International Economics Paul krugman

International

Economics

Theory and Policy

SIXTH EDITION

Paul R. Krugman

Princeton University

Maurice Obstfeld

University of California, Berkeley

Boston San Francisco New York

London Toronto Sydney Tokyo Singapore Madrid

Mexico City Munich Paris Cape Town Hong Kong Montreal Frete Universal Berlin

Wlrtschaftswissenschatilicte

Bibliothek

For Robin and Leslie Ann

Editor-in-Chief: Denise Clinton

Executive Development Manager: Sylvia Mallory

Development Editor: Jane Tufts

Web Development: Melissa Honig

Managing Editor: James Rigney

Production Supervisor: Katherine Watson

Design Manager: Regina Kolenda

Text Design, Electronic Composition, and Project Management:

Elm Street Publishing Services, Inc.

Cover Designer: Regina Kolenda

Cover Image: © Digital Vision Ltd.

Supplements Editor: Andrea Basso

Marketing Manager: Adrienne D'Ambrosio

Manufacturing Coordinator: Hugh Crawford

International Economics: Theory and Policy

Copyright © 2003 by Paul R. Krugman and Maurice Obstfeld

All rights reserved. No part of this publication may be reproduced, stored in a retrieval

system, or transmitted, in any form or by any means, electronic, mechanical, photocopying,

recording, or otherwise, without the prior written consent of the publisher.

For information on obtaining permission for the use of material from this work, please

submit a written request to Pearson Education, Inc., Rights and Contracts Department,

75 Arlington St., Suite 300, Boston, MA 02116 or fax your request to (617) 848-7047.

Printed in the United States of America.

ISBN: 0-321-11639-9

WORLD STUDENT SERIES

This edition may be sold only in those countries to which it is consigned by Pearson

Education International. It is not to be re-exported and it is not for sale in the U.S.A.

or Canada.

03 02

BRIEF CONTENTS

Contents vii

Preface xxii

1 Introduction 1

Part I International Trade Theory 9

2 Labor Productivity and Comparative Advantage:

The Ricardian Model 10

3 Specific Factors and Income Distribution 38

4 Resources and Trade: The Heckscher-Ohlin Model 67

5 The Standard Trade Model 93

6 Economies of Scale, Imperfect Competition,

and International Trade 120

7 International Factor Movements 160

Part 2 International Trade Policy 185

8 The Instruments of Trade Policy 186

9 The Political Economy of Trade Policy 218

10 Trade Policy in Developing Countries 255

11 Controversies in Trade Policy 276

Part 3 Exchange Rates and Open-Economy

Macroeconomics 293

12 National Income Accounting and the Balance of Payments 294

13 Exchange Rates and the Foreign Exchange Market:

An Asset Approach 324

14 Money, Interest Rates, and Exchange Rates 357

15 Price Levels and the Exchange Rate in the Long Run 388

16 Output and the Exchange Rate in the Short Run 433

17 Fixed Exchange Rates and Foreign Exchange Intervention 481

Part 4 International Macroeconomic Policy 53 I

18 The International Monetary System, 1870-1973 532

19 Macroeconomic Policy and Coordination under Floating

Exchange Rates 568

20 Optimum Currency Areas and the European Experience 604

21 The Global Capital Market: Performance

and Policy Problems 636

22 Developing Countries: Growth, Crisis, and Reform 665

vi Brief Contents

Mathematical Postscripts 707

Postscript to Chapter 3: The Specific Factors Model 708

Postscript to Chapter 4: The Factor Proportions Model 714

Postscript to Chapter 5: The Trading World Economy 717

Postscript to Chapter 6: The Monopolistic

Competition Model 726

Postscript to Chapter 21: Risk Aversion and

International Portfolio Diversification 728

Index 737

CONTENTS

Preface xxii

1 Introduction I

What Is International Economics About? 3

The Gains from Trade 3

The Pattern of Trade 4

How Much Trade? 5

The Balance of Payments 6

Exchange Rate Determination 6

International Policy Coordination 7

The International Capital Market 7

International Economics: Trade and Money 8

Part I

International Trade Theory 9

2 Labor Productivity and Comparative Advantage:

The Ricardian Model 10

The Concept of Comparative Advantage 10

A One-Factor Economy 12

Production Possibilities 12

Relative Prices and Supply 14

Trade in a One-Factor World 14

Box: Comparative Advantage in Practice: The Case of Babe Ruth 16

Determining the Relative Price after Trade 16

The Gains From Trade 19

A Numerical Example 20

Relative Wages 22

Misconceptions about Comparative Advantage 23

Productivity and Competitiveness 23

The Pauper Labor Argument 24

Exploitation 24

Box: Do Wages Reflect Productivity? 25

Comparative Advantage with Many Goods 26

Setting Up the Model 26

Relative Wages and Specialization 27

Determining the Relative Wage in the Multigood Model 28

Adding Transport Costs and Nontraded Goods 30

Empirical Evidence on the Ricardian Model 31

Summary 34

VII

viii Contents

3 Specific Factors and Income Distribution 38

The Specific Factors Model 39

Assumptions of the Model 39

Box: What Is a Specific Factor? 40

Production Possibilities 40

Prices, Wages, and Labor Allocation 44

Relative Prices and the Distribution of Income 49

International Trade in the Specific Factors Model 50

Resources and Relative Supply 51

Trade and Relative Prices 52

The Pattern of Trade 53

Income Distribution and the Gains From Trade 54

The Political Economy of Trade: A Preliminary View 57

Optimal Trade Policy 57

Income Distribution and Trade Politics 58

Box: Specific Factors and the Beginnings of Trade Theory 59

Summary 60

Appendix: Further Details on Specific Factors 63

Marginal and Total Product 63

Relative Prices and the Distribution of Income 64

4 Resources and Trade: The Heckscher-Ohlin Model 67

A Model of a Two-Factor Economy 68

Assumptions of the Model 68

Factor Prices and Goods Prices 69

Resources and Output 72

Effects of International Trade Between Two-Factor Economies 75

Relative Prices and the Pattern of Trade 76

Trade and the Distribution of Income 76

Factor Price Equalization 78

Case Study: North-South Trade and Income Inequality 80

Empirical Evidence on the Heckscher-Ohlin Model 82

Testing the Heckscher-Ohlin Model , 82

Implications of the Tests 85

Summary 86

Appendix: Factor Prices, Goods Prices, and Input Choices 89

Choice of Technique 89

Goods Prices and Factor Prices 91

5 The Standard Trade Model 93

A Standard Model of a Trading Economy 94

Production Possibilities and Relative Supply 94

Relative Prices and Demand 95

The Welfare Effect of Changes in the Terms of Trade 98

Contents ix

Determining Relative Prices 98

Economic Growth: A Shift of the RS Curve 99

Growth and the Production Possibility Frontier 100

Relative Supply and the Terms of Trade . 101

International Effects of Growth 101

Case Study: Has the Growth of Newly Industrializing

Countries Hurt Advanced Nations? 103

International Transfers of Income: Shifting the RD Curve 104

The Transfer Problem 105

Effects of a Transfer on the Terms of Trade 105

Presumptions about the Terms of Trade Effects of Transfers 107

Case Study: The Transfer Problem and the Asian Crisis 108

Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD 109

Relative Demand and Supply Effects of a Tariff 109

Effects of an Export Subsidy 110

Implications of Terms of Trade Effects: Who Gains and Who Loses? 111

Summary 113

Appendix: Representing International Equilibrium

with Offer Curves 117

Deriving a Country's Offer Curve 117

International Equilibrium 118

6 Economies of Scale, Imperfect Competition,

and International Trade 120

Economies of Scale and International Trade: An Overview 120

Economies of Scale and Market Structure 122

The Theory of Imperfect Competition 123

Monopoly: A Brief Review 123

Monopolistic Competition 126

Limitations of the Monopolistic Competition Model 131

Monopolistic Competition and Trade 132

The Effects of Increased Market Size 132

Gains from an Integrated Market: A Numerical Example 133

Economies of Scale and Comparative Advantage 136

The Significance of Intraindustry Trade 139

Why Intraindustry Trade Matters 140

Case Study: Intraindustry Trade in Action: The North

American Auto Pact of 1964 141

Dumping 142

The Economics of Dumping 142

Case Study: Antidumping as Protectionism 145

Reciprocal Dumping 146

The Theory of External Economies 147

Specialized Suppliers 147

Labor Market Pooling 148

Knowledge Spillovers 149

Contents

External Economies and Increasing Returns 150

External Economies and International Trade 150

External Economies and the Pattern of Trade 150

Trade and Welfare with External Economies 151

Dynamic Increasing Returns 152

Box: Tinseltown Economics 153

Summary 155

Appendix: Determining Marginal Revenue 158

7 International Factor Movements 160

International Labor Mobility 161

A One-Good Model Without Factor Mobility 161

International Labor Movement 162

Extending the Analysis 163

Case Study: Wage Convergence in the Age of Mass Migration 165

Case Study: Immigration and the U.S. Economy 166

International Borrowing and Lending 167

Intertemporal Production Possibilities and Trade 167

The Real Interest Rate 168

Intertemporal Comparative Advantage 169

Direct Foreign Investment and Multinational Firms 169

Box: Does Capital Movement to Developing Countries Hurt

Workers in High-Wage Countries? 170

The Theory of Multinational Enterprise 172

Multinational Firms in Practice 173

Case Study: Foreign Direct Investment in the United States 175

Box: Taken for a Ride? 177

Summary 177

Appendix: More on Intertemporal Trade 181

Part 2

International Trade Policy 185

8 The Instruments of Trade Policy 186

Basic Tariff Analysis 186

Supply, Demand, and Trade in a Single Industry 187

Effects of a Tariff 189

Measuring the Amount of Protection 190

Costs and Benefits of a Tariff 192

Consumer and Producer Surplus 192

Measuring the Costs and Benefits 195

Other Instruments of Trade Policy 196

Export Subsidies: Theory 197

Case Study: Europe's Common Agricultural Policy 198

Contents xi

Import Quotas: Theory 200

Case Study: An Import Quota in Practice: U.S. Sugar 200

Voluntary Export Restraints 202

Case Study: A Voluntary Export Restraint in Practice:

Japanese Autos 203

Local Content Requirements 203

Box: American Buses, Made in Hungary 204

Other Trade Policy Instruments 205

The Effects of Trade Policy: A Summary 206

Summary 206

Appendix I: Tariff Analysis in General Equilibrium 210

A Tariff in a Small Country 210

A Tariff in a Large Country 212

Appendix II: Tariffs and Import Quotas in the Presence

of Monopoly 214

The Model with Free Trade M 214

The Model with a Tariff 215

The Model with an Import Quota 216

Comparing a Tariff and a Quota 216

9 The Political Economy of Trade Policy 218

The Case for Free Trade 218

Free Trade and Efficiency 219

Additional Gains from Free Trade 219

Political Argument for Free Trade 221

Case Study: The Gains from 1992 221

National Welfare Arguments Against Free Trade 223

The Terms of Trade Argument for a Tariff 223

The Domestic Market Failure Argument Against Free Trade 224

How Convincing Is the Market Failure Argument? 226

Box: Market Failures Cut Both Ways: The Case of California 227

Income Distribution and Trade Policy 229

Electoral Competition 229

Collective Action 230

Modeling the Political Process 231

Who Gets Protected? 232

Box: Politicians for Sale: Evidence from the 1990s 233

International Negotiations and Trade Policy 234

The Advantages of Negotiation 235

International Trade Agreements: A Brief History 237

The Uruguay Round 239

Trade Liberalization 239

From the GATT to the WTO 240

Benefits and Costs 241

Box: Settling a Dispute—and Creating One 242

Preferential Trading Agreements 243

xii Contents

Box: Free Trade Area versus Customs Union 244

Box: Do Trade Preferences Have Appeal? 245

Case Study: Trade Diversion in South America 246

Summary 247

Appendix: Proving that the Optimum Tariff

Is Positive 252

Demand and Supply 252

The Tariff and Prices 252

The Tariff and Domestic Welfare 253

10 Trade Policy in Developing Countries 255

Import-Substituting Industrialization 256

The Infant Industry Argument 256

Promoting Manufacturing Through Protection 258

Case Study: The End of Import Substitution in Chile 260

Results of Favoring Manufacturing: Problems

of Import-Substituting Industrialization 261

Problems of the Dual Economy 263

The Symptoms of Dualism 263

Case Study: Economic Dualism in India 264

Dual Labor Markets and Trade Policy 264

Trade Policy as a Cause of Economic Dualism 267

Export-Oriented Industrialization: The East Asian

Miracle 267

The Facts of Asian Growth 268

Trade Policy in the HPAEs 269

Box: China's Boom 270

Industrial Policy in the HPAEs 270

Other Factors in Growth 271

Summary 272

I I Controversies in Trade Policy 276

Sophisticated Arguments for Activist Trade Policy 276

Technology and Externalities 277

Imperfect Competition and Strategic Trade Policy 278

Case Study: When the Chips Were Up 282

Globalization and Low-Wage Labor 283

The Anti-Globalization Movement 284

Trade and Wages Revisited 285

Labor Standards and Trade Negotiations 287

Environmental and Cultural Issues 288

The WTO and National Independence 288

Case Study: The Shipbreakers of Alang 289

Summary 290

Contents xiii

Part 3

Exchange Rates and Open-Economy

Macroeconomics 293

I 2 National Income Accounting and the Balance

of Payments 294

The National Income Accounts 295

National Product and National Income 296

Capital Depreciation, International Transfers, and Indirect

Business Taxes 297

Gross Domestic Product 298

National Income Accounting for an Open Economy 299

Consumption 299

Investment t 299

Government Purchases 299

The National Income Identity for an Open Economy 300

An Imaginary Open Economy 300

The Current Account and Foreign Indebtedness 301

Saving and the Current Account 303

Private and Government Saving 305

Case Study: Government Deficit Reduction May Not Increase

the Current Account Surplus 306

The Balance of Payment Accounts 307

Examples of Paired Transactions 309

The Fundamental Balance of Payments Identity 310

The Current Account, Once Again 310

The Capital Account 312

The Financial Account 312

The Statistical Discrepancy 313

Official Reserve Transactions 313

Box: The Mystery of the Missing Surplus 314

Case Study: Is the United States the World's Biggest Debtor? 316

Summary 320

I 3 Exchange Rates and the Foreign Exchange Market:

An Asset Approach 324

Exchange Rates and International Transactions 325

Domestic and Foreign Prices 325

Exchange Rates and Relative Prices 327

The Foreign Exchange Market 328

The Actors 328

Box: A Tale of Two Dollars 329

Characteristics of the Market 330

Spot Rates and Forward Rates 331

xiv Contents

Foreign Exchange Swaps 332

Future and Options 333

The Demand for Foreign Currency Assets 334

Assets and Asset Returns 334

Risk and Liquidity 335

Interest Rates 336

Exchange Rates and Asset Returns ' 337

A Simple Rule 338

Return, Risk, and Liquidity in the Foreign Exchange Market 340

Equilibrium in the Foreign Exchange Market 341

Interest Parity: The Basic Equilibrium Condition 341

How Changes in the Current Exchange Rate Affect Expected Returns 342

The Equilibrium Exchange Rate 344

Interest Rates, Expectations, and Equilibrium 346

The Effect of Changing Interest Rates on the Current Exchange Rate 347

The Effect of Changing Expectations on the Current Exchange Rate 347

Box: The Perils of Forecasting Exchange Rates 349

Summary 350

Appendix: Forward Exchange Rates and Covered

Interest Parity 354

I 4 Money, Interest Rates, and Exchange Rates 357

Money Defined: A Brief Review 358

Money as a Medium of Exchange 358

Money as a Unit of Account 358

Money as a Store of Value 358

What Is Money? 359

How the Money Supply Is Determined -359

The Demand for Money by Individuals 359

Expected Return 360

Risk 360

Liquidity 361

Aggregate Money Demand 361

The Equilibrium Interest Rate: The Interaction of Money

Supply and Demand 362

Equilibrium in the Money Market 362

Interest Rates and the Money Supply 365

Output and the Interest Rate 366

The Money Supply and the Exchange Rate in the Short Run 366

Linking Money, the Interest Rate, and the Exchange Rate 367

U.S. Money Supply and the Dollar/Euro Exchange Rate 369

Europe's Money Supply and the Dollar/Euro Exchange Rate 370

Money, the Price Level, and the Exchange Rate in the Long Run 373

Money and Money Prices 373

The Long-Run Effects of Money Supply Changes 374

Empirical Evidence on Money Supplies and Price Levels 375

r

Contents XV

Money and the Exchange Rate in the Long Run 376

Box: Inflation and Money-Supply Growth in Latin America 377

Inflation and Exchange Rate Dynamics 378

j: Short-Run Price Rigidity versus Long-Run Price Flexibility 378

Box: Money Supply Growth and Hyperinflation in Bolivia 380

Permanent Money Supply Changes and the Exchange Rate 381

Exchange Rate Overshooting 383

| Summary 384

t I 5 Price Levels and the Exchange Rate in the Long Run 388

The Law of One Price 389

Purchasing Power Parity 389

The Relationship between PPP and the Law of One Price 390

• Absolute PPP and Relative PPP 391

\ A Long-Run Exchange Rate Model Based on PPP , 392

; The Fundamental Equation of the Monetary Approach 392

Ongoing Inflation, Interest Parity, and PPP 394

[ The Fisher Effect 396

; Empirical Evidence on PPP and the Law of One Price 400

! Box: Some Meaty Evidence on the Law of One Price 402

Explaining the Problems with PPP 404

' Trade Barriers and Nontradables 404

: Departures from Free Competition 405

• Box: Hong Kong's Surprisingly High Inflation 406

International Differences in Price Level Measurement 408

PPP in the Short Run and in the Long Run 408

Case Study: Why Price Levels Are Lower in Poorer Countries 409

Beyond Purchasing Power Parity: A General Model

of Long-Run Exchange Rates 411

The Real Exchange Rate 411

Box: Sticky Prices and the Law of One Price: Evidence

from Scandinavian Duty-Free Shops 412

Demand, Supply, and the Long-Run Real Exchange Rate 415

Nominal and Real Exchange Rates in Long-Run Equilibrium 416

Case Study: Why Has the Yen Kept Rising? 419

International Interest Rate Differences and the Real

Exchange Rate 421

Real Interest Parity 423

Summary 424

Appendix: The Fisher Effect, the Interest Rate,

and the Exchange Rate under the Flexible-Price

Monetary Approach 430

16 Output and the Exchange Rate in the Short Run 433

Determinants of Aggregate Demand in an Open Economy 434

xvi Contents

Determinants of Consumption Demand 434

Determinants of the Current Account 435

How Real Exchange Rate Changes Affect the Current Account 436

How Disposable Income Changes Affect the Current Account 437

The Equation of Aggregate Demand 437

The Real Exchange Rate and Aggregate Demand 437

Real Income and Aggregate Demand 438

How Output Is Determined in the Short Run 438

Output Market Equilibrium in the Short Run:

The DD Schedule 440

Output, the Exchange Rate, and Output Market Equilibrium 440

Deriving the DD Schedule 441

Factors that Shift the DD Schedule 443

Asset Market Equilibrium in the Short Run: The AA Schedule 445

Output, the Exchange Rate, and Asset Market Equilibrium 445

Deriving the AA Schedule 446

Factors that Shift the AA Schedule 446

Short-Run Equilibrium for an Open Economy: Putting

the DD and AA Schedules Together 448

Temporary Changes in Monetary and Fiscal Policy 450

Monetary Policy 451

Fiscal Policy 451

Policies to Maintain Full Employment 452

Inflation Bias and Other Problems of Policy Formulation 455

Permanent Shifts in Monetary and Fiscal Policy 456

A Permanent Increase in the Money Supply 456

Adjustment to a Permanent Increase in the Money Supply 456

A Permanent Fiscal Expansion 458

Macroeconomic Policies and the Current Account 460

Box: The Dollar Exchange Rate and the U.S. Economic

Slowdown of 2000-2001 461

Gradual Trade Flow Adjustment and Current

Account Dynamics 463

The J-Curve 464

Exchange Rate Pass-Through and Inflation 465

Summary 466

Appendix I: The IS-LM Model and the DD-AA Model 470

Appendix II: Intertemporal Trade and Consumption

Demand 475

Appendix III: The Marshall-Lerner Condition and

Empirical Estimates of Trade Elasticities 477

17 Fixed Exchange Rates and Foreign Exchange

Intervention 481

Why Study Fixed Exchange Rates? 481

Contents xvii

Central Bank Intervention and the Money Supply 482

The Central Bank Balance Sheet and the Money Supply 486

Foreign Exchange Intervention and the Money Supply 487

Sterilization 488

The Balance of Payments and the Money Supply 489

How the Central Bank Fixes the Exchange Rate 490

Foreign Exchange Market Equilibrium under a Fixed

Exchange Rate 491

Money Market Equilibrium under a Fixed Exchange Rate 491

A Diagrammatic Analysis 492

Stabilization Policies with a Fixed Exchange Rate 494

Monetary Policy 494

Fiscal Policy 495

Changes in the Exchange Rate 496

Adjustment to Fiscal Policy and Exchange Rate Changes 498

Case Study: Fixing the Exchange Rate to Escape

from a Liquidity Trap 499

Balance of Payments Crises and Capital Flight 502

Managed Floating and Sterilized Intervention 505

Perfect Asset Substitutability and the Ineffectiveness

of Sterilized Intervention 505

Box: Mexico's 1994 Balance of Payments Crisis 506

Foreign Exchange Market Equilibrium under Imperfect

Asset Substitutability 507

The Effects of Sterilized Intervention with Imperfect

Asset Substitutability 508

Evidence on the Effects of Sterilized Intervention 510

The Signaling Effect of Intervention 510

Reserve Currencies in the World Monetary System 511

The Mechanics of a Reserve Currency Standard 512

The Asymmetric Position of the Reserve Center 512

The Gold Standard 513

The Mechanics of a Gold Standard 513

Symmetric Monetary Adjustment under a Gold Standard 514

Benefits and Drawbacks of the Gold Standard 515

The Bimetallic Standard 516

The Gold Exchange Standard 516

Summary 517

Appendix I: Equilibrium in the Foreign Exchange

Market with Imperfect Asset Substitutability 522

Demand 522

Supply 523

Equilibrium 523

Appendix II: The Monetary Approach to the Balance

of Payments 525

Appendix III: The Timing of Balance of Payments Crises 527