short-Run Money Market Equilibrium  531
Changes in Money Supply and the Nominal Interest Rate  531
APPLICATION  Can Central Banks Always Control the Interest Rate?
A Lesson from the Crisis of 2008–2009  533
Changes in Real Income and the Nominal Interest Rate  534
The Monetary Model: The Short Run Versus the Long Run  534

3 The Asset Approach: Applications and Evidence  535
The Asset Approach to Exchange Rates: Graphical Solution  535


CONTENTS  xix

Short-Run Policy Analysis  537
APPLICATION  The Rise and Fall of the Dollar, 1999–2004  540

4 A Complete Theory: Unifying the Monetary and
Asset Approaches  541
Long-Run Policy Analysis 542
SIDE BAR  Confessions of a Foreign Exchange Trader  544
Overshooting 548
SIDE BAR  Overshooting in Practice  550

5 Fixed Exchange Rates and the Trilemma  551
What Is a Fixed Exchange Rate Regime?  551
Pegging Sacrifices Monetary Policy Autonomy in the Short Run:
Example 551
Pegging Sacrifices Monetary Policy Autonomy in the Long Run:
Example 553
The Trilemma  554
SIDE BAR  Intermediate Regimes 556
APPLICATION  The Trilemma in Europe 557

6 Conclusions 558
APPLICATION  News and the Foreign Exchange Market in
Wartime 558

Key Points, Key Terms, and Problems

CHAPTER 16 National and International Accounts: Income,
Wealth, and the Balance of Payments  567
1 Measuring Macroeconomic Activity: An Overview  568
The Flow of Payments in a Closed Economy: Introducing the National
Income and Product Accounts  568
The Flow of Payments in an Open Economy: Incorporating the Balance of
Payments Accounts  570

2 Income, Product, and Expenditure  573
Three Approaches to Measuring Economic Activity  573
From GNE to GDP: Accounting for Trade in Goods and Services  573
From GDP to GNI: Accounting for Trade in Factor Services  574
APPLICATION  Celtic Tiger or Tortoise?  575
From GNI to GNDI: Accounting for Transfers of Income  577
What the National Economic Aggregates Tell Us  578
HEADLINES Are Rich Countries “Stingy” with Foreign
Aid? 579
Understanding the Data for the National Economic Aggregates  580
What the Current Account Tells Us  582

PART 7

The Balance of
Payments


xx CONTENTS

APPLICATION Global Imbalances 583

3 The Balance of Payments  588
Accounting for Asset Transactions: The Financial Account  588
Accounting for Asset Transactions: The Capital Account  588
Accounting for Home and Foreign Assets  589
How the Balance of Payments Accounts Work: A Macroeconomic
View 590
How the Balance of Payments Accounts Work: A Microeconomic
View 591
SIDE BAR  The Double-Entry Principle in the Balance of
Payments 592
Understanding the Data for the Balance of Payments Account  593
What the Balance of Payments Account Tells Us  595

4 External Wealth  596
The Level of External Wealth  597
Changes in External Wealth  597
Understanding the Data on External Wealth  599
What External Wealth Tells Us  601

5 Conclusions 601
SIDE BAR  Beware of Greeks Bearing Statistics  601
Key Points, Key Terms, and Problems

Appendix to Chapter 16  607

CHAPTER 17 Balance of Payments I: The Gains from Financial
Globalization 609
1 The Limits on How Much a Country Can Borrow: The Long-Run

Budget Constraint  611
How The Long-Run Budget Constraint Is Determined  612
The Budget Constraint in a Two-Period Example  613
A Long-Run Example: The Perpetual Loan  615
Implications of the LRBC for Gross National Expenditure and Gross
Domestic Product  616
Summary 617
APPLICATION  The Favorable Situation of the United States  617
APPLICATION  The Difficult Situation of the Emerging Markets  620

2 Gains from Consumption Smoothing  622
The Basic Model  623
Consumption Smoothing: A Numerical Example and Generalization  623
Summary: Save for a Rainy Day  627