Ekinter Cheat Sheet

Institute for Development
Of Economics and Finance
International Economics
Chapter 9: Instruments of Trade Policy
A. Basic Tariff Analysis

● The importance of tariffs has declined in modern times because modern
governments usually prefer to protect domestic industries through a variety of
non tariff barriers, such as import quotas (limitations on the quantity of imports)
and export restraints (limitations on the quantity of exports—usually imposed by
the exporting country at the importing country’s request).
● A specific tariff is levied as a fixed charge for each unit of imported goods. For
example, $3 per barrel of oil.
● An ad valorem tariff is levied as a fraction of the value of imported goods. For
example, a 25% tariff on the value of imported trucks.
● Free trade setting :Import Demand in a Single Industry
➔ Suppose that in the absence of trade the price of wheat is higher in Home
than it is in Foreign.
➔ With trade, wheat will be shipped from Foreign to Home until the price
difference is eliminated.
➔ An import demand curve is the difference between the quantity that Home
consumers demand minus the quantity that Home producers supply, at
each price.
➔ As price increases, the quantity of imports demanded declines
● Free trade setting : Export Supply in a Single Industry
➔ An export supply curve is the difference between the quantity that

Foreign producers supply minus the quantity that Foreign consumers
demand, at each price.
➔ As price increases, the quantity of exports supplied rises.
● Free trade setting: World Equilibrium in a Single Industry
➔ In equilibrium :
➔ import demand = export supply,
➔ home demand + foreign demand
➔ = home supply + foreign supply,
➔ world demand = world supply.
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● The Effects of a Tariff on World Market
B. Measuring the Amount of Protection
● When a country is small, a tariff it imposes cannot lower the foreign price of the
goods it imports. As a result, the price of the import rises from PW to PW + t and
the quantity of imports demanded falls from D1 - S1 to D2 - S2.
● Problems:
➔ First, if the small country assumption is not a good approximation, part of
the effect of a tariff will be to lower foreign export prices rather than to
raise domestic prices. This effect of trade policies on foreign export
prices is sometimes significant.
➔ Second, the problem is that tariffs may have very different effects on
different stages of production of a good.
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● Effective Rate Protection: ERP is a measure of the total effect of the entire tariff
structure on the value added per unit of output in each industry, when both
intermediate and final goods are imported.
C. Cost and Benefits of Tariff

● Consumer surplus: The amount consumers gain from a purchase by calculating
their willingness to pay subtracted by the price they paid.
● Producer surplus: The amount producers gain from a purchase by calculating
what they're willing to sell for a good subtracted by the price they sold it for.
● Measure the cost and benefits:
➔ A tariff raises the price in the importing country: consumer surplus decreases
(consumers worse off), producer surplus increases (producers better off).
➔ the government collects tariff revenue equal to the tariff rate times the
quantity of imports with the tariff.
𝑡𝑄𝑇 = (𝑃𝑇 − 𝑃𝑇 *)(𝐷2 − 𝑆2)
➔ Change in welfare due to the tariff is : e – (b + d)
➔ The welfare effect of a tariff is ambiguous.
➔ The triangles b and d represent the efficiency loss.
➔ The tariff distorts production and consumption decisions: producers
produce too much and consumers consume too little.
➔ The rectangle e represents the terms of trade gain.
➔ The tariff lowers the Foreign price, allowing Home to buy its imports cheaper.
➔ If the terms of trade gain exceed the efficiency loss, then national welfare will
increase under a tariff, at the expense of foreign countries.
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D. Other Instruments
● Export subsidy:
➔ An export subsidy is a payment to a firm or individual that ships goods

abroad.
➔ An export subsidy lowers the price paid in importing countries 𝑃𝑆 *= 𝑃𝑆 − 𝑠
➔ An export subsidy raises the price in the exporting country, decreasing its
consumer surplus (consumers worse off) and increasing its producer surplus
(producers better off).
➔ Also, government revenue falls due to paying
for the export subsidy.
➔ The net welfare loss is therefore the sum of the areas b+d+e+f+g .
➔ b and d represent consumption and production distortion losses.
➔ e+f+g represent terms of trade loss. an export subsidy worsens the
terms of trade by lowering the price of exports in world markets.
➔ The triangles b and d represent the efficiency loss.
➔ The export subsidy distorts production and consumption decisions:
producers produce too much and consumers consume too little
compared to the market outcome.
● Import Quota:
➔ An import quota is a restriction on the quantity of a good that may be
imported.
➔ This restriction is usually enforced by issuing licenses or quota rights.
➔ A binding import quota will push up the price of the import because the
quantity demanded will exceed the quantity supplied by Home producers
and from imports.
➔ When a quota instead of a tariff is used to restrict imports, the government
receives no revenue.
➔ Instead, the revenue from selling imports at high prices goes to quota
license holders.
➔ These extra revenues are called quota rents.
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● Voluntary Export Restraint

➔ A voluntary export restraint works like an import quota, except that the quota
is imposed by the exporting country rather than the importing country.
➔ These restraints are usually requested by the importing country. Usually
imposed on industry or products which are not a perfect substitute.
➔ Example : in 1981, limited Japanese exports to the USA to 1.68 million
automobile
➔ The profits or rents from this policy are earned by foreign governments or
foreign producers.
➔ Foreigners sell a restricted quantity at an increased price.
● Local Content Requirement
➔ A local content requirement is a regulation that requires a specified fraction
of a final good to be produced domestically.
➔ It may be specified in value terms, by requiring that some minimum share of
the value of a good represent home value added, or in physical units.
➔ Local content laws have been widely used by developing countries trying to
shift their manufacturing base from assembly back into intermediate goods
➔ From the viewpoint of domestic producers of inputs, a local content
requirement provides protection in the same way that an import quota would
(additional producer gain)
➔ From the point of view of the firms : it allows firms to import more, provided
that they also buy more domestically. This means that the effective price of
inputs to the firm is an average of the price of imported and domestically
produced inputs
● Others:
➔ Export credit subsidies: A subsidized loan to exporters, U.S. Export-Import
Bank subsidizes loans to U.S. exporters.
➔ Government procurement: Government agencies are obligated to purchase
from home suppliers, even when they charge higher prices
(or have inferior quality) compared to foreign suppliers.
➔ Bureaucratic regulations (red tape): Safety, health, quality, or customs
regulations can
act as a form of
protection and
trade restriction
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Chapter 10: The Political Economy of Trade Policy
A. The Case for Free Trade

● Free Trade Improve Efficiency
➔ Producers and consumers allocate
resources most efficiently when governments
do not distort market prices through trade
policy.
➔ With restricted trade, consumers pay higher
prices and consume too little while firms
produce too much.
➔ National welfare of a small country is highest
with free trade.
➔ Against it:
➔ Tariff rates are already low for most countries,
➔ protection costs less than 1 percent of GDP.
➔ The gains from free trade are somewhat smaller for advanced
economies and larger for poorer developing countries.
● Free Trade Provides additional gains
➔ Allows firms or industry to take advantage of economies of scale. With a
protected market : Too many firms enter the protected industry & The scale
of production of each firm becomes inefficient.
➔ Provides competition and opportunities for innovation (dynamic benefits):
By providing entrepreneurs with an incentive to seek new ways to export or
compete with imports, free trade offers more opportunities for learning and
innovation.
● Rent Seeking
➔ Free trade avoids the loss of resources through rent seeking: Spend time and
other resources seeking quota rights and the profit that they will earn.
● Political Argument
➔ Trade is the best feasible political policy, even though there may be better
policies in principle: Any policy that deviates from free trade would be quickly
manipulated by political groups, leading to decreased national welfare.
B. The Cases against Free Trade
● The Terms of Trade Argument for a Tariff
➔ For a “large” country, a tariff lowers the price of imports in world markets and
generates a terms of trade gain.
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➔ This benefit may exceed the losses caused by distortions in production

and consumption.
➔ A small tariff will lead to an increase in national welfare for a large country.
➔ But at some tariff rate, the national welfare will begin to decrease as the economic
efficiency loss exceeds the terms of trade gain.
➔ tariff rate 𝑡𝑜 maximizes national welfare, so called- an
optimum tariff.
➔ An export tax (a negative export subsidy) that
completely prohibits exports leaves a country worse off,
but an export tax rate may exist that maximizes national
welfare through the terms of trade.
➔ An export subsidy lowers the terms of trade for a large
country; an export tax raises the terms of trade for a large
country.
➔ An export tax may raise the price of exports in the world market, increasing
the terms of trade.
➔ For some countries like the U.S., an import tariff and/or export tax could
improve national welfare at the expense of other countries.
➔ Ignores the likelihood that other countries may retaliate against large
countries by enacting their own trade restrictions.
● The domestic market failure argument
➔ Domestic market failures may exist that cause free trade to be a suboptimal
policy.
➔ Types of market failures include
➔ Persistently high underemployment of workers (wages do not adjust)
➔ Persistently high underutilization of structures, equipment, and other
forms of capital
➔ Property rights not well defined or well enforced
➔ technological benefits for society discovered through private
production, but from which private firms cannot fully profit
➔ environmental costs for society caused by private production, but for
which private firms do not fully pay
➔ sellers that are not well informed about the (opportunity) cost of
production or buyers that are not well informed about value from
consumption
➔ marginal social benefit represents the additional

benefit to society from private production.
➔ With a market failure, marginal social benefit is
not accurately measured by the producer surplus of
private firms, and economic efficiency losses are
misleading.
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➔ when a tariff increases domestic production, the benefit to domestic society will
increase due to a market failure.
➔ Government intervention in the market may be the “second-best” way of fixing the
problem.
● Counter arguments
➔ domestic market failures should be corrected by a “first-best” policy
➔ If persistently high underemployment of labor is a problem, then the
cost of labor or production of labor-intensive products could be
subsidized by the government.
➔ Unclear when and to what degree a market failure exists in the real world.
➔ Government policies to address market failures are likely to be manipulated
by politically powerful groups.
C. Income Distribution and Trade Policy
Voters are lined up in order of the tariff rate they
prefer. If one party proposes a high tariff of 𝑡𝐴,
the other party can win over most of the voters
by offering a somewhat lower tariff, 𝑡𝐵. This
political competition drives both parties to
pro- pose tariffs close to 𝑡𝑀, the tariff preferred
by the median voter.
➔ Collective action: While it is in the interests of the group as a whole to press

for favorable policies, it is not in any individual’s interest to do so.
➔ Which industries are protected?
➔ Agriculture: In the U.S., Europe, and Japan, farmers make up a small
fraction of the electorate but receive generous subsidies and trade
protection. Examples: European Union’s Common Agricultural Policy,
Japan’s 1000% tariff on imported rice, America’s sugar quota.
➔ Clothing: textiles (fabrication of cloth) and apparel (assembly of cloth
into clothing). Until 2005, quota licenses granted to textile and apparel
exporters were specified in the Multi-Fiber Agreement between the
United States and many other nations.
D. International Negotiations and Trade Policy
➔ After rising sharply at the beginning of the 1930s, the average U.S. tariff rate
has decreased substantially from the mid-1930s to 1998.
➔ Since 1944, much of the reduction in tariffs and other trade restrictions has
come about through international negotiations.
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➔ The General Agreement of Tariffs and Trade was begun in 1947 as a provisional
international agreement and was replaced by a more formal international
institution called the World Trade Organization in 1995.
➔ Multilateral negotiations also help avoid a trade war between countries,
where each country enacts trade restrictions.
● The Problem of Trade Warfare
➔ In this example, each country

acting individually would be better off with
protection (20 > 10), but both would be
better off if both chose free trade than if
both choose protection (10 > –5).
➔ If Japan and the U.S. can establish a binding agreement to maintain free
trade, both can avoid the temptation of protection and both can be made
better off.
➔ Or if the damage has already been done, both countries can agree to return
to free trade.
● International Trade Agreements
➔ In 1995, the World Trade Organization, or WTO, was established as a formal
organization for implementing multilateral trade negotiations.
➔ WTO negotiations address trade restrictions in at least 3 ways:
➔ Reducing tariff rates through multilateral negotiations.
➔ Binding tariff rates: a tariff is “bound” by having the imposing country
agree not to raise it in the future.
➔ Eliminating non tariff barriers: quotas and export subsidies are changed
to tariffs because the costs of tariff protection are more apparent and
easier to negotiate.
➔ The World Trade Organization is based on a number of agreements:
➔ General Agreement on Tariffs and Trade: covers trade in goods.
➔ General Agreement on Tariffs and Services: covers trade in services (ex.,
insurance, consulting, legal services, banking).
➔ Agreement on Trade-Related Aspects of Intellectual Property: covers
international property rights (ex., patents and copyrights).
➔ The dispute settlement procedure: a formal procedure where countries
in a trade dispute can bring their case to a panel of WTO experts to rule
upon.
E. The Doha Disappointment
● Preferential Trading Agreements
➔ Preferential trading agreements are trade agreements between countries in
which they lower tariffs for each other but not for the rest of the world.
➔ There are two types of preferential trading agreements in which tariff rates
are set at or near zero:
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➔ A free trade area: an agreement that allows free trade among members,
but each member can have its own trade policy towards non-member
countries. An example is the North American Free Trade Agreement
(NAFTA).
➔ A customs union: an agreement that allows free trade among members
and requires a common external trade policy towards non-member
countries. An example is the European Union.
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Chapter 11: Trade Policy in Developing Countries
A. Import-Substituting Industrialization
● The Infant Industry Argument: Developing countries have a potential
comparative advantage in manufacturing, but it cannot initially compete with
well-established manufacturing in developed countries
➔ Problems with the Infant Industry Argument:
- Not a good idea to try to move the industries that will have a comparative
advantage in the future
- Protecting manufacturing does no good unless the protection itself helps
make industry competitive
- Tt is costly and time-consuming
➔ Market Failure Justifications for Infant Industry Protection:
- imperfect capital markets justification:
- appropriability argument:
- Both, for infant industry protection are special cases of the market failure
justification for interfering with free trade
- The difference is that in this case, the arguments apply specifically to new
industries rather than to any industry
● Promoting Manufacturing Through Protection

➔ Many developing countries have seen this argument as a compelling reason,
for example:
- Could provide subsidies to manufacturing production in general
- Could focus their efforts on subsidies for the export
- Import-substituting industrialization: the strategy that is used in most
developing countries to encourage domestic industry (tariffs and quotas)
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➔ Why not encourage both import substitution and exports?

- By protecting import-substituting industries, countries draw resources
away from actual or potential export sectors
- until the 1970s many developing countries were skeptical about the
possibility of exporting manufactured goods
- In many cases, import-substituting industrialization policies dovetailed
naturally with existing political biases.
B. Results of Favoring Manufacturing: Problems of Import-Substituting Industrialization

➔ Why didn’t import-substituting industrialization work the way it was supposed
to?
- Infant industry argument is not universally valid
- Lacks a comparative advantage in manufacturing
○ lack of skilled labor
- Can be solved by trade policy
○ An import quota can allow an inefficient manufacturing sector to
survive, but it cannot directly make that sector more efficient
- Import-substituting industrialization worsened income inequality and
unemployment
○ Protectionist policies often led to higher consumer prices and
reduced access to foreign goods → increase income inequality
○ Domestic industries developed under protectionist policies, tended
to concentrate in urban areas, increasing the rural-urban income gap
C. Trade Liberalization
➔ 1980: developing countries moved to lower tariff rates and removed import
quotas and other restrictions on trade
➔ 1985: many developing countries reduced tariffs, removed import quotas, and in
general opened their economies to import competition
➔ Trade liberalization effect:
- increase in the volume of trade → increase in GDP
- change in the nature of trade → exports surged
➔ Has the switch to more open trade delivered better results?
- It depend since there are different result
○ Brazil and other Latin American have experienced slower growth rates,
yet India experienced an acceleration of growth
D. Trade and Growth: Takeoff in Asia

➔ Trade liberalization caused these economic takeoffs in Asian
- Industrialization
- reductions in tariffs
- lifting of other import restrictions
➔ Example: South Korea, India (India’s boom), and China (Began at Deng Xiaoping)
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➔ India’s boom → India is a growing force in world trade due to its sluggish
economy and extreme import-substituting industrialization strategy
- Higher population → but the gov. Take note to make skilled labor
- Produce everything by their own
Participation in world trade surged as tariffs were brought down and
import quotas were removed
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Chapter 12: Controversies in Trade Policy
Three controversies over international trade have arisen over the past quarter-century:
1. In the 1980s a new set of sophisticated arguments for government intervention in
trade emerged in advanced countries. These arguments focused on the
“high-technology” industries that came to prominence as a result of the rise of
the silicon chip
2. In the 1990s a heated dispute arose over the effects of growing international
trade on workers in developing countries—and whether trade agreements
should include standards for wage rates and labor conditions.
3. there has been growing concern about the intersection between environmental
issues—which increasingly transcend national boundaries—and trade policy,
with a serious economic and legal dispute about whether policies such as
“carbon tariffs” are appropriate
Arguments for Activist Trade Policy:
1. Technology and Externalities

There is a potential market failure arising from difficulties of appropriating
knowledge. If firms in an industry generate knowledge that other firms can use without
paying for it, the industry is in effect producing some extra output—the marginal social
benefit of the knowledge—that is not reflected in the incentives of firms. Where such
externalities (benefits that accrue to parties other than the firms that produce them) can
be shown to be important, there is a good case for subsidizing the industry
At an abstract level, this argument is the same for the infant industries of less
developed countries as it is for the established industries of the advanced countries. In
advanced countries, however, the argument has a special edge because in those
countries, there are important high-technology industries in which the generation of
knowledge is in many ways the central aspect of the enterprise. In high-technology
industries, firms devote a great deal of their resources to improving technology, either
by explicitly spending on research and development or by being willing to take initial
losses on new products and processes to gain experience. Because such activities take
place in nearly all industries, there is no sharp line between high-tech and the rest of the
economy.
The point for activist trade policy is that while firms can appropriate some of the
benefits of their own investment in knowledge (otherwise they would not be investing!),
they usually cannot appropriate them fully. Some of the benefits accrue to other firms
that can imitate the ideas and techniques of the leaders. In electronics, for example, it is
not uncommon for firms to “reverse engineer” their rivals’ designs, taking their products
apart to figure out how they work and how they were made. Because patent laws
provide only weak protection for innovators, one can reasonably presume that under
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laissez-faire, high-technology firms do not receive as strong an incentive to innovate as

they should.
2. Imperfect Competition and Strategic Trade Policy
During the 1980s a new argument for industrial targeting received substantial
theoretical attention. Originally proposed by economists Barbara Spencer and James
Brander of the University of British Columbia, this argument identifies the market failure
that justifies government intervention as the lack of perfect competition. In some
industries, they point out, there are only a few firms in effective competition. Because of
the small number of firms, the assumptions of perfect competition do not apply. In
particular, there will typically be excess returns; that is, firms will make profits above
what equally risky investments elsewhere in the economy can earn. There will thus be an
international competition over who gets these profits
Spencer and Brander noticed that, in this case, it is possible in principle for a
government to alter the rules of the game to shift these excess returns from foreign to
domestic firms. In the simplest case, a subsidy to domestic firms, by deterring
investment and production by foreign competitors, can raise the profits of domestic
firms by more than the amount of the subsidy. Setting aside the effects on
consumers—for example, when the firms are selling only in foreign markets—this
capture of profits from foreign competitors would mean the subsidy raises national
income at other countries’ expense.
Globalization and Low-Wage Labor
Should low wages and poor working conditions be a cause for concern? Many
people think so. In the 1990s the anti-globalization movement attracted many
adherents in advanced countries, especially on college campuses. Outrage over low
wages and poor working conditions in developing-country export industries was a large
part of the movement’s appeal, although other concerns (discussed below) were also
part of the story.
It’s fair to say that most economists have viewed the anti-globalization
movement as at best misguided. The standard analysis of comparative advantage
suggests that trade is mutually beneficial to the countries that engage in it; it suggests,
furthermore, that when labor-abundant countries export labor-intensive manufactured
goods like clothing, not only should their national incomes rise but the distribution of
income should also shift in favor of labor. But is the anti-globalization movement entirely
off base?
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1. The Anti-Globalization Movement
Before 1995 most complaints about international trade made by citizens of

advanced countries targeted its effects on people who were also citizens of advanced
countries. In the United States, most critics of free trade in the 1980s focused on the
alleged threat of competition from Japan; in the early 1990s there was substantial
concern in both the United States and Europe over the effects of imports from
low-wage countries on the wages of less-skilled workers at home.
In the second half of the 1990s, however, a rapidly growing movement—drawing
considerable support from college students—began stressing the alleged harm that
world trade was doing to workers in the developing countries. Activists pointed to the
low wages and poor working conditions in the third world factories that produced
goods for Western markets. A crystallizing event was the discovery in 1996 that clothes
sold at Wal-Mart, and endorsed by television personality Kathie Lee Gifford, were
produced by very poorly paid workers in Honduras.
2. Trade and Wages Revisited
One strand of the opposition to globalization is familiar from the analysis in

Chapter 3. Activists pointed to the very low wages earned by many workers in
developing-country export industries. These critics argued that the low wages (and the
associated poor working conditions) showed that, contrary to the claims of free trade
advocates, globalization was not helping workers in developing countries
The standard economist’s answer to this argument goes back to our analysis in
Chapter 3 of the misconceptions about comparative advantage. We saw that it is a
common misconception that trade must involve the exploitation of workers if they earn
much lower wages than their counterparts in a richer country.
A critic of globalization might look at this trading equilibrium and conclude that
trade works against the interest of workers. First of all, in low-tech industries, highly paid
jobs in the United States are replaced with lower-paid jobs in Mexico. Moreover, you
could make a plausible case that the Mexican workers are underpaid: Although they are
half as productive in low-tech manufacturing as the U.S. workers they replace, their
wage rate is only 1/4 (not 1/2) that of U.S. workers. But as shown in the lower half of Table
12-3, in this example the purchasing power of wages has actually increased in both
countries. U.S. workers, all of whom are now employed in high-tech, can purchase more
low-tech goods than before: two units per hour of work versus one. Mexican workers, all
of whom are now employed in low-tech, find that they can purchase more high-tech
goods with an hour’s labor than before: 1/4 instead of 1/8 Because of trade, the price of
each country’s imported goods in terms of that country’s wage rate has fallen.
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The standard economist’s argument, in other words, is that despite the low
wages earned by workers in developing countries, those workers are better off than
they would have been if globalization had not taken place. Some activists do not accept
this argument—they maintain that increased trade makes workers in both advanced and
developing countries worse off. It is hard, however, to find a clear statement of the
channels through which this is supposed to happen. Perhaps the most popular
argument is that capital is mobile internationally, while labor is not; and that this mobility
gives capitalists a bargaining advantage. As we saw in Chapter 4, however, international
factor mobility is similar in its effects to international trade.
3. Labor Standards and Trade Negotiations
Free trade proponents and anti-globalization activists may debate the big
questions such as, is globalization good for workers or not? Narrower practical policy
issues are at stake, however: whether and to what extent international trade
agreements should also contain provisions aimed at improving wages and working
conditions in poor countries. The most modest proposals have come from economists
who argue for a system that monitors wages and working conditions and makes the
results of this monitoring available to consumers.
Because consumers can choose to buy only “certified” goods, they are better
off because they feel better about their purchases. Meanwhile, workers in the certified
factories gain a better standard of living than they otherwise would have had.
Proponents of such a system admit that it would not have a large impact on the
standard of living in developing countries, mainly because it would affect only the
wages of workers in export factories, who are a small minority of the workforce even in
highly export-oriented economies. But they argue that it would do some good and little
harm. A stronger step would be to include formal labor standards—that is, conditions
that export industries are supposed to meet—as part of trade agreements. Such
standards have considerable political support in advanced countries; indeed, President
Bill Clinton spoke in favor of such standards at the disastrous Seattle meeting
described above. The economic argument in favor of labor standards in trade
agreements is similar to the argument in favor of a minimum wage rate for domestic
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workers: While economic theory suggests that the minimum wage reduces the number
of low-skill jobs available, some (though by no means all!) reasonable economists argue
that such effects are small and are outweighed by the effect of the minimum wage in
raising the income of the workers who remain employed.
Labor standards in trade, however, are strongly opposed by most developing
countries, which believe that the standards would inevitably be used as a protectionist
tool: Politicians in advanced countries would set standards at levels that developing
countries could not meet, in effect pricing their goods out of world markets. A particular
concern— in fact, it was one of the concerns that led to the collapse of the talks in
Seattle—is that labor standards would be used as the basis for private lawsuits against
foreign companies, similar to the way anti dumping legislation has been used by private
companies to harass foreign competitors.
4. Environmental and Cultural Issues
Complaints against globalization go beyond labor issues. Many critics argue that
globalization is bad for the environment. It is unmistakably true that environmental
standards in developing-country export industries are much lower than in
advanced-country industries. It is also true that in a number of cases, substantial
environmental damage has been and is being done in order to provide goods to
advanced-country markets. A notable example is the heavy logging of Southeast Asian
forests carried out to produce forest products for sale to Japanese and Western
markets. On the other hand, there are at least as many cases of environmental damage
that has occurred in the name of “inward-looking” policies of countries reluctant to
integrate with the global economy
As in the case of labor standards, there is debate over whether trade agreements
should include environmental standards. On one side, proponents argue that such
agreements can lead to at least modest improvements in the environment, benefiting
all concerned. On the other side, opponents insist that attaching environmental
standards to trade agreements will in effect shut down potential export industries in
poor countries, which cannot afford to maintain anything like Western standards.
5. The WTO and National Independence
One recurrent theme in the anti-globalization movement is that the drive for free
trade and free flow of capital has undermined national sovereignty. In the extreme
versions of this complaint, the World Trade Organization is characterized as a
supranational power able to prevent national governments from pursuing policies in
their own interests. How much substance is there to this charge?
The short answer is that the WTO does not look anything like a world government;
its authority is basically limited to that of requiring countries to live up to their
international trade agreements. However, the small grain of truth in the view of the WTO
as a supranational authority is that its mandate allows it to monitor not only the
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traditional instruments of trade policy—tariffs, export subsidies, and quantitative

restrictions—but also domestic policies that are de facto trade policies. And since the
line between legitimate domestic policies and de facto protectionism is fuzzy, there
have been cases in which the WTO has seemed to some observers to be interfering in
domestic policy
Globalization and the Environment
Concerns about human impacts on the environment are growing in much of the
world. In turn, these concerns are playing a growing role in domestic politics. For
example, in November 2007, the government of Australian Prime Minister John Howard
was voted out of office; most political analysts believed that the ruling party’s decisive
defeat had a lot to do with public perceptions that Australia’s Liberal Party (which is
actually conservative— Labor is on the left) was unwilling to act against environmental
threats.
1. Globalization, Growth and Pollution
Both production and consumption often lead, as a byproduct, to environmental

damage. Factories emit pollution into the air and sometimes dump effluent into rivers;
farmers use fertilizer and pesticides that end up in water; consumers drive
pollution-emitting cars. As a result—other things equal—economic growth, which
increases both production and consumption, leads to greater environmental damage.
However, other things are not equal. For one thing, countries change the mix of
their production and consumption as they grow richer, to some extent in ways that tend
to reduce the environmental impact. For example, as the U.S. economy becomes
increasingly devoted to the production of services rather than goods, it tends to use
less energy and raw material per dollar of GDP.
In the early 1990s, Princeton economists Gene Grossman and Alan Krueger,
studying the relationship between national income levels and pollutants such as sulfur
dioxide, found that these offsetting effects of economic growth lead to a distinctive
“inverted U” relationship between per-capita income and environmental damage
known as the environmental Kuznets curve. 1 This concept, whose relevance has been
confirmed by a great deal of further research, is illustrated schematically in Figure 12-3.
19
2. The Problem of “Pollution Havens”
A pollution haven: Thanks to international trade, an economic activity that is

subject to strong environmental controls in some countries can take
place in other countries with less strict regulation
There are really two questions about pollution havens. The first is whether they are really
an important factor. The second is whether they deserve to be a subject of international
negotiation. On the first question, most empirical research suggests that the pollution's
effect on international trade is relatively small. That is, there is not much evidence that
“dirty” industries move to countries with lax environmental regulation.2 Even in the case
of the shipbreaking industry, India’s low wages seem to have been more of a lure than its
loose environmental restrictions. Second, do nations have a legitimate interest in each
other’s environmental policies? That turns out to depend on the nature of the
environmental problem. Pollution is the classic example of a negative externality—a
cost that individuals impose on others but don’t pay for. That’s why pollution is a valid
reason for government intervention. However, different forms of pollution have very
different geographical reach—and only those that extend across national boundaries
obviously justify international concern
3. The Carbon Tariff Dispute
In 2009 the U.S. The House of Representatives passed a bill that would have
created a cap-and-trade system for greenhouse gasses—that is, a system under which
a limited number of emissions licenses are issued and firms are required to buy enough
licenses to cover their actual emissions, in effect putting a price on carbon dioxide and
other gasses. The Senate failed to pass any comparable bill, so climate-change
legislation is on hold for the time being. Nonetheless, there was a key trade provision in
the House bill that may represent the shape of things to come: It imposed carbon tariffs
on imports from countries that fail to enact similar policies.
So what’s the answer? The idea behind carbon tariffs is to charge importers of
goods from countries without climate-change policies an amount proportional to the
20
carbon dioxide emitted in the production of those goods. The charge per ton of
emissions would be equal to the price of carbon dioxide emission licenses in the
domestic market. This would give overseas producers an incentive to limit their carbon
emissions and would remove the incentive to shift production to countries with lax
regulation. In addition, it would, possibly, give countries with lax regulations an incentive
to adopt climate-change policies of their own. Critics of carbon tariffs argue that they
would be protectionist, and also violate international trade rules, which prohibit
discrimination between domestic and foreign products. Supporters argue that they
would simply place producers of imported goods and domestic producers on a level
playing field when selling to domestic consumers, with both required to pay for their
greenhouse gas emissions. And because carbon tariffs create a level playing field, they
argue, such tariffs—carefully applied—should also be legal under existing trade rules.
21
Chapter 13: National Income Accounting and Balance of Payment
I. NATIONAL INCOME ACCOUNTING

a. Gross National Product (GNP)
All the final goods and services produced by the country’s factors of production and
sold on the market given a given time period. GNP calculated by adding up the market
value of all expenditure on final output.
GNP by expenditure variables:
- Consumption – amount consumed by private domestic residents
- Investment – amount by private firms to build new plant/equipment for future
prod.
- Government purchase – the amount used by the government
- Current account balance – amount of net exports
→ classification country’s income = country’s output
Why is it important?
Understand the main categories of spending to analyze particular recession/boom.
Provide essential information country’s main source of income (some country are rich)
b. National Income
Recorded value results from production and expenditure
Income = expenditure → producers earn income from buyers who spend = value of prod.
→ to avoid double counting → we only accounted for the sale of final good and services
National income = GNP - Depreciation + net unilateral transfer
GNP does not take an account of economic loss due to tendency of machinery
Depreciation → loss of machinery performance that results in loss of income to capital
Unilateral transfer → payments of expatriate workers to their home country, foreign aid,
and pension payment
c. Gross Domestic Products
→ GDP measures the volume of production within a country's borders, whereas GNP
equals the volume of production within citizenship’s scope.
I.1 NATIONAL INCOME ACCOUNTING FOR OPEN ECONOMY

The national income identity for an open economy is
𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝐸𝑋 − 𝐼𝑀 = 𝐶 + 𝐼 + 𝐺 + 𝐶𝐴
C+I+G = Expenditure by domestic individuals and institutions
CA= current account balance → Net expenditure by foreign individuals and institution
CA Interpretation:
- When IM > EX – current account deficit → have to borrows – increasing net foreign
debts
- When EX > IM – current account surplus
- current account also measure the size and direction of international borrowing
22
- Current Account Balance = Change in Net Foreign Wealth
Y - (C+I+G) = CA
Current account as the difference between national income and domestic resident’s
total spending
Scheme:
- When production > domestic expenditure → exports > imports → CA > 0 , NX > 0
It earns more income from exports then it spend on imports, net foreign wealth
increasing
- When production < domestic expenditure → exports < imports → CA < 0 , NX < 0
It earns less income from exports then it spend on imports, net foreign wealth
decreasing
Saving and The current Account:

Close economy : whereas there’s no export and imports going on
𝑆 = 𝑌 − 𝐶 − 𝐺 −−> 𝑆 = 𝐼
Open economy: we have to account for capital account (international trade)
𝑆 = 𝐼 + 𝐶𝐴
→ in an open economy, the increase in investment might not increase the savings. It can
account for the capital account. For example, if New Zealand decides to build a new
hydroelectric plant, it can import the materials it needs from the United States and
borrow American funds to pay for them. This transaction raises New Zealand’s domestic
investment and current account deficit (net foreign investment – country current
account surplus when a saving in country 1 use for increase country 2 capital, I)
Private and Government Savings:
Private saving: part of disposable income (Y - T) that saved rather than consumed
𝑝
𝑆 =𝑌− 𝑇 − 𝐶
Government saving: net tax revenue minus the government purchase
𝐺
𝑆 =𝑇 − 𝐺
Private and government saving add up to national saving
𝑝 𝐺
𝑆 = ( 𝑌 − 𝑇 − 𝐶) + (𝑇 − 𝐺) =𝑆 + 𝑆
𝑝 𝐺
𝑆 = I + CA - 𝑆 = 𝐼 + 𝐶𝐴 − (𝑇 − 𝐺) = 𝐼 + 𝐶𝐴 + (𝐺 − 𝑇)
G - T = government budget deficit
𝑝
Twin Deficit : CA = 𝑆 - I - (T - G)--> if govt deficit (𝐺 − 𝑇 < 0) creating CA deficit (-)
II. BALANCE OF PAYMENTS ACCOUNT (BOP)

- Current account: account for flow of good and services (import and exports)
23
It measure the size and direction of international borrowing

- Financial account : account fo flows of financial assets (financial capital)
- Capital account: flows of special categories of assets (capita) typically
nonmarket, non produced or intangible assets like debt forgiveness, trademark
and copyright.
→ Every international transaction automatically enters the balance of payments twice,
once as a credit and once as a debit.
Current account + Financial account = Capital account
Example of BOP Accounting:

1. Import a fax machine from 2. US Bank debt forgiveness
French
II.1 Current Account

→ accounted for import and
exports; merchandise, service,
income receipts - interest and
dividend payments, meaning of
firms and workers operating in
foreign countries .
→ Accounted for net unilateral
transfer: gift (transfers) across
countries
II.2 Capital Account
→ records special transfer of
assets. Minor account for the
US.
II.3 Financial Account
→ the differences between
sales of domestic assets to
foreigners and purchase of
foreign assets by domestic
citizens. Financial inflow:
foreigners buying domestic
assets and domestic assets sold to foreigners are a credit (+). Vica versa.
→ data from transactions may come from different sources that differ in coverage,
accuracy and timing hence in practice balance of payments accounts seldom balance.
→ statistical discrepancy is the account added/subtracted from the financial account to
make the BOP balance with the current account and capital account
II.4 Official (international) reserve asset
Foreign assets held by central bank to cushion against financial instability
24
→ assets include government bonds, currency, gold and account at the IMF
- Official reserve assets owned by (sold to) foreign central bank are credit (+)
because the domestic central bank can spend more money to cushion against instability
- Official reserve assets owned by (purchased by) the domestic central bank are a debit (–)
because the domestic central bank can spend less money to cushion against instability.
II.5 Negative Value of BoP
The negative value of the official reserve asset: official settlements balance (BoP)
- Risk of capital flight → causes a loss of confidence by foreign investors
- Indication of an unbalanced economy → persistent current account deficit depict that the
government relying on consumer spending and the economy becoming unbalanced
between sectors and between short-term consumption and long-term investment
- Indication of an uncompetitive economy
- risk of depreciation → country that run a large current account deficit will always at risk of
seeing the value of currency falls
25
Chapter 14: Exchange Rates and The Foreign Exchange Market: An Asset Approach
Definition of Exchange Rates: Quoted as foreign currency per unit of domestic currency
● Yen → How much can be exchanged for one dollar? ¥97.385/$
● US $ → How much can be exchanged for one yen? $0.01027/¥
● Exchange rates allow us to denominate the cost or price of a good or service in a
common currency
Depreciation and Appreciation

● Depreciation → A decrease in the value of a currency relative to another currency
○ Depreciated currency: less valuable (less expensive) → can be exchanged
for a smaller amount of foreign currency
● Appreciation → An increase in the value of a currency relative to another currency
○ Appreciated currency: more valuable (more expensive) → can be
exchanged for a larger amount of foreign currency
Spot Rates and Forward Rates

● Spot Rates → Exchange rates for currency exchanges “on the spot” (when trading
is executed in the present)
● Forward Rates → Exchange rates for currency exchanges that will occur at a
future date
○ Forward dates → Usually 30, 90, 180, or 360 days in the future (Rates
negotiated now, exchange occurs in the future)
The Demand of Currency Deposits

● Rate of Return → % change in value that an asset offers during a time period
○ E.g. $100 savings deposit, interest rate 2% → Annual return = $100 x
(1+2%) = $102, Rate of Return = ($102-$100)/($100) = 2%
● Real Rate of Return → Inflation-adjusted rate of return (the additional amount of
goods and services that can be purchased with earnings from the asset)
○ Rate of Return = 2%, Inflation = 1.5% → Real Rate of Return = 2%-1.5% =
0.5%
○ After accounting for inflation, asset can purchase 0.5% more goods and
services after 1 year
● Assumption: Risk & Liquidity of currency deposits in foreign exchange markets
are essentially the same, regardless their currency denomination
● Rates of Return of Currency Deposits (Getting rid of assumption above)
● To compare the rate of return on a deposit in domestic currency with the one in
foreign currency, consider:
○ Interest rate of foreign currency deposit
26
○ Expected rate of appreciation/depreciation of foreign currency relative

to domestic currency
● Demand of Currency Deposits (EXAMPLE)
○ Interest rate on a dollar deposit = 2%, Interest rate on a Euro deposit = 4%
○ Does a Euro deposit yield a higher expected rate of return?
■ Today’s exchange rate → $1/€1
■ Expected Exchange Rate 1 Year from today → $0.97/€1 (USD$
Depreciate)
■ $100 can be exchanged today for €100. These €100 will yield
€104 after one year.
■ These €104 are expected to be worth $0.97/€1 x €104 = $100.88
in one year
○ Rate of return in terms of dollars from investing in euro deposits is
($100.88 - $100) / $100 = 0.88%
○ Rate of return from a dollar deposit → After 1 year, the $100 is expected to
yield $102 → ($102 - $100)/$100 = 2%
○ Euro deposit has a lower expected rate of return
○ Expected rate of appreciation of Euro → ($0.97-$1)/$1 = -0.03 = -3%
○ Dollar rate of return on euro deposits approximately equals:
■ Interest rate on euro deposits
■ Plus the expected rate of appreciation of euro deposits
■ 4% + (-3%) = 1% ≈ 0.88%
Difference in the rate of return on dollar deposits and euro deposits is:
𝑒
𝑅$ − (𝑅€ + (𝐸$/€ − 𝐸$/€)/𝐸$/€) =
𝑒
𝑅$ − 𝑅€ − (𝐸$/€ − 𝐸$/€)/𝐸$/€
Where,
➔ 𝑅$ = Expected rate of return (interest rate on dollar deposits)
➔ 𝑅€ = Interest rate on euro deposits
𝑒
➔ 𝐸$/€= Expected exchange rate
➔ 𝐸$/€= Current exchange rate
𝑒
➔ − (𝐸$/€ − 𝐸$/€)/𝐸$/€= Expected rate of appreciation of the Euro
𝑒
➔ − 𝑅€− (𝐸$/€ − 𝐸$/€)/𝐸$/€ = Expected rate of return on euro deposits
Example (Figure 1):
27
● If rate of return difference between dollar and euro deposits:

○ Positive (+) → Dollar deposits yield > Euro yield → Hold dollar deposits
○ Negative (-) → Euro deposits yield > Dollar yield → Hold euro deposits
○ Zero (0) → Holds either
Equilibrium in the Foreign Exchange Market
● Interest Parity: The basic equilibrium condition
● The Basic Equilibrium Condition:
○ When deposits of all currencies offer the same expected rate of return
○ Expected returns on deposits of any two currencies are equal when
measured in the same currency
○ Suppose R$ > R€ + (Ee$/€ – E$/€)/E$/€
■ No investor would want to hold Euro deposits → Demand and price
of Euros decrease
■ All investors would want to hold dollar deposits → Demand and
price of Dollars increase
■ Dollars would appreciate and Euro would depreciate, increasing
right side until equality was achieved
○ Figure 1 → Case 2: Expected rate of return are equal, which means it
achieves interest parity condition and no excess demand and supply
How does change in the current exchange rate affect expected return?
● Depreciation of the domestic currency today lowers the expected rate of return
28
○ Why? → Initial cost of investing in foreign currency deposits increases,

thereby lowering the expected rate of return of foreign currency deposits
● Appreciation of the domestic currency today raises the expected rate of return
○ Why? → The initial cost of investing in foreign currency deposits decrease,
thereby lowering the expected rate of return of foreign currency deposits
Fig 14.3: The relation between the current dollar/euro exchange rate and the expected
dollar return on euro deposits
Fig 14.4: Determination of the Equilibrium Dollar/Euro Exchange Rate
Interest Rate, Expectation, and Equilibrium

● The effects of changing interest rates:
○ An increase in the interest rate paid on deposits denominated in a
particular currency will increase the rate of return on those deposits
○ Leads to an appreciation of the currency
29
○
The Effect of an Expected Appreciation of the Euro
● If people expect the euro to appreciate in the future → future euros will be able to
buy many dollars
○ The expected rate of return on euros therefore increases
○ An expected appreciation of a currency (euros) leads to an actual
appreciation
30
Chapter 15: Monet, Interest Rates, and Exchange Rates
A. Functions of Money
● Medium of Exchange
A generally accepted means of payment. It eliminates the enormous search
costs during the barter system.
● Unit of Account
Measure of value ex: prices of goods, assets, services or exchange rates.
● Store of Value
Money can be used to transfer purchasing power from the present into the
future, it is also an asset, or a store value. Most liquid of all assets (can be used
immediately)
Commonly, Money Supply → M0 + M1
B. The Demand for Money by Individuals Determined by..

1. The expected return the asset offers compared with the return offered by
other assets
2. The riskiness of the asset’s expected return
3. The asset's liquidity
C. Aggregate Money Demand Determined by..

1. Interest rates/expected rates of return (-) A higher interest rate means a
higher opportunity cost of holding monetary assets → lower demand for
money.
2. Prices (+) A higher level of average prices means a greater need for liquidity
to buy the same amount of goods and services → higher demand for money.
3. Income (+) A higher real national income (GNP) means more goods and
services are being produced and bought in transactions, increasing the
need for liquidity → higher demand for money.
The aggregate demand of money can be expressed as:

Md = P x L(R,Y)
where:
P is the price level
Y is real national income
R is a measure of interest rates on nonmonetary assets
L(R,Y) is the aggregate demand of real monetary assets
Alternatively:
31
Md/P = L(R,Y)
Aggregate demand of real monetary assets is a function of national income and
interest rates.
D. The equilibrium Interest Rate : The interaction of Money Supply and Demand
• When no shortages (excess demand) or surpluses (excess supply) of monetary
assets exist, the model achieves an equilibrium:
Ms = Md
• Alternatively, when the quantity of real monetary assets supplied matches the
quantity of real monetary assets demanded, the model achieves an equilibrium:
Ms/P = L(R,Y)
Effect of an Increase in the Money

Supply on the Interest Rate
Effect on the Interest Rate of a Rise

in a Real Income
E. The Money Supply and the Exchange

Rate in the Short Run : Equilibrium
An increase in a country’s money supply

causes its currency to depreciate in the
foreign exchange market, while reduction in
the money supply causes its currency to
32
appreciate.
Both asset markets are in equilibrium at the interest rate and exchange rate ; at these
values:
● money supply equals money demand
(point 1)
● the interest parity condition holds (point
1’)
F. Increase in Money Supply and the Exchange Rate in the Short Run
Given Pus and Yus when the money supply rises

from M1us to M2us the dollar interest rate
declines (as money market equilibrium is
reestablished at point 2) and the dollar
depreciates against the euro (as foreign
exchange market equilibrium is reestablished at
point 2').
G. Effect of an Increase in Foreign Money

Supply on the Exchange Rate
● The increase in the supply of euros

reduces interest rates in the EU,
reducing the expected rate of return
on euro deposits.
● This reduction in the expected rate
of return on euro deposits causes
the euro to depreciate.
● We predict no change in the U.S.
money market due to the change in
the supply of euros.
33
H. Long Run & Short Run

• In the short run, prices do not have sufficient time to adjust to market
conditions.
• In the long run, the quantity of money supplied is predicted not to influence
the amount of output, (real) interest rates, and the aggregate demand of real
monetary assets L(R,Y).
– Wages adjust to the demand and supply of labor.
– Real output and income are determined by the amount of workers and
other factors of production—by the economy’s productive
capacity—not by the quantity of money supplied.
– the quantity of money supplied is predicted to make the level of
average prices adjust proportionally in the long run
– The equilibrium condition Ms/P = L(R,Y) shows that P is predicted to
adjust proportionally when Ms adjusts, because L(R,Y) does not change
• In the long run, there is a direct relationship between the inflation rate and
changes in the money supply
I. Long Run Price Adjustments

Although the price levels appear to display short-run stickiness, a change in the
Ms creates immediate demand and cost pressures that eventually lead to future
increases in the price level.
1. Excess demand for output and labor
Raising the total demand for goods and services will leads the company
to employ more workers overtime and make new hires → rising cost
2. Inflationary expectations
Workers bargaining over wage contracts will insist on higher money
wages to counteract the effect on their real wages of the anticipated
general increase in prices
3. Raw material prices
By causing the prices of such materials to jump upward, a money supply
increase raises production costs in materials-using industries and
eventually increases the product prices
J. Short-Run and Long-Run Effects of an Increase in the U.S. Money Supply (Given
Real Output, Y)
34
K. Time Paths of the U.S. Economic Variables after a Permanent Increase in the U.S.
Money Supply
After the Ms increases in panel A, the interest rate, price level, and exchange rate
move as shown toward their long-run levels. The exchange rate overshoots in the
short run before settling down to its long run
• A permanent increase in a country’s money supply causes a proportional
long-run depreciation of its currency.
– However, the dynamics of the model predict a large depreciation first and
a smaller subsequent appreciation.
• A permanent decrease in a country’s money supply causes a proportional

long-run appreciation of its currency.
35
– However, the dynamics of the model predict a large appreciation first and a
smaller subsequent depreciation.
L. Exchange Rate Overshooting

The exchange rate is said to overshoot when its immediate response to a
disturbance is greater than its long-run response. Exchange rate overshooting is
an important phenomenon because it helps explain why exchange rates move so
sharply from day to day.
36
Chapter 17: Output and the Exchange Rate in the Short Run
Determinants of Aggregate Demand in an Open Economy
● Aggregate Demand: The amount of a country’s goods and services demanded

by households and firms throughout the world
● Determinants of Consumption Demand

𝐷
○ 𝐶 = 𝐶(𝑌 ) → Consumption increases as disposable income increases at
the aggregate level (Consumption increases by less because a part of it
goes to savings)
● Determinants of the Current Account

○ The current account balance is determined by two main factors: the
domestic currency’s real exchange rate against foreign currency and
domestic disposable Income. We express a country’s current account
balance as a function of its currency’s real exchange rate, q = EP*/P, and
𝐷
of domestic disposable income, 𝑌
The real exchange rate q, defined as the price of the foreign basket in
terms of the domestic one is therefore EP*/P. Real exchange rate
changes affect the current account because they reflect changes in the
prices of domestic goods and services relative to foreign goods and
services. Disposable income affects the current account through its
effect on total spending by domestic consumers.
● How Real Exchange Rate Changes Affect the Current Account

A representative domestic expenditure basket focuses more on goods and
services produced domestically, while a representative foreign basket
emphasizes foreign-produced goods and services. An increase in the price of
the foreign basket relative to the domestic basket leads to a rise in the relative
price of foreign output compared to domestic output.
When the foreign basket becomes more expensive compared to the domestic
basket, foreign products are relatively more costly, and each unit of domestic
output can purchase fewer units of foreign output. Foreign consumers tend to
demand more of the domestic country's exports in response to this price shift,
improving the domestic country's account. On the other hand, domestic
consumers purchase fewer units of expensive foreign products. However, this
doesn't necessarily mean that imports will decrease since imports denote the
value of imports.
37
Whether the current account improves or worsens depends on whether the

volume effect or the value effect dominates. The volume effect refers to
changes in export and import quantities due to shifts in consumer spending,
while the value effect relates to changes in the domestic output equivalent of a
given volume of foreign imports. Assuming the volume effect outweighs the
value effect, a real depreciation of the currency improves the current account,
while a real appreciation worsens the current account.
● How Disposable Income Changes Affect the Current Account

○ The second factor influencing the current account is domestic
𝐷
disposable income. Since a rise in 𝑌 causes domestic consumers to
increase their spending on all goods, including imports from abroad, an
increase in disposable income worsens the current account, other things
equal
● The Equation of Aggregate Demand

A real depreciation of the home currency increases aggregate demand, while a
real appreciation decreases it. An increase in domestic real income raises
aggregate demand, while a decrease in domestic real income lowers it.
The equation for aggregate demand (denoted as D) combines the components

of consumption (C), investment (I), government spending (G), and current
account balance (CA) to form the expression:
D = C(Y - T) + I + G + CA(EP*/P, Y - T).
In this equation, disposable income (Y - T) represents output minus taxes. It

shows that aggregate demand for home output is influenced by the real
exchange rate, disposable income, investment demand, and government
spending.
Short Run Equilibrium for Aggregate Demand and Output
• Equilibrium is achieved when the value of income from production (output) Y equals
the value of aggregate demand D.
Y = D(EP*/P, Y – T, I, G)
● How does the exchange rate affect the short run equilibrium of aggregate
demand and output?
38
● With fixed domestic and foreign levels of average prices, a rise in the nominal
exchange rate makes foreign goods and services more expensive relative to
domestic goods and services.
● A rise in the nominal exchange rate (a domestic currency depreciation) increases
aggregate demand of domestic products.
• In equilibrium, production will increase to match the higher aggregate demand.
Shifting in DD Curve
• Changes in the exchange rate cause movements along a DD curve. Other changes
cause it to shift:
1. Changes in G: more government purchases cause higher aggregate demand and

output in equilibrium. Output increases for every exchange rate: the DD curve shifts
right.
2. Changes in T: lower taxes generally increase consumption expenditure,

increasing aggregate demand and output in equilibrium for every exchange rate:
the DD curve shifts right.
3. Changes in I: higher investment expenditure is represented by shifting the DD
curve right.
4. Changes in P relative to P*: lower domestic prices relative to foreign prices are
represented by shifting the DD curve right.
5. Changes in C: willingness to consume more and save less is represented by
shifting the DD curve right.
6. Changes in demand of domestic goods relative to foreign goods: willingness to
consume more domestic goods relative to foreign goods is represented by
shifting the DD curve right.
39
Short Run Equilibrium in Asset Markets (cont.)
● When Income And Production Increase,

demand of real monetary assets increases,
leading to an increase in domestic interest rates,
leading to an appreciation of the domestic currency.
● Recall that an appreciation of the domestic currency is represented by a fall in E.
● Whenincomean Production Decrease,the domestic currency depreciates and E
rises.
Shifting in AA Curve
1. Changes in Ms: an increase in the money supply reduces interest rates in the short run,
causing the domestic currency to depreciate (a rise in E) for every Y: the AA curve shifts
up (right).
2. Changes in P: An increase in the level of average domestic prices decreases the

supply of real monetary assets, increasing interest rates, causing the domestic
currency to appreciate (a fall in E): the AA curve shifts down (left).
3. Changes in the demand of real monetary assets: if domestic residents are willing
to hold a lower amount of real money assets and more nonmonetary assets,
interest rates on non-monetary assets would fall, leading to a depreciation of the
domestic currency (a rise in E): the AA curve shifts up (right).
4. Changes in R*: An increase in the foreign interest rates makes foreign currency
deposits more attractive, leading to a depreciation of the domestic currency (a
rise in E): the AA curve shifts up (right).
5. Changes in Ee: if market participants expect the domestic currency to
depreciate in the future, foreign currency deposits become more attractive,
40
causing the domestic currency to depreciate (a rise in E): the AA curve shifts up
(right).
● Monetary policy: policy in which the central bank influences the supply of
monetary assets.
Monetary policy is assumed to affect asset markets first.
● Fiscal policy: policy in which governments (fiscal authorities) influence the
amount of government purchases and taxes.
Fiscal policy is assumed to affect aggregate demand and output first.
J CURVE
● If the volume of imports and exports is fixed in the short run, a depreciation of the
domestic currency
will not affect the volume of imports or exports,
but will increase the value/price of imports in domestic
currency and decrease the current account: CA ≈ EX – IM. The value of exports in
domestic currency does not change.
The current account could immediately decrease after a currency depreciation,

then increase gradually as the volume effect begins to dominate the value
effect.
41
SUMMARY
1. Aggregate demand is influenced by disposable income and the real exchange

rate.
2. The DD curve shows combinations of exchange rates and output where

aggregate demand = aggregate output.
3. The AA curve show combinations of exchange rates and output where the foreign
exchange markets and money market are
in equilibrium.
4. In the DD-AA model, we assume that a depreciation of the domestic currency leads
to an increase in the current account and aggregate demand.
5. But reality is more complicated, and the J-curve shows that the value effect at first
dominates the volume effect.
6. A temporary increase in the money supply is predicted to increase output and

depreciate the domestic currency.
7. A permanent increase does both to a larger degree in the short run, but in the
long run output returns to its normal level.
8. A temporary increase in government purchases is predicted to increase output
and appreciate the domestic currency.
9. A permanent increase in government purchases is predicted to completely
crowd out net exports, and therefore to have no effect on output.
42
Chapter 18: Fixed Exchange Rates & Foreign Exchange Intervention
FACTS!
● Between the end of WWII & 1973, the world operated a fixed $ exchange rate:
central banks routinely trading foreign exchange to hold their exchange rates at
internationally agreed levels
● NOW → industrialized countries operated with floating exchange rate: a system in
which governments could try to control exchange rate fluctuations without
maintaining them in a fixed position
WHY STUDY FIXED EXCHANGE RATE?
1. Managed Floating: central banks often intervene in currency markets to

influence exchange rate. Clean floating is questionable, therefore, countries are
assumed to have a dirty floating exchange rate (not always fluctuating).
2. Regional currency arrangements: Some countries belong to exchange rate
unions, organizations whose members agree to fix their mutual exchange rates
while allowing their currencies to fluctuate in value against the currencies of
nonmember countries
3. Developing countries: Many developing countries try to peg the values of their
currencies, frequently to the US dollar, but occasionally to another currency or
"basket" of currencies decided upon by the authorities.
4. Lessons of the past for the future: A type of fixed-rate system might be revived
through new international accords, according to economists and policymakers
today who are unhappy with floating exchange rates.
CENTRAL BANK INTERVENTION & MONEY SUPPLY
a. The CB Balance Sheet & MS → sama kayak ekmon
Foreign assets Deposits held by private banks

● Liabilities of CB that can be withdrawn by private banks if needed
● foreign currency bonds owned by the CB
● International CB’s reserve (ex: gold) → level
will change if CB intervenes in ER market
(buy/sell)
Domestic assets: Currency in Circulation

● Notes & coins
● CB holdings of claims (govt’ bonds/loans to ● central banks were obliged to give a certain amount of gold or silver to anyone
private banks) to future payments by its own wishing to exchange domestic currency for one of those precious metals
citizens and domestic institutions
43
b. Foreign Exchange Intervention and the Money Supply
c. Sterilization → to counter the monetary effects of reserves changes
“sterilized foreign exchange intervention: To reduce the effects of their foreign exchange
operations on the domestic money supply, central banks occasionally conduct equivalent
foreign and domestic asset transactions in the opposite direction.”
d. The Balance of Payments and the Money Supply
connection between the balance of payments and the growth of money supplies at home and
abroad:
“If central banks are not sterilizing and the home country has a balance of payments surplus, for
example, any associated increase in the home central bank’s foreign assets implies an increased
home money supply. Similarly, any associated decrease in a foreign central bank’s claims on the
home country implies a decreased foreign money supply.”
44
HOW CENTRAL BANK FIXES THE EXCHANGE RATE
a. Foreign Exchange Market Equilibrium Under a Fixed Exchange Rate

● foreign exchange market can be maintained when the central bank fixes the
exchange rate permanently at the level 𝐸0
(𝐸𝑒−𝐸)
● Equilibrium → 𝑅 = 𝑅*+ 𝐸
(𝐸𝑒−𝐸)
** Ps. R: domestic interest rate, R*: foreign interest rate, 𝐸
: expected rate of
depreciation of the domestic currency against foreign currency
● when the exchange rate is fixed at 𝐸0 and market participants expect it to remain
fixed, the expected rate of domestic currency depreciation is zero.
● To ensure equilibrium in the foreign exchange market when the exchange rate is
fixed permanently at 𝐸0 → the central bank must therefore hold R = R*
b. Money Market Equilibrium Under a Fixed Exchange Rate
𝑠
𝑀
To hold fixed domestic interest rate at R* → 𝑃
= 𝐿(𝑅 *, 𝑌) → P & Y determine the
MS
Requirements: R = R* and E = E0
c. A Diagrammatic Analysis
45
STABILIZATION POLICIES WITH A FIXED EXCHANGE RATE

Monetary Policy Changes in ER
“A devaluation occurs when the central bank

Under a fixed exchange rate, central bank raises the domestic currency price of foreign
monetary policy tools are powerless to affect currency, E, and a revaluation occurs when
the economy’s money supply or its output the central bank lowers E.”
Govt’ sometimes allows devaluation to:
1. fight domestic unemployment

despite the lack of effective
monetary policy
2. improve the current account
3. Draw more reserves if the CB is
running low of reserves
Fiscal Policy Adjustment of Changes in Fiscal Policy &

ER
Scenario 1: ER
full employment → fiscal expansion raises

output > full employment → domestic price
(P) ↑ → home output becomes more
expensive → AD ↓ → returning output to the
initial, full-employment level (the end of ↑
P)
Appreciation prevention: a central bank that is
fixing the exchange rate is forced to expand the Long run:
money supply through foreign exchange Short run: Real exchange rate will
purchases appreciate by the same
amount in the short run
There is no appreciation,
yet there is floating
46
exchange rate
𝐸𝑃*
Real appreciation
𝐸
→ takes the form of a rise in P
rather than a fall in E
Scenario 2: Fiscal Policy
To fix the ER: Fiscal expansion → Long run P

↑ → MS ↑ → intervene in the foreign
exchange market
Scenario 3: Devaluation
Devaluation → long run P ↑ → ER ↑ proportionally
Fixed ER → devaluation → long run effect: same

as a proportional increase in the MS under a
floating rate
BALANCE OF PAYMENTS CRISES & CAPITAL FIGHT
“The expectation of a future devaluation causes a balance of payments crisis marked by a sharp
fall in reserves and a rise in the home interest rate above the world interest rate. Similarly, an
expected revaluation causes an abrupt rise in foreign reserves together with a fall in the home
47
interest rate below the world rate.”
** Capital flight: The reserve loss accompanying a devaluation scare
MANAGED FLOATING & STERILIZED INTERVENTION
The foreign exchange intervention will tend to reduce the money supply, hindering but not
necessarily nullifying the central bank’s attempt to reduce unemployment
1. Perfect Asset Substitutability and the Ineffectiveness of Sterilized Intervention

● perfect asset substitutability: assumption that the foreign exchange market is in
equilibrium only when the expected returns on domestic and foreign currency bonds are
the same
● imperfect asset substitutability: it is possible for assets’ expected returns to differ in
equilibrium
2. Foreign Exchange Market Equilibrium Under Imperfect Asset Substitutability
(𝐸𝑒−𝐸)
When domestic and foreign currency bonds are imperfect substitutes → 𝑅 = 𝑅*+ 𝐸
+ 𝑝
ρ = ρ(𝐵 − 𝐴)
** ρ = risk premium, B = domestic govt’ debt , A = domestic assets of the CB
The risk premium on domestic bonds therefore rises when B – A rises. This relation between the
risk premium and the central bank’s domestic asset holdings allows the bank to affect the
exchange rate through sterilized foreign exchange intervention. It also implies that official
operations in domestic and foreign assets may differ in their asset market impacts.
3. The Effects of Sterilized Intervention with Imperfect

Asset Substitutability
48
4. Evidence on the Effects of Sterilized Intervention
If market participants are unsure about the future direction of macroeconomic policies,
however, sterilized intervention may give an indication of where the central bank expects (or
desires) the exchange rate to move → signaling effect of foreign exchange intervention → can
alter the market’s view of future monetary or fiscal policies and cause an immediate exchange
rate change
RESERVE CURRENCIES IN THE WORLD MONETARY SYSTEM
Fixed-rate system:
1. Reserve Currency → the currency central banks hold in their international reserves
● The central bank of each country establishes the exchange rate between its own
currency and the reserve currency by being prepared to swap domestic currency
for reserves at that rate
● the country whose currency is held as reserves occupies a special position
because it never has to intervene in the foreign exchange market → can use its
monetary policy for macroeconomic stabilization even though it has fixed
exchange rates
● effect of a purchase of domestic assets by the central bank of the reserve
currency country → push its interest rate below those prevailing abroad + cause
an excess demand for foreign currencies in the foreign exchange market
● To prevent their currencies from appreciating against the reserve currency: all
other central banks in the system would be forced to buy reserve assets with their
49
own currencies, expanding their money supplies and pushing their interest rates
down to the level established by the reserve center
2. Gold Standard → central banks peg the prices of their currencies in terms of gold and
hold gold as official international reserves
● places undesirable constraints on the use of monetary policy to fight
unemployment
● Tying currency values to gold ensures a stable overall price level only if the
relative price of gold and other goods and services is stable.
● An international payments system based on gold is problematic because central
banks cannot increase their holdings of international reserves as their economies
grow unless there are continual new gold discoverie
● The gold standard could give countries with potentially large gold production,
such as Russia and South Africa, considerable ability to influence
macroeconomic conditions throughout the world through market sales of gold
50
Chapter 19: International Monetary Systems - An Historical Overview
MACROECONOMIC GOALS
• “Internal balance” describes the macroeconomic goals of producing at potential
output (at “full employment”) and of price stability (low inflation).
– overemployment tends to increase prices; underemployment tends to

decrease prices.
• “External balance” achieved when a current account is

– neither so deeply in deficit that the country may be unable to repay its
foreign debts,
– nor so strongly in surplus that foreigners are put in that position. For
example, Japan's current account surplus is as much due to low domestic
demand as due to its competitiveness in exports.
The Open-Economy Trilemma
Impossible for a country to achieve more than two items

from the following list:
1.Exchange rate stability.

2.Monetary policy oriented toward domestic goals.
3.Freedom of international capital movements.
Bretton-Woods system: 1944-1973
● In July 1944, 44 countries met in Bretton Woods, NH, to design the Bretton
Woods system:
a fixed exchange rate against the U.S. dollar and a fixed dollar price of gold ($35
per ounce).
● They also established other institutions:

1. The International Monetary Fund
2. The World Bank
3. General Agreement on Trade and Tariffs (GATT), the predecessor to the World
Trade Organization (WTO).
International Monetary Fund
The IMF was constructed to lend to countries with persistent balance of payments
deficits (or current account deficits), and to approve of devaluations.
- Loans were made from a fund paid for by members in gold and currencies.
- Each country had a quota, which determined its contribution to the fund and the
maximum amount it could borrow.
- Large loans were made conditional on the supervision of domestic policies by
51
the IMF: IMF conditionality.

- Devaluations could occur if the IMF determined that the economy was
experiencing a “fundamental disequilibrium.”
IMF and Bretton Woods System
- Under a system of fixed exchange rates, the principal tool for internal balance
was fiscal policy (government purchases or taxes).
- The principal tools for external balance were borrowing from the IMF, restrictions
on financial asset flows, and infrequent changes in exchange rates.
Policies for Internal and External Balance
● Suppose internal balance in the short run occurs

when production is at potential output 🡺 an
increase in government purchases increases
aggregate demand and output above its full
employment level.
● To restore internal balance in the short run, a
revaluation (a fall in E) must occur.
● Suppose external balance in the short run
occurs🡺 an increase in government purchases
increases aggregate demand, output and
income, decreasing the current account.
● To restore external balance in the short run, a
devaluation (a rise in E) must occur.
U.S. External Balance Problems under Bretton Woods

The collapse of the Bretton Woods system was caused primarily by imbalances of the
U.S. during the 1960s and 1970s.
- The U.S. current account surplus became a deficit in 1971.
- Rapidly increasing government purchases increased aggregate demand and
output, as well as prices.
- Rising prices and a growing money supply caused the U.S. dollar to become
overvalued in terms of gold and in terms of foreign currencies.
Case for Floating Exchange Rates

1. Monetary policy autonomy
- Without a need to trade currency in foreign exchange markets, central banks are
more free to influence the domestic money supply, interest rates, and inflation.
- Central banks can more freely react to changes in aggregate demand, output,
and prices in order to achieve internal balance.
2. Automatic stabilization
- Flexible exchange rates change the prices of a country’s products and help
reduce “fundamental disequilibria.”
- One fundamental disequilibrium is caused by an excessive increase in money
supply and government purchases, leading to inflation, as we saw in the US
during 1965–1972.
52
- Inflation causes the currency’s purchasing power to fall, both domestically and
internationally, and flexible exchange rates can automatically adjust to account
for this fall in value, as purchasing power parity predicts.
Case for Floating Exchange Rates (cont.)
3. Flexible exchange rates may also prevent speculation in some cases.

- Fixed exchange rates are unsustainable if markets believe that the central bank
does not have enough official international reserves.
4. Symmetry (not possible under Bretton Woods)

- The U.S. is now allowed to adjust its exchange rate, like other countries.
- Other countries are allowed to adjust their money supplies for macroeconomic
goals, like the U.S. could.
53
Chapter 20: Optimum Currency Areas and the European Experience
HOW EUROPEAN SINGLE CURRENCY EVOLVED

The birth of the euro on January 1, 1999 happened because EU countries let go of
Bretton Woods' fixed rate influence allowing their currencies to float and hence create
fluctuations.
What Has Driven European Monetary Cooperation?

1. To enhance europe’s role in the world monetary system
→ the fall of the Bretton Woods system decreased the European confidence in the
readiness of the US to place its monetary responsibilities ahead of its own interest.
2. To turn european union into truly unified market
→ The EU believed that the exchange rate uncertainty was a major factor reducing trade
within Europe. They also feared the ER swings causing large changes in intra-european
relative price would strengthen political forces hostile to the free trade market within
europe.
The European Monetary System, 1979 - 1998

➢ significant institutional step on the road to european monetary unifications
➢ There are 8 original participants; france, germany, italy belgium, denmark, ireland,
luxembourg, and netherlands that began the operating formal network of mutually
pegged exchange rate
➢ In 1979, inflation rates ranged from germany 2.7% To italy 12.1%. EMS fixed ER
survived and grew adding Spain, Britain and Portugal in 1989 and 1992. Britain and
Italy left at the start of european currency crisis → hence remaining members retreat
to wide exchange rate margin
➢ Safety valves helped reduce the frequency of crises. The EMS developed
provisions to extend credit from strong-to-weak-currency members and maintain
capital controls to limit domestic residents' sales of home for foreign currencies –
attempting to reduce the possibility of speculative attacks.
➢ 1987 removal of capital control → increased the possibility of speculative attack and
reduced government's willingness to evaluate/devalue. It reduce member country
monetary independence, but freedom of payment and capital movements → the
key element of eu countries plan to turn europe into unified single market
➢ In 1992, German reunification caused a boom in Germany and higher inflation. High
German interest rates to hold their currencies fixed against Germany make other
countries unwillingly push their economy into deep recession. Hence it leads to a
series of fierce speculative attacks.
German Monetary Dominance and the Credibility Theory of the EMS

The European Union sought to fix internal exchange rates in order to defend
Europe's economic interests and achieve greater economic unity. The credibility theory
54
of the EMS suggests that the political costs of violating an international exchange rate
agreement may be useful, as they can restrain governments from depreciating their
currencies to gain the short-term advantage of an economic boom at the long-term
cost of higher inflation.
Policy makers in inflation-prone EMS countries, ex italy, gained credibility by
placing monetary policy decisions in the hand of inflation-fearing german central bank.
This is supported by the behavior of inflation rates relative to Germany, which gradually
converged towards the low German levels.
Market Integration Initiatives

The EU countries have attempted to achieve greater internal economic unity
through mutual exchange rates and direct measures to encourage the free flow of
goods, services, and factors of production. Market unification began when the original
EU members formed their customs union in 1957, but was hindered by
government-imposed standards and registration requirements. In the Single European
Act of 1986, EU members removed remaining internal barriers to trade, capital
movements, and labor migration. Financial capital can now move freely within and
between the EU and outside jurisdictions.
European Economic and Monetary Union

The early EMS was characterized by frequent currency realignments and government
control over capital movements. In 1989, the European Commission recommended a
three-stage transition to an EMU, a European Union in which national currencies would
be replaced by a single EU currency managed by a sole central bank. The Maastricht
Treaty proposed amendments to the Treaty of Rome to introduce a single European
currency and a European Central Bank by 1999.
Why did EU countries shift from EMS (goals: easier trade) to aim for a single shared
currency?
1. The EU leaders believed that a single EU currency would create a greater degree
of European market integration than fixed exchange rates.
2. They hoped that Germany's management of EMS monetary policy would be
more considerate of other countries' problems.
3. Freedom of capital movement though Fixed ER subject to speculative attacks
4. They also hoped that the Maastricht Treaty's provisions would guarantee political
stability and align the economic interests of individual European nations to
create an overwhelming political constituency for peace on the continent.
THE EURO AND ECONOMIC POLICY IN THE EUROZONE

Maastricht Convergence Criteria and The Stability and Growth Pact
The Maastricht Treaty provides for the monitoring of criteria 3 and 4 by the
European Commission and the levying of penalties on countries that violate these rules.
This puts national governments under constraints in the exercise of their national fiscal
55
powers, and a supplementary Stability and Growth Pact (SGP) tightens the fiscal
straitjacket further. Low-inflation countries such as Germany wanted assurance that
their EMU partners had learned to prefer an environment of low inflation and fiscal
restraint. The German government demanded the Stability and Growth Pact (SGP) to
convince domestic voters that the new eurosystem would produce low inflation. At the
urging of France and Germany, the EU watered down the SGP in 2005.
By May 1998, 11 EU countries had satisfied the convergence criteria and were
founding members of EMU. Greece failed to qualify on any of the criteria in 1998, but
eventually passed all of its tests and entered EMU on January 1, 2001.
The European System of Central Banks

The European System of Central Banks (ESCB) is composed of the European Central
Bank (ECB) and 17 national central banks. Decisions are made by votes of the governing
council of the ECB. The Maastricht Treaty aims to create an independent central bank
free of political influence. The ESCB operates above and beyond the reach of any single
national government. Critics argue that it goes too far in shielding the ESCB from
democratic processes.
The Revised Exchange Rate Mechanism

ERM 2 for EU countries and not a members of EMU– revised exchange rate mechanism
that defines broad exchange rate zone against the euro (± 15%) and provides
reciprocal intervention arrangements to support them. It is asymmetric, with peripheral
countries pegging to the euro and adjusting passively to ECB decisions on interest rate.
THE THEORY OF OPTIMUM CURRENCY AREAS

The European monetary integration process has helped advance the political goals of
its founders, but its survival and future development depend more heavily on its ability
to help countries reach their economic goals. To weigh the economic costs against the
advantages of joining a group of countries with mutually fixed exchange rates, a
framework for thinking systematically about the stabilization powers and the gains in
efficiency and credibility is needed – optimum currency areas.
Economic Integration and the Benefit of a Fixed ER: GG Schedule

Monetary efficiency gain from joining the fixed exchange rate system. Benefits:
avoid uncertainty, confusion, and calculation and transaction costs arise when
exchange rates are floating. A schedule called GG that shows how the potential gain to
individual countries (Ex: norway) from joining the euro zone depends on Norway’s
trading links with that region.
It is actually hard to precisely calculate the total monetary efficiency gain in
results of pegging the euro. Some of benefit consideration of a fixed ER:
1. Gain higher if Norway trades a lot with eurozone countries
2. Production can migrate freely between norway and euro area
56
→ a high degree of economic integration between a country and a fixed exchange rate
magnifies the monetary efficiency gain the country reaps when it fixes its exchange rate
against the area’s currencies.
The main conclusion follows that when Norway

pegs to the euro, it gains from the stability of its
currency against the euro, and this efficiency
gain is greater the more closely tied are Norway’s
markets with eurozone markets.
Economic Integration and the Cost of a Fixed ER:

LL Schedule
The economic stability loss from joining an exchange rate area is related to the
country's economic integration with its exchange rate partners. To derive the LL
schedule, we must understand how the extent of Norway's economic integration with
the euro zone will affect the size of this loss in economic stability; if the world demand
for oil drops, The severity of employment, reduction in its prices will lead to an increase
in euro zone demand for Norwegian goods that is large relative to Norway’s output, FDI
and employment.
→ a high degree of economic integration between a
country and the fixed exchange rate area that it joins
reduces the resulting economic stability loss due to
output market disturbances.
The LL schedule shown in Figure 20-4 summarizes

this conclusion, with a negative slope because the
economic stability loss from pegging to the area's
currencies falls as the degree of economic
interdependence rises.
The Decision to Join a Currency Area: GG and LL Schedule

- Should do economic integration if at least in point θ1when GG and LL intersect
- Below θ1 → Norway would suffer loss from greater output and employment
instability after joining
- Higher θ1 → efficiency gain
57
#CASE: Increase in size and frequency in the demand for the country exports → it will
push LL1 → LL2. The extra output and unemployment instability the country suffers by
fixing its exchange rate now is greater.
What is an Optimum Currency Area?

The GG-LL model we have developed suggests a theory of the optimum currency area.
Optimum currency areas are groups of regions with economies closely linked by trade
in goods and services and by factor mobility. Fixed exchange rate would be best
implemented if the degree of output and factor trade among the included economies
is high.
Is Europe an Optimum Currency Area?

The theory of optimum currency areas suggests that Europe's product and factor
markets are not yet sufficiently unified to make it an optimum currency area. However,
there is evidence that national financial markets have become better integrated with
each other as a result of the euro, but labor mobility is low. This suggests that economic
stability loss from eurozone membership could be high due to high unemployment rates
and asymmetric shocks. The European Union's success in liberalizing its capital flows
may have worked perversely to worsen the economic stability loss due to the process
of monetary unification.
THE FUTURE OF EMU

1. Europe is not an optimum currency area hence it will be hard to handle through
monetary policy. Ex German economy experiencing negative growth whilst
spain,portugal,ireland were growing healthy → it can lead to regional political pressure
on the ECB
2. The single currency project has taken economic union to a higher level than the EU has
been able to do in the area of political union. Quarrels over economic policies and lack
of a strong EU political center may limit the ECB's political legitimacy.
3. The EU's labor markets remain highly unionized and subject to employment taxes and
regulations, leading to high unemployment. Advocates of the euro argue that it will
discipline wage demands and speed the reallocation of labor, but workers may also
press for wage harmonization.
58
4. The EU has made efforts to reduce government budget deficits, but some countries
have run afoul of the Maastricht Treaty. Further fiscal restructuring is needed to avoid
increased deficits and debt crises, but it will be difficult until economic growth returns.
5. Large expansion members → ESCB's governing council becoming unwieldy. The
possible asymmetric economic shock will rise → countries may become less able to
delegate their votes to regional representatives.
59
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Institute for Development

Of Economics and Finance

A. Basic Tariff Analysis

➔ An export supply curve is the difference between the quantity that

● The Effects of a Tariff on World Market

B. Measuring the Amount of Protection

C. Cost and Benefits of Tariff

➔ An export subsidy is a payment to a firm or individual that ships goods

● Voluntary Export Restraint

A. The Case for Free Trade

➔ This benefit may exceed the losses caused by distortions in production

➔ marginal social benefit represents the additional

➔ Collective action: While it is in the interests of the group as a whole to press

➔ In this example, each country

● Promoting Manufacturing Through Protection

➔ Why not encourage both import substitution and exports?

B. Results of Favoring Manufacturing: Problems of Import-Substituting Industrialization

D. Trade and Growth: Takeoff in Asia

Arguments for Activist Trade Policy:

1. Technology and Externalities

laissez-faire, high-technology firms do not receive as strong an incentive to innovate as

2. Imperfect Competition and Strategic Trade Policy

Globalization and Low-Wage Labor

1. The Anti-Globalization Movement

Before 1995 most complaints about international trade made by citizens of

2. Trade and Wages Revisited

One strand of the opposition to globalization is familiar from the analysis in

3. Labor Standards and Trade Negotiations

4. Environmental and Cultural Issues

5. The WTO and National Independence

traditional instruments of trade policy—tariffs, export subsidies, and quantitative

Globalization and the Environment

1. Globalization, Growth and Pollution

Both production and consumption often lead, as a byproduct, to environmental

2. The Problem of “Pollution Havens”

A pollution haven: Thanks to international trade, an economic activity that is

3. The Carbon Tariff Dispute

I. NATIONAL INCOME ACCOUNTING

I.1 NATIONAL INCOME ACCOUNTING FOR OPEN ECONOMY

- Current Account Balance = Change in Net Foreign Wealth

Saving and The current Account:

II. BALANCE OF PAYMENTS ACCOUNT (BOP)

It measure the size and direction of international borrowing

Example of BOP Accounting:

II.1 Current Account

Depreciation and Appreciation

Spot Rates and Forward Rates

The Demand of Currency Deposits

○ Expected rate of appreciation/depreciation of foreign currency relative

● If rate of return difference between dollar and euro deposits:

○ Why? → Initial cost of investing in foreign currency deposits increases,

Fig 14.4: Determination of the Equilibrium Dollar/Euro Exchange Rate

Interest Rate, Expectation, and Equilibrium

Commonly, Money Supply → M0 + M1

B. The Demand for Money by Individuals Determined by..

C. Aggregate Money Demand Determined by..

The aggregate demand of money can be expressed as:

Effect of an Increase in the Money

Effect on the Interest Rate of a Rise

E. The Money Supply and the Exchange

An increase in a country’s money supply

Given Pus and Yus when the money supply rises

G. Effect of an Increase in Foreign Money