Contents
1 Introduction 1
Learning objectives 1
Why international economics is a separate field 7
The organization of this volume 8
Information about international economics 10
Summary of key concepts 12
Questions for study and review 13
Suggested further reading 13
PART ONE
International trade and trade policy 15
2 Patterns of trade and the gains from trade: insights from classical theory 17
Learning objectives 17
Absolute advantage 17
Comparative advantage 19
Additional tools of analysis 22
International trade with constant costs 27
International trade with increasing costs 32
The effect of trade 35
The division of the gains from trade 36
Comparative advantage with many goods 41
Summary of key concepts 44
Questions for study and review 45
Suggested further reading 47
Appendix: the role of money prices 47
Notes 49
3 Trade between dissimilar countries: insights from the factor
proportions theory 51
Learning objectives 51
Factor proportions as a determinant of trade 52
Implications of the factor proportions theory 55
Empirical verification in a world with many goods 68
Summary of key concepts 70
Questions for study and review 71
Suggested further reading 72
Appendix: a more formal presentation of the Heckscher–Ohlin model with
two countries, two commodities, and two factors 73
Notes 80
4 Trade between similar countries: implications of decreasing costs and
imperfect competition 82
Learning objectives 82
External economies of scale 84
The product cycle 89
Preference similarities and intra-industry trade 91
Economies of scale and monopolistic competition 94
Trade with other forms of imperfect competition 97
Cartels 101
Further aspects of trade with imperfect competition 103
Summary of key concepts 104
Questions for study and review 105
Suggested further reading 106
Appendix: derivation of a reaction curve 106
Notes 107
5 The theory of protection: tariffs and other barriers to trade 109
Learning objectives 109
Administrative issues in imposing tariffs 110
Tariffs in a partial equilibrium framework 111
Quotas and other nontariff trade barriers 116
Production subsidies 122
Tariffs in the large-country case 123
General equilibrium analysis 124
The effective rate of protection 127
Export subsidies 132
Export tariffs 134
Summary of key concepts 135
Questions for study and review 137
Suggested further reading 138
Notes 138
6 Arguments for protection and the political economy of trade policy 140
Learning objectives 140
Arguments for restricting imports 141
Dumping 154
Secondary arguments for protectionism 158
The political economy of trade policy 161
Summary of key concepts 163
Questions for study and review 164
Suggested further reading 165
Notes 165
7 Regional blocs: preferential trade liberalization 167
Learning objectives 167
Alternative forms of regional liberalization 168
Efficiency gains and losses: the general case 168
Efficiency gains and losses with economies of scale 171
Dynamic effects and other sources of gain 172
The European Union 173
NAFTA 177
Other regional groups 181
Summary of key concepts 181
Questions for study and review 182
Suggested further reading 182
Notes 182
8 Commercial policy: history and recent controversies 184
Learning objectives 184
British leadership in commercial policy 184
A US initiative: the Reciprocal Trade Agreements program 186
The shift to multilateralism under the GATT 187
The Kennedy Round 189
The Tokyo Round 190
The Uruguay Round 191
Intellectual property 197
The rocky road to further multilateral agreements 199
The Doha Development Agenda 200
Expanding the World Trade Organization 200
Summary of key concepts 202
Questions for study and review 202
Suggested further reading 203
Notes 203
9 International mobility of labor and capital 205
Learning objectives 205
Arbitrage in labor and capital markets 206
Additional issues raised by labor mobility 210
Multinational corporations 212
Summary of key concepts 220
Questions for study and review 221
Suggested further reading 221
Notes 221
10 Trade and growth 223
Learning objectives 223
The effects of economic growth on trade 224
Trade policies in developing countries 231
Primary-product exporters 233
Deteriorating terms of trade 235
Alternative trade policies for developing countries 236
Summary of key concepts 239
Questions for study and review 240
Suggested further reading 241
Notes 241
11 Issues of international public economics 242
Learning objectives 242
Environmental externalities 244
The tragedy of the commons 249
Taxation in an open economy 251
Summary of key concepts 259
Questions for study and review 260
Suggested further reading 261
Notes 261
PART TWO
International finance and open economy macroeconomics 263
12 Balance-of-payments accounting 267
Learning objectives 267
Distinguishing debits and credits in the accounts 268
Analogy to a family’s cash-flow accounts 271
Calculation of errors and omissions 273
Organizing the accounts for a country with a fixed exchange rate 274
Balance-of-payments accounting with flexible exchange rates 280
The international investment position table 281
Trade account imbalances through stages of development 285
Intertemporal trade 288
Summary of key concepts 290
Questions for study and review 291
Suggested further reading 291
Notes 292
13 Markets for foreign exchange 293
Learning objectives 293
Supply and demand for foreign exchange 294
Exchange market intervention regimes 295
Exchange market institutions 300
Alternative definitions of exchange rates 302
Alternative views of equilibrium nominal exchange rates 307
Summary of key concepts 308
Questions for study and review 309
Suggested further reading 309
Notes 310
14 International derivatives: foreign exchange forwards, futures, and options 312
Learning objectives 312
Forward exchange markets 312
Foreign exchange options 321
Other international derivatives 325
Summary of key concepts 326
Questions for study and review 327
Suggested further reading 328
Notes 328
15 Alternative models of balance-of-payments or exchange-rate determination 329
Learning objectives 329
Why the balance of payments (or the exchange rate) matters 331
Alternative views of balance-of-payments (or exchange rate) determination 334
Exchange rates and the balance of payments: theory versus reality 348
Summary of key concepts 349
Questions for study and review 350
Suggested further reading 350
Notes 351
16 Payments adjustment with fixed exchange rates 352
Learning objectives 352
David Hume’s specie flow mechanism 352
The Bretton Woods adjustment mechanism: Fiscal and monetary policies 364
The policy assignment model: one last hope for fixed exchange rates 369
Macroeconomic policy coordination 373
Summary of key concepts 374
Questions for study and review 375
Suggested further reading 375
Notes 376
17 Balance-of-payments adjustment through exchange rate changes 377
Learning objectives 377
A return to supply and demand 377
Requirements for a successful devaluation 379
Effects of the exchange rate on the capital account 391
Capital losses and other undesirable effects of a devaluation 392
A brief consideration of revaluations 396
The Meade cases again 396
Summary of key concepts 399
Questions for study and review 399
Suggested further reading 400
Notes 401
18 Open economy macroeconomics with fixed exchange rates 403
Learning objectives 403
The Keynesian model in a closed economy 404
An open economy 410
The international transmission of business cycles 415
Foreign repercussions 416
Some qualifications 417
Capital flows, monetary policy, and fiscal policy 418
Domestic macroeconomic impacts of foreign shocks 425
Domestic impacts of monetary policy shifts abroad 426
Conclusion 427
Summary of key concepts 427
Questions for study and review 428
Suggested further reading 428
Notes 429
19 The theory of flexible exchange rates 430
Learning objectives 430
Clean versus managed floating exchange rates 431
The stability of the exchange market 432
Impacts of flexible exchange rates on international transactions 433
Open economy macroeconomics with a floating exchange rate 434
The domestic impacts of foreign monetary and fiscal policy shifts with
flexible exchange rates 447
Mercantilism and flexible exchange rates 449
Purchasing power parity and flexible exchange rates 451
Summary of key concepts 452
Questions for study and review 453
Notes 454
20 The international monetary system: history and current controversies 455
Learning objectives 455
Events before 1973 456
The Eurocurrency market 459
Floating exchange rates 465
Alternatives to flexible exchange rates 471
The European Monetary Union 473
Changes in the role of the SDR 478
Two decades of developing country debt crises 478
The new financial architecture 486
Sovereign bankruptcy for heavily indebted crisis countries 488
Prospective issues in international economic policy in the next decade 489
Summary of key concepts 491
Questions for study and review 492
Suggested further reading 493
Notes 494
Glossary 496
Index 510
Preface
This book is an introduction to international economics, intended for students who are
taking their first course in the subject. The level of exposition requires as a background no
more than a standard introductory course in the principles of economics. Those who have
had intermediate micro and macro theory will find that background useful, but where the
tools of intermediate theory are necessary in this book they are taught within the text.
The primary purpose of this book is to present a clear, straightforward, and current
account of the main topics in international economics. We have tried to keep the student’s
perspective constantly in mind and to make the explanations both intuitively appealing and
rigorous.
Reactions from users of the first five editions – both students and faculty – have been
encouraging. The passage of time, however, erodes the usefulness of a book in a constantly
evolving area such as international economics, and we have consequently prepared a sixth
edition.
The book covers the standard topics in international economics. Each of the two main
parts, International Trade and Trade Policy (Part One) and International Finance and Open
Economy Macroeconomics (Part Two), develops the theory first, and then applies it to
recent policy issues and historical episodes. This approach reflects our belief that economic
theory should be what J.R. Hicks called “a handmaiden to economic policy.”
Whenever possible, we use economic theory to explain and interpret experience. That is
why this book contains more discussion of historical episodes than do most other international
economics textbooks. The historical experience is used as the basis for showing how
the theoretical analysis works. We have found that students generally appreciate this
approach.
This is the second edition of this book with John Mutti as co-author and with Routledge
as the publisher. John Mutti replaced James Ingram, who is now Emeritus at the University
of North Carolina, Chapel Hill, who authored the first two editions alone, and who coauthored
the next two with Robert Dunn. Both authors of this edition would like to express
their great appreciation for the help which Jim Ingram provided, including his permission
to carry over some material which he wrote for previous editions. It would have been
impossible to continue this project without Jim’s help, and his spirit and many of his
concepts remain central to the book.
Changes in the coverage of international trade
In the first half of the book some important changes in the presentation of conceptual
in commercial policy and multilateral trade negotiations. Chapter 3 pays greater attention
material should be noted, in addition to the inclusion of several more recent developments
to common extensions of the Heckscher–Ohlin framework for analyzing patterns of trade.
It gives a more systematic presentation of the effects on patterns of production from growth
in factor endowments, and it addresses the conditions for factor price equalization more
formally. Chapter 5 extends the analysis of tariffs to consider tariff escalation and tariff-rate
quotas, and it assesses US safeguard protection in the steel industry and EU export subsidies
for sugar.
Following the treatment of arguments for protection in Chapter 6, the order of the next
three chapters changes. Chapter 7 now presents the analysis of regional trade blocs. The
decision of the European Union in 2002 to offer membership to ten additional countries
raises several important issues of governance and economic policy that are discussed there.
With respect to the North American Free Trade Agreement, because a longer time frame
is available to observe the consequences of its creation, the scope of adjustments faced by
US industries is put in better perspective. Chapter 8 now reviews world commercial policy.
It especially notes significant issues that arose in initiating the Doha Development Round
of multilateral trade talks in 2001, and it notes others that will be addressed in the negotiations.
Chapter 9 now covers issues of capital mobility, immigration, and multinational
corporations.
Chapter 10 on trade and growth pays particular attention to the position of the least
developed countries. Chapter 11, which discusses issues of public economics, notes the
advance of the Kyoto Protocol to the Climate Change Convention, in spite of US
opposition, and the success of the Irish in international tax competition.
Changes in the discussion of international finance and open economy
macroeconomics
First, all graphs and tables have been updated to what was available in early 2003. Within
Chapter 12, the coverage of intertemporal trade has been moved forward from an appendix
into the main text. The discussion of what assets constitute foreign exchange reserves has
been extended, and the discussion of the IMF format for the balance of payments accounts
made more thorough. In Chapter 13 the discussion of various means of evading exchange
controls has been made far more complete, and now includes a discussion of hawala banking.
The fact that all of these techniques are relevant for criminal or terrorist groups which wish
to move money in undetected ways, makes this topic of greater importance than it was before
September 11, 2001.
In Chapter 14 the discussion of foreign exchange options, which some readers found to
be confusing, has been rewritten and extended, with an emphasis on intrinsic and time
values in determining premiums on foreign exchanged puts and calls. In Chapter 16, the
treatment of currency boards has been extended, with an emphasis on why Argentina’s
institution failed. Dollarization is also covered more thoroughly. Chapter 17 now includes
far more on the disastrous effects of currency mismatches when a country devalues. If banks
and other firms in a country have large liabilities denominated in foreign exchange without
offsetting foreign exchange assets of other forms of cover, a devaluation can produce a wave
of insolvencies and create something approaching a depression, as Argentina discovered very
unhappily. The diagram developed by Trevor Swann to analyze a devaluation has been
added at the end of this chapter, with the accompanying discussion emphasizing how both
the exchange rate and domestic macroeconomic policies must be adjusted to produce both
trinity” of “trilemma,” which is associated with Robert Mundell is introduced. If a country
payments equilibrium and an acceptable level of GDP. In Chapter 19, the “impossibility
wishes to have a stable price level through a fixed exchange rate, an independent national
monetary policy, and free mobility for international capital flows, it can have any two of the
three, but not the third. In theory a fixed rate and independent monetary policy are possible
through rigid exchange controls, but if one believes that such controls are not likely
to succeed, the options decline to two. A country can have an independent monetary policy
at the cost of living with a floating exchange rate and some price instability, or it can have
a fixed exchange rate and stable prices if it gives up all monetary policy independence,
perhaps through a currency board.
The largest changes in the second half of the book are in what were the last two chapters.
Chapter 20 in the fifth edition has been combined with Chapter 21 to produce a new
Chapter 20. The discussion of the history of the international financial system before 1973
had to be considerably reduced in length to stay within the planned length for the book. The
treatment of the eurodollar, or eurocurrency, market has, however, been fully retained.
The section on the history of floating exchange rates has, of course, been updated to early
2003. The European Monetary Union, which is now in full operation, is covered far more
thoroughly than was the case in the previous edition. The main change in this chapter,
however, is in the discussion of developing country debt crises. Less emphasis is put on the
Latin American crisis of the 1980s, and far more is put on the events in Asia during 1997–9.
Recent research on such crises, including the issue of crisis contagion, is covered. Late in the
chapter, the so-called New Financial Architecture is introduced, with the Basel I and
proposed Basel II accords. Sovereign bankruptcy for heavily indebted developing countries,
as proposed by Anne Krueger at the IMF, is also introduced. The chapter closes with a list
of likely international policy issues during the next decade. Some of those issues are carried
over from the fifth edition, but a number of them are new. Finally, the Glossary has been
updated and new terms have been added.
Instructors’ options for the use of this book
Those instructors using this book for a full-year course can cover the entire volume and
assign a supplementary book of readings. Those who choose to use this book for a onesemester
(or one-quarter) course will probably want to eliminate some chapters. The core
chapters are 2 through 7, and 12 through 19. For a one-semester chapter emphasizing trade,
Chapters 1 through 11 provide a compact, self-contained, unit. For a one-term course emphasizing
international finance and open economy macroeconomics, Chapter 1 and Chapters
12 through 20 are the appropriate choice.
In writing this book, we have accumulated a number of obligations: to our students and
colleagues, and to international economists too numerous to mention whose work is drawn
upon in preparing a textbook such as this. We also gratefully acknowledge the economics
editors and outside reviewers both at Wiley and at Routledge: for the second edition,
Maurice B. Ballabon of Baruch College, Elias Dinopoulos of the University of California at
Davis, Geoffrey Jehle of Vassar College, Marc Lieberman of Vassar College, Don Shilling
of the University of Missouri, and Parth Sen of the University of Illinois at Champaign/
Urbana; for the third edition, Robert Gillispie of the University of Illinois at Champaign/
Urbana, Henry Goldstein of the University of Oregon, Gerald Lage of Oklahoma State
University, Robert Murphy of Boston College, William Phillips of the University of South
Carolina, and Henry Thompson of Auburn University; for the fourth edition, Ron Schramm
of Columbia University, John Carlson of Purdue University, Wayne Grove of the College
of William and Mary, Oded Galor of Brown University, Chong Kip of Georgia State
University, Chi-Chur Chao of Oregon State University, Zelgian Suster of the University of
New Haven, Mark Shupack of Brown University, Paolo Pesenti of Princeton University,
and Francis Lees of St. John’s University; for the fifth edition, Keith Bain of the University
of East London, Christopher Dent of the University of Lincoln and Humberside, Miroslav
Jovanovic of the Economics Commission for Europe, United Nations, Jean-Claude Léon of
the Catholic University of America, Richard Schatz of the Nanjing University, China, and
Houston Stokes at the University of Illinois at Chicago. We would like to thank Professor
Ronald Shone of Stirling University in the United Kingdom, and Walter Vanthielen of
Limburg University in Belgium for their help in reviewing drafts of this edition.
Finally, we thank users of the first five editions of the book who made useful comments
and suggestions.
Robert M. Dunn, Jr.
George Washington University
Washington, DC
John H. Mutti
Grinnell College
Grinnell, Iowa
July 2003
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