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 BAD GUY NOTICE:  I only scanned this book to help my fellow students. If you like the book, go buy it.  However, if you can't afford it, or you're simply too tired to go to the library every time you  need to read it or copy pages from it, then don't complain about the quality.   Dear Mr Krugman, dear Mr Obstfeld,  I honestly advise you to offer us a downloadable PDF-Version of your book. It would be a  lot cheaper for you and us, and a lot easier to get. Maybe for the next time. Welcome to  the new Millenium! 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. 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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 [...]... Market: Performance and Policy Problems The International Capital Market and the Gains from Trade Three Types of Gain from Trade Risk Aversion Portfolio Diversification as a Motive for International Asset Trade The Menu of International Assets: Debt Versus Equity International Banking and the International Capital Market The Structure of the International Capital Market Growth of the International Capital... covered in class and the exciting issues that dominate current research and policy debates That gap has widened dramatically as the importance of international economic problems and enrollments in international economics courses— have grown This book is our attempt to provide an up-to-date and understandable analytical framework for illuminating current events and bringing the excitement of international. .. Employment and Price-Level Stability External Balance: The Optimal Level of the Current Account International Macroeconomic Policy under the Gold Standard, 1870-1914 Origins of the Gold Standard External Balance under the Gold Standard The Price-Specie-Flow Mechanism The Gold Standard "Rules of the Game": Myth and Reality Box: Hume versus the Mercantilists Internal Balance under the Gold Standard Case... The Demand for Money by Individuals Expected Return Risk Liquidity 358 358 358 358 359 -359 359 360 360 361 Aggregate Money Demand The Equilibrium Interest Rate: The Interaction of Money Supply and Demand 361 362 Equilibrium in the Money Market Interest Rates and the Money Supply Output and the Interest Rate The Money Supply and the Exchange Rate in the Short Run Linking Money, the Interest Rate, and. .. Conflict over America's Monetary Standard During the 1890s The Interwar Years, 1918-1939 The German Hyperinflation The Fleeting Return to Gold International Economic Disintegration Case Study: The International Gold Standard and the Great Depression The Bretton Woods System and the Internationa] Monetary Fund Goals and Structure of the IMF Convertibility Internal and External Balance under the Bretton... Dominance and the Credibility Theory of the EMS The EU "1992" Initiative European Economic and Monetary Union The Euro and Economic Policy in the Euro Zone The Maastricht Convergence Criteria and the Stability and Growth Pact The European System of Central Banks Box: Designing and Naming a New Currency The Revised Exchange Rate Mechanism The Theory of Optimum Currency Areas Economic Integration and the... Fiscal Policy Monetary Policy Fiscal Policy Policies to Maintain Full Employment Inflation Bias and Other Problems of Policy Formulation Permanent Shifts in Monetary and Fiscal Policy A Permanent Increase in the Money Supply Adjustment to a Permanent Increase in the Money Supply A Permanent Fiscal Expansion Macroeconomic Policies and the Current Account Box: The Dollar Exchange Rate and the U.S Economic... Currencies in the World Monetary System The Mechanics of a Reserve Currency Standard The Asymmetric Position of the Reserve Center The Gold Standard The Mechanics of a Gold Standard Symmetric Monetary Adjustment under a Gold Standard Benefits and Drawbacks of the Gold Standard The Bimetallic Standard The Gold Exchange Standard Summary 486 487 488 489 490 508 510 510 511 512 512 513 513 514 515 516... industrializing and newly industrialized countries The chapter reviews emerging market crises and places in historical perspective the interactions among developing country borrowers, developed country lenders, and official financial institutions such as the International Monetary Fund International Factor Movements In Chapter 7 we emphasize the potential substitutability of international trade and international. .. coffee beans from both Mexico and Hawaii; the sequence of events that brought those beans to the shop is not very different, and the imported beans traveled a much shorter distance! Yet international economics involves new and different concerns, because international trade and investment occur between independent nations The United States and Mexico are sovereign states; Florida and Hawaii are not Mexico's . 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. 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. 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