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INTERNATIONAL ECONOMICS

13th Edition

Robert J. Carbaugh Professor of Economics Central Washington University

Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States

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International Economics, 13th Edition Robert J. Carbaugh

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Contents in Brief

PREFACE ................................................................................................ ................................................................ xv

CHAPTER 1 The International Economy and Globalization.....................................................1

PART 1 International Trade Relations 29 CHAPTER 2 Foundations of Modern Trade Theory: Comparative Advantage ............31 CHAPTER 3 Sources of Comparative Advantage ....................................................................... 69 CHAPTER 4 Tariffs................................................................................................ ................................... 111 CHAPTER 5 Nontariff Trade Barriers.............................................................................................. 155 CHAPTER 6 Trade Regulations and Industrial Policies ......................................................... 187 CHAPTER 7 Trade Policies for the Developing Nations ...................................................... 231 CHAPTER 8 Regional Trading Arrangements............................................................................ 271 CHAPTER 9 International Factor Movements and Multinational Enterprises ........... 309

PART 2 International Monetary Relations 341 CHAPTER 10 The Balance of Payments.......................................................................................... 343 CHAPTER 11 Foreign Exchange ................................................................................................ ......... 369 CHAPTER 12 Exchange-Rate Determination ................................................................................ 405 CHAPTER 13 Mechanisms of International Adjustment......................................................... 433 CHAPTER 14 Exchange-Rate Adjustments and the Balance of Payments.................... 441 CHAPTER 15 Exchange-Rate Systems and Currency Crises ................................................. 461 CHAPTER 16 Macroeconomic Policy in an Open Economy................................................. 495 CHAPTER 17 International Banking: Reserves, Debt, and Risk ........................................... 513

GLOSSARY................................................................................................ ........................................................... 535 INDEX ................................................................................................ .................................................................. 547

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Contents

Preface ........................................................................................ xv CHAPTER 1 The International Economy and Globalization ....................................... 1

Globalization of Economic Activity . . . . . . . . . . . . . . . . . . 2 Waves of Globalization .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

First Wave of Globalization: 1870–1914 . . . . . . . . . 4 Second Wave of Globalization: 1945–1980 . . . . . . 4 Latest Wave of Globalization . . . . . . . . . . . . . . . . . . . . . . 5

The United States as an Open Economy .. . . . . . . . . . 7 Trade Patterns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Labor and Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Why Is Globalization Important? . . . . . . . . . . . . . . . . . . 11 The Global Recession of 2007–2009 .. . . . . . . . . . 12

Globalization: Increased Competition From Abroad . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Bicycle Imports Force Schwinn to Downshift . . 16

Dell Sells Factories in Effort to Slash Costs . . . . 17 Common Fallacies of International Trade .. . . . . . . 18 Does Free Trade Apply to Cigarettes? . . . . . . . . . . . . . 19 Is International Trade an Opportunity or a Threat to Workers? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Backlash Against Globalization .. . . . . . . . . . . . . . . . . . . . 22 Terrorism Jolts the Global Economy .. . . . . . . . . . . . . 24 Competition in the World Steel Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 The Plan of this Text . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Summary .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Key Concepts & Terms .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

PART 1: International Trade Relations 29 CHAPTER 2 Foundations of Modern Trade Theory: Comparative Advantage ............ 31

Historical Development of Modern Trade Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

The Mercantilists . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Why Nations Trade: Absolute Advantage . . . . . . 32 Why Nations Trade: Comparative Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

David Ricardo .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 Production Possibilities Schedules . . . . . . . . . . . . . . . . . . 37 Trading Under Constant-Cost Conditions . . . . . . . 38

Basis for Trade and Direction of Trade . . . . . . . . 38

Production Gains from Specialization . . . . . . . . . . . 39 Consumption Gains from Trade . . . . . . . . . . . . . . . . . . 40 Distributing the Gains from Trade . . . . . . . . . . . . . . 42 Equilibrium Terms of Trade . . . . . . . . . . . . . . . . . . . . . . 43

Babe Ruth and the Principle of Comparative Advantage .. . . . . . . . . . . . . . . . . . . . . . . . . . 44

Terms-of-Trade Estimates . . . . . . . . . . . . . . . . . . . . . . . . . . 44 Dynamic Gains From Trade .. . . . . . . . . . . . . . . . . . . . . . . . 45

How Global Competition Led to Productivity Gains for U.S. Iron Ore Workers . . . . . . . . . . . . . . . . . 46

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Changing Comparative Advantage . . . . . . . . . . . . . . . . . 47 Trading Under Increasing-Cost Conditions . . . . . . 49

Increasing-Cost Trading Case . . . . . . . . . . . . . . . . . . . . . 50 Partial Specialization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

The Impact of Trade on Jobs . . . . . . . . . . . . . . . . . . . . . . . . 52 Comparative Advantage Extended to Many Products and Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

More Than Two Products . . . . . . . . . . . . . . . . . . . . . . . . . 54 More Than Two Countries . . . . . . . . . . . . . . . . . . . . . . . . 55

Exit Barriers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Empirical Evidence on Comparative Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

Does Comparative Advantage Apply in the Face of Job Outsourcing? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

Advantages of Outsourcing . . . . . . . . . . . . . . . . . . . . . . . . 58 Outsourcing of Boeing 787 Dreamliner Triggers Machinist’s Strike . . . . . . . . . . . . . . . . . . . . . . . . 60

Outsourcing and the U.S. Automobile Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 Burdens of Outsourcing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 Some U.S. Manufacturers Prosper by Keeping Production in the United States . . . . . . . . . . . . . . . . . . 62

Summary .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 Key Concepts & Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

CHAPTER 3 Sources of Comparative Advantage .................................................... 69

Factor Endowments as a Source of Comparative Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

The Factor-Endowments Theory . . . . . . . . . . . . . . . . . . 70 Visualizing the Factor-Endowment Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72 Applying the Factor-Endowment Theory to U.S.-China Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 Factor-Price Equalization . . . . . . . . . . . . . . . . . . . . . . . . . . 74 Who Gains and Loses From Trade? The Stolper-Samuelson Theorem . . . . . . . . . . . . . . . . . 76

Globalization Drives Changes for U.S. Automakers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

Is International Trade a Substitute for Migration? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 Specific Factors: Trade and the Distribution of Income in the Short Run . . . . . . . . . . . . . . . . . . . . . . . 81

Does Trade Make the Poor Even Poorer? . . . . . . . . 82 Does a “Flat World” Make Ricardo Wrong? .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

Skill as a Source of Comparative Advantage . . . . 85 Increasing Returns to Scale and Comparative Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 External Economies of Scale and Comparative Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 Overlapping Demands as a Basis for Trade .. . . . . 90

Intra-industry Trade .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 Technology as a Source of Comparative Advantage: The Product Cycle Theory . . . . . . . . . . . . 93

Radios, Pocket Calculators, and the International Product Cycle . . . . . . . . . . . . . . . . . . . . . . . 95

Dynamic Comparative Advantage: Industrial Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Government Subsidies Support Boeing and Airbus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 Government Regulatory Policies and Comparative Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 Transportation Costs and Comparative Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

Trade Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Falling Transportation Costs Foster Trade Boom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

Rising Energy Costs Hinder Trade Flows .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104

Terrorist Attack Results in Added Costs and Slowdowns for U.S. Freight System: A New Kind of Trade Barrier? . . . . . . . . . . . . . . . . . 105

Summary .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107 Key Concepts & Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108 Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

vi Contents

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CHAPTER 4 Tariffs ............................................................................................. 111

The Tariff Concept . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 Types of Tariffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

Specific Tariff . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 Ad Valorem Tariff . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 Compound Tariff . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114

Effective Rate of Protection .. . . . . . . . . . . . . . . . . . . . . . . . 115 Tariff Escalation .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117 Outsourcing and Offshore-Assembly Provision .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119 Dodging Import Tariffs: Tariff Avoidance and Tariff Evasion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

Ford Strips Its Wagons to Avoid High Tariff . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 Smuggled Steel Evades U.S. Tariffs . . . . . . . . . . . . . 121

Postponing Import Tariffs . . . . . . . . . . . . . . . . . . . . . . . . . . 122 Bonded Warehouse . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122 Foreign-Trade Zone . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122 FTZ’s Benefit Motor Vehicle Importers . . . . . . . 124

Tariff Effects: An Overview .. . . . . . . . . . . . . . . . . . . . . . . . 124 Tariff Welfare Effects: Consumer Surplus and Producer Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125 Tariff Welfare Effects: Small-Nation Model . . . . . 127 Trade Protectionism Intensifies as Global Economy Falls into Recession .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128

Tariff Welfare Effects: Large-Nation Model . . . . . 131 The Optimum Tariff and Retaliation . . . . . . . . . 134

Gains from Eliminating Import Tariffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 How a Tariff Burdens Exporters . . . . . . . . . . . . . . . . . . . 135 Steel Tariffs Buy Time for Troubled Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138 Tariffs and the Poor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 Arguments for Trade Restrictions . . . . . . . . . . . . . . . . . 140

Job Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141 Protection Against Cheap Foreign Labor . . . . . 142 Fairness in Trade: A Level Playing Field . . . . . 143 Maintenance of the Domestic Standard of Living . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144 Equalization of Production Costs . . . . . . . . . . . . . . 145 Infant-Industry Argument . . . . . . . . . . . . . . . . . . . . . . . 145 Noneconomic Arguments . . . . . . . . . . . . . . . . . . . . . . . . . 145

Petition of the Candle Makers . . . . . . . . . . . . . . . . . 147 The Political Economy of Protectionism . . . . . . 147 A Supply and Demand View of Protectionism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149

Summary .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150 Key Concepts & Terms .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151 Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

CHAPTER 5 Nontariff Trade Barriers ................................................................... 155

Import Quota . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155 Trade and Welfare Effects . . . . . . . . . . . . . . . . . . . . . . . 156 Allocating Quota Licenses . . . . . . . . . . . . . . . . . . . . . . . . 159

Quotas Versus Tariffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159 Tariff-Rate Quota: A Two-Tier Tariff . . . . . . . . . . . . 161

Sugar Tariff-Rate Quota Bittersweet for Consumers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162

Export Quotas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163

Japanese Auto Restraints Put Brakes on U.S. Motorists . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164

Domestic Content Requirements . . . . . . . . . . . . . . . . . . 165 Subsidies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166

Domestic Production Subsidy . . . . . . . . . . . . . . . . . . . 166 How “Foreign” Is Your Car? . . . . . . . . . . . . . . . . . . . . 168

Export Subsidy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169 Dumping .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170

Contents vii

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Forms of Dumping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170 International Price Discrimination . . . . . . . . . . . . 170

Antidumping Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . 173 Smith Corona Finds Antidumping Victories Are Hollow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174 Canadians Press Washington Apple Producers for Level Playing Field . . . . . . . . . . . . . . 174

Swimming Upstream: The Case of Vietnamese Catfish . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175 Is Antidumping Law Unfair? . . . . . . . . . . . . . . . . . . . . . . . 176

Should Average Variable Cost Be the Yardstick for Defining Dumping? . . . . . . . . . . . . . . 176

Should Antidumping Law Reflect Currency Fluctuations? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177 Are Antidumping Duties Overused? . . . . . . . . . . . 178

Other Nontariff Trade Barriers . . . . . . . . . . . . . . . . . . . . 178 Government Procurement Policies . . . . . . . . . . . . . 179

U.S. Fiscal Stimulus and Buy American Legislation .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180

Social Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180 Sea Transport and Freight Regulations . . . . . . . 182

Summary .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183 Key Concepts & Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184 Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184

CHAPTER 6 Trade Regulations and Industrial Policies .......................................... 187

U.S. Tariff Policies Before 1930 .. . . . . . . . . . . . . . . . . . . 187 Smoot-Hawley Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188 Reciprocal Trade Agreements Act . . . . . . . . . . . . . . . . . 190 General Agreement on Tariffs and Trade .. . . . . . 190

Trade Without Discrimination . . . . . . . . . . . . . . . . . 191 Promoting Freer Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . 192 Predictability: Through Binding and Transparency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 Multilateral Trade Negotiations . . . . . . . . . . . . . . . . 193

World Trade Organization .. . . . . . . . . . . . . . . . . . . . . . . . . 195 Settling Trade Disputes . . . . . . . . . . . . . . . . . . . . . . . . . . . 196 Does the WTO Reduce National Sovereignty? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197 Should Retaliatory Tariffs Be Used for WTO Enforcement? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198 Does the WTO Harm the Environment? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199

Burning Rubber: Obama’s Tire Tariff Ignites Chinese Officials . . . . . . . . . . . . . . . . . . . . . . . . . 201 From Doha To Hong Kong: Failed Trade Negotiations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202 Trade Promotion Authority (Fast-Track Authority) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203 Safeguards (The Escape Clause): Emergency Protection From Imports . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203

U.S. Safeguards Limit Surging Imports of Textiles from China . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205

Countervailing Duties: Protection Against Foreign Export Subsidies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206

Lumber Duties Hammer Home Buyers . . . . . . . 207 Antidumping Duties: Protection Against Foreign Dumping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207

Remedies Against Dumped and Subsidized Imports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209 U.S. Steel Companies Lose an Unfair Trade Case and Still Win . . . . . . . . . . . . . . . . . . . . . . . . 211

Section 301: Protection Against Unfair Trading Practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212 Protection of Intellectual Property Rights . . . . . . . 213 Trade Adjustment Assistance . . . . . . . . . . . . . . . . . . . . . . . 215 Will Wage and Health Insurance Make Free Trade More Acceptable to Workers? . . . . . . . . . . . . . 216 Industrial Policies of the United States . . . . . . . . . . . 218

Export Promotion and Financing . . . . . . . . . . . . . . 219 Industrial Policies of Japan .. . . . . . . . . . . . . . . . . . . . . . . . . 220 Strategic Trade Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221 Economic Sanctions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223

Factors Influencing the Success of Sanctions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225

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Economic Sanctions and Weapons of Mass Destruction: North Korea and Iran . . . . . . . . . . . . 225

Do Automaker Subsidies Weaken the WTO? .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227

Summary .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227 Key Concepts & Terms .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228 Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229

CHAPTER 7 Trade Policies for the Developing Nations ......................................... 231

Developing-Nation Trade Characteristics . . . . . . . . 231 Tensions Between Developing and Advanced Nations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233 Trade Problems of the Developing Nations . . . . . 234

Unstable Export Markets . . . . . . . . . . . . . . . . . . . . . . . . . 234 Falling Commodity Prices Threaten Growth of Exporting Nations .. . . . . . . . . . . . . . . . . . 235

Worsening Terms of Trade . . . . . . . . . . . . . . . . . . . . . . 236 Limited Market Access . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238 Agricultural Export Subsidies of Advanced Nations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240

Stabilizing Primary-Product Prices . . . . . . . . . . . . . . . . 241 Production and Export Controls . . . . . . . . . . . . . . . . 241 Buffer Stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242 Multilateral Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243 Does the Fair-Trade Movement Help Poor Coffee Farmers? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244

The Opec Oil Cartel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245 Maximizing Cartel Profits . . . . . . . . . . . . . . . . . . . . . . . 245 OPEC as a Cartel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247

Are International Labor Standards Needed to Prevent Social Dumping? .. . . . . . . 248 Aiding the Developing Nations . . . . . . . . . . . . . . . . . . . . 249

The World Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249 International Monetary Fund . . . . . . . . . . . . . . . . . . . 251 Generalized System of Preferences . . . . . . . . . . . . . 252

Does Aid Promote Growth of Developing Nations? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253 How to Bring Developing Nations in From the Cold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253

Economic Growth Strategies: Import Substitution Versus Export-Led Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255

Import Substitution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255 Import-Substitution Laws Backfire on Brazil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256 Export-Led Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257 Is Economic Growth Good for the Poor? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259 Can All Developing Nations Achieve Export-Led Growth? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259

East Asian Economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260 Flying-Geese Pattern of Growth . . . . . . . . . . . . . . . . 261

China’s Transformation to Capitalism .. . . . . . . . . . 262 China’s Export Boom Comes at a Cost: How to Make Factories Play Fair . . . . . . . . . . . . . . 264

Does Foreign Direct Investment Hinder or Help Economic Development? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265 India: Breaking Out of the Third World .. . . . . . . 266 Summary .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268 Key Concepts & Terms .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269 Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269

CHAPTER 8 Regional Trading Arrangements ....................................................... 271

Regional Integration Versus Multilateralism .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271 Types of Regional Trading Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272

Missing Benefits: The United States Falls Behind on Trade Liberalization .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274 Impetus for Regionalism .. . . . . . . . . . . . . . . . . . . . . . . . . . . . 275

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Effects of a Regional Trading Arrangement . . . . . 275 Static Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276 Did the United Kingdom (UK) Gain from Entering the European Union? . . . . . . . . . . . . . . . . . . 278 Dynamic Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278

The European Union .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280 Pursuing Economic Integration . . . . . . . . . . . . . . . . . 280 French and Dutch Voters Sidetrack Integration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282 Agricultural Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283

Economic Costs and Benefits of a Common Currency: The European Monetary Union .. . . . . 286

Optimum Currency Area . . . . . . . . . . . . . . . . . . . . . . . . 287 Europe as a Suboptimal Currency Area . . . . . . 288 Challenges for the EMU . . . . . . . . . . . . . . . . . . . . . . . . . . 289

The Euro, Ten Years Later: How Has It Performed? .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290

Does the Eurozone Need a Bailout Fund? . . . . 290 North American Free Trade Agreement . . . . . . . . . 292

NAFTA’s Benefits and Costs for Mexico and Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293 NAFTA’s Benefits and Costs for the United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294 NAFTA and Trade Diversion: Textiles and Apparel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297 Is NAFTA an Optimum Currency Area? . . . . . 298

From NAFTA to CAFTA .. . . . . . . . . . . . . . . . . . . . . . . . . . 299 Free Trade Area of the Americas . . . . . . . . . . . . . . . . . . 300 Asia-Pacific Economic Cooperation .. . . . . . . . . . . . . . 302 Transition Economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302

The Transition Toward a Market-Oriented Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303 Russia and the World Trade Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305

Summary .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306 Key Concepts & Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307 Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308

CHAPTER 9 International Factor Movements and Multinational Enterprises ........... 309

The Multinational Enterprise . . . . . . . . . . . . . . . . . . . . . . . 309 Motives for Foreign Direct Investment . . . . . . . . . . 311

Demand Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312 Do U.S. Multinationals Exploit Foreign Workers? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313

Cost Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314 Supplying Products to Foreign Buyers: Whether to Produce Domestically or Abroad .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315

Direct Exporting versus Foreign Direct Investment/Licensing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315 Foreign Direct Investment versus Licensing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

Country Risk Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318 International Trade Theory and Multinational Enterprise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319 Japanese Transplants in the U.S. Automobile Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320 International Joint Ventures . . . . . . . . . . . . . . . . . . . . . . . . 321

Welfare Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323

Multinational Enterprises as a Source of Conflict . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325

Employment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325 Technology Transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326 National Sovereignty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328 Balance of Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329 Transfer Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329

Does the U.S. Tax Code Send American Jobs Offshore? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330 International Labor Mobility: Migration .. . . . . . . . 331

The Effects of Migration . . . . . . . . . . . . . . . . . . . . . . . . . 331 Immigration as an Issue . . . . . . . . . . . . . . . . . . . . . . . . . 334

Does U.S. Immigration Policy Harm Domestic Workers? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336

Do Immigrants Really Hurt American Workers’ Wages? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337

Summary .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337 Key Concepts & Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338 Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338

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PART 2: International Monetary Relations 341 CHAPTER 10 The Balance of Payments ................................................................. 343

Double-Entry Accounting .. . . . . . . . . . . . . . . . . . . . . . . . . . 343 International Payments Process . . . . . . . . . . . . . . . 345 Balance-of-Payments Structure . . . . . . . . . . . . . . . . . . . . . 346

Current Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346 Capital and Financial Account . . . . . . . . . . . . . . . . . 347 Statistical Discrepancy: Errors and Omissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349

U.S. Balance of Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . 350 The Paradox of Capital Flows from Developing to Industrial Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352 What Does a Current Account Deficit (Surplus) Mean? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354

Net Foreign Investment and the Current Account Balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354 Impact of Capital Flows on the Current Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355

Is a Current Account Deficit a Problem? . . . . . 356 Business Cycles, Economic Growth, and the Current Account . . . . . . . . . . . . . . . . . . . . . . . . 357

Economic Downturn of 2007–2009: Effect on Foreign Investment in the United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358

How the United States Has Borrowed at Very Low Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359 Do Current Account Deficits Cost Americans Jobs? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360 Can the United States Continue to Run Current Account Deficits Indefinitely? . . . . . . . . 361

Balance of International Indebtedness . . . . . . . . . . . . 363 United States as a Debtor Nation . . . . . . . . . . . . . . 365

Summary .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365 Key Concepts & Terms .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366 Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366

CHAPTER 11 Foreign Exchange ........................................................................... 369

Foreign-Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . 369 Types of Foreign-Exchange Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371 Interbank Trading .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373 Reading Foreign-Exchange Quotations . . . . . . . . . . . 375 Forward and Futures Markets . . . . . . . . . . . . . . . . . . . . . . 377 Foreign-Currency Options . . . . . . . . . . . . . . . . . . . . . . . . . . 379 Exchange-Rate Determination .. . . . . . . . . . . . . . . . . . . . . 380

Demand for Foreign Exchange . . . . . . . . . . . . . . . . . . 380 Weak Dollar Is a Bonanza for European Tourists . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381

Supply of Foreign Exchange . . . . . . . . . . . . . . . . . . . . . 381 Equilibrium Rate of Exchange . . . . . . . . . . . . . . . . . . 382

Indexes of the Foreign-Exchange Value of the Dollar: Nominal and Real Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383

Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385 The Forward Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 387

The Forward Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 387 Relation Between the Forward Rate and Spot Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388 Managing Your Foreign Exchange Risk: Forward Foreign-Exchange Contract . . . . . . . . . . 389 How Markel Rides Foreign-Exchange Fluctuations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391 Volkswagen Hedges Against Foreign-Exchange Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392 Does Foreign-Currency Hedging Pay Off? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392

Exchange-Rate Risk: The Hazard of Investing Abroad .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 394 Interest Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 394

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Uncovered Interest Arbitrage . . . . . . . . . . . . . . . . . . . . 395 Covered Interest Arbitrage . . . . . . . . . . . . . . . . . . . . . . . 396

Foreign-Exchange Market Speculation .. . . . . . . . . . 397 How to Play the Falling (Rising) Dollar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399 Foreign Exchange Trading as a Career . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399

Foreign Exchange Traders Hired by Commercial Banks, Companies, and Central Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 Currency Markets Draw Day Traders . . . . . . . . 400

Summary .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 401 Key Concepts & Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 402 Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 402

CHAPTER 12 Exchange-Rate Determination .......................................................... 405

What Determines Exchange Rates? . . . . . . . . . . . . . . . 405 Determining Long-Term Exchange Rates . . . . . . . 407

Relative Price Levels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408 Relative Productivity Levels . . . . . . . . . . . . . . . . . . . . . . 408 Preferences for Domestic or Foreign Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408 Trade Barriers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410

Inflation Rates, Purchasing Power Parity, and Long-Term Exchange Rates . . . . . . . . . . . . . . . . . . . 410

Law of One Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410 The “Big Mac” Index and the Law of One Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411 Purchasing Power Parity . . . . . . . . . . . . . . . . . . . . . . . . . 412

Determining Short-Term Exchange Rates: The Asset-Market Approach .. . . . . . . . . . . . . . . . . . . . . . . 415 Inflation Differentials and the Exchange Rate .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416

Relative Levels of Interest Rates . . . . . . . . . . . . . . . . 417 Expected Change in the Exchange Rate . . . . . . . 420

Diversification, Safe Havens, and Investment Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 421

The Ups and Downs of the Dollar . . . . . . . . . . . . . . . . 421 The 1980s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 421 The 1990s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422 The First Decade of the 2000s . . . . . . . . . . . . . . . . . . 423

Exchange-Rate Overshooting .. . . . . . . . . . . . . . . . . . . . . . 423 Forecasting Foreign-Exchange Rates . . . . . . . . . . . . . . 425

Judgmental Forecasts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 426 Technical Forecasts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 426 Fundamental Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . 428

International Comparisons of GDP: Purchasing Power Parity . . . . . . . . . . . . . . . . . . . . . . . . . 429 Comercial Mexicana Gets Burned By Speculation .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 430 Summary .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 430 Key Concepts & Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431 Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431

CHAPTER 13 Mechanisms of International Adjustment .......................................... 433

Price Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 434 Gold Standard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 434 Quantity Theory of Money . . . . . . . . . . . . . . . . . . . . . . 434 Current-Account Adjustment . . . . . . . . . . . . . . . . . . . 435

Financial Flows and Interest-Rate Differentials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 436 Income Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438

Disadvantages of Automatic Adjustment Mechanisms .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 439 Monetary Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 439 Summary .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440 Key Concepts & Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440 Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440

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CHAPTER 14 Exchange-Rate Adjustments and the Balance of Payments ................. 441

Effects of Exchange-Rate Changes on Costs and Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 441 Japanese Firms Outsource Production to Limit Effects of Strong Yen .. . . . . . . . . . . . . . . . 444 Cost-Cutting Strategies of Manufacturers in Response to Currency Appreciation .. . . . . . . . . . . . . 445

Appreciation of the Yen: Japanese Manufacturers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445 Appreciation of the Dollar: U.S. Manufacturers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 447

Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach . . . . . . . . . . 447 J-Curve Effect: Time Path of Depreciation .. . . . . 451 Exchange Rate Pass-Through . . . . . . . . . . . . . . . . . . . . . . . 453

Partial Exchange Rate Pass-Through . . . . . . . . . . 453 Invoice Practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 454 Market Share Considerations . . . . . . . . . . . . . . . . . . . 454 Distribution Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455

Why a Dollar Depreciation May Not Close the U.S. Trade Deficit . . . . . . . . . . . . . . . . . . . . . 456 The Absorption Approach to Currency Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 456 The Monetary Approach to Currency Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 458 Summary .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 458 Key Concepts & Terms .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 459 Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 459

CHAPTER 15 Exchange-Rate Systems and Currency Crises ..................................... 461

Exchange-Rate Practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 461 Choosing an Exchange Rate System: Constraints Imposed by Free Capital Flows .. . . . . . . . . . . . . . . . . . . 462 Fixed Exchange-Rate System .. . . . . . . . . . . . . . . . . . . . . . 464

Use of Fixed Exchange Rates . . . . . . . . . . . . . . . . . . . . 464 Par Value and Official Exchange Rate . . . . . . . . 465 Exchange-Rate Stabilization . . . . . . . . . . . . . . . . . . . . . 466 Devaluation and Revaluation . . . . . . . . . . . . . . . . . . . 467 Bretton Woods System of Fixed Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469

Is China a Currency Manipulator? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 470 Floating Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 471

Achieving Market Equilibrium . . . . . . . . . . . . . . . . . . 471 Trade Restrictions, Jobs, and Floating Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473 Arguments for and Against Floating Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473

Managed Floating Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474 Managed Floating Rates in the Short and Long Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 475

Exchange-Rate Stabilization and Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 476 Is Exchange-Rate Stabilization Effective? . . . . . 478

The Crawling Peg .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479 Currency Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480

Sources of Currency Crises . . . . . . . . . . . . . . . . . . . . . . . 482 Speculators Attack East Asian Currencies . . . . 484

Capital Controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484 Should Foreign-Exchange Transactions Be Taxed? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485

Increasing the Credibility of Fixed Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 486

Currency Board . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487 For Argentina, No Panacea in a Currency Board . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489 Dollarization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489

The Global Economic Crisis of 2007–2009 .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492 Summary .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 493 Key Concepts & Terms .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494 Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494

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CHAPTER 16 Macroeconomic Policy in an Open Economy ..................................... 495

Economic Objectives of Nations . . . . . . . . . . . . . . . . . . . 495 Policy Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 496 Aggregate Demand and Aggregate Supply: A Brief Review .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 496 Monetary and Fiscal Policy Respond to Financial Turmoil in the Economy .. . . . . . . . . . . 497 Monetary and Fiscal Policy in a Closed Economy .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 498 Monetary and Fiscal Policy in an Open Economy .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Does Crowding Occur in an Open Economy? .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 501

Effect of Fiscal and Monetary Policy Under Fixed Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502 Effect of Fiscal and Monetary Policy Under Floating Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . 503

Macroeconomic Stability and the Current Account: Policy Agreement Versus Policy Conflict . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504 Inflation With Unemployment . . . . . . . . . . . . . . . . . . . . . 505 International Economic-Policy Coordination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 506 G-20 Agrees to Cooperate on Global Economic Policy: International Policy Coordination .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507

Policy Coordination in Theory . . . . . . . . . . . . . . . . . . 508 Does Policy Coordination Work? . . . . . . . . . . . . . . . 509

Summary .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510 Key Concepts & Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511 Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511

CHAPTER 17 International Banking: Reserves, Debt, and Risk ................................. 513

Nature of International Reserves . . . . . . . . . . . . . . . . . . 513 Demand for International Reserves . . . . . . . . . . . . . . . 514

Exchange-Rate Flexibility . . . . . . . . . . . . . . . . . . . . . . . . 514 Other Determinants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516

Supply of International Reserves . . . . . . . . . . . . . . . . . . . 517 Foreign Currencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517 Should SDRs Replace the Dollar as the World’s Reserve Currency? . . . . . . . . . . . . . . . . 518 Gold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521

International Gold Standard . . . . . . . . . . . . . . . . . . . . 521 Gold Exchange Standard . . . . . . . . . . . . . . . . . . . . . . . . . 522 Demonetization of Gold . . . . . . . . . . . . . . . . . . . . . . . . . . 523

Special Drawing Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524 Facilities for Borrowing Reserves . . . . . . . . . . . . . . . . . . 524

IMF Drawings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525 General Arrangements to Borrow . . . . . . . . . . . . . . 525 Swap Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526

International Lending Risk . . . . . . . . . . . . . . . . . . . . . . . . . . 526 The Problem of International Debt . . . . . . . . . . . . . . . 527

Dealing with Debt-Servicing Difficulties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 528

Reducing Bank Exposure to Developing- Nation Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 529 Debt Reduction and Debt Forgiveness . . . . . . . . . . . 530 The Eurodollar Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 531 Summary .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 532 Key Concepts & Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 532 Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533

Glossary .................................................................................... 535 Index ........................................................................................ 547

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Preface

My belief is that the best way to motivate students to learn a subject is to demon- strate how it is used in practice. The first twelve editions of International Economics reflected this belief and were written to provide a serious presentation of interna- tional economic theory with an emphasis on current applications. Adopters of these editions strongly supported the integration of economic theory with current events.

The thirteenth edition has been revised with an eye toward improving this presentation and updating the applications as well as toward including the latest theoretical developments. Like its predecessors, this edition is intended for use in a one-quarter or one-semester course for students who have no more of a background than the principles of economics. This book’s strengths are its clarity, organization, and applications, which demonstrate the usefulness of theory to students. The revised and updated material in this edition emphasizes current applications of economic theory and incorporates recent theoretical and policy developments in international trade and finance.

International Economics Themes This edition highlights six current themes that are at the forefront of international economics: • The Global Economic Downturn of 2007–2009

• Anatomy of the economic crisis—Ch. 1 • Trade protectionism intensifies as economies fall into recession—Ch. 4 • U.S. fiscal stimulus and “Buy American” legislation—Ch. 5 • Do government subsidies to automakers weaken the World Trade

Organization?—Ch. 6 • Falling commodity prices squeeze the economies of developing nations—Ch. 7 • Does the U.S. tax code send American jobs offshore?—Ch. 9 • The paradox of capital flows from developing countries to advanced

countries—Ch. 10 • Globalization of economic activity

• Waves of globalization—Ch. 1 • Has globalization gone too far?—Ch. 1 • Putting the H-P Pavilion together—Ch. 1 • Soaring transportation costs hinder globalization—Ch. 3 • Constraints imposed by capital flows on the choice of an exchange rate

system—Ch. 15

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• Free trade and the quality of life issues • Does the principle of comparative advantage apply in the face of job

outsourcing?—Ch. 2 • Boeing outsources work, but protects its secrets—Ch. 2 • Does trade make the poor even poorer?—Ch. 3 • Does wage insurance make free trade more acceptable to workers?—Ch. 6 • The environment and free trade—Ch. 6

• Trade conflicts between developing and advanced nations • Is international trade a substitute for migration?—Ch. 3 • Economic growth strategies—import substitution versus export-led

growth—Ch. 7 • Does foreign aid promote the growth of developing countries?—Ch. 7 • How to bring developing countries in from the cold—Ch. 7 • The Doha Round of multilateral trade negotiations—Ch. 6 • China’s export boom comes at a cost: how to make factories play fair—Ch. 7 • Do U.S. multinationals exploit foreign workers?—Ch. 9

• Liberalizing trade: the WTO versus regional trading arrangements • Does the WTO reduce national sovereignty?—Ch. 6 • Regional integration versus multilateralism—Ch. 8 • Is Europe really a common market?—Ch. 8 • French and Dutch Voters Sidetrack European Integration—Ch. 8 • From NAFTA to CAFTA—Ch. 8 • Will the Euro Fail?—Ch. 8

• The dollar as a reserve currency • Paradox of foreign debt: how the United states has borrowed without

cost—Ch. 10 • Why a dollar depreciation may not close the U.S. trade deficit—Ch. 14 • Preventing currency crises: currency boards versus dollarization—Ch. 15 • China lets Yuan rise against dollar—Ch. 15 • Should the Special Drawing Right replace the dollar as the world’s reserve

currency?—Ch. 17 Besides emphasizing current economic themes, the thirteenth edition of this text contains many new contemporary topics such as outsourcing and the U.S. auto industry, U.S. safeguards limit imports of textiles from China, bailout fund for the Eurozone, bike imports force Schwinn to downshift, and currency markets draw day traders. Faculty and students will appreciate how this edition provides a contem- porary approach to international economics.

Organizational Framework: Exploring Further Sections Although instructors generally agree on the basic content of an international econom- ics course, opinions vary widely about which arrangement of material is appropriate. This book is structured to provide considerable organizational flexibility. The topic of international trade relations is presented before international monetary relations, but the order can be reversed by instructors who choose to start with monetary theory. Instructors can begin with Chapters 10–17 and conclude with Chapters 2–9. Those who do not wish to cover all the material in the book can easily omit all or parts of Chapters 6–9 and Chapter 13, and Chapters 15–17 without loss of continuity.

xvi Preface

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The thirteenth edition streamlines its presentation of theory so as to provide greater flexibility for instructors. This edition uses online Exploring Further sections to discuss more advanced topics: They can be found at www.cengage.com/ economics/Carbaugh. By locating the Exploring Further sections online rather than in the textbook, as occurred in previous editions, more textbook coverage can be de- voted to contemporary applications of theory. The Exploring Further sections consist of the following: • Comparative advantage in money terms—Ch. 2 • Indifference curves and trade—Ch. 2 • Offer curves and the equilibrium terms of trade—Ch. 2 • The specific-factors theory—Ch. 3 • WTO Makes Ruling on Boeing-Airbus Aircraft Subsidy Dispute—Ch. 3 • Offer curves and tariffs—Ch. 4 • Tariff-rate quota welfare effects—Ch. 5 • Export quota welfare effects—Ch. 5 • Welfare effects of strategic trade policy—Ch. 6 • Government procurement policy and the European Union—Ch. 8 • Economies of scale and NAFTA—Ch. 8 • Can the Euro Survive?—Ch. 8 • Techniques of foreign-exchange market speculation—Ch. 11 • A primer on foreign-exchange trading—Ch. 11 • Fundamental forecasting—regression analysis—Ch. 12 • Income adjustment mechanism—Ch. 13 • Exchange rate pass-through—Ch. 14

Supplementary Materials International Economics Web Site (www.cengage.com/economics/Carbaugh)

In this age of technology, no text package would be complete without Web-based resources. An international economics website is offered with the thirteenth edition. This site, www.cengage.com/economics/Carbaugh, contains many useful pedagogi- cal enrichment features including NetLink Exercises, which draw upon the expanded NetLinks feature at the end of each chapter. While the NetLinks direct the student to an appropriate international economics website to gather data and other relevant in- formation, the NetLink Exercises allow students to access these Web sites to answer pertinent and practical questions that relate to international economics. As an added enrichment feature, a Virtual Scavenger Hunt engages and encourages students to search for international economics answers at various Internet Web sites.

PowerPoint Slides The thirteenth edition also includes PowerPoint slides created by Andreea Chiritescu of Eastern Illinois University. These slides can be easily downloaded from the Carbaugh Web site (www.cengage.com/economics/Carbaugh). The slides offer pro- fessors flexibility in enhancing classroom lectures. Slides may be edited to meet indi- vidual needs.

Preface xvii

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http://www.cengage.com/
http://www.cengage.com/economics/Carbaugh
http://www.cengage.com/economics/Carbaugh
http://www.cengage.com/economics/Carbaugh
http://www.cengage.com/economics/Carbaugh
Instructor’s Manual To assist instructors in the teaching of international economics, I have written an Instructor’s Manual with Test Bank that accompanies the thirteenth edition. It contains: (1) brief answers to end-of-chapter study questions; (2) multiple-choice questions for each chapter; and (3) true-false questions for each chapter. The Instructor’s Manual with Test Bank is available for download for qualified instructors from the Carbaugh Web site (www.cengage.com/economics/Carbaugh).

Study Guide To accompany the thirteenth edition of the international economics text, Professor Jim Hanson of Willamette University has prepared an online Study Guide for stu- dents. This guide reinforces key concepts by providing a review of the text’s main topics and offering practice problems, true-false and multiple-choice questions, and short-answer questions.

Acknowledgments I am pleased to acknowledge those who aided me in preparing the current and past editions of this textbook. Helpful suggestions and often detailed reviews were provided by: • Burton Abrams, University of Delaware • Richard Adkisson, New Mexico State University • Richard Anderson, Texas A&M • Brad Andrew, Juniata College • Richard Ault, Auburn University • Mohsen Bahmani-Oskooee, University of Wisconsin—Milwaukee • Kevin Balsam, Hunter College • Kelvin Bentley, Baker College Online • Robert Blecker, Stanford University • Scott Brunger, Maryville College • Jeff W. Bruns, Bacone College • Roman Cech, Longwood University • John Charalambakis, Asbury College • Mitch Charkiewicz, Central Connecticut State University • Xiujian Chen, California State University, Fullerton • Miao Chi, University of Wisconsin—Milwaukee • Howard Cochran, Jr., Belmont University • Charles Chittle, Bowling Green University • Christopher Cornell, Fordham University • Elanor Craig, University of Delaware • Manjira Datta, Arizona State University • Ann Davis, Marist College • Firat Demir, University of Oklahoma • Gopal Dorai, William Paterson College • Veda Doss, Wingate University • Seymour Douglas, Emory University • G. Rod Erfani, Transylvania University • Carolyn Fabian Stumph, Indiana University-Purdue University Fort Wayne

xviii Preface

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http://www.cengage.com/economics/Carbaugh
http://www.cengage.com/economics/Carbaugh
• Farideh Farazmand, Lynn University • Daniel Falkowski, Canisius College • Patrice Franko, Colby College • Emanuel Frenkel, University of California—Davis • Norman Gharrity, Ohio Wesleyan University • Sucharita Ghosh, University of Akron • Jean-Ellen Giblin, Fashion Institute of Technology (SUNY) • Leka Gjolaj, Baker College • Thomas Grennes, North Carolina State University • Darrin Gulla, University of Kentucky • Li Guoqiang, University of Macau (China) • William Hallagan, Washington State University • Jim Hanson, Willamette University • Bassam Harik, Western Michigan University • John Harter, Eastern Kentucky University • Seid Hassan, Murray State University • Phyllis Herdendorf, Empire State College (SUNY) • Pershing Hill, University of Alaska-Anchorage • David Hudgins, University of Oklahoma • Ralph Husby, University of Illinois-Urbana/Champaign • Robert Jerome, James Madison University • Mohamad Khalil, Fairmont State College • Wahhab Khandker, University of Wisconsin—La Crosse • Robin Klay, Hope College • William Kleiner, Western Illinois University • Anthony Koo, Michigan State University • Faik Koray, Louisiana State University • Peter Karl Kresl, Bucknell University • Fyodor Kushnirsky, Temple University • Edhut Lehrer, Northwestern University • Jim Levinsohn, University of Michigan • Benjamin Liebman, St. Joseph’s University • Susan Linz, Michigan State University • Andy Liu, Youngstown State University • Alyson Ma, University of San Diego • Mike Marks, Georgia College School of Business • John Muth, Regis University • Al Maury, Texas A&I University • Jose Mendez, Arizona State University • Mary Norris, Southern Illinois University • John Olienyk, Colorado State University • Shawn Osell, Minnesota State University—Mankato • Terutomo Ozawa, Colorado State University • Peter Petrick, University of Texas at Dallas • Gary Pickersgill, California State University, Fullerton • William Phillips, University of South Carolina • John Polimeni, Albany College of Pharmacy and Health Sciences • Rahim Quazi, Prairie View A&M University • Chuck Rambeck, St. John’s University

Preface xix

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• James Richard, Regis University • Daniel Ryan, Temple University • Manabu Saeki, Jacksonville State University • Nindy Sandhu, Claifornia State University, Fullerton • Jeff Sarbaum, University of North Carolina, Greensboro • Anthony Scaperlanda, Northern Illinois University • Juha Seppälä, University of Illinois • Ben Slay, Middlebury College (now at PlanEcon) • Gordon Smith, Anderson University • Robert Stern, University of Michigan • Paul Stock, University of Mary Hardin-Baylor • Laurie Strangman, University of Wisconsin—La Crosse • Manjuri Talukdar, Northern Illinois University • Nalitra Thaiprasert, Ball State University • William Urban, University of South Florida • Jorge Vidal, The University of Texas Pan American • Adis M. Vila, Esq., Winter Park Institute Rollins College • Jonathan Warshay, Baker College • Darwin Wassink, University of Wisconsin—Eau Claire • Peter Wilamoski, Seattle University • Harold Williams, Kent State University • Chong Xiang, Purdue University • Hamid Zangeneh, Widener University

I would like to thank my colleagues at Central Washington University—Tim Dittmer, David Hedrick, Koushik Ghosh, Tyler Prante, Peter Saunders, Thomas Tenerelli, Chad Wassell—for their advice and help while I was preparing the manuscript. I am also indebted to Shirley Hood who provided advice in the manu- script’s preparation.

It has been a pleasure to work with the staff of South-Western—Mike Worls, Katie Yanos and Lena Mortis—who provided many valuable suggestions and assistance in see- ing this edition to its completion. Thanks also go to Jennifer Ziegler and Jean Buttrom, who orchestrated the production of this book in conjunction with Mary Stone, project manager at PreMediaGlobal. I also appreciate the meticulous efforts that Jonathan Moore did in the copyediting of this textbook. Moreover, Keri Witman and Betty Jung did a fine job in advertising and marketing the thirteenth edition. Finally, I am grateful to my students, as well as the faculty and students at other universities, who provided helpful comments on the material contained in this new edition.

I would appreciate any comments, corrections, or suggestions that faculty or stu- dents wish to make so I can continue to improve this text in the years ahead. Please contact me! Thank you for permitting this text to evolve to a thirteenth edition.

Bob Carbaugh Department of Economics Central Washington University Ellensburg, Washington 98926 Phone: (509) 963–3443 Fax: (509) 963–1992 Email: Carbaugh@cwu.edu

xx Preface

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mailto:Carbaugh@cwu.edu
TheInternationalEconomy and Globalization

C H A P T E R 1

In today’s world, no nation exists in economic isolation. All aspects of a nation’seconomy—its industries, service sectors, levels of income and employment, and living standard—are linked to the economies of its trading partners. This linkage takes the form of international movements of goods and services, labor, business enterprise, investment funds, and technology. Indeed, national economic policies cannot be formulated without evaluating their probable impacts on the economies of other countries.

The high degree of economic interdependence among today’s economies reflects the historical evolution of the world’s economic and political order. At the end of World War II, the United States was economically and politically the most powerful nation in the world, a situation expressed in the saying, “When the United States sneezes, the economies of other nations catch a cold.” But with the passage of time, the U.S. economy has become increasingly integrated into the economic activities of foreign countries. The formation in the 1950s of the European Community (now known as the European Union), the rising importance in the 1960s of multinational corporations, the market power in the 1970s enjoyed by the Organization of Petroleum Exporting Countries (OPEC), and the creation of the euro at the turn of the twenty-first century have all resulted in the evolution of the world community into a complicated system based on a growing interdependence among nations.

Recognizing that world economic interdependence is complex and its effects uneven, the economic community has taken steps toward international cooperation. Conferences devoted to global economic issues have explored the avenues through which cooperation could be fostered between industrial and developing nations. The efforts of developing nations to reap larger gains from international trade and to participate more fully in international institutions have been hastened by the impact of the global recession, industrial inflation, and the burdens of high-priced energy.

Over the past 50 years, the world’s market economies have become increasingly interdependent. Exports and imports as a share of national output have risen for most industrial nations, while foreign investment and international lending have

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expanded. This closer linkage of economies can be mutually advantageous for trading nations. It permits producers in each nation to take advantage of the specialization and efficiencies of large scale production. A nation can consume a wider variety of products at a cost less than that which could be achieved in the absence of trade. Despite these advantages, demands have grown for protection against imports. Protectionist pressures have been strongest during periods of rising unemployment caused by economic recession. Moreover, developing nations often maintain that the so-called liberalized trading system called for by industrial nations serves to keep the developing nations in poverty.

Economic interdependence also has direct consequences for a student taking an introductory course in international economics. As consumers, we can be affected by changes in the international values of currencies. Should the Japanese yen or British pound appreciate against the U.S. dollar, it would cost us more to purchase Japanese television sets or British automobiles. As investors, we might prefer to purchase Swiss securities if Swiss interest rates rise above U.S. levels. As members of the labor force, we might want to know whether the president plans to protect U.S. steelworkers and autoworkers from foreign competition.

In short, economic interdependence has become a complex issue in recent times, often resulting in strong and uneven impacts among nations and among sectors within a given nation. Business, labor, investors, and consumers all feel the repercussions of changing economic conditions and trade policies in other nations. Today’s global economy requires cooperation on an international level to cope with the myriad issues and problems.

Globalization of Economic Activity When listening to the news, we often hear about globalization. What does this term mean? Globalization is the process of greater interdependence among countries and their citizens. It consists of the increased interaction of product and resource mar- kets across nations via trade, immigration, and foreign investment—that is, via inter- national flows of goods and services, of people, and of investments in equipment, factories, stocks, and bonds. It also includes non-economic elements such as culture and the environment. Simply put, globalization is political, technological, and cultural, as well as economic.

In terms of people’s daily lives, globalization means that the residents of one country are more likely now than they were 50 years ago to consume the products of another country, to invest in another country, to earn income from other coun- tries, to talk by telephone to people in other countries, to visit other countries, to know that they are being affected by economic developments in other countries, and to know about developments in other countries.

What forces are driving globalization?1 The first and perhaps most profound influence is technological change. Since the industrial revolution of the late 1700s, technical innovations have led to an explosion in productivity and slashed transpor- tation costs. The steam engine preceded the arrival of railways and the mechanization of a growing number of activities hitherto reliant on muscle power. Later discoveries

1World Trade Organization, Annual Report, 1998, pp. 33–36.

2 The International Economy and Globalization

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and inventions such as electricity, the telephone, the automobile, container ships, and pipelines altered production, communication, and transportation in ways unimagined by earlier generations. More recently, rapid developments in computer information and communications technology have further shrunk the influence of time and geography on the capacity of individuals and enterprises to interact and transact around the world. For services, the rise of the Internet has been a major factor in fall- ing communication costs and increased trade. As technical progress has extended the scope of what can be produced and where it can be produced, and advances in trans- port technology have continued to bring people and enterprises closer together, the boundary of tradable goods and services has been greatly extended.

Also, continuing liberalization of trade and investment has resulted from multi- lateral trade negotiations. For example, tariffs in industrial countries have come down from high double digits in the 1940s to about five percent in the early 2000s. At the same time, most quotas on trade, except for those imposed for health, safety, or other public policy reasons, have been removed. Globalization has also been pro- moted through the widespread liberalization of investment transactions and the development of international financial markets. These factors have facilitated inter- national trade through the greater availability and affordability of financing.

Lower trade barriers and financial liberalization have allowed more and more companies to globalize production structures through investment abroad, which in turn has provided a further stimulus to trade. On the technology side, increased information flows and the greater tradability of goods and services have profoundly influenced production location decisions. Businesses are increasingly able to locate different components of their production processes in various countries and regions and still maintain a single corporate identity. As firms subcontract part of their pro- duction processes to their affiliates or other enterprises abroad, they transfer jobs, technologies, capital, and skills around the globe.

How significant is production sharing in world trade? Researchers have esti- mated production sharing levels by calculating the share of components and parts in world trade. They have concluded that global production sharing accounts for about 30 percent of the world trade in manufactured goods. Moreover, the trade in components and parts is growing significantly faster than the trade in finished pro- ducts, highlighting the increasing interdependence of countries through production and trade.2

Waves of Globalization In the past two decades, there has been pronounced global economic interdepen- dence. Economic interdependence occurs through trade, labor migration, and capital (investment) flows such as corporation stocks and government securities. Let us con- sider the major waves of globalization that have occurred in recent history.3

2A. Yeats, Just How Big Is Global Production Sharing? World Bank, Policy Research Working Paper No. 1871, 1998, Washington, DC. 3This section draws from World Bank, Globalization, Growth and Poverty: Building an Inclusive World Economy, 2001.

Chapter 1 3

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First Wave of Globalization: 1870–1914 The first wave of global interdependence occurred from 1870 to 1914. It was sparked by decreases in tariff barriers and new technologies that resulted in declining trans- portation costs, such as the shift from sail to steamships and the advent of railways. The main agent that drove the process of globalization was how much muscle, horsepower, wind power, or later on, steam power a country had and how creatively it could deploy that power. This wave of globalization was largely driven by European and American businesses and individuals. Therefore, exports as a share of world income nearly doubled to about eight percent while per capita incomes, which had risen by 0.5 percent per year in the previous 50 years, rose by an annual average of 1.3 percent. The countries that actively participated in globalization, such as the United States, became the richest countries in the world.

However, the first wave of globalization was brought to an end by World War I. Also, during the Great Depression of the 1930s, governments responded by practic- ing protectionism: a futile attempt to enact tariffs on imports to shift demand into their domestic markets, thus promoting sales for domestic companies and jobs for domestic workers. For the world economy, increasing protectionism caused exports as a share of national income to fall to about five percent, thereby undoing 80 years of technological progress in transportation.

Second Wave of Globalization: 1945–1980 The horrors of the retreat into nationalism provided renewed incentive for interna- tionalism following World War II. The result was a second wave of globalization that took place from 1945 to 1980. Falling transportation costs continued to foster increased trade. Also, nations persuaded governments to cooperate to decrease pre- viously established trade barriers.

However, trade liberalization discriminated both in terms of which countries participated and which products were included. By 1980, trade between developed countries in manufactured goods had been largely freed of barriers. However, bar- riers facing developing countries had been eliminated for only those agricultural products that did not compete with agriculture in developed countries. For manufac- tured goods, developing countries faced sizable barriers. However, for developed countries, the slashing of trade barriers between them greatly increased the exchange of manufactured goods, thus helping to raise the incomes of developed countries rel- ative to the rest.