Economics 306 – A01: International Economics

Summer term 2008: MTWRF 10:30-12:30 in CLEA311

Instructor: Brian L. Scarfe

Business telephone: 360-0300; e-mail: brianscarfe@shaw.ca

Office hours: MTWRF 9:15-10:15 in BEC 328; tel: 721-6520

Required Text: Paul R. Krugman and Maurice Obstfeld, International Economics:

Theory and Policy, eighth edition, Addison-Wesley, 2008, ISBN

0-321-49304-4

Given the condensed nature of summer session courses, we will only be able to cover the

main highlights of the International Economics syllabus. The course will move quickly

through the following topics. Students are strongly advised to keep their reading of the

textbook and lecture notes on pace.

Lecture outline: Text chapters

May 12-16: Part One: International Trade Theory (5 classes) Ch. 1-7

May 12: Introduction and Overview: Main Themes, Gravity Model Ch. 1 and 2

May 13: Comparative Advantage: the Ricardian Model Ch. 3

May 14: The Heckscher-Ohlin Factor Proportions Model Ch. 4

May 15: The Standard Trade Model: Growth, Terms of Trade Ch. 5

May 16: Economies of Scale, Intra-Industry Trade and Factor Mobility Ch. 6 and 7

May 20-22: Part Two: International Trade Policy (3 classes) Ch. 8-11

May 20: Instruments of Trade Policy: Tariffs Ch. 8

May 21: Other Instruments of Trade Policy: Worked Examples Ch. 9

May 22: Free Trade versus Protectionism: Customs Unions Ch. 10 and 11

May 23 (Friday): Midterm Examination (40 marks)

May 26-29: Part Three: Exchange Rates and Open-Economy

Macroeconomics (4 classes) Ch. 12-17

May 26: The Balance of Payments and Exchange Rates Ch. 12 and 13

May 27: The Asset Approach: Money, Interest Rates and Exchange Rates Ch. 14

May 28: Real Exchange Rates and Purchasing Power Parity Ch. 15

May 29: Macro-Economic Adjustment under Flexible Exchange Rates:

The Marshall-Lerner Condition and the Current Account Ch. 16

May 30-June 3: Part Four: International Macroeconomic Policy

(3 classes) Ch. 18-22

May 30: Fixed Exchange Rates and Macro-Economic Adjustment Ch. 17 and 18

June 2: External and Internal Balance: Exchange Rate Regimes and

Optimal Currency Areas Ch. 19 and 20

June 3: International Capital Markets and International Debt Problems Ch. 21 and 22

June 4 (Wednesday): Final Examination (60 marks)

Examinations and Grading Equivalencies:

Midterm examination (1 hr, 45 min): 40% Final examination (1 hr, 45 min): 60%

A+ = 90-100% A = 85-89% A- = 80-84% B+ = 75-79%

B = 70-74% B- = 65-69% C+ = 60-64% C = 55-59%

D = 50-54% F = 0-49%

Plagiarism and cheating: Students are expected to observe the same standards of scholarly

integrity as their academic and professional counterparts. Students who are found to have

engaged in unethical academic behaviour, including the practices described on pages 31-32

of the calendar, are subject to penalty by the University.

Inclusivity and diversity: The University of Victoria is committed to providing an

environment that affirms and promotes the dignity of human beings of diverse backgrounds

and needs.

Workshop Questions: Workshop questions will be taken up in class from time to time.

Students are advised to work on these questions in advance of the workshops.

Workshop One, for in class discussion on Wednesday, May 14

This question is essentially similar to problems 1 to 5 on p. 52 of the textbook.

Two countries, Home and Foreign, trade apples and bananas in a Ricardian trade world.

Home has 1,200 units of labour available, and requires 3 units of labour to produce one

tonne of apples and 2 units of labour to produce one tonne of bananas. Foreign has 800

units of labour available, and requires 5 units of labour to produce one tonne of apples and

1 unit of labour to produce one tonne of bananas.

(a) Construct graphically the world relative supply curve which relates the relative price of

apples to the relative quantity of apples produced.

(b) On the same graph, draw the world relative demand curve under the assumption that (in

both countries) expenditure is equally divided between the two goods, so that p(A) Q(A) =

p(B) Q(B), where p(A) and p(B) are the prices of apples and bananas, and Q(A) and Q(B)

are the overall quantities of apples and bananas produced (and consumed), respectively.

(c) Calculate the values of p(A)/p(B), Q(A) and Q(B) in trading equilibrium.

(d) Based upon comparative advantage theory, which country exports apples (how many

tonnes?), and which country exports bananas (how many tonnes?), in trading equilibrium?

(e) Calculate the increased volumes of apples and bananas that become available in trading

equilibrium when compared with the pre-trade situation, and thereby demonstrate that there

are consumption gains from trade (how are these gains shared between the two countries?).

Answer Guide: Workshop One

(a) The relative supply curve is horizontal at p(A)/p(B) = 3/2 (the relative cost ratio in

Home), has a vertical section at Q(A)/Q(B) = ½ (when all Home labour is allocated to

apples, and all Foreign labour is allocated to bananas), and has a further horizontal section

at p(A)/p(B) = 5/1 (the relative cost ratio in Foreign).

(b) The relative demand curve is a rectangular hyperbola which intersects the relative

supply curve in the vertical section.

(c) In trading equilibrium, p(A)/p(B) = 2, Q(A) = 400 tonnes, and Q(B) = 800 tonnes.

(d) As expected from the theory of comparative advantage, Home will export apples and

Foreign will export bananas. If D(A) and D(B) are Home’s consumption of apples and

bananas, respectively, then p(A) D(A) = p(B) D(B) and p(A) [ 400 – D(A)] = p(B) D(B). It

follows that D(A) = 200, and D(B) = 400. Thus, Home will export 200 tonnes of apples in

exchange for 400 tonnes of bananas, which are imported from Foreign.

(e) However, in the pre-trade situation at a relative cost ratio of 3/2, Home produces 200

tonnes of apples and 300 tonnes of bananas, fully employing 1,200 units of labour. In the

pre-trade situation at a relative cost ratio of 5/1, Foreign produces 80 tonnes of apples and

400 tonnes of bananas, fully employing 800 units of labour. Free trade increases the

overall production of apples from 280 tonnes to 400 tonnes, with all of the additional 120

tonnes consumed by Foreign. Free trade also increases the overall production of bananas

from 700 tonnes to 800 tonnes, with all of the additional 100 tonnes consumed by Home.

Workshop Two, for in class discussion on Wednesday, May 21

A country imports 3 billion barrels of crude oil per year and domestically produces another

3 billion barrels of crude oil per year. The world price of crude oil is $18 per barrel.

Assuming linear schedules, economists estimate the price elasticity of domestic supply to

be 0.25 and the price elasticity of domestic demand to be - 0.10 in the neighbourhood of the

current equilibrium.

(a) Assuming that the world price of crude oil does not change when the country imposes a

$6 per barrel import duty on crude oil, determine the domestic price, and the three

quantities: domestic consumption, domestic production, and import volume after the

imposition of the import duty.

(b) Calculate the impact on producer surplus, consumer surplus, and government revenues.

Also calculate the net social benefits associated with the imposition of the import duty.

(c) and (d) Redo the calculations under (a) and (b) on the assumption that the reduction in

the country’s demand for crude oil reduces the world price by $2 per barrel.

(e) By how much does the “terms of trade effect” of the import duty offset the efficiency

losses (i.e., what are the net social benefits to the importing country)? If foreign exporters

also had standing, would overall welfare be increased?

Answer Guide: Workshop Two

(a) A small open economy is a price-taker for its imports in the world market place. Since

none of the tariff incidence can be shifted backwards to foreign producers, the whole

burden of an import tariff falls on domestic consumers. In this case, the domestic price of

crude oil rises by $6 per barrel from $18 to $24. The resulting change in domestic quantity

supplied is given by 0.25 x 3 x 6/18 = 0.25 bbls (billion barrels), resulting in 3.25 bbls

being the new quantity supplied. The resulting change in domestic quantity demanded is

given by – 0.10 x 6 x 6/18 = - 0.20 bbls, resulting in 5.80 bbls being the new quantity

demanded. As a result, imports fall by 0.45 bbls to 2.55 bbls.

(b) The positive effect on producer surplus is given by area a in the diagram. This area is

equal to (3 + 3.25) x 6/2 = $18.75 b. The negative effect on consumer surplus is given by

area a+b+c+d in the diagram. This area is equal to (6 + 5.80) x 6/2 = $35.40 b. The

positive effect on net government revenues is given by area c in the diagram. This area is

equal to (5.80 – 3.25) x 6 = $15.30 b.

The net social benefits associated with the imposition of the import duty are negative,

and equal in size to area b+d in the diagram. This deadweight loss of $1.35 b. is made up

of a combination of the production side efficiency loss, area b in the diagram, which is

equal to (3.25 – 3) x 6/2 = $0.75 b, and the consumption side efficiency loss, area d in the

diagram, which is equal to (6 – 5.80) x 6/2 = $0.60 b.

(c) When the economy is no longer a price-taker in the world market place for its crude oil

imports, and the world price falls by $2 per barrel in response to the imposition of the

import duty, the domestic price rises by only $4 per barrel. As a result, the quantities

supplied, demanded, and imported all need to be recalibrated. The new quantity supplied is

3 + 0.25 x 3 x 4/18 = 3.17 bbls. The new quantity demanded is 6 – 0.10 x 6 x 4/18 = 5.87

bbls. As a result, imports fall by only 0.30 bbls to 2.70 bbls.

(d) The change in producer surplus is equal to (3 + 3.17) x 4/2 = $12.33 b. The change in

consumer surplus is equal to - (6 + 5.87) x 4/2 = - $23.73 b. The change in government

revenues is equal to (5.87 – 3.17) x 6 = $16.20 b. Notice that only 2/3s of this revenue is

raised from domestic consumers, while the remaining 1/3 is raised from foreign producers.

Thus, there is a terms of trade gain of $5.40 b. Net social benefits are equal to $4.80 b.

(e) The producer and consumer side efficiency losses are, respectively, equal to (3.17 – 3) x

4/2 = $0.34 b. and (6 – 5.87) x 4/2 = $0.26 b. The terms of trade gain exceeds the

deadweight efficiency loss by $5.40 b. - $0.60 b. = $4.80 b. or by the net social benefits.

However, the terms of trade gain to the importing country implies a terms of trade loss to

foreign exporters, so that if these exporters had standing there would be an overall welfare

loss. This loss would consist of the producer side and consumer side efficiency losses in

the importing country and two similar losses in the exporting country.

Workshop Three, for in class discussion on Thursday, May 22

Work through questions 1-4 and 7 on pp. 201-2 of the Textbook

Answer Guide: Workshop Three

Question One:

The relevant diagram is Figure 8-4, as adapted in the attached schematic. Home’s import

demand schedule is D – S = 80 – 40P. In the absence of trade, the price of wheat in Home

would be $2 per bushel.

Question Two:

Foreign’s export supply schedule is S* - D* = - 40 + 40P. In the absence of trade, the price

of wheat in Foreign would be $1 per bushel. In free trade equilibrium, one must have D – S

= S* - D*, and thus that 80 – 40P = - 40 + 40P. It follows that the world equilibrium price

of wheat is P = $1.50 per bushel. Home produces 50 bushels of wheat, consumes 70

bushels, and imports 20 bushels from Foreign. Foreign produces 70 bushels of wheat,

consumes 50 bushels, and exports 20 bushels to Home.

Question Three:

Now suppose that Home places a specific duty of $0.50 on wheat imports. This creates a

wedge between the Home and Foreign wheat prices such that P(H) = P(F) + 0.50. When

Home’s import demand is now equated to Foreign’s export supply, one has 80 – 40P(H) =

-40 + 40[P(H) - 0.50]. This equation solves for P(H) = $1.75 per bushel of wheat, so that

P(F) = $1.25 per bushel. Home now produces 55 bushels of wheat, consumes 65 bushels,

and imports 10 bushels from Foreign. Foreign produces 65 bushels of wheat, consumes 55

bushels, and exports 10 bushels to Home. The volume of trade has been cut in half by the

imposition of the import duty, as illustrated in the attached diagram. The welfare

implications for Home and Foreign are as follows:

Welfare effects for Home

Gain in producer surplus: area a (50 + 55) x 0.25/2 = $13.125

Loss in consumer surplus: area a+b+c+d (65 + 70) x 0.25/2 = $16.875

Tariff revenue gain: area c+e (65 – 55) x 0.50 = $ 5.000

Net social benefit: area e-b-d = $ 1.250

Terms of trade gain: area e (65 – 55) x 0.25 = $ 2.500

Production efficiency loss: area b (55 – 50) x 0.25/2 = $ 0.625

Consumption efficiency loss: area d (70 – 65) x 0.25/2 = $ 0.625

Welfare effects for Foreign

Gain in consumer surplus: area a* (50 + 55) x 0.25/2 = $13.125

Loss in producer surplus: area a*+b*+c*+d* (65 + 70) x 0.25/2 = $16.875

Net social loss: area b*+c*+d* = $ 3.750

Term of trade loss: area c* = area e (65 – 55) x 0.25 = $ 2.500

Consumption efficiency loss: area b* (55 – 50) x 0.25/2 = $ 0.625

Production efficiency loss: area d* (70 – 65) x 0.25/2 = $ 0.625

World welfare implications

Net social loss: area b+d+b*+d* = $ 2.500

Although Home gains at the expense of Foreign when a tariff is imposed on wheat imports,

the distortion to the world market place generates a net social loss from a world perspective.

Question Four:

When Foreign is ten times as large as before, its export supply function becomes S* - D* =

- 400 + 400P. In the absence of trade, the price of wheat in Foreign would be $1 per bushel.

In free trade equilibrium, one must have D – S = S* - D*, and thus that 80 – 40P = - 400 +

400P. It follows that the world equilibrium price of wheat is P = $1.091 per bushel. Home

produces 41.8 bushels of wheat, consumes 78.2 bushels, and imports 36.4 bushels from

Foreign. Foreign produces 618.2 bushels of wheat, consumes 581.8 bushels, and exports

36.4 bushels to Home.

Now suppose that Home places a specific duty of $0.50 on wheat imports. This creates a

wedge between the Home and Foreign wheat prices such that P(H) = P(F) + 0.50. When

Home’s import demand is now equated to Foreign’s export supply, one has 80 – 40P(H) =

-400 + 400[P(H) – 0.50]. This equation solves for P(H) = $1.545 per bushel of wheat, so

that P(F) = $1.045. Home now produces 50.9 bushels of wheat, consumes 69.1 bushels,

and imports 18.2 bushels from Foreign. Foreign produces 609.1 bushels of wheat,

consumes 590.9 bushels, and exports 18.2 bushels to Home. Again the volume of trade has

been cut in half by the imposition of the import duty. However, almost all the incidence of

the import duty is borne by domestic consumers rather than by foreign producers because

the world price is hardly affected by the import duty. The welfare implications for the

Home country are as follows:

Welfare effects for Home

Gain in producer surplus: (41.8 + 50.9) x 0.454/2 = $21.04

Loss in consumer surplus: (69.1 + 78.2) x 0.454/2 = $33.44

Tariff revenue gain: (69.1 – 50.9) x 0.50 = $ 9.10

Net social loss: = $ 3.30

Terms of trade gain: (69.1 – 50.9) x 0.046 = $ 0.84

Production efficiency loss: (50.9 – 41.8) x 0.454/2 = $ 2.07

Consumption efficiency loss: (78.2 – 69.1) x 0.454/2 = $ 2.07

A small open economy is unlikely to gain from imposing import duties because it is unable

to generate terms of trade gains of any substance. Moreover, because most of the tariff

shows up as a domestic price increase, the deadweight losses are more likely to be

substantial.

Question Seven:

Going back to the situation of symmetric size between Home and Foreign, in this example

Foreign grants an export subsidy of $0.50 per bushel to its wheat producers. A wedge is

created between the Home and Foreign wheat prices such that P(H) = P(F) – 0.50. When

Home’s import demand is now equated to Foreign’s export supply, one has 80 – 40P(H) =

-40 + 40[P(H) + 0.50]. This equation solves for P(H) = $1.25 per bushel of wheat, so that

P(F) = $1.75 per bushel. Home now produces 45 bushels of wheat, consumes 75 bushels,

and imports 30 bushels from Foreign. Foreign produces 75 bushels of wheat, consumes 45

bushels, and exports 30 bushels to Home. In comparison with the free trade situation, the

volume of trade has been expanded by 50% by the imposition of the export subsidy. The

welfare implications for Home and Foreign are as follows:

Welfare effects for Home

Gain in consumer surplus: (75 + 70) x 0.25/2 = $18.125

Loss in producer surplus: (50 + 45) x 0.25/2 = $11.875

Net social benefit: = $ 6.250

Terms of trade gain: (75 – 45) x 0.25 = $ 7.500

Production efficiency loss: (50 – 45) x 0.25/2 = $ 0.625

Consumption efficiency loss: (75 – 70) x 0.25/2 = $ 0.625

Welfare effects for Foreign

Gain in producer surplus: (75 + 70) x 0.25/2 = $18.125

Loss in consumer surplus: (50 + 45) x 0.25/2 = $11.875

Government subsidy outlay: (75 – 45) x 0.50 = $15.000

Net social loss: = $ 8.750

Terms of trade loss: (75 – 45) x 0.25 = $ 7.500

Consumption efficiency loss: (50 – 45) x 0.25/2 = $ 0.625

Production efficiency loss: (75 – 70) x 0.25/2 = $ 0.625

World welfare implications:

Net social loss: = $ 2.500

Although Home gains substantially at the expense of Foreign when a subsidy is granted on

wheat exports, the distortion to the world market place generates a net social loss from a

world perspective. It should, however, be noted that an export subsidy is a particularly

perverse form of industrial protection from the perspective of the subsidising country, in

large part because an export subsidy is costly to government and turns the terms of trade

against the subsidising country. The relevant diagram is Figure 8-11.

Workshop Four, for in class discussion on Wednesday, May 28

This assignment expands upon problem 6 on page 345 of the textbook.

Suppose that the US dollar interest rate and the pound sterling interest rate are the same, 5

percent per year, but that there is a risk premium of 1 percent associated with holding

sterling rather than US dollars over the year.

(a) What is the relationship (in percentage terms) between the current equilibrium

dollar/pound exchange rate and its expected future level?

(b) If the expected future exchange rate is $1.52 per pound, what is the equilibrium

dollar/pound (spot) exchange rate?

Now suppose that the expected future exchange rate, $1.52 US per pound, remains constant

as Britain’s interest rate rises to 10 percent per year.

(c) If the US interest rate also remains constant, what is the new equilibrium dollar/pound

exchange rate?

(d) What is the expected rate of return over the year from holding a sterling deposit in a

London bank?

Now suppose that the actual exchange rate at the end of the year turns out to be $1.55 US

per pound.

(e) By how much does the actual return over the year from holding a sterling deposit in

London exceed or fall short of the expected rate of return? Would the actual dollar/pound

exchange rate rise or fall if, in response to the falsification of their expectations, currency

traders adapted their view of the expected future exchange rate towards the observed year

end outcome of $1.55 US per pound?

Answer Guide: Workshop Four

(a) The relevant formula is the uncovered interest rate parity formula:

E = E(e) (1+R*) / (1+R) (1+q),

where E is the spot exchange rate in US dollars per pound, E(e) is the expected exchange

rate at the end of the year, R* is the pound interest rate per annum in London, R is the

dollar interest rate per annum in New York, and q is the risk premium on holding pounds

rather than US dollars. Thus, when R* = R = 5% and q = 1%, the pound must be expected

to appreciate by 1% per annum. That is, E(e) must exceed E by 1%.

(b) The equilibrium spot exchange rate would be $1.505 US per pound, consistent with an

expected pound appreciation of 1% per annum, given E(e) = $1.52 US per pound.

(c) If the expected exchange rate remains at $1.52 US per pound, and the pound interest

rate rises from 5% to 10%, then the uncovered interest parity formula is satisfied only if the

current exchange rate changes such that there is an expected appreciation of the dollar equal

to approximately 4%. More precisely, this will occur when the exchange rate rises to $1.58

US per pound (a depreciation of the US dollar against the pound).

(d) The expected rate of return over the year from holding a sterling deposit in a London

bank is 6% per annum, which is the US dollar interest rate in New York plus the sterling

risk premium.

(e) If the actual exchange rate at the end of the year is $1.55 US per pound, the actual return

on holding a sterling deposit in a London bank would be approximately 8%, which exceeds

the expected rate of return by 2%. If currency traders adapt their view of the expected

future exchange rate towards the observed year end outcome of $1.55 US per pound, the

dollar/pound exchange rate would appreciate.

Economics 306: International Economics: Lecture Notes

Course Overview

International economics involves the study of the issues arising from economic interactions

among sovereign nations. This study centres around seven main themes:

The gains from international trade

Explanations of the pattern of trade

Ricardian productivity differences

The Heckscher-Ohlin factor proportions model

The standard trade model

Product differentiation and scale economies

Technological convergence and capital mobility

The impact of protectionist devices

Import duties/tariffs

Export subsidies

Quantitative restrictions/quotas

Voluntary export restraints

Customs unions and free trade areas

The balance of payments

Export and import flows and the current account

Asset transactions and the capital account

Exchange reserves and official settlements balances

Exchange rate determination

The interest rate parity relationship

Real exchange rate movements

Terms of trade effects

Macroeconomic adjustment

Flexible exchange rate regimes

Fixed exchange rate regimes

Employment fluctuations and price inflation

International policy co-ordination

The international capital market

The first three themes focus on real transactions and flows of imports and exports in the

international trading system. The final four themes relate to international monetary

economics.

The volume of trade between any two countries depends positively upon their economic

size and negatively on the distance (and therefore the associated transportation costs)

between them, as captured by the log-linear gravity equation:

ln T(i,j) = ln A + a ln Y(i) + b ln Y(j) - c ln D(i,j) + u(i,j) ,

where T(i,j) is the total trade value (exports plus imports) between countries i and j, Y(i)

and Y(j) are the gross domestic products of countries i and j, respectively, D(i,j) is the

distance between the two countries (or their central trading hubs), u(i,j) is an error term, A

is a constant, and a, b and c are positive parameters (or regression coefficients).

The gravity model has also been used to demonstrate that borders matter. That is to say,

the intensities of economic exchange within and across national borders are remarkably

dissimilar. Economic linkages are much tighter within, than among, nation-states. For

example, if the model was applied to the trade of British Columbia with other Canadian

provinces and individual US states, it would under-predict BC’s actual trade with Canadian

provinces and over-predict BC’s actual trade with most US states. The opposite effects

would be observed for the trade of Washington State.

There are many reasons why borders matter. These reasons are associated with transactions

costs, differential access to information, institutional differences, separate currencies, home

biases in preferences, and various barriers to the free flow of trade across international

boundaries. While strong, the forces of globalization do not seem to lead to a borderless

world.

Part One: International Trade Theory

Ricardo’s model of comparative advantage

The fundamental concept on which the theory of international trade is based is the principle

of comparative advantage. This principle may be defined by the statement that trade will

be mutually advantageous whenever the relative prices of various commodities differ from

country to country before trade by an amount great enough to over-offset the costs of

transferring the commodities in question from one country to another. A country will

export those goods that it produces relatively cheaply before trade in exchange for imports

of those goods that it produces relatively expensively before trade. This process of

profitable exchange leads countries to specialise (not necessarily completely) in the

production of those commodities in which they have a comparative advantage. A country

has a comparative advantage in producing a good if the opportunity cost of producing that

good in terms of other goods is lower in that country than it is in other countries.

The theory of international trade suggests that there are basically three reasons why the

relative production costs of various commodities might differ among countries. These are

(a) different resource endowments, (b) different production functions, and (c) different

scales of output. The Ricardian model of comparative advantage focuses on the second of

these reasons and, in particular, differences in relative labour-productivities in different

activities. To export those commodities in the production of which labour-productivity is

relatively high in exchange for those whose production exhibits relatively low labour-

productivity results in a gain in real income for a trading country. Thus, there are gains to

be made from international trade.

Consider an economy with a finite supply of labour that produces and consumes two

commodities, wine and cheese. The production possibility frontier may be written as:

a(L,C) Q(C) + a(L,W) Q(W) < L,

where L is labour supply, Q(C) is cheese output (measured on the horizontal axis), Q(W) is

wine output (measured on the vertical axis), a(L,C) is the unit labour requirement in the

production of cheese, and a(L,W) is the unit labour requirement in the production of wine.

Notice that a(L,C) is the reciprocal of the productivity of labour in cheese production, and

a(L,W) is the reciprocal of the productivity of labour in wine production. The absolute

slope of the production possibility frontier is the opportunity cost of cheese in terms of

wine, namely a(L,C)/a(L,W), which measures the number of litres of wine the economy

would have to give up in order to produce an extra kilogram of cheese.

If our simple economy (called Home) produces both goods, then the relative price of cheese,

p(C)/p(W), is equal to the unit labour requirement ratio, a(L,C)/a(L,W). However, if the

relative price of cheese exceeds its opportunity cost, the economy will specialise in cheese

production, while if the relative price of cheese is less than its opportunity cost, the

economy will specialise in wine production.

Now introduce a second country, called Foreign, which also has a production possibility

frontier of the form:

a*(L*,C) Q*(C) + a*(L*,W) Q*(W) < L*,

where the *-notation refers to the foreign country. Now assume that a(L,C)/a(L,W) <

a*(L*,C)/a*(L*,W) or, equivalently, that a(L,C)/a*(L*,C) < a(L,W)/a*(L*,W). This

assumption implies that the production possibility frontier for Foreign is steeper than the

production possibility frontier for Home, that Foreign has a higher opportunity cost of

cheese production than Home, that Home’s relative productivity in cheese production is

higher than it is in wine production, that Home has a comparative advantage in cheese

production, and that if trade opens up between Home and Foreign, Home will export cheese

to Foreign while importing wine. Notice that all four labour requirement coefficients are

necessary to determine comparative advantage and the direction of trade.

Demonstrate trading equilibrium in terms of the relative price and quantity of cheese

produced and consumed. See text, diagram 3-3. Note that in trading equilibrium the

relative price of cheese, p(C)/p(W) is bounded by a(L,C)/a(L,W) and a*(L*,C)/a*(L*,W).

Demonstrate also that there are gains from trade. These gains are shared between Home

and Foreign except where one of the two countries does not completely specialise, and the

relative price of cheese remains equal to that country’s labour requirement ratio.

The gains from trade depend upon comparative advantage and not upon absolute advantage.

If Home has an absolute productivity advantage in the production of both goods, it will

have a higher wage rate than Foreign. Home’s relative wage rate, w/w*, will lie between

Home’s productivity advantage in its exported good and its productivity advantage in its

imported good. The competitive advantage of an industry depends not only on its

productivity relative to the foreign industry, but also on the domestic wage rate relative to

the foreign wage rate. Finally, if there are many possible goods, j = 1…n, Home will

export all those goods for which w a(L,j) < w* a(L*,j), and import all those goods for

which w a(L,j) > w* a(L*,j). Thus, if goods are ordered by the productivity ratios,

a(L*,j)/a(L,j), then w/w* will determine where along this ordering the cut will occur

between Home’s potential exports and Home’s potential imports. Home will have a cost

advantage in any good for which its relative productivity is higher than its relative wage,

and Foreign will have a cost advantage in the other goods. However, if transport costs are

introduced, some commodities will become non-traded goods.

The Heckscher-Ohlin factor proportions model

Whereas the Ricardian model of comparative advantage focuses on differences in

production functions and, more explicitly, on differences in labour productivity as an

explanation of trade patterns, the Heckscher-Ohlin model focuses on differences in factor

endowments. A country will export those commodities which use intensively its relatively

abundant factor. Underlying this model are two key assumptions: (a) goods may be

ordered unambiguously by factor- intensities, and (b) countries have different factor

endowments.

Let there be two factors of production, land (N) and labour (L), which can be used in the

production of food (F) and cloth (C). Food production is land-intensive relative to cloth

production, which is labour-intensive. That is to say, the ratio of labour to land used in the

production of cloth is higher than the ratio of labour to land used in the production of food.

Thus,

a(L,C)/a(N,C) > a(L,F)/a(N,F),

where a(i,j) refers to the amount of factor i that is used in the production of one unit of good

j, where i = labour (L) or land (N), and j = cloth (C) or food (F). There are now two

resource constraints, which may be written as:

a(L,C) Q(C) + a(L,F) Q(F) < L, and

a(N,C) Q(C) + a(N,F) Q(F) < N,

where Q(C) and Q(F) refer to the outputs of cloth and food, respectively.

If each of the a(i,j)’s were fixed technical coefficients, the production possibilities frontier

would consist of two straight lines, one representing the labour constraint and the other

representing the land constraint. There would be a kink in the production possibilities locus

where these two constraint functions intersect. However, if there is a choice of technique,

with the a(i,j)’s depending upon relative factor input prices, then the production

possibilities frontier will be a downwards sloping line which is convex outwards from the

origin. The opportunity cost of cloth in terms of food (the absolute slope of the production

possibilities frontier) increases as the economy produces more cloth and less food. An

increase in the relative price of cloth, p(C)/p(F), would generate such a shift in production

volumes. The maximisation of production value requires that the opportunity cost of cloth

production be equated to the relative price of cloth.

Although cost minimisation implies that both a(L,C)/a(N,C) and a(L,F)/a(N,F) will

decrease if the wage paid for labour (w) rises relative to the rental price of land (r), we will

continue to assume that a(L,C)/a(N,C) > a(L,F)/a(N,F). It follows that the relative price of

cloth, p(C)/p(F) will increase as w/r increases. This is because an increase in the cost of

labour has a larger impact on the price of cloth than it has on the price of food. Taken in

reverse, an increase in p(C)/p(F) will redistribute factor income towards labour.

An increase in the supply of labour will lead to a biased expansion of production

possibilities, with the production possibilities frontier shifting outwards much more

prominently in the direction of cloth production. Indeed, if relative prices remain constant,

full employment of both factors of production would require an increase in cloth production

and a decrease in food production. However, prices may not remain constant in the face of

the increased labour supply. In particular, the relative price of labour, w/r, and the relative

price of cloth, p(C)/p(F), may fall in response to the increased availability of both labour

and cloth. It follows that a country with a relatively abundant supply of labour is likely to

be relatively effective at (and, thus, have a comparative advantage in) producing labour-

intensive goods.

Now consider a trading situation in which Home has a higher ratio of labour to land than

does Foreign. Thus, L/N > L*/N*. Home’s production possibility frontier is skewed

towards cloth production, while Foreign’s is skewed towards food production. Assuming

that Home and Foreign have similar demand functions for cloth and food, the pre-trade

relative price of cloth will be lower in Home than in Foreign. Thus, Home will begin to

export cloth and import food from Foreign. Moreover, Home’s food import quantity will

be equal to p(C)/p(F) times Home’s cloth export quantity, a fundamental budget constraint.

Countries tend to export goods whose production is intensive in factors with which they are

abundantly endowed. International trade in goods indirectly implies the international

exchange of factor services. More labour is embodied in Home’s exports than in its

imports.

On the assumption that both countries continue to produce both goods, as relative product

prices converge, relative factor prices will also tend to converge. w/r will rise in Home,

while w*/r* will fall in Foreign, implying a tendency towards international factor price

equalisation. In reality, however, factor price equalisation may be less likely than it

appears to be within the Heckscher-Ohlin model because (a) complete specialisation may

occur if factor endowments are very different, (b) production functions may differ

internationally because of technological leads and lags, and because the quality of factor

inputs may differ across countries and/or productive sectors, (c) transportation costs and

other impediments to trade may prevent full commodity price equalisation, and (d) factor-

intensity orderings may not be unambiguous.

Although there will be overall income gains from international trade, there will be changes

in income distribution that imply gains for some factors and losses for others. In particular,

each country’s abundant factor will receive an income gain, while its scarce factor will

experience an income loss. However, since trade expands a country’s overall consumption

possibilities in the sense that it would be possible to increase consumption of both goods, it

is clear that the gainers could fully compensate the losers and still have left-over gains.

Despite income distribution effects, there are gains to be achieved from international trade.

The expansion of the economy’s choices implies that it is always possible to redistribute

income in such a way that everyone gains from trade. Free trade satisfies the normal cost-

benefit criterion. Nevertheless, arguments over trade policies often reflect distributional

concerns.

The standard trade model

The standard trade model is agnostic as to whether trade patterns are determined by

Ricardian differences in production technologies or by Heckscher-Ohlinian differences in

factor endowments. The standard trade model is built on four key relationships: (a) the

relationship between the production possibility frontier and the relative supply curve; (b)

the relationship between relative prices and relative demand; (c) the determination of world

equilibrium by world relative supply and world relative demand; and (d) the effect of the

terms of trade – the price of a country’s exports divided by the price of its imports – on a

nation’s welfare.

The standard trade model proceeds in diagrammatic terms; see text figures 5-3, which

illustrates a trading equilibrium with a given terms of trade, and 5-4, which illustrates the

effects of a change in the terms of trade. The production and consumption points for a

given country must lie on an iso-value line, or budget constraint line, of the form:

p(C) Q(C) + p(F) Q(F) = p(C) D(C) + p(F) D(F),

where D(C) and D(F) are, respectively, the quantities of cloth and food consumed. The

budget constraint line may also be written as:

p(F) [D(F) – Q(F)] = p(C) [ Q(C) – D(C)],

so that import value equals export value. An increase in the terms of trade increases a

country’s welfare, while a decline in the terms of trade reduces its welfare. In trading

equilibrium, relative prices are determined by the intersection of the upward-sloping world

relative supply curve for cloth with the downward-sloping world relative demand curve for

cloth.

Export-biased growth tends to worsen a growing country’s terms of trade, to the benefit of

the rest of the world; import-biased growth tends to improve a growing country’s terms of

trade at the rest of the world’s expense. Thus, the effects of economic growth on the

welfare of the Home country will normally be as follows:

(a) Export-biased growth in Home’s production possibilities: normally positive

(b) Import-biased growth in Home’s production possibilities: positive

(c) Export-biased growth in Foreign’s production possibilities: positive

(d) Import-biased growth in Foreign’s production possibilities: normally negative

An income transfer worsens the donor’s terms of trade if the donor has a higher propensity

to spend on its export good than the recipient, i.e. if there is home country preference in

demand functions, as may be implied by the presence of non-traded goods.

For large countries, import tariffs improve the country’s terms of trade. The welfare

consequences depend upon the net effect of the terms of trade improvement when offset by

the efficiency losses associated with tariff-induced price distortions. For small price-taker

countries, import tariffs may not affect the terms of trade, while tariff-induced price

distortions generate a welfare loss. Export subsidies normally lower a country’s terms of

trade as well as generating efficiency losses; welfare is unambiguously reduced. Trade

barriers also have impacts on the internal distribution of income.

The Heckscher-Ohlin model assumes that factors are mobile between production sectors

within countries, but internationally immobile. An alternative model, the specific factors

model, separates factor inputs into three types: (a) specific resource inputs that are

immobile between production sectors, (b) generic inputs such as labour which are mobile

between sectors, but immobile internationally, and (c) capital, which is assumed to be

mobile between countries. Assume that the economy has three sectors: (a) an export sector

uses a specific natural resource (such as timber lands), labour and capital to produce a

tradable output (such as lumber), (b) an import-competing sector uses labour and capital,

plus a different specific factor, as inputs, and (c) a non-traded goods sector uses labour and

capital, but no specific factors, to produce its output. The non-traded good is taken to be

the numeraire, so that its price is unity.

There are three exogenous world prices: (a) the price of the country’s exports, (b) the price

of the country’s imports, and (c) the world price of capital funds. There are three

endogenous prices: (a) the rental price of resource inputs, (b) the price the specific factor

used in the import-competing sector, and (c) the wage of labour. Exports are resource

intensive, while imports are intensive in the use of the alternative specific factor.

Within this model, an increase in the world price of capital funds will lower the domestic

wage rate, but have ambiguous impacts on the rental price of resource inputs and the price

of the specific factor used in the import-competing sector. This ambiguity can be sorted out

if more is specified about the capital/labour ratios that pertain to these sectors in

comparison to the non-traded goods sector. Resource production often involves capital-

intensive techniques so that, in this case, the rental price of resource inputs would fall in

response to an increase in the world price of capital funds.

Also within this model, an increase in the world price of a tradable commodity will have an

impact on the associated specific factor price which is magnified in proportional terms, but

will have no impact on the price of specific factors that do not enter the cost function for

the commodity, or on the price of a generic factor such as labour. Thus, changes in the

terms of trade (the relative price of the resource-related export commodity relative to the

price of imported goods) will have important effects on internal income distribution, and

especially on the welfare of specific factor owners, while changes in the world price of

capital funds will have important effects on labour income, as well as on the level of

employment if wage rates are inflexible.

Product differentiation and scale economies

The third explanation of trade patterns is economies of scale. Scale economies are an

important explanation of intra-industry trade, whereas factor endowments and

technological differences may explain inter-industry trade. Internal economies of scale

occur at the firm level, and give rise to imperfectly competitive markets. These markets

often exhibit product differentiation, with consumers benefiting from the variety of goods

that are made available through trade. External economies of scale occur at the industry

level and are largely based upon synergistic relationships among firms. These synergistic

relationships may involve (a) specialised suppliers, (b) labour market pooling, and (c)

knowledge spill-overs.

We turn first to a model involving internal economies of scale and monopolistic

competition. Assuming that the representative firm faces a downward-sloping but linear

demand curve, one has:

Q = S/n – bS(P – P*),

where Q is quantity demanded, P is the firm’s price, P* is average price charged by the

firm’s competitors, S is total industry sales or overall market size, n is the number of firms

in the industry, and b is a positive parameter which measures the responsiveness of the

firm’s sales to its own price, given S and P*. Now let a = S/n + bSP*. It follows that PQ =

(a – Q)Q / bS, and that MR = (a – 2Q)/bS = P – Q/bS, where MR is marginal revenue.

Assuming also that the representative firm experiences both fixed costs and constant

marginal costs, the firm’s average cost (AC) function may be written as:

AC = c + F/Q,

where F is fixed costs, Q is output, and c is marginal (and average variable) costs. Setting

MR = c to maximise profits, one discovers that:

P = c + (Q / bS).

With symmetry among firms so that P = P* and Q = S/n, this expression becomes:

P = c + 1 / bn.

The larger is the number of firms competing within the industry, the smaller will each

firm’s price be. Also, with symmetry among firms, average costs may be re-written as:

AC = c + nF/S.

The larger is the number of firms in the industry, the less will scale economies be exploited,

and the higher will average costs be. If there is free entry into the industry, profits will be

driven to zero, with P = AC. Industry equilibrium thus implies that 1/bn must be equated to

nF/S, so that the equilibrium number of firms in the industry is equal to the square root of

S/bF.

The division of labour is limited by the extent of the market. However, when trade is

opened up in a monopolistically competitive industry, overall market size expands. This

increases the number of firms that can be profitably sustained within the industry, permits

these firms to take advantage of more scale economies, lowers the prices of products, and

expands the variety of products available to consumers. Because of economies of scale,

neither country is able to produce the full range of manufactured products by itself; thus,

although both countries may produce some manufactures, they will be producing different

things. Two-way trade, or intra-industry trade, occurs in manufactured goods. Whereas

inter-industry trade reflects comparative advantage, either based on Ricardian technological

differences or Heckscher-Ohlinian factor endowments, intra-industry trade reflects

economies of scale. Although there are overall gains to be made from both kinds of trade,

intra-industry trade is much less likely than inter-industry trade to have significant effects

on the distribution of income among productive factors. Examples: the formation of the

European Common Market, and the North American Auto Pact of 1964.

Dumping is a form of international price discrimination which occurs in oligopolistic

industries. Dumping occurs when it is possible for a firm to segment its markets and

proceed to sell its products at a lower price in foreign markets than in domestic markets.

Since profit maximising price discrimination requires marginal revenue to be equated in all

markets in which the firm’s output is sold, the lower price should be charged in the market

where the elasticity of demand is higher. Because greater competition is likely to exist for

a firm’s products in foreign markets than in domestic markets, the elasticity of demand is

likely to be greater in the foreign market. In terms of the linear demand curve used

previously, where MR = P – Q/bS, the lower price would be charged where Q/bS is smaller.

Given home market preference, this is most likely to be the foreign market. Thus, firms

have an incentive to dump products in the foreign market whenever the responsiveness of

quantity sold to price is greater in that market than at home.

The US International Trade Administration regards dumping as an unfair trading practice,

and often assesses anti-dumping duties against foreign firms that are alleged to be dumping

products into the US market. However, in many cases anti-dumping duties, like the

countervailing duties that are applied in the case of alleged foreign subsidies, are really

another example of trade protection.

External economies are observed when industrial clustering leads to lower costs for all

firms within the cluster. The main reasons why costs might fall when similar firms cluster

together in one location relate to the emergence of specialised suppliers, to labour market

pooling, and to knowledge spill-overs – the diffusion of new technological ideas occurs

more quickly among firms which are in close proximity to each other. All three reasons

generate synergism among firms within the cluster. Example: Silicon Valley in California.

External economies give rise to first-mover advantages, and make it more difficult for

potential competitors in other locations to break into the market. Learning-by-doing effects,

where costs fall in response to cumulative output, give rise to the phenomenon of dynamic

increasing returns. Infant-industry protection is sometimes justified on the assumption that

costs will fall as experience rises.

Technological convergence and capital mobility

International factor mobility may be either a complement to, or a substitute for,

international trade in goods and services. If the basis for the international exchange of final

commodities resides in differences in factor endowments as in Heckscher-Ohlinian trade

theory, allowing these factors to move directly between countries obviates the need for

commodity trade. However, if the basis for trade lies in other reasons (technological

differences, as in Ricardian trade theory, increasing returns to scale, etc.) trade by itself will

tend to raise the return to factors used intensively in each nation’s export sector. Factor

mobility that responds to such differences adds a factor endowment basis for expanded

commodity trade.

Sometimes the international mobility of factors is a prerequisite for the development of

commodity trade, particularly where extractive industries are concerned. On the other hand,

deliberate protectionist policies may reduce trade significantly if they encourage the flow of

capital to avoid the tariff barriers. Thus, foreign investment may serve to expand

production of a nation’s exportables, or serve to encourage production of importables.

International factor mobility responds to perceived differences in factor returns among

countries, and leads to the convergence of factor prices. International factor mobility also

increases world income, but there may be important distributional consequences. In

general, there are more important barriers to international factor mobility, perhaps with the

exception of capital mobility, than there are to the movement of goods and services in

international trade. There is limited mobility of labour between countries, and virtually no

mobility of land-based natural resources.

International capital mobility reflects borrowing and lending transactions between countries,

and gives rise to inter-temporal exchanges. Real interest rates are the key price variable

which influences these transactions. The number of units of future consumption that must

be foregone to obtain an additional unit of present consumption is equal to 1+r, where r is

the real interest rate. Alternatively, the relative price of future consumption is 1/(1+r).

Countries with a relatively low rate of interest will export capital by lending to foreign

countries. Countries with a relatively high rate of interest will import capital by borrowing.

Look at relevant diagrams.

Multinational enterprises choose to locate their operations in more than one country, and by

so doing are involved in the transfer of their core competencies and/or proprietary

technologies for use in other countries. They are, therefore, an important vehicle for

international technology transfers.

Technological convergence may be said to occur whenever the underlying technology of a

“less advanced economy” becomes more similar to that of a “more advanced economy”

through a process of technological diffusion. Recent empirical research related to (a) the

explanation of observed differences in postwar growth rates among advanced economies,

and (b) the explanation of observed changes in the pattern of international trade among

advanced economies in the postwar period, seems to suggest the following broad

generalisation, namely, that it is difficult, if not impossible, to explain either the differences

in growth rates or the changes in trade patterns if one starts from the supposition that, sector

by sector, these economies employ the same average levels of technological know-how at

any given point of time.

When the production function in any given productive sector is defined in terms of the

average degree of application of technological knowledge to production processes within

the sector, this production function will generally be observed to differ from one economy

to another. But these differences in sectoral production functions (or technological leads

and lags) among advanced economies do not remain unchanged through time. Indeed, the

effects generated by intertemporal changes in these sectoral differences are, in combination,

largely responsible for the observed differences in overall rates of economic growth and for

the observed changes in broad trading patterns.

This broad generalisation suggests that the comparative advantage positions underlying the

exchange of manufactured products are largely acquired through the combined processes of

technological change and capital accumulation. These processes are at the same time

responsible for the determination of overall rates of economic growth. Moreover, just as

comparative advantage positions can be acquired they can also be lost as the application of

technological knowledge becomes more widely diffused among trading economies. While

an original innovation may lead to a short term or medium term technological advantage,

the ensuing diffusion process tends to reduce this advantage. Such a diffusion process may

be called technological convergence.

The process of technological convergence involves the diffusion of the usage of “best-

practice techniques” across the various producers of a particular commodity, in whichever

countries these producers are located. This diffusion process normally implies some degree

of “anti-import bias” in the pattern of productivity improvements introduced by countries

which are, on the whole, importers of new techniques of production, and makes it

progressively more difficult for a country which is largely an exporter of new production

techniques to continue exporting relatively large quantities of commodities in the

production of which initially possesses a comparative advantage. Illustrate why this is

likely to be the case when diffusion processes lead to “catching up”.

Economies that grow rapidly through the reduction of an existing productivity gap

experience higher rates of return on capital investment and higher rates of capital

accumulation than a slower growing economy with a higher level of productivity. If long

term direct foreign investment responds to relative rates of return, capital will flow from a

slower growing more advanced economy to faster growing less advanced economies, this

flow tending to equalise rates of return among the countries under consideration.

International technological diffusion and international capital mobility go hand in hand,

with a major vehicle being the multinational enterprise.

In addition to the “anti-import bias” problem associated with the process of technological

convergence, an initial technological leader may also be faced with a transfer problem

associated with its long term capital outflows. The appropriate response to these two

related problems would be an overall reduction in the real exchange rate (the external value

of the technological leader’s currency adjusted for relative price levels). However,

eventually the growth rates of “catch-up” economies will slow down from their higher

levels as the process of technological convergence runs its course.

Part Two: International Trade Policy

Import duties/tariffs

A tariff is a tax levied when a good is imported. Specific duties, taxes or tariffs differ from

ad valorem duties. A specific duty involves a fixed charge for each unit of goods imported,

and tends to be independent of the point along the transportation and distribution network

at which the duty is levied. Ad valorem duties involve a percentage charge on the value of

the imported goods, and their impact depends upon where along the transportation and

distribution network the duty is levied. The cyclical impact of specific tariffs also differs

from the cyclical impact of ad valorem tariffs. An ad valorem duty that raises the same

amount of revenues as a specific duty in a normal or average market will raise larger

revenues in a buoyant market where goods prices are high, and smaller revenues in a down

market where goods prices are low. The burden of ad valorem duties on the market place is

higher than that of specific duties in buoyant markets, but is smaller than that of specific

duties in down markets. The distribution of the burden across high value products and low

value products within the same commodity class also differs between specific tariffs and ad

valorem tariffs. A blended tariff system could have the form T = a + bP, where T refers to

tariff revenues per unit, P refers to product price, and the parameters (a and b) refer to the

specific and ad valorem components, respectively. The blended tariff rate, t = T/P, would

then be equal to b + a/P.

If there are no impediments to trade, the equation of world demand to world supply

establishes an equilibrium price. In a two country world, equilibrium implies that the sum

of Home and Foreign demand must be equal to the sum of Home and Foreign supply. Thus,

the world market price is established where Home’s import demand (Home demand minus

Home supply) is equal to Foreign’s export supply (Foreign supply minus Foreign demand).

See diagrams 8-1, 8-2 and 8-3.

When Home implements an import tariff, a wedge is created between the Home and

Foreign market prices. The import tariff raises the price in Home and (except where Home

is a small price-taking country) lowers the price in Foreign. The volume traded declines.

See diagrams 8-4 and 8-5. The incidence or burden of the tariff is shared between Home

and Foreign in a manner which depends upon the elasticity of Home import demand and

the elasticity of Foreign export supply. There are also deadweight efficiency losses

associated with tariff distortions. As a result, import tariffs fail the cost-benefit test from a

world point of view. Home producers and Foreign consumers gain while Home consumers

and Foreign producers lose, but the overall net gain is negative. This negative effect is

exacerbated if Foreign retaliates to Home’s tariff by imposing protective tariffs on its

imports from Home. On the other hand, there are gains from trade from a world

perspective if one moves from tariff protection to free trade.

Whether or not Home gains or loses from implementing an import tariff depends upon the

size of the deadweight efficiency losses it incurs in relationship to the extent to which the

burden of the tariff is passed back to Foreign exporters (the terms of trade gain). Using a

cost-benefit analysis framework, Home’s net social benefits (NSB) from tariff

implementation are equal to NSB = dCS + dPS + dGR, where dCS is the change in

consumer surplus, dPS is the change in producer surplus, and dGR is the change in

government revenues associated with the tariff. The consumer surplus loss will inevitably

be larger than the producer surplus gain, and the government revenue gain may or may not

offset the difference. A small open economy will generally lose by imposing a tariff on

imports, because there will be little or no terms of trade gain. See diagrams 8-9 and 8-10.

Work through examples, including the effects of the imposition of tariffs on petroleum

imports and the impact of US countervailing duties on Canadian softwood lumber. In this

context, discuss the concept of effective protection, and why Canada needs to maintain log

export controls as long as the US continues to impose tariffs on softwood lumber imports.

Export subsidies

Export subsidies always fail the cost-benefit criterion. The wedge created between

domestic and foreign prices is associated with the diversion of production to the foreign

market. As a result, the exporting country creates a consumer surplus loss for domestic

consumers and a producer surplus gain for domestic producers, accompanied by a drain

from government revenues. There are again deadweight losses from the subsidy distortion,

to which must be added a terms of trade loss. See diagram 8-11.

On the other hand, an export tax can generate a terms of trade gain for an exporting country.

The effects of an export tax are similar to the effects of an import duty, but with the

important difference that the tax revenues accrue to the government of the exporting

country rather than to the government of the importing country.

Quantitative restrictions/quotas

Like a tariff, an import quota raises the domestic price of the imported good. However,

rather than generating tariff revenues for government, an import quota generates quota rents

for those companies who hold import licences, or quota rights. If these licences are held by

domestic importers, then the importing country may experience a gain or a loss from

imposing quotas depending upon the balance between efficiency losses and terms of trade

gains. However, if the import licences are held by foreign exporters, the importing country

suffers a net loss from a cost-benefit perspective. See diagram 8-13.

Voluntary export restraints

Voluntary export restraints are usually imposed at the request of an importing country.

However, from a cost-benefit perspective the request makes little sense because the

importing country suffers a terms of trade loss as well as the usual efficiency losses from

market distortion. The exporting country may enjoy a terms of trade gain, with its

exporters enjoying rents that arise from the restraints. Indeed, voluntary export restraints

operate like import quotas where the quota rights (or import licences) are assigned to

foreign exporters. As one form of managed trade, multilateral export restraints are often

called orderly marketing agreements.

Other trade policy instruments include local content requirements and national procurement,

regulated product standards and red-tape barriers, and export credit subsidies. The

summary table, 8-1, should be studied in detail. Although the effects on national welfare of

tariffs and import quotas are ambiguous (except for small countries where national welfare

falls), the effects on national welfare of export subsidies and voluntary export restraints are

negative. From a cost-benefit perspective, free trade should be preferred to protectionism.

Moreover, when monopoly power exists within a country, free trade can help to reduce this

power. Free trade is therefore a useful form of industrial policy.

Free trade versus protectionism

The case for free trade is based upon (a) economic efficiency gains through the harnessing

a comparative advantage and the avoidance of market distortions, (b) scale economies,

longer production runs, and enhanced product variety, (c) greater opportunities for learning

and innovation, and (d) the fact that retaliatory trade protection is a negative sum game.

The case against free trade is based upon (a) the terms of trade argument (optimum tariff

argument) for protection, (b) domestic market failure (second best arguments, including

infant industry arguments for protection), and (c) income distribution concerns. However,

it is always preferable to deal with market failures as directly as possible, because indirect

policy responses lead to unintended distortions of incentives elsewhere in the economy.

Thus, trade policies justified by domestic market failure are never the most efficient

response; they are always “second best” rather than “first best” policies. Indeed, most

deviations from free trade are adopted not because their benefits exceed their costs but

because the public fails to understand their true cost.

Movements towards free trade normally require international negotiation in which import

protection is traded off for export access, and the avoidance of trade wars. This process

mobilises the collective support of exporters and the general public to overcome the

concentrated lobbies of import competing industries and the workers they employ.

Customs unions and free trade areas

Trade liberalisation rounds under the General Agreement of Tariffs and Trade (GATT), and

now the World Trade Organisation (WTO) normally involve multilateral tariff reductions

based upon most favoured nation clauses. However, preferential trading agreements in the

form of customs unions and free trade areas are also permitted under the GATT/WTO.

Whereas a customs union involves a common set of external tariffs, which must be

determined by prior negotiation, a free trade area does not. The management of a free trade

area therefore requires a elaborate set of “rules of origin”. The European Community is a

customs union, while NAFTA is a free trade area. Preferential trading agreements involve

trade creation among the members of the customs union or free trade area, and trade

diversion from non-members of the preferential trading agreement. Welfare implications

involve balancing the gains from trade creation against the losses from trade diversion. The

gains are likely to exceed the losses if most of the trade creation effects involve intra-

industry trade based upon economies of scale, longer production runs, and increased

consumer choice.

Miscellaneous trade issues

The rationale for strategic trade policy in industrialised countries is based upon two kinds

of market failure. One of these is the inability of firms in high-technology industries to

capture or appropriate the externality benefits of contributions to knowledge that spill-over

to other firms. The other is the presence of monopoly profits in highly concentrated

oligopolistic firms. However, entry deterrence (i.e. a head start) seems to be required if a

subsidy is to generate an addition to oligopoly profits that exceed the subsidy, and the

whole strategy risks retaliatory activity (e.g. Boeing vs. Airbus, Embraer vs Bombardier).

Import-substituting industrialisation based upon the infant industry argument, which was

popular in developing countries during the first 30 postwar years, has largely been

superseded by export-orientated industrialisation during later years due to the example set

by a group of high performance Asian economies. The pre-conditions for rapid growth

through technological convergence appear to be: (a) the existence of a productivity gap to

be exploited, (b) the ability to invest in new capital equipment of the latest vintage (which

itself requires a high rate of savings), (c) the existence of a reasonable infrastructure of

social overhead facilities, including educational facilities, (d) a labour force with a

reasonably high level of education and skills, (e) the ability to release labour resources from

less productive sectors, including agriculture, (f) wage rates and labour income at a level

which creates a market for mass produced goods, (g) alert entrepreneurs and dynamic

management, and (h) respect for international comparative advantages and openness to

international trade. A threshold level of per capita income may be required before take-off

can occur.

The effects of globalisation on the real incomes of low-wage workers in both developing

and industrialised countries have given rise to various concerns. However, some of these

concerns are not well founded in economic logic. In developing countries, low-wage

workers would be worse off without the ability to work in growing export industries (e.g.

Mexico’s maquiladoras). In industrialised countries, it is technological change rather than

international trade which appears to be the main driving force behind labour market duality

(high wage, high skilled jobs versus low wage, low skilled jobs). Debate continues to

occur over whether labour standards and environmental standards should be included as a

component in trade negotiations.

Part Three: Exchange Rates and Open-Economy Macroeconomics

Export and import flows and the current account of the balance of payments

The national income accounting identity for an open economy may be written as:

Y = C + I + G + EX – IM,

where Y stands for gross national product, I for investment, G for government expenditure,

EX for exports and IM for imports. Within this identity, the difference between the value

of goods and services that are exported, EX, and the value of goods and services that are

imported, IM, equals the current account balance, CA = EX – IM. If EX > IM, the current

account is said to be in surplus, while if EX < IM, the current account is said to be in deficit.

A current account deficit implies that domestic absorption, or C + I + G, exceeds gross

national product, Y, and that the economy is spending more on imports than it is earning

from its exports. The economy is therefore borrowing from foreigners and reducing its net

foreign wealth. A current account surplus implies that domestic absorption is smaller than

gross national product, and that the economy is spending less on imports than it is earning

on exports. The economy is therefore lending to foreigners and increasing its net foreign

wealth.

Now define national saving, S, as the sum of private sector saving, SP = Y – T - C, and

public sector saving, SG = T – G, where T refers to tax revenues. Public sector saving will

be negative if government expenditure, G, exceeds tax revenues, T, so that the

government’s fiscal accounts are in deficit. It follows that national saving is the difference

between gross national product and the sum of private and public consumption

expenditures. Thus, S = Y – C – G, from which it follows that:

S = I + CA, where CA = EX – IM.

A country that saves more than it invests at home will be building up its stock of net

foreign wealth by running a current account surplus. A country whose domestic investment

exceeds national savings will be running a current account deficit and thereby financing

part of its investment needs by borrowing foreign savings.

Another way of looking at these accounting identities is to note that:

CA = SP – I – (G – T),

from which it becomes evident that, depending upon its private saving and investment

decisions, an economy that runs a large government sector deficit may find that deficit

mirrored in a current account deficit. The large US current account deficit reflects a

deficiency in national saving relative to investment. Part of the explanation of the shortfall

in national saving is the size of the government sector deficit. This is known as the twin

deficits problem. On the other side of the Pacific, China and Japan are generating large

current account surpluses because their national savings exceed their domestic investments.

In a sense, they are currently financing the US government deficit.

Asset transactions and the capital account of the balance of payments

The balance of payments records all transactions that occur between the Home country and

foreign countries. All transactions that result in a payment to foreigners (for example,

import purchases) are recorded as a debit (or negative) item in the balance of payments,

while all transactions that result in receipts from foreigners (for example, export sales) are

recorded as a credit (or positive) item in the balance of payments. Since export values and

import values are recorded in the balance of payments, the balance of payments includes

the current account.

Notice, however, that export values include exports of both goods and services, where

services include tourist services provided to foreign visitors and income receipts that

represent a return on the Home country’s foreign asset holdings. Similarly, import values

include imports of both goods and services, where services include the tourist services

provided when Home country residents visit foreign lands and income payments that

represent a return on foreign investments in the Home country. It follows that the current

account balance is a more inclusive concept than the merchandise trade balance, which

usually refers to the difference between the value of goods exports and the value of goods

imports.

The balance of payments also includes a capital account. (Although the textbook follows

US guidelines and distinguishes a capital account from an asset account, Canada does not

follow this classification, so we will treat the two accounts as merged.) The capital

account includes all exchanges of capital assets between the Home country and foreign

countries. If Canadians purchase US government bonds, or a condominium in the French

Riviera, this represents a capital outflow and would be recorded as a debit item in the

capital account. If foreigners purchase shares in well known Canadian companies, or a

chalet at Whistler, BC, the associated capital inflow would be recorded as a credit item in

the capital account. More generally, capital outflows are associated with an increase in

foreign assets held by residents of the Home country, while capital inflows are associated

with an increase in Home country assets held by residents of foreign countries.

Exchange reserves and official settlements balances

The balance of payments includes both the current account and the capital account. Double

entry accounting principles ensure that a current account surplus implies a capital account

deficit and that a current account deficit implies a capital account surplus. Current account

surpluses are lent back to foreign countries through capital outflows. Current account

deficits are covered by borrowing from foreign countries through capital inflows. In this

accounting sense, the balance of payments always balances.

However, included within the capital account are official settlement transactions. Central

banks hold exchange reserve accounts which are comprised of short term money market

instruments (such as Treasury bills) denominated in foreign currencies, normally US dollars,

euros, pounds, or yen. Thus, official settlements transactions involve the purchase or sale

of foreign exchange reserves by a country’s central bank. Official purchases of foreign

exchange reserves imply that the balance of payments would otherwise have been in overall

surplus had these purchases not occurred. Official sales of foreign exchange reserves imply

that the balance of payments would otherwise have been in overall deficit had these sales

not occurred. Thus, one may write:

dRH = CA + NF,

where dRH is the change in official holdings of foreign exchange reserves, CA is the

current account balance, and NF is net capital inflows excluding official settlement

transactions. If there is no official intervention in the foreign exchange market, dRH = 0,

and thus CA = - NF. A current account surplus, CA > 0, is associated with a net capital

outflow, so that NF < 0. A current account deficit, CA < 0, is associated with a net capital

inflow, so that NF > 0.

However, if CA + NF > 0, official foreign exchange reserve holdings must be increasing,

while if CA + NF < 0, official foreign exchange reserve holdings must be decreasing. (In

the case of a reserve currency country such as the United States, it may be that foreign

central banks, in aggregate, increase their holdings of US dollar exchange reserve assets

when the US balance of payments is in overall deficit, and decrease their holdings of US

dollar exchange reserve assets when the US balance of payments is in overall surplus.)

Exchange rate determination: the interest rate parity relationship

The price of one currency in terms of another is called an exchange rate. In a world with n

currencies, there are n-1 independent exchange rates. Since the US dollar is the most

universally traded currency, and since foreign central banks hold much of their exchange

reserves in short-term US dollar denominated assets, such as US Treasury bills, we will

normally use the term exchange rate to refer to the US dollar price of a unit of another

country’s currency. Thus, it costs approximately $0.89, $1.28, $0.87, $1.89 and $0.81 US

dollars to purchase one Canadian dollar, one euro, 100 yen, one pound, and one Swiss franc,

respectively. These exchange rates imply various currency cross-rates. For example, the

Canadian dollar price of one euro is approximately $1.44 Canadian, which can be obtained

by dividing the US dollar price of one euro by the US dollar price of one Canadian dollar

(i.e. $1.28 US / euro divided by $0.89 US / Can$ = $1.44 Can$ / euro). Arbitrage

operations keep currency cross-rates in line at all times. Although foreign exchange

transactions can occur anywhere in the world, the world’s most important foreign exchange

market continues to be in London, England.

This way of viewing exchange rates implies that, from the US perspective, an exchange rate

is the price of a unit of foreign exchange. Thus, the Canadian dollar appreciates in terms of

US dollars when its value moves upwards from $0.78 US/Can$ to $0.82 US/Can$, and

depreciates when the opposite movement occurs. Note, however, that from a Canadian

perspective the price of foreign exchange falls from $1.28 Can/US$ to $1.22 Can/US$ as

the Canadian dollar appreciates in this range, while rising as the Canadian dollar

depreciates in this range.

An appreciation of a country’s currency raises the relative price of its exports and lowers

the relative price of its imports. Thus, when a country’s currency appreciates, foreigners

pay more for the country’s products and domestic consumers pay less for foreign products.

Conversely, a depreciation lowers the relative price of a country’s exports and raises the

relative price of its imports. Thus, when a country’s currency depreciates, foreigners find

that its exports are cheaper and domestic residents find that imports from abroad are more

expensive.

The asset approach to foreign exchange rate determination begins from the proposition that,

among those assets that relate to the same risk and liquidity class, individuals prefer to hold

the assets which offer the highest expected real rate of return. Consider, then, the choice

between investing for a year in a secure US dollar bank deposit versus investing in a secure

bank deposit denominated in euros. If R is the rate of interest paid on the US dollar bank

deposit, then at the end of the year, each dollar invested will return 1 + R dollars.

Alternatively, if R* is the rate of interest paid on the euro bank deposit, and z is the

expected rate of appreciation in the exchange rate over the course of the year (where the

exchange rate is the price of euros in terms of US dollars), then each dollar that is converted

into euros at the beginning of the year, invested in a euro bank deposit, and reconverted

back into US dollars at the end of the year, will return (1 + R*)(1 + z) dollars. If there is to

be no incentive for investors to switch between these two alternative assets, they must

generate the same rate of return. Thus, asset market equilibrium implies that:

(1 + R) = (1 + R*) (1 + z) and, therefore, that R* = (R – z) / (1 + z).

This formula is known as the interest parity condition, which says that the foreign

exchange market is in equilibrium when deposits in both currencies offer the same expected

rate of return. Assuming that z is relatively small, the previous formulas may be

approximated by the formula, R = R* + z. Thus, asset market equilibrium implies that the

rate of interest on euro deposits plus the expected rate of appreciation of the euro relative to

the dollar must be equal to the rate of interest on US dollar deposits.

Now let z = [E(e) – E] / E, where E is the spot (or current) exchange rate at the beginning

of the year, and E(e) is the exchange rate that market participants at the beginning of the

year expect to occur at the end of the year. It follows that 1 + z = E(e) / E and, therefore,

that the formula for determining the current exchange rate may be written as:

E = E(e) (1 + R*) / (1 + R) or, alternatively, (1 + R) = E(e) (1 + R*) / E.

Given an initial interest rate differential, an increase in the expected US dollar price of

euros must increase the current exchange rate for euros in terms of US dollars. Given the

expected future exchange rate, an increase in the interest rate differential in favour of

Europe must increase the current exchange rate for euros in terms of US dollars. Moreover,

if the interest rate on euro deposits exceeds (falls short of) that on US dollar deposits, then

the current exchange rate must be at a level from which the euro is expected to depreciate

(appreciate). A country that maintains relatively high interest rates is essentially

compensating for the expected future depreciation of the external value of its currency.

It follows from these statements that the behaviour of exchange rates in response to changes

in monetary tightness or monetary ease will exhibit overshooting. An increase in European

interest rates will increase the current exchange rate (the US dollar price of euros) to a level

from which it is expected to fall, while a decrease in European interest rates will decrease

the current exchange rate to a level from which it is expected to rise. All of these points

may be illustrated in diagrams that relate the exchange rate (the US dollar price of euros) to

expected rates of return in US dollar terms on euro and dollar deposits. See, for example,

diagrams 13-4, 13-5, and 13-6.

Finally, assuming (as we have done) that foreign and domestic deposits are equally risky

(there is no differential risk premium), the forward exchange rate (the contracted US price

today of euros to be delivered in the future) is an unbiased predictor of the expected future

exchange rate. However, if for whatever reason it is more risky to hold euro deposits than

US dollar deposits, then not only will euro-zone interest rates tend to exceed US interest

rates when there is no expectation of a change in currency values, but also the forward rate

will tend to be a downwards biased predictor of the expected future exchange rate. In fact,

if q is the risk premium on holding euros, and E(f) is the forward price of euros, then E(e) =

E(f) (1 + q). In this situation, asset market equilibrium implies that:

E = E(e) (1+R*) / (1+R) (1+q) or, alternatively, E(e) (1+R*) / E = (1+R) (1+q),

which we will now call the uncovered interest parity condition. An increase in the risk

premium associated with holding euro deposits relative to holding US dollar deposits will

need to be compensated by a higher expected return on euro deposits relative to US dollar

deposits. The alternative covered (or hedged) interest parity condition is:

E = E(f) (1+R*) / (1+R).

Thus, if R* > R, euros are trading at a forward discount, [E(f) – E] / E < 0, whereas if R* <

R, euros are trading at a forward premium, [E(f) – E] / E > 0.

Money, interest rates, and exchange rates

An exchange rate is the relative price of one country’s money in terms of another’s. Thus,

factors which affect a country’s money supply and/or demand have powerful effects on the

exchange rate for its currency. Monetary developments influence the exchange rate both by

changing interest rates and by changing people’s expectations about future exchange rates.

Moreover, expectations about future exchange rates are influenced by expectations about

the future purchasing power of a country’s money, which itself reflects output price

developments that are themselves influenced by changes in money supply and/or demand.

As is well known, money serves as (a) a medium of exchange, (b) a unit of account, and (c)

a store of value. Money is the most liquid of all assets, where an asset is said to be liquid if

it is readily realisable (or converted into other asset forms) at short notice without

significant cost. Thus, the demand for money is essentially the demand for liquidity. The

supply of money, defined as the sum of currency outstanding and commercial bank deposits

on which cheques can be written, is determined by the actions of the country’s central bank.

When the central bank increases (decreases) its asset holdings by open market purchases

(sales) of government bonds, the domestic money supply will increase (decrease).

The demand for money depends positively on the economy’s price level, P, and on the

economy’s overall level of real output, Y, and negatively on the interest rate, R, which

measures the opportunity cost of holding money rather than an interest-bearing asset.

Money demand is assumed to respond proportionately to movements in the price level, so

that the demand for money may be written as:

M(d) = P L(Y, R),

where M(d) is money demand, P is the price level, and L(Y, R) is the demand for real

balances, or for money of constant purchasing power. Monetary equilibrium occurs when

money demand is equal to the money supply, M(s), so that:

M(s) = M(d) = P L(Y, R) or, alternatively, M(s)/ P = M(d)/ P = L(Y, R).

Given the level of output, Y, an increase in the supply of real balances, M(s)/P, will lower

the rate of interest, R, whereas a decrease in the real money supply will raise the rate of

interest. Given the real money supply, an increase (decrease) in the level of output will

expand (contract) the transactions demand for real balances and lead to an increase

(decrease) in the rate of interest. The relevant diagrams are 14-3, 14-4 and 14-5.

An increase in a country’s money supply causes its currency to depreciate in the foreign

exchange market, while a reduction in the money supply causes its currency to appreciate.

When the domestic money supply increases, downward pressure is placed on the domestic

interest rate. Given an unchanged foreign interest rate, the lower domestic interest rate is

only compatible with the interest parity condition if the domestic currency is expected to

appreciate (that is, the price of foreign exchange is expected to fall, so that E(e) < E).

Given the expected exchange rate, this can only occur if the external value of the domestic

currency falls (that is, E increases). Another way of looking at this point is to note that a

lower anticipated return on domestic assets would lead to substantial short-term capital

outflows seeking higher foreign returns, and these outflows (sales of domestic assets in

order to purchase foreign assets) push the external value of the domestic currency

downwards (and the price of foreign exchange upwards) in the foreign exchange market.

On the other hand, when the domestic money supply decreases, upward pressure is placed

on the domestic interest rate. Given an unchanged foreign interest rate, the higher domestic

interest rate is only compatible with the interest parity condition if the domestic currency is

expected to depreciate (that is, the price of foreign exchange is expected to rise, so that

E(e) > E). Given the expected exchange rate, this can only occur if the external value of

the domestic currency rises (that is, E decreases). Another way of looking at this point is to

note that a higher anticipated return on domestic assets would lead to substantial short-term

capital inflows seeking higher domestic returns, and these inflows (sales of foreign assets in

order to purchase domestic assets) push the external value of the domestic currency

upwards (and the price of foreign exchange downwards) in the foreign exchange market.

Thus, when M(s) increases, one should observe that R falls and E (the price of foreign

exchange) rises, whereas when M(s) decreases, one should observe that R rises and E falls.

However, an increase in the foreign money supply would reduce both R* and E, as the

domestic currency appreciates, while a decrease in the foreign money supply would raise

both R* and E, as the domestic currency depreciates. It follows that relative money

supplies are an important determinant of foreign exchange rates, and that the exchange

values of currencies issued by countries experiencing higher money supply growth rates

will tend to depreciate over time. Diagrams 14-6, 14-8, and 14-9 illustrate these points.

It should be noted that the repercussions we have illustrated so far are short-run in nature,

because they assume that output, Y, the price level, P, and the expected exchange rate, E(e),

all remain unchanged in response to money supply changes. In the long-run, however,

money supply changes lead to proportional changes in the price level, where one of the

prices that is proportionately affected is the price of foreign exchange. Thus, a permanent

increase in a country’s money supply causes a proportional long-run depreciation of its

currency against foreign currencies. Similarly, a permanent decrease in a country’s money

supply causes a proportional long-run appreciation of its currency against foreign

currencies.

Prices tend to be sticky in the short-run and flexible in the long-run. Unlike the exchange

rate, prices do not jump immediately in response to monetary changes. Despite the short-

run stickiness of price levels, however, money supply increases create immediate demand

and cost pressures that eventually lead to future increases in the price level. These

pressures come from (a) excess demand for output and labour, (b) increases in commodity

prices, which do move with flexibility in response to changes in demand and supply, and (c)

the destabilisation of inflationary expectations.

Because the price level is sticky in the short-run, the response path of the economy to a

permanent increase in the money supply involves (a) an initial fall in interest rates, which

gradually return to their original level as prices rise over time, and (b) an initial fall in the

value of the currency to a level from which it is expected to appreciate. Although long-run

equilibrium implies a lower value of the currency, the initial fall in currency value is larger

than the long-run fall. The exchange rate overshoots its eventual equilibrium level along

the adjustment path. The relevant diagrams are figures 14-12 and 14-13.

Real exchange rate movements

The real exchange rate is a broad summary measure of the prices of one country’s goods

and services relative to another’s. If P is the domestic price level and P* is the foreign

price level, then P*E / P is the relative price of foreign goods in terms of domestic goods.

Notice that the nominal exchange rate, E, which measures the price of foreign currency in

terms of domestic currency, is a central element in the real exchange rate. The real

exchange rate measures the number of units of domestic production that are required to

purchase one unit of foreign production.

An increase in the real exchange rate implies a depreciation in the purchasing power of

domestic products over foreign products. Foreign products are thus becoming relatively

more expensive to purchase than domestic products, and there will be a tendency to

substitute domestic products for foreign products. The real exchange rate will rise over

time whenever the difference between the foreign inflation rate and the domestic inflation

rate is less than fully offset by a decline in the exchange value of the foreign currency.

A decrease in the real exchange rate implies an appreciation in the purchasing power of

domestic products over foreign products. Foreign products are thus becoming relatively

cheaper to purchase than domestic products, and there will be a tendency to substitute

foreign products for domestic products. The real exchange rate will fall over time if the

difference between the domestic and foreign inflation rates is less than fully offset by a

decline in the exchange value of the domestic currency.

Deviations in the real exchange rate from unity imply deviations from purchasing power

parity. Put differently, the purchasing power parity value of the nominal exchange rate

would be given by the equation, P*E = P. If this equation were to hold, it would assert that,

when measured in terms of the same currency, the price levels in the foreign and domestic

countries are equal. The purchasing power of a US dollar would be the same in Europe as

it is in the United States. Although there are good reasons to believe that, transport costs

and trade impediments apart, the law of one price should hold across countries for

individual commodities, there are several reasons why purchasing power parity does not

seem to hold at the level of broad price level aggregates. These reasons include: (a) the

market basket of goods and services included in aggregate price indices differs across

countries, (b) the domestic price level will place a heavier weight on commodities produced

and consumed at home, while the foreign price level will place a heavier weight on

commodities produced and consumed in the foreign country, (c) there are many goods and

services that are not traded between countries, and (d) transport costs and other trade

impediments interact with oligopolistic and monopolistic practices, such as pricing to

market, so as to distort the competitive norm of the law of one price. For example, the

purchasing power of the US dollar in developing countries usually exceeds its purchasing

power in the United States because labour-intensive non-traded goods and services are

cheaper in developing countries because wage rates are relatively low there.

Both monetary and real shocks will affect the value of the real exchange rate, P*E / P. If

these shocks are transitory in nature, the effects on P*E / P will tend to be self- reversing.

In addition, the short-run effects of permanent changes in relative money supplies will tend

to be self-reversing in the longer-run. There is, therefore, some tendency for the real

exchange rate to return to a long-run equilibrium value when initially perturbed by money

supply changes that turn out to be permanent. This tendency is consistent with the concept

of relative (as opposed to absolute) purchasing power parity. However, real shocks that

turn out to be permanent will alter the long-run equilibrium value of the real exchange rate.

Prominent among real shocks are changes in relative prices, or terms of trade changes.

Consider the response path of two countries that are engaged in international trade to a

permanent increase in the money supply in the home country, while the foreign money

supply is held constant. In the short-run, the domestic interest rate will fall and the price of

foreign exchange (the nominal exchange rate) will increase to a level from which it

expected to depreciate. As domestic prices gradually adjust in response to the monetary

expansion, the domestic interest rate will begin to return to its initial value, and the nominal

exchange rate will move downwards towards a long-run equilibrium value which is higher

than its initial value. Notice again that exchange rate over-shooting occurs along the

response path.

In the final equilibrium, the domestic price level will have risen in proportion to the

increase in the home country’s money supply, and the nominal exchange rate will have

fallen in the same proportion. While the real exchange rate initially increases in response to

the domestic money supply increase, in the final equilibrium the real exchange rate returns

to its initial value. P and E are both proportionately higher, leaving P*E / P unchanged. If

economic agents understand the process involved, it would be rational for them to form

expectations of the nominal exchange rate that are based on relative purchasing power

parity considerations.

We will see later that the initial increase in the real exchange rate leads to a temporary

expansion in the trade balance, and that the resulting expansion in aggregate demand is one

of the forces that drives up prices in the domestic economy. Another force is the increased

price of imported goods and services, perhaps including raw material inputs, in response to

the higher price of foreign exchange. Thus, both demand-pull and cost-push forces

affecting the domestic price level are set in play in response to the initial money supply

increase.

With the foreign money supply held constant, a permanent decrease in the home country’s

money supply works in the opposite direction. Domestic price deflation and a matching

appreciation of the home country currency would be the eventual outcome. Moreover, the

domestic economy can, in principle, insulate its price level from an increase in the foreign

price level that is induced by foreign monetary expansion by appreciating the external value

of its currency, so that a falling E offsets a rising P*.

The impacts of a permanent shift in relative money supply growth rates (as opposed to

levels) may also be analysed, but to do so requires consideration of the Fisher effect. The

Fisher effect states that an increase in an economy’s expected inflation rate will be reflected

in a one-for-one manner in the economy’s interest rates. Nominal interest rates embody a

premium for expected inflation which compensates lenders for the falling value of money

in response to ongoing inflation. The real interest rate is approximately equal to the

nominal interest rate less the expected rate of price inflation. More precisely, if x is the

expected rate of price inflation and R is the nominal interest rate, then the real interest rate

is equal to r = (1+R)/(1+x) – 1, or r = (R – x)/(1+x).

Suppose now that expected inflation in the foreign economy is equal to x*. Then the real

interest rate in the foreign economy is r* = (1+R*)/(1+x*) – 1, or r* = (R* – x*)/(1+x*),

where R* is the nominal interest rate in the foreign country. If the home and foreign

countries have the same real rate of interest, then (1+r) = (1+r*), from which it follows that

(1+R)/(1+x) is equal to (1+R*)/(1+x*). But when differential risk is ignored, the interest

parity condition implies that (1+R) = (1+R*) (1+z), where z = [E(e) – E] / E is the expected

rate of appreciation of the foreign currency. It follows that:

E(e) / E = (1+z) = (1+x)/(1+x*) and, hence, that z = (x – x*) / (1+x*).

Assuming that x* is fairly small, this equation says that the expected rate of appreciation of

the foreign currency is equal to the difference between the expected rate of inflation in the

domestic economy and the expected rate of inflation in the foreign economy. The currency

of a country whose price level is expected to increase faster than the price level of its

trading partners will be expected to experience a depreciation in the value of its currency

that is equal to the difference in inflation rates. The resulting nominal exchange rate

adjustment will maintain the real exchange rate at a given level, consistent with the

maintenance of relative purchasing power parity. (It should be noted that there is a two-

way relationship between the maintenance of relative purchasing power parity and the

equivalence of real interest rates in the two trading countries. More generally, relative

movements in real interest rates will be associated with changes in the real exchange rate.)

One may now consider the impact of a permanent shift in relative money supply growth

rates. The long run effects of an increase in the domestic money supply growth rate

relative to the foreign money supply growth rate are to generate a higher rate of inflation in

the domestic economy, raise the nominal interest rate in the domestic economy above that

in the foreign economy due to the Fisher effect, and lead to a continuous depreciation in the

value of the domestic currency, while real interest rates and the real exchange rate remain

unchanged. The relevant diagram is figure 15-1.

Terms of trade effects

Unlike permanent monetary shocks, permanent real shocks will have a lasting effect on the

real exchange rate. Suppose that there is an increase in world demand for the types of

goods and services that the US exports relative to the demand for the types of goods and

services that it imports. This increase will lead to an increase in the price of US exports

relative to the price of its imports. A movement in the terms of trade (the relative price of

US exports relative to its imports) that is favourable to the US economy occurs. As a result,

P*E / P must decrease, implying a real appreciation of the US dollar. If overall price

levels remain roughly unchanged, the real appreciation will be accompanied by an increase

in the external value of the US dollar. On the other hand, a decrease in world demand for

the types of goods and services that the US exports relative to the demand for the types of

goods and services that it imports will lead to an unfavourable movement in the US terms

of trade. As a result, P*E / P must increase, implying a real depreciation of the US dollar.

If overall price levels remain roughly unchanged, the real depreciation will be accompanied

by a decrease in the external value of the US dollar. If the process of technological

convergence implies “anti-import biased” growth in “catch-up” countries, then the

technological leading country will experience real depreciation. However, the effects of

changes in national output, and output growth rates, will be discussed more generally below.

Terms of trade effects are particularly important to understanding Canadian dollar

exchange rate movements. Indeed, given the importance of natural resource based

commodities in the Canada’s export trade, the Canadian dollar is sometimes referred to as a

“commodity currency”. Various authors, with relatively more or less success, have tried to

explain movements in Canada’s real exchange rate using variables such as a raw materials

price index relative to the prices of all other goods (a proxy for the Canadian terms of trade),

and the real interest rate differential between Canada and the United States. More recently,

the high prices being received for exports of crude petroleum and natural gas have been one

of the explanations of Canadian dollar appreciation. Since the appreciation has also been a

real one, cost-price pressure has been placed on Canadian sectors other than its energy

producing sector.

The real income of a small open economy such as Canada can move differentially in

relationship to its real output if the terms of trade change substantially. Real income equals

money income divided by the consumer price index. Money income equals the overall

volume of output times the average price at which output is sold. The price of exportables

enters the overall output price, whereas the price of importables enters the consumer price

index. Hence, if the terms of trade improve, output prices increase relative to the consumer

price index, and real income goes up in relationship to real output. On the other hand, if the

terms of trade decline, output prices fall relative to the consumer price index, and real

income falls in relationship to real output. The specific factors model can be helpful in

analysing terms of trade effects for a small open economy.

In summary, when all disturbances are monetary in nature, nominal exchange rates reflect

relative purchasing power parity in the long run. In the long run, a monetary disturbance

affects only the general purchasing power of a currency, and this change in purchasing

power is equally reflected in the currency’s value in terms of both domestic and foreign

goods. However, when disturbances occur in output markets, including situations

involving terms of trade changes, nominal exchange rates are unlikely to reflect purchasing

power parity. Real appreciation or depreciation is likely to be observed in response to real

shocks.

Macroeconomic adjustment: flexible exchange rate regimes

In terms of units of domestic output, the current account balance of the home country may

be written as:

CA = EX - IM = X(P*E / P, Y*, Y),

where X refers to net exports, which are a function of the real exchange rate, P*E / P,

foreign output, Y*, and domestic output, Y. An increase in foreign output will expand the

home country’s net exports because export demand increases. For Canada, US gross

national product provides a good proxy for foreign output. An increase in domestic output

will lower net exports because import demand increases. The impact of the real exchange

rate on net exports is usually assumed to be positive because of substitution effects. That is

to say, if the relative price of foreign goods and services increases, substitution effects will

lead to larger purchases of domestic goods and services in both the home and foreign

markets. As a result, export quantities will rise and import quantities will fall. Provided

that these substitution effects are large enough to overcome the fact that import prices are

rising relative to domestic output prices, net exports will increase in response to an increase

in the real exchange rate, P*E / P.

The exact condition that needs to hold for net exports to respond positively to the real

exchange rate is known as the Marshall-Lerner elasticity condition. Let the current account

balance (or more strictly the merchandise trade balance) be written in units of domestic

output as x – qm, where x measures physical exports, m measures physical imports, and q

measures the real exchange rate, or the price of foreign products (including imports)

relative to the price of domestic products (including exports). The derivative of x – qm

with respect to q is equal to dx/dq – qdm/dq – m. We are interested in whether this

derivative is positive or negative. Now dx/dq = e(x) x/q, where e(x) is the elasticity of

demand for exports, which is positive since q is the inverse of the relative price of exports.

Moreover, dm/dq = - e(m) m/q, where e(m) > 0 is the absolute value of the elasticity of

demand for imports. It follows that the derivative of x –qm with respect to q is equal to e(x)

x/q + e(m) m – m. If it is assumed that trade is initially balanced so that x – qm = 0, the

sign of the derivative will be positive if and only if:

e(x) + e(m) > 1.

This is the Marshall-Lerner condition. It says that the home country’s trade balance will

improve in response to an increase in the real exchange rate (a real depreciation for the

home country) if and only if there are sufficient substitution possibilities between home and

foreign goods and services, as measured by the elasticities of export and import demand, to

overcome the fact that imported goods and services become more expensive for domestic

consumers.

Empirical estimates of trade elasticities suggest that, for most countries, the Marshall-

Lerner condition is satisfied in both the short-run and the long-run. However, since

substitution effects take time to materialise, impact elasticities may be insufficient. If this

is the case, the trade balance will weaken in response to a real depreciation of the country’s

currency before it eventually strengthens. This response pattern is known as the J-curve

effect. Thus, except over short time periods, real depreciation is likely to improve the trade

balance while real appreciation is likely to worsen it. The impact on the current account

will correspond to the impact on the trade balance in most instances, with the possible

exception of countries with a large external indebtedness which is denominated in foreign

currencies. In this case, an increased burden of interest payments may offset the positive

trade balance effects that real depreciation brings about.

The current account balance is an important component of the aggregate demand for an

open economy’s output. Indeed, aggregate demand may be written as:

D = C(Y – T) + I(r) + G + X(P*E / P, Y*, Y),

where consumption, C, is a positive function of deposable income, Y – T, with less than

unit slope, investment, I, is a function of the real interest rate, r = (R – x)/(1 + x),

government expenditure, G, and taxes, T, are taken to be autonomous, and net exports, X,

are a function of the real exchange rate, P*E / P, foreign output, Y*, and domestic output, Y,

as previously outlined. It is assumed that the Marshall-Lerner elasticity condition holds, so

that a real depreciation (appreciation) of the home currency raises (lowers) aggregate

demand for home output.

Equilibrium output occurs when aggregate demand, D, is equal to domestic output, Y. An

increase in D will lead to a corresponding increase in Y, while a decrease in D will lead to a

corresponding decrease in Y. Notice that there is a positive transmission mechanism from

movements in foreign output, Y*, to movements in domestic output, Y, which works

through the current account balance. In addition, an increase (decrease) in the real

exchange rate, P*E / P, will cause an upward (downward) shift in aggregate demand, and

therefore an expansion (contraction) in domestic output. These responses illustrate two of

the ways in which the US economy dog wags the Canadian economy tail.

The short-run behaviour of an open economy under flexible exchange rates may be

described by three equations. These equations describe the conditions for equilibrium in

the output market, the money market and the foreign exchange market, respectively. The

three equations are:

Y = D = C(Y – T) + I(R) + G + X(P*E / P, Y*, Y),

M(s) = M(d) = P L(Y, R), and

E = E(e) (1 + R*) / (1 + R) (1 + q).

In the short-run, prices are taken to be given and, thus, the inflation rate is taken to be zero

so that the nominal and real interest rates coincide (R = r). To keep matters simple, we

assume that the risk premium, q, is also zero, and that the expected exchange rate, E(e), is

predetermined. M(s), G and T are policy variables, which are also taken to be

predetermined. Finally, one should note that all three foreign variables, Y*, P*, and R*,

have an impact on the equilibrium equations, indicating that there are important linkages

(or transmission mechanisms) between the rest of the world and the economy being

analysed. Given the small open economy assumption, however, all foreign variables are

taken to be exogenously determined. The three endogenous variables are output, Y, the

interest rate, R, and the exchange rate, E.

There are two different diagrammatic ways of analysing this three equation equilibrium

system. One of these is the standard IS-LM diagram, which works with Y and R as the

primary variables, with movements in E taken to be behind the scene. The other of these is

the AA-DD diagram, which works with Y and E as the primary variables, with movements

in R taken to be behind the scene. We begin by considering the IS-LM diagram.

In the IS-LM diagram, output, Y, appears on the horizontal axis, and the interest rate, R,

appears of the vertical axis. The LM curve depicts all Y, R combinations at which the

money market is in equilibrium. The LM curve is drawn up for a given real money supply,

M(s)/ P, and is an upward sloping line in Y, R space. The upward slope of the LM curve

reflects the fact that higher levels of output expand the transactions demand for money,

which leads to tighter credit conditions if the money supply remains unchanged.

The IS curve depicts all Y, R combinations at which the output market and the foreign

exchange market are in equilibrium. The IS curve is drawn up for given foreign variables,

and given domestic fiscal policy, and is a downward sloping line in Y, R space. The

downward slope of the IS curve relates to two separate forces. First, a reduction in interest

rates stimulates additional investment activity. Secondly, a reduction in domestic interest

rates in relationship to foreign interest rates will reduce the external value of the domestic

currency. That is to say, it will increase the nominal exchange rate (the price of foreign

exchange, E) relative to the expected exchange rate, which may temporarily be taken to be

given. The resulting increase in the real exchange rate, P*E / P, will expand the current

account balance. Both the increase in the volume of exports relative to imports, and the

increase in investment activity, will generate an increase in domestic output in the short-run.

Of course, although the nominal exchange rate adjusts quickly in response to relative

interest rate movements, both processes may be subject to response lags. Investment may

expand only gradually in response to a decrease in the domestic interest rate, and the

current account balance may expand only gradually in response to an increase in the real

exchange rate (or even contract initially if substitution effects take time, as illustrated by

the J-curve effect).

Simultaneous equilibrium in all three markets occurs at the intersection of the IS and LM

curves. It should, nevertheless, be pointed out that although the expected exchange rate,

E(e), may not be affected by temporary shocks to the equilibrium situation, it will be

affected by permanent shocks. An increase in E(e) will shift the IS curve to the right, while

a decrease in E(e) will shift the IS curve to the left. As a result, permanent changes in the

money supply have a larger impact on the level of output than temporary changes, while

permanent changes in fiscal policy have a smaller impact on the level of output than

temporary changes. These consequences arise from the fact that changes in E(e) tend to

generate further changes in E in the same direction.

The relevant diagrams for analysing shifts in domestic monetary and fiscal policy are A-2

and A-3. In diagram A-2, a temporary increase in the domestic money supply shifts the

LM curve to the right, lowering the domestic interest rate, increasing the price of foreign

exchange, and increasing the volume of output. A permanent increase in the money supply

will also increase the expected exchange rate, E(e), leading to a rightward shift in the IS

curve, which tends to increase output further due to additional exchange rate changes, while

the interest rate moves back towards its original level. Perhaps with some lag, upwards

pressure on the domestic price level will also be observed. As prices increase, real balances

will begin to fall back towards their initial level. This will ultimately reduce the impact on

output and interest rates, as the LM and IS curves both begin shifting back towards their

original positions. All of the movements described in this paragraph would proceed in

reverse in response to a reduction in the domestic money supply.

In diagram A-3, a temporary increase in government expenditure (or reduction in taxes)

shifts the IS curve to the right. Domestic output and interest rates both increase, while the

price of foreign exchange falls. The expansionary impact of fiscal policy is limited by

crowding out effects on both private investment and the trade balance. Permanent fiscal

expansion will also lower the expected exchange rate, E(e), leading to further crowding out

effects as the IS curve moves back towards its initial position. Indeed, a permanent fiscal

expansion has no effect on domestic output or the interest rate. All of the movements

described in this paragraph would proceed in reverse in response to fiscal contraction.

It follows that, when exchange rates are flexible, monetary policy has powerful short-run

effects on the volume of domestic output, and therefore on employment, while fiscal policy

has limited power. Fiscal policy does affect the composition of the balance of payments

and, eventually, the country’s net foreign indebtedness position. Indeed, while the effects

of fiscal expansion tend to appreciate the external value of the domestic currency (that is,

generate a fall in E), the long-run impact of a sustained build-up of foreign indebtedness

may be to depreciate the domestic currency, due to the increasing debt service burden on

the current account of the balance of payments.

The alternative diagrammatic treatment of simultaneous short-run equilibrium in the output

market, the money market and the foreign exchange market uses the AA and DD

relationships. The AA curve represents asset market equilibrium, and depicts all those

combinations of output and the exchange rate at which the domestic money market and the

foreign exchange market are simultaneously in equilibrium. The AA curve is downward

sloping in Y, E space, and is drawn up on the assumption that real balances, M(s)/ P, the

expected exchange rate, E(e), and the foreign interest rate, R*, are given.

The downward slope of the AA curve relates to the fact that a higher level of output is

associated with a larger transactions demand for money, and therefore with higher domestic

interest rates. Higher domestic interest rates are only compatible with equilibrium in the

foreign exchange market if the domestic currency is expected to depreciate. Given the

expected exchange rate, this can only occur if the nominal exchange rate (that is, the price

of foreign exchange) is lower than it was previously. This is illustrated in Figure 16-6. For

asset markets to remain in equilibrium, a rise in domestic output must be accompanied by

an appreciation of the domestic currency (a fall in the price of foreign exchange), all else

equal, and a fall in domestic output must be accompanied by a depreciation of the domestic

currency (a rise in the price of foreign exchange).

The AA curve will shift to the right (left) if the volume of real balances, M(s)/ P, increases

(decreases). The AA curve will also shift to the right if either the expected exchange rate,

E(e), or the foreign interest rate, R*, increases (decreases). The reason for this is that either

of these changes will, other things equal, increase (decrease) the price of foreign exchange

that is associated with any given level of output. The linkage here is that increases

(decreases) in either E(e) or R* tend to generate capital outflows (inflows), with resulting

impacts on the foreign exchange rate.

The DD curve represents output market equilibrium, and depicts all those combinations of

output and the exchange rate that are consistent with output market equilibrium. The DD

curve is upward sloping in Y, E space, and is drawn up on the assumption that fiscal policy

(government expenditure and taxation), investment demand, the home and foreign price

levels, foreign output, and relative product demands (and, thus, the terms of trade) are given.

Any disturbance that raises aggregate demand for domestic output shifts the DD schedule

to the right; any disturbance that lowers aggregate demand shifts the DD schedule to the

left.

The upward slope of the DD curve relates to the effects of changes in the nominal exchange

rate on changes in the real exchange rate (P*E / P, given P and P*), and to the effects of

changes in the real exchange rate on the current account balance. It is assumed that the

Marshall-Lerner elasticity condition holds, so that the current account balance increases in

response to an increase in the real exchange rate (a real depreciation of the home currency).

Thus, all else equal, any rise (fall) in the real exchange rate, P*E / P, will cause an upward

(downward) shift in the aggregate demand function and an expansion (contraction) in the

level of domestic output. This is illustrated in Figure 16-4.

One may now put the DD and AA schedules together into one diagram. Simultaneous

short-run equilibrium in the asset and output markets occurs at the intersection of the DD

and AA schedules, as illustrated in Figure 16-8. A temporary increase in the money supply

will shift the AA schedule to the right and lead to an increase in both the exchange rate (the

price of foreign currency) and the level of domestic output. The causal sequence is that the

money supply increase lowers domestic interest rates and, thereby, depreciates the domestic

currency to a level from which it is expected to appreciate. The depreciation of the

domestic currency expands the trade balance, and the resulting increase in aggregate

demand leads to an increase in domestic output.

A permanent increase in the money supply also raises the expected exchange rate, E(e), and

this further increases the nominal exchange rate, so that the short-run effects of a permanent

increase in the money supply are larger than the short-run effects of a temporary increase.

However, the expansionary effects of a permanent increase in the money supply will begin

to place upward pressure on domestic prices. Thus, the initial increase in real money

balances will gradually reverse itself, with the AA schedule moving back to the left as in

Figure 16-15. In addition, the initial increase in the real exchange rate will reverse itself as

the domestic price level rises. Thus, the DD schedule will also move to the left. In the

ultimate equilibrium, the real exchange rate and the level of output will return to their initial

levels, but the nominal exchange rate (E, the price of foreign exchange) will be higher than

its initial level, but lower than the temporary level reached before domestic prices started to

adjust. This overshooting phenomenon relates to the fact that the impact of the permanent

increase in the money supply on interest rates is also self-reversing. The causal sequences

emanating from temporary and permanent decreases in the domestic money supply

essentially work in the opposite direction.

Temporary and permanent fiscal policy changes may also be analysed within the AA-DD

framework. Expansionary fiscal policy shifts the DD curve to the right. As a result, the

level of output rises while the price of foreign exchange falls. The impact on output levels

is, however, damped by the crowding out effects of government expenditure increases

(and/or taxation reductions) that occur through the impacts of exchange rate movements on

the trade balance, and interest rate movements on investment demand. Working in reverse,

contractionary fiscal policy shifts the DD curve to the left. As a result, the level of output

falls while the price of foreign exchange rises.

Nevertheless, fiscal policy changes that become permanent lead to self-reversing effects on

output because the expected exchange rate, E(e), adjusts, generating larger effects on the

nominal exchange rate and, thus, complete crowding out of the fiscal policy changes. As a

result, the AA curve must also shift (to the left for a permanent fiscal expansion, and to the

right for a permanent fiscal contraction, as illustrated in Figure 16-16). Effects on the

composition of the balance of payments remain. Expansionary fiscal policy reduces the

current account balance, while dis-absorption through fiscal contraction may be necessary

to augment the current account balance. On the other hand, monetary expansion

(contraction) generally augments (reduces) the current account balance through real

depreciation (appreciation) of the home currency, at least until the real exchange rate is

restored to its initial position through adjustments in the domestic price level.

Macroeconomic adjustment: fixed exchange rate regimes

The impact of monetary and fiscal policies under a fixed exchange rate regime differs from

their impact under a flexible exchange rate regime. Fixed exchange rates were the norm

under the historic gold standard regime, during the 1920s, and under the Bretton Woods

system that operated internationally between 1945 and the beginning of the 1970s.

Regional currency areas and many developing countries still operate with fixed (or pegged)

exchange rates today. Moreover, most countries operate with managed floating exchange

rates in which foreign exchange market intervention (the buying and selling of foreign

exchange reserves) is frequently used to prevent the exchange rate from moving too quickly

in one direction or the other. Monetary authorities often “lean against the wind” in order to

stabilise the foreign exchange market. Understanding how fixed exchange rate systems

operate is useful for understanding the nature and implications of exchange market

intervention.

The most important lesson to be learned about fixed exchange rates is that the monetary

authorities of a small open economy give up control over the domestic money supply by

pegging the value of the currency to an external benchmark, usually the currency of a large

trading partner such as the United States. Unless a rigid system of exchange controls is

applied, fixed exchange rates are incompatible with monetary independence. Monetary

policy is essentially held hostage to keeping the external value of the currency from

changing. If the monetary authorities want to maintain a fixed external value of the

currency, they need to forego control over the domestic money supply, whereas if they wish

to control the domestic money supply, they need to forego control over the currency’s

external value.

When the foreign exchange rate is fixed, and market participants expect it to remain fixed,

E = E(e), and the interest parity condition becomes:

(1 + R) = (1 + R*) (1 + q), or R* = (R – q) / (1 + q),

where R is the domestic interest rate, R* is the foreign interest rate, and q is now the risk

premium associated with holding domestic rather than foreign assets. Except for a possible

risk premium, the domestic interest rate is equal to the foreign interest rate. If a small open

economy pegs the external value of its currency to the currency of a larger trading partner,

the small open economy essentially becomes an interest rate taker. For example, if the

Canadian dollar was pegged to the US dollar (as it was during the period 1961-1970), then

Canadian interest rates would essentially be determined in New York. Canadian monetary

policy would be held hostage to the maintenance of interest rate parity with the United

States.

Consider the implications of a tightening (loosening) of US monetary policy. As the US

money supply contracts (expands), US interest rates will increase (decrease). The further

consequences of these changes may also reduce (augment) US output and prices. However,

the immediate repercussion on Canada works through induced capital outflows (inflows)

due to the high substitutability between domestic and foreign capital assets. The induced

capital outflows (inflows) imply excess demand for (supply of) foreign exchange, and the

residual seller (buyer) of foreign exchange must be the Canadian foreign exchange

equalisation account, which is run by the Bank of Canada on behalf of the Government of

Canada. As the Bank of Canada sells (buys) foreign exchange assets, it automatically

reduces (augments) its holdings of foreign exchange reserves. The open market sale

(purchase) of assets by the Bank of Canada reduces (augments) the Canadian money supply.

Through this process, the change in the US money supply generates a corresponding

change in the Canadian money supply. Under a fixed exchange rate system, US monetary

contraction (expansion) leads to Canadian monetary contraction (expansion).

Further light can be shone on this monetary transmission mechanism by considering the

combined balance sheet of the Bank of Canada and the foreign exchange equalisation

account.

Assets Liabilities

Foreign exchange reserve assets Deposits held by commercial banks

Domestic assets (government bonds) Currency in circulation

Central bank liabilities are the base of the monetary pyramid (or high powered money). It

follows that as the central bank sells (buys) foreign exchange reserve assets, it must

automatically generate a contraction (expansion) in the domestic money supply through the

usual commercial bank reserve multiplier process. Any central bank sale (purchase) of

assets automatically results in a decrease (increase) in the domestic money supply.

In the short run, the central bank can prevent a change in its foreign exchange reserve

holdings from affecting the domestic money supply by making offsetting changes to its

domestic asset holdings. Such a process is called sterilisation of the foreign exchange

intervention. For example, if there is excess demand for (supply of) foreign exchange, the

central bank can provide additional (soak up) foreign exchange, while simultaneously

buying (selling) domestic government bonds in the market place. However, this process

cannot be continued for very long. By preventing the domestic interest rate from matching

the foreign interest rate, the central bank leaves in place a reason for there to be large-scale

capital outflows or inflows.

As sustained capital outflows (inflows) generate an ongoing run-down (run-up) of the

central bank’s holdings of foreign exchange reserves, foreign exchange market participants

will be presented with a one-way bet that the central bank will be unable to maintain the

fixed exchange rate. A sustained run-down (run-up) of the central bank’s foreign exchange

reserve holdings will generate an increase (decrease) in E(e), the expected price of foreign

exchange. The resulting currency crisis will generate a stark choice for the monetary

authorities: either stop sterilising the foreign exchange losses (gains) or allow the domestic

currency to be devalued (revalued), that is for E to rise (fall) by a discrete interval.

Devaluation (revaluation) of the domestic currency creates large gains for currency

speculators who wind up buying low and selling high, and correspondingly large losses for

the monetary authorities.

More generally, when sterilisation does not occur under fixed exchange rates, overall

balance of payments deficits (surpluses) lead to monetary contraction (expansion). This is

just as it was under the historic gold standard, where money supplies were backed by gold

reserve holdings and foreign exchange took the form of gold. A country that ran a balance

of payments deficit (surplus) would lose (gain) gold holdings to (from) other countries.

Balance of payments equilibrium would be restored through a Humean adjustment process

as contractionary (expansionary) pressure was placed on countries that lost (gained) gold

reserves. Domestic inflation would ultimately undermine the mercantilist objective of

always running a trade surplus.

Under flexible exchange rates, the money supply may be taken to be predetermined, while

the exchange rate is an endogenous variable. Under fixed exchange rates, by contrast, the

exchange rate is predetermined, while the money supply is an endogenous variable. Events

that would lead to depreciation (appreciation) of the domestic currency under flexible

exchange rates, would lead to monetary contraction (expansion) under fixed exchange rates.

Moreover, devaluation (revaluation) of the domestic currency from one fixed exchange rate

to another has similar implications to monetary expansion (contraction) under flexible

exchange rates.

Under fixed exchange rates, any attempt to increase (decrease) the money supply in

relationship to the level that is necessary to maintain the fixed exchange rate will either be

self-reversing or incompatible with the existing exchange rate peg. As long as the

exchange rate is fixed, central bank monetary policy tools are powerless to affect the

economy’s money supply or its output level. The relevant AA-DD diagram is Figure 17-2.

Under fixed exchange rates, monetary policy (open market operations) can affect the level

of foreign exchange reserve holdings but nothing else.

However, under fixed exchange rates, fiscal policy becomes an effective device for internal

stabilisation purposes. Whereas under flexible exchange rates, the effectiveness of fiscal

policy was undermined by strong crowding out effects operating through the domestic

interest rate and the foreign exchange rate, under fixed exchange rates a fiscal expansion

(contraction) induces a simultaneous monetary expansion (contraction) which is necessary

to prevent domestic interest rates and the external value of the currency from increasing

(decreasing). Put differently, fiscal expansion (contraction) places upwards (downwards)

pressure on domestic interest rates, leading to capital inflows (outflows) that generate

excess supply of (demand for) foreign exchange. Since the central bank must act as the

residual buyer (seller) of foreign exchange, the result is an increase (decrease) in the

domestic money supply. The relevant AA-DD diagram is Figure 17-3.

If a permanent increase in government expenditure leads to a continuing fiscal deficit, the

increasing public debt burden may increase the risk premium (or sovereign risk) on holding

domestic rather than foreign assets. Moreover, if the debt build-up is largely financed by

foreign purchases of domestic bonds and international debt service charges escalate, foreign

bondholders may eventually become concerned about the future value of the currency. E(e)

may rise relative to E, generating an expectation of future devaluation. The expectation of

a future devaluation of the home currency causes a balance of payments crisis marked by a

sharp fall in foreign exchange reserves (or capital flight) and an increase in the domestic

interest rate above the world interest rate. Similarly, an expected revaluation causes an

abrupt rise in foreign exchange reserves together with a fall in the home interest rate below

the world rate.

Most of our analysis has dealt with a small open economy. However, for a large open

economy, such as the United States, which has emerged as a reserve currency country,

some additional comments are necessary. The main comment relates to the asymmetric

position of the reserve centre. Provided that all other countries are willing to hold short-

term reserve currency assets, and their central banks run monetary policies which maintain

the system of fixed exchange rates, the reserve currency country does not have to intervene

in the foreign exchange market. Indeed, it can follow a policy of benign neglect of its own

balance of payments situation. In addition, as foreign countries expand their holdings of

exchange reserves, the reserve currency country earns seigniorage that allows it to purchase

imported goods and services without directly paying for them in terms of exported goods

and services.

However, in these circumstances it is essential that the reserve currency country provide a

price-stable anchor for the world economy. The fact that the United States failed to provide

such an anchor in the late 1960s and early 1970s led to the breakdown of the Bretton

Woods fixed exchange rate system, and to the emergence of managed flexible exchange

rates as the predominant exchange rate system in the industrialised world. In retrospect, it

is not surprising that the Bretton Woods system broke down under inflationary conditions.

Under a fixed exchange rate system, there are three basic transmission mechanisms through

which inflation in a major trading partner gets imported into the domestic economy. The

first is through demand-pull linkages or substitution effects which work through the current

account of the balance of payments. The second is through cost-push linkages and cost-of-

living effects resulting from the rise in the price of imported materials. The third is through

monetary linkages or overall balance of payments effects.

Through these three linkages, foreign inflation will eventually be fully transmitted to the

domestic economy. Indeed, a country which tries to prevent inflation at home while

inflation is going on abroad cannot succeed in the longer run unless it is willing to alter its

foreign exchange rate. So long as the rate is kept fixed the central bank is bound to lose

control over the money supply, and therefore over the level of total spending. It follows

from this that a rational anti-inflationary stabilisation policy for any small open economy

requires, as a necessary ingredient, a willingness to allow the domestic currency to

appreciate whenever foreign inflation rates are accelerating to levels which are

incompatible with the norms established for the rate of domestic price inflation. To

maintain a fixed exchange rate in the face of fluctuations in the rate of world price inflation

is to keep the big lever tied behind ones back and, thus, to make it exceedingly difficult to

stabilise the domestic economy.

We are now in a position to provide a broad summary of the medium term effects of

various external and internal shocks on the basic macroeconomic variables of a small open

economy that operates under a managed flexible exchange rate regime. Under a managed

flexible exchange rate regime, the monetary authorities may decide to moderate the

exchange rate impacts of particular economic shocks that might lead to the appreciation

(depreciation) of the domestic currency by permitting some of the impact to come out as an

increase (decrease) in the money supply. When the authorities so choose to “lean against

the wind”, the resulting exchange rate regime operates as a halfway house between the

flexible and fixed exchange rate regimes. The broad summary is presented in tableau form.

Each row of the tableau considers the causal linkages pertaining to a different economic

shock, while the implications for the key domestic macro-economic variables are provided

in the different columns of the tableau. The signs relate to the directional impact on the

variable in question. Economic shocks in the opposite direction would change all of the

signs in the tableau.

Output (Y) & Prices (P) Interest Exchange

Employment & Wages Rates (R) Rate (E)

Money Supply Increase

[M(s) up] + + - +

Government Expenditure

Increase (G up) + + + -

Cost Increasing Shock to

Wage/Price Nexus - + + -

Export Demand

Expansion (Y* up) + ? - -

Foreign Price Level

Increase (P* up) 0 + 0 -

Foreign Interest Rate

Increase (R* up) - ? + +

Foreign Money Supply

Increase [M*(s) up] + + - -

Foreign Gov’t Expenditure

Increase (G* up) ? ? + +

One should work through each of these economic shocks to make sure one understands the

causal linkages that are involved. It should be noted that most of the listed economic

shocks affect the demand side of the economy, and thus tend to move domestic output and

the price level in the same direction. The exception pertains to the impact of cost

increasing shocks, which affect the supply side of the economy, and therefore tend to move

domestic output and the price level in opposite directions. The price-quantity movements

that are observed as the economy responds to an adverse supply-side shock are thus

associated with the phenomenon of inflationary recession (or stagflation). Inflationary

recession may also be observed as the delayed response to a previous demand expansion if

price movements lag behind quantity movements as the economy adjusts to demand-side

shocks.

It should also be noted that domestic shocks tend to move interest rates and the external

value of the domestic currency in the same direction. This response occurs because higher

(lower) domestic interest rates stimulate capital inflows (outflows) that tend to appreciate

(depreciate) the external value of the domestic currency. Put differently, domestic shocks

that increase (decrease) interest rates tend to lower (raise) the price of foreign exchange (the

nominal exchange rate). However, foreign shocks tend to move domestic interest rates in

the opposite direction to the external value of the domestic currency. This response occurs

because capital outflows (inflows) that put downwards (upwards) pressure on the external

value of the domestic currency may need to be kept in check by an increase (decrease) in

domestic interest rates. Put differently, foreign shocks that increase (decrease) the price of

foreign exchange (the nominal exchange rate) tend to raise (lower) domestic interest rates.

Foreign shocks, however, do not usually take the form of isolated changes in either Y*, P*,

or R*. Foreign shocks are more likely to involve combinations of changes in Y*, P* and

R*. For example, increases in the foreign money supply will expand Y* and P* while

lowering R*, while decreases in the foreign money supply will reduce Y* and P* while

raising R*. Under fixed exchange rates, these impacts will be mirrored in the domestic

economy as the domestic money supply moves in the same direction as the foreign money

supply. Under flexible exchange rates, the domestic economy can be at least partially

insulated from the effects of foreign monetary expansion (contraction) by allowing the

domestic currency to appreciate (depreciate), that is by allowing the nominal exchange rate

(E) to fall (rise).

The directional effects of changes in foreign fiscal policy on the domestic economy are

more difficult to sign than the effects of changes in the foreign money supply. However,

foreign fiscal expansion (contraction) will put upwards (downwards) pressure on foreign

interest rates. The higher (lower) interest rates will induce capital inflows into (outflows

from) the foreign economy, which generate pressure for the nominal exchange rate (E) to

appreciate (depreciate). Interest rates in the smaller home country will need to increase

(decrease) to offset these capital flows, especially if the domestic monetary authorities wish

to prevent the nominal exchange rate from moving too far. The impact on the home

country’s output and prices remains ambiguous because the impact on aggregate demand

which occurs through the trade balance goes in the opposite direction to the impact which

occurs through domestic investment.

Part Four: International Macroeconomic Policy

Employment fluctuations and price inflation

Macroeconomic policy in an open economy has two basic goals: maintaining full

employment with price stability (or internal balance), and avoiding excessive imbalances in

its international payments (external balance). The means for achieving internal and

external balance simultaneously differ between fixed and flexible exchange rates. Under

the postwar Bretton Woods system, financial discipline was to be maintained through a

system of fixed (or pegged) exchange rates. However, countries that found themselves in

fundamental disequilibrium were permitted to adjust the pegged value of their US dollar

exchange rate through devaluations or revaluations, which were to be used sparingly.

Under fixed exchange rates, monetary policy is tied to the maintenance of the fixed

exchange rate (and thus the overall state of the balance of payments), and thus is not free to

be used to meet either internal balance (full employment with price stability) or external

balance (a viable current account balance, or other compositional target for the balance of

payments). Fiscal policy might, therefore, provide insufficient instruments for achieving

both internal and external balance.

Four zones of discomfort can be identified. The first of these combines substantial

unemployment with a current account surplus. Here, expansionary fiscal policy may not

only reduce unemployment, but also move the current account back towards balance. The

second zone of discomfort couples excess demand and inflationary pressures with a current

account deficit. Here, fiscal contraction may not only serve to curtail demand, but would

also help to reduce the current account deficit. However, what does one do if excess

demand and inflationary pressures are coupled with a large current account surplus (the

third zone of discomfort), or substantial unemployment is coupled with a large current

account deficit (the fourth zone of discomfort)? Under both of these circumstances, it turns

out that expenditure-switching policies are required in addition to expenditure-changing

policies. In particular, in the third discomfort zone, upwards revaluation of the domestic

currency needs to be considered in addition to fiscal contraction, while in the fourth

discomfort zone, devaluation of the domestic currency may be necessary in addition to

fiscal expansion. The relevant diagram is Figure 18-2.

The “beggar my neighbour” devaluations of the 1930s depression years resulted because

many countries found themselves in the fourth discomfort zone, while Keynesian fiscal

policy was not yet in fashion. Indeed, the postwar Bretton Woods system, and with it the

International Monetary Fund as an international lender of last resort, were established

largely to prevent a repeat of the 1930s situation.

When the United States failed to provide a price-stable anchor to the Bretton Woods system

during the late 1960s and early 1970s, many countries found themselves in the third

discomfort zone. In the face of these inflationary pressures, many pegged rates were

ultimately abandoned, which ushered in the floating exchange rate system of the later

postwar period.

The case for floating exchange rates rests upon three important principles: monetary policy

autonomy (the freeing of an additional instrument to meet the objectives of internal and

external balance), symmetry in the adjustment processes to surpluses and deficits and

between the reserve currency country and all other countries, and the use of exchange rates

as automatic stabilisers that would reduce the occurrence of currency crises.

In principle, flexible exchange rates can provide an important insulating device in the face

of foreign shocks, whether these shocks are monetary (e.g. foreign inflation) or real (e.g.

terms of trade changes). For example, if world demand for the home country’s exports falls

(rises), the terms of trade shock can be partially offset by depreciation (appreciation) of the

domestic currency, thereby preventing output from falling (rising) as much as it would

under fixed exchange rates. Indeed, adjustment to terms of trade shocks requires changes

in the real exchange rate. If the nominal exchange rate is held constant, the required real

exchange rate adjustment is forced to occur through domestic inflation or deflation, which

may be a much more painful process.

The case against floating exchange rates relates to discipline effects, possible destabilising

speculation, trade effects through price uncertainty and higher transactions costs, and lack

of economic policy coordination. In addition, the gains associated with enhanced monetary

autonomy may be partly illusory. Moreover, the economy may be more unstable in the

face of domestic (as opposed to foreign) shocks. This explains why smaller developing

countries often choose to peg their currencies to an external island of stability.

Nevertheless, between industrialised countries and/or trading blocks with well-developed

and integrated capital markets, flexible exchange rates seem to work sufficiently well that

today there seem to be few viable alternatives.

The most important recent experiment with fixed exchange rates involves the European

monetary system, which has emerged into a single currency, called the euro, from a

currency block with fixed parities all of which floated together (as a “snake”) in

relationship to the US dollar, British pound and Japanese yen. Key currencies within the

“snake” included the Deutschemark and (to a lesser extent) the French franc. European

monetary cooperation has been driven by the desire to enhance Europe’s role in the world

monetary system, and to turn the European Union into a truly unified market. Less

disciplined members of the European monetary system believed that the credibility of their

domestic monetary management would be enhanced by the discipline imposed by joining

the “snake”, essentially pegging their currencies to the Deutschemark as an island of

monetary stability. Not surprisingly, as they have moved towards a common monetary

policy, members of the European monetary system have, as time has gone on, experienced

converging inflation rates (see Figure 20-2).

The Maastricht Treaty established the principles underlying the formation of a common

currency area, with the euro replacing the national currencies of the signing partners. These

principles were strengthened by the Stability and Growth Pact. Together, these principles

place considerable constraints on fiscal and debt management policies among the signing

partners. A new monetary institution, the European Central Bank, was created to manage

monetary policy within the euro-area. The central banks of the signing partners now

operate more or less like the regional branches of the US Federal Reserve System. How

does the theory of optimum currency areas apply to European monetary integration?

The theory of optimum currency areas predicts that fixed exchange rates are most

appropriate for areas that are closely integrated through international trade and factor

movements. More particularly, the formation of a monetary union may make sense if much

of the trade between the potential members is intra-industry trade, rather than inter-industry

trade, so that substantial movements in the terms of trade between the potential members

are unlikely. The formation of a monetary union may also make sense if there are

reasonable possibilities for labour to migrate between the potential members. On the other

hand, monetary union between countries which have very different resource endowments

and comparative advantages, and between which labour mobility is difficult if not

impossible, is unlikely to be warranted, and could indeed prove costly from a

macroeconomic adjustment perspective.

A high degree of economic integration between a country and a fixed exchange rate area

magnifies the monetary efficiency gain (reduction in transactions costs) that the country

reaps when it fixes its exchange rate against the area’s currencies. However, fixing the

exchange rate will be associated with an economic stability loss because monetary policy

instruments can no longer be used to meet stabilisation objectives. The insulating

properties of a flexible exchange rate are no longer available when the exchange rate is

pegged to the currencies of the monetary union. These properties are particularly useful in

the face of substantial demand shifts (asymmetric shocks) that lead to terms of trade

changes. It is nevertheless the case that 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. This is particularly the case if fiscal

federalism ties (and associated transfers of the equalisation type) provide a form of income

insurance among the members of a monetary union.

The decision whether or not to join a monetary union requires one to weigh the potential

monetary efficiency gains against the potential economic stability losses. The textbook

provides a diagrammatic presentation of this decision in Figure 20-5. The textbook also

suggests that the European monetary union is not an optimum currency area. Some of the

reasons for this conclusion are (a) substantial impediments that regulations have imposed

on labour market adjustment within many Western European countries, let alone between

countries, (b) substantial differences in economic structure between northern European

countries, the Mediterranean countries of southern Europe, and the ex-Comecon countries

of eastern Europe (the minority of whom are currently in the euro-zone), (c) restrictions

imposed on fiscal policies through the Stabilisation and Growth Pact, and (d) the difficulty

of finding a common monetary policy that would be appropriate to all euro-zone member

countries over time. The politics of European integration seem to have dominated the

economics since, for several countries within the European monetary union, economic

stability losses seem to outweigh monetary efficiency gains, and it is notable that Britain

and the Scandinavian countries have not, as yet, joined the euro-zone, although all but

Norway are members of the European Community. The lessons for Canada, when coupled

with Canada’s long experience with managing a flexible exchange rate regime, suggest that

forming a monetary union with the United States is unlikely to pass the cost-benefit

analysis test. Indeed, given its regional production structure differences, Canada itself

sometimes appears to be larger than an optimum currency area.

International policy co-ordination and the international capital market

There are three types of gains from international trade: gains accruing when current goods

and services are exchanged, gains accruing when current goods and services are exchanged

for assets, and gains accruing when assets are exchanged for assets. The first category

includes the standard gains from merchandise trade. The second category involves gains

from inter-temporal trade, or international borrowing and lending contracts. The third

category (along with the second) involves the international capital market. International

asset for asset exchanges reflect the portfolio diversification need to minimise the financial

risk associated with the maintenance of a given average rate of return on an asset portfolio.

Freedom of international capital movements as an objective is compatible with either (a)

fixed exchange rates, or (b) monetary policy orientated towards domestic goals, but not

both. The simultaneous pursuit of both (a) and (b) would require the implementation of a

rigid set of exchange controls that would seriously curtail capital mobility.

The international capital market has grown by leaps and bounds in the postwar period. The

development of electronic communications technology has essentially made this market

both instantaneous and never closed. Offshore currency trading activities (as in the so-

called Euro-dollar market) have also greatly expanded. Regulatory asymmetries exist

between domestic money market management and the management of offshore currency

trading. Deposit insurance, statutory reserve requirements, bank capitalisation and asset

requirements, commercial bank supervision, and lender of last resort facilities are all

significantly less in evidence for offshore (foreign currency) deposits than for domestic

deposits. The growth of the international capital market has increased the need for

international regulatory co-operation, and for orderly monetary adjustment when required.

Co-ordinated intervention in foreign exchange markets is sometimes warranted if

substantial imbalances in trade and payments occur, while the International Monetary Fund

(IMF) continues to be an important source of liquidity when temporary currency crises

occur.

The combined forces of technological convergence and capital accumulation have led to

some tendency for per capita real income convergence between the emergent newly

industrialised countries (particularly in Eastern Asia) and Western economies. However,

there is less evidence of “catch-up” elsewhere in the developing world. Industrialisation

via the development of import-competing industries behind high tariff barriers has turned

out to be much less successful than industrialisation via export-expansion that is based

upon existing or recently-acquired comparative advantages.

The absence of development success in some countries has been related to (a) excessive

government control of the economy (e.g. experiments with socialism in several African

countries), (b) high inflation due to the monetisation of government debt and the absence of

effective taxation systems, (c) weak development of domestic financial markets, (d)

exchange controls to defend temporarily pegged exchange rates, (e) poor terms of trade for

primary agricultural commodities due in part to farm subsidies in the Western world, and (f)

corruption and black market emergence. The vicious and tragic cycle of poverty and

disease, lack of available domestic savings to support investment in capital goods, social

infrastructure, health care, and K-12 education, and continued poverty and disease is

particularly evident in sub-Saharan Africa.

International lending to developing countries is impeded by country-specific risk premiums

that may reflect the likelihood of debt default, so that the relief of international debt

burdens for the poorest developing countries has become of vital importance. This is

particularly important because much of the debt of developing countries is denominated in

foreign currencies so that the debt burden increases as currency devaluation occurs.

Devaluation may often be triggered by a collapse in the terms of trade for one of the

country’s major export commodities; indeed, several of the poorer developing countries are

virtual monocultures, exhibiting very little export diversification. The expansion of

international equity investment as an alternative to increased international debt borrowing

is of vital importance (and may sometimes be facilitated by debt-equity swaps), while

targeted foreign aid flows also appear to be essential.

The key formula that is involved in external debt management is as follows:

d(D/Y)/dt = (R – G) (D/Y) – B/Y,

where D/Y is the ratio of external debt (D) to gross national product (Y), d(D/Y)/dt is the

time rate of change of D/Y, B/Y is the ratio of the trade balance (exports minus imports) to

gross national product, R is the interest rate on external debt, and G = dY/Ydt is the

economy’s output growth rate. (For consistency, both R and G must either be interpreted in

real terms or in nominal terms; they cannot be mismatched.) This formula is easily derived

from the basic equation that dD/dt = RD – B; the change in external debt equals debt

service payments plus any new borrowing required to finance a trade deficit (- B).

If R exceeds G, as will normally be the case, stabilisation of the D/Y ratio implies that the

economy must generate a sufficiently large trade surplus, which in turn implies that

domestic absorption must be smaller than gross national product. Although loan

restructuring may temporarily ease a developing country’s debt burden by lowering the

interest rate (R), continued open access of developing countries to the markets of the

industrialised world is essential if the world debt problem is to be manageable. However, if

existing global imbalances lead to high world interest rates, the possibility of recession

and/or a rise in protectionism, international attempts to ease the debt burden of developing

countries would be seriously undermined.

From a financial management perspective, developing countries need to (a) keep inflation

under control, (b) choose the right exchange rate regime, (c) recognise the central

importance of banking institutions, (d) sequence reform measures in an appropriate way, (e)

understand the importance of contagion, or the spill-over of financial crises from one

developing country to another, and (f) recognise the macroeconomic policy trilemma that

only two of monetary policy independence, stability in the exchange rate, and free

movement of capital are compatible with each other.

Monetary policy autonomy is compatible with exchange rate stability only if binding

capital controls are implemented. Monetary autonomy is compatible with free capital

mobility only if the exchange rate is allowed to float. Exchange rate stability and free

capital mobility are compatible only if the exchange rate is fixed, and can be expected to

remain fixed, which may require the establishment of a currency board. The relevant

diagram is Figure 22-2. However, there are substantial grounds for pegging the external

value of the currency to a market basket of currencies rather than a single currency, given

the volatility of exchange rates between the US dollar, the euro, the pound and the yen.

China is cautiously moving from a monetary system which combines a fixed US dollar

exchange rate for the remnimbi or yuan with exchange controls on capital movements, to a

monetary system which combines an exchange rate that is adjusted in response to

movements in a market basket of currencies with increased freedom in the mobility of

financial capital. It will be interesting to see how this new experiment works out, and

whether or not it helps to resolve existing global imbalances in an orderly fashion.

Ricardo and Comparative Advantage: A Worked Example

Unit Labour Requirements Labour Availability

Clothing Widgets

Home 1 2 120

Foreign 6 3 180

Relative demand function (both countries): p(C)C = 2 p(W)W

Home has an absolute advantage in the production of clothing

and widgets, but a comparative advantage in the production of

clothing. Foreign has a comparative advantage in the

production of widgets.

Before trade, the relative price of clothing, p(C)/p(W), is 0.5 in

Home, and Home produces 80 units of clothing and 20 units of

widgets. Solution: 1C + 2W = 120, and 2W = C p(C)/p(W).

Thus, with p(C)/p(W) = 0.5, C = 80 and W = 20. In Foreign, the

pre-trade relative price of cloth is 2.0, and 20 units of each good

are produced. Solution: 6C + 3W = 180, and 2W = C p(C)/p(W).

Thus, with p(C)/p(W) = 2.0, C = 20 and W = 20.

After trade, the relative price of clothing is 1.0. World clothing

production (all in Home) is 120 units, and world widget

production (all in Foreign) is 60 units. Solution: C = 120, W =

60, and 2W = C p(C)/p(W). Hence, p(C)/p(W) = 1.0.

In trading equilibrium, Home consumes 80 units of clothing and

exports 40 units to Foreign in exchange for 40 units of widgets.

Foreign consumes 20 units of widgets and exports 40 units in

exchange for 40 units of clothing. Solution: X(C) = M(W) =

D(W) = 0.5 D(C) = 0.5[120 – X(C)]. Thus, 120 = 3X(C), and X(C)

= 40.

The relative wage between Home and Foreign is 3 to 1, given

Home’s productivity advantage. Notice that 6/1 > 3/1 > 3/2.

However, both countries gain from specialisation and trade.

The four relevant diagrams pertaining to this example have

been drawn on the blackboard. These diagrams also illustrate

the following points.

An increase in the relative supply of Home labour implies an

increase in the relative supply of clothing, since Home has a

comparative advantage in clothing production. As a result, both

the relative wage in Home and the relative price of clothing

decrease. A limit on these wage and price movements occurs

when Home ceases to be completely specialised in clothing

production, producing both clothing and widgets, and no longer

shares in the gains from trade.

An increase in the relative demand for clothing implies an

increase in the relative demand for Home labour, again since

Home has a comparative advantage in clothing production. As a

result, both the relative price of clothing and the relative wage in

Home increase. A limit on these wage and price movements

occurs when Foreign ceases to be completely specialised in

widget production, producing both widgets and clothing, and no

longer shares in the gains from trade.

Both of these points illustrate the importance of relative price

(or terms of trade) movements.

Understanding the concept of comparative advantage helps to

explode three myths about international trade. The myths are:

(a) Free trade is beneficial only if your country is strong enough

to stand up to foreign competition (the productivity and

competitiveness argument);

(b) Foreign competition is unfair and hurts other countries when

it is based on low wages (the pauper labour argument); and

(c) Trade exploits a country and makes it worse off if its workers

receive much lower wages than workers in other nations (the

exploitation argument).

Heckscher-Ohlin Trade Theory: A Worked Example

Factor requirements Home’s Factor

Wheat Cloth Endowments

Land 2 1 60

Labour 1 2 60

Commodity prices 1.0 1.4

If production costs are equal to output prices, the wage rate (w)

for labour will be 0.6 and the rental rate (r) on land will be 0.2.

Solution: 2r + w = 1 and r + 2w = 1.4 imply w = 0.6 and r = 0.2.

Changes in product prices lead to changes in factor prices. If the

price of cloth were to fall from 1.4 to 1.1, the wage rate would

fall to 0.4, while the rental rate on land would rise to 0.3.

Solution: 2r + w = 1 and r + 2w = 1.1 imply w = 0.4 and r = 0.3.

If land and labour are both fully employed, then the outputs of

wheat and cloth will both be equal to 20 units. Solution: 2Q(W)

+ Q(C) = 60 and Q(W) + 2Q(C) = 60 imply Q(W) = Q(C) = 20.

Changes in factor endowments lead to changes in output

quantities. Suppose that Home’s labour supply expands by 25%

to 75 units. If relative prices remain constant, then full

employment of both factors would imply an expansion in cloth

production to 30 units and a contraction in wheat production to

15 units. Solution: 2Q(W) + Q(C) = 60 and Q(W) + 2 Q(C) = 75

imply Q(W) = 15 and Q(C) = 30. Home would have a “vent for

surplus” in cloth production, making it more likely that Home

will export cloth in exchange for imports of wheat.

However, relative prices may not remain constant. A downwards

adjustment in the wage-rental ratio may lead to substitution of

labour for land in the production processes for both wheat and

cloth. This would make it easier to employ the expanded labour

supply without as much change in relative outputs, but the

direction of the required adjustment is clear.

Increasing Returns and Intra-Industry Trade

Demand Function: Q = S/n - bS(P - P*),

where S is industry output, P* is average industry price, n is the

number of firms, P is firm price, Q is firm output, and b

measures the responsiveness of firm output to variations in firm

price relative to average industry price.

Cost Function: AC = c + F/Q,

where AC is average cost, c is marginal cost (and average

variable cost), F is fixed cost, and Q is firm output, so that F/Q is

average fixed cost.

Profit maximisation implies setting marginal revenue (MR)

equal to marginal cost, where MR = P – Q/Sb. Hence,

P = c + Q/Sb.

Symmetry across firms implies that Q = S/n. Hence,

P = c + 1/bn. In addition, AC = c + nF/S. Thus, when the

industry breaks even, P = AC, and the equilibrium number of

firms, n, is equal to the square root of S/bF.

When market size increases, the number of firms (n) rises less

than proportionally, since firm size also increases. Costs and

prices fall due to increasing returns. Product variety expands.

Example Home Market Foreign Market Integrated

Before Trade Before Trade Market

Total sales 900,000 1,600,000 2,500,000

No. of firms 6 8 10

Sales per firm 150,000 200,000 250,000

Average cost 10,000 8,750 8,000

Average price 10,000 8,750 8,000

This example uses the data points: c = 5,000, F = 750,000,000,

and b = 1/30,000.

Free Trade versus Protection

The economic case for free trade is based upon:

(a) economic efficiency gains through the harnessing of comparative

advantages and the avoidance of market distortions;

(b) scale economies, longer production runs, and enhanced product

variety;

(c) greater opportunities for learning and innovation; and

(d) the fact that retaliatory trade protection is a negative sum game.

The economic case against free trade is based upon:

(a) the terms of trade argument (optimum tariff argument) for

protection;

(b) domestic market failure (second best arguments, including the

infant industry and strategic trade policy arguments for protection);

and

(c) employment and income distribution concerns.

The Behaviour of Natural Resource Commodity Markets

Let the flow demand (e) for a natural resource commodity be a positive function of world

income (y) and a negative function of world price (p). Thus, e = F(p, y). Let the flow

supply (q) for a natural resource commodity be a positive function of world price (p) and a

negative function of factor input costs (w). Thus, q = G(p, w).

Let the change (ds/dt) in the actual inventory stock (s) of the natural resource commodity

be equal to the difference between flow supply and flow demand. Thus, ds/dt = q – e.

Stocks will change as long as q differs from e, and will stop changing whenever flow

equilibrium, given by the condition q = e, occurs. It follows from these assumptions that

ds/dt = G(p, w) – F(p, y), so that ds/dt is an increasing function of p, and a decreasing

function of both w and y. This function may also be written as ds/dt = H(p, w, y), where

the partial derivatives are +, - , and -, respectively.

Let the expected price of the commodity (p*) depend, in rational expectation fashion, on

the condition for flow equilibrium. Thus, p* is determined by the condition G(p*, w) =

F(p*, y), or H(p*, w, y) = 0. It follows that p* is a positive function of both w and y. It

also follows that inventory stocks will rise or fall in response to the sign of the price

discrepancy, p – p*. A price above the flow equilibrium price will lead to stock build-ups,

while a price below the flow equilibrium price will lead to stock reductions.

Let the desired inventory stock (s*) of the natural resource commodity (the stock that

market participants want to hold) have a transactions component that is a positive function

of world income (y) and a negative function of factor input costs (w), and a speculative

component which is a positive function of the difference between the expected price (p*) of

the commodity and the actual price (p) of the commodity, and a negative function of the

cost of carrying the inventory stock, as measured by the rate of interest (r). Thus, s* =

J(p*- p, r, w, y), so that if p* increases relative to p, a larger capital gain, or a smaller

capital loss, from holding the inventory stock would be expected, making the stock

temporarily more desirable to hold, given r, w and y.

Let actual prices rise or fall in response to the difference between desired inventory stocks

(s*) and actual inventory stocks (s). Thus, dp/dt = k(s* - s), where k measures the speed of

the price response. Prices will change as long as s* differs from s, and will stop changing

whenever stock equilibrium, given by the condition s* = s, occurs. Substituting for s* in

dp/dt = k(s* - s), one obtains a second dynamic equation of the form

dp/dt = k[J(p*- p, r, w, y) – s], where the partial derivatives of the J-function are,

respectively, +, -, -, and +.

The complete dynamic system thus takes the form:

ds/dt = H(p, w, y), where H(p*, w, y) = 0, and dp/dt = k[J(p*- p, r, w, y) – s],

so that ds/dt takes the sign of p – p*, while dp/dt takes the sign of s* - s. Various diagrams

may be used to describe the behaviour of prices (p) and inventory stocks (s) within this

system, and the manner in which the system responds to changes in the exogenous

variables, such as the rate of interest (r), factor input costs (w), and world income (y).

National Income Accounting Identity

Y = C + I + G + EX – IM,

where Y = gross domestic product, C + I + G = domestic absorption,

and EX – IM = CA = current account balance.

CA = EX – IM > 0 iff Y > C + I + G.

Savings, Investment and the Current Account Balance

S = SP + SG = (Y – T – C) + (T – G), so that

S = I + CA, where CA = EX – IM, and

CA = SP – I – (G – T).

Asset Transactions and Exchange Reserve Holdings

dRH = CA + NF, where dRH is the change in official holdings of

foreign exchange reserves, CA is the current account balance, and

NF is net capital inflows (the capital account balance).

The Balance of Payments

Exports – Imports = Current A/C (CA)

+ + +

Capital Inflows – Capital Outflows = Capital A/C (NF)

= = =

Sources of For Exch – Uses of For Exch = Official Settle-

ments A/C (dRH)

Uncovered Interest Parity Condition

(1 + R) = E(e) (1 + R*) / E, or E = E(e) (1 + R*) / (1 + R),

assuming no differential risk. With differential risk,

(1 + R) (1 + q) = E(e) (1 + R*) / E, or

E = E(e) (1 + R*) / (1 + R) (1 + q),

where q is the risk premium on holding foreign assets.

Worked Exercise on Exchange Rates

(a) Suppose that the uncovered interest parity condition holds, so

that

E = E(e) (1+R*) / (1+R) (1+q),

where E is the spot exchange rate in US dollars per 100 Mexican

pesos, E(e) is the exchange rate that is expected to occur at the end

of the year, R* is the Mexican interest rate per annum, R is the US

dollar interest rate per annum, and q is the risk premium on holding

pesos rather than US dollars.

(b) If the US dollar interest rate is 4%, the Mexican peso interest rate

is 9%, and the risk premium associated with holding pesos rather

than US dollars is equivalent to 3% per annum, what is the

relationship (in percentage terms) between the current equilibrium

dollar/peso exchange rate and its expected future level?

E(e)/E = (1.04) (1.03) / (1.09) = 0.983.

The Mexican peso is expected to depreciate by 1.7% per annum.

Thus, if the expected exchange rate is $9.83 per 100 pesos, the spot

exchange rate would be $10.00 per 100 pesos.

(c) Now suppose that the expected exchange rate remains constant at

$9.83 per 100 pesos as the peso interest rate rises to 12% per annum.

If the US interest rate remains constant, what is the new dollar/peso

exchange rate?

E = $9.83 (1.12) / (1.04) (1.03) = $10.28.

The peso rises from $10.00 per 100 pesos to $10.28 per 100 pesos,

or by roughly 3% over its initial value. Other things being equal, an

increase in a country’s interest rate will lead to an appreciation in the

external value of the country’s currency (that is, a decline in the

price of foreign exchange).

NAFTA: The North American Free Trade Agreement

(One of the best references on NAFTA is the 1994 CD Howe

Institute book, The NAFTA: What’s In, What’s Out, What’s Next, by

Lipsey, Schwanen, and Wonnacott.)

NAFTA refers to the Free Trade Area that includes Canada, the

United States and Mexico. NAFTA came into effect on January 1,

1994, and is the successor to the Free Trade Agreement between the

U.S. and Canada, which dates back to January 1, 1989.

NAFTA is one of four major preferential trading agreements. The

other three are:

European Union (EU), which now includes 25 member

countries having expanded in stages from the original six (Belgium,

France, Germany, Italy, Luxembourg and the Netherlands), with

Austria joining during the 1996 enlargement; 12 of the 15 countries

that were members in 1996 have now adopted the Euro as their

internal currency unit (Denmark, Sweden and the United Kingdom

remain outside the Euro zone);

Association of Southeast Asian Nations (ASEAN), which now

includes 10 members having expanded from the original six (Brunei,

Indonesia, Malaysia, Philippines, Singapore, and Thailand); Taiwan

is not a member of ASEAN; and

Mercosur, which currently has four South American members

(Argentina, Brazil, Paraguay and Uruguay).

NAFTA is a Free Trade Area. It is neither a Customs Union, nor a

Common Market. Whereas a customs union involves a common set

of external tariffs, which must be determined by prior negotiation, a

free trade area does not. The management of a free trade area

therefore requires an elaborate set of “rules of origin”. Unrestricted

factor mobility is the feature that takes a common market (e.g. the

precursor to the European Union) beyond a customs union.

However, language, cultural barriers and mobility costs continue to

affect inter-country labour mobility within the European Union.

Preferential trading agreements involve trade creation among the

members of the common market, customs union or free trade area,

and trade diversion from non-members of the preferential trading

agreement. Welfare implications involve balancing the gains from

trade creation against the losses from trade diversion. The gains are

likely to exceed the losses if most of the trade creation effects

involve intra-industry trade based upon economies of scale, longer

production runs, and increased consumer choice, rather than inter-

industry trade based upon differences in factor endowments.

Canada’s interests in NAFTA are complementary to its interests in

liberalised multilateral trade under the auspices of the World Trade

Organisation. From a trade perspective, we have no interest in a

trade-diverting “fortress North America”. Our offshore trade ties are

too important to us.

Canada had several objectives in entering a free trade agreement

with the United States, and in the expansion to NAFTA:

to permit the Canadian economy to become more efficient by

exposing the Canadian economy to the greater competition and scale

economies (including longer production runs) that a larger market

area provides;

to enable Canada to exploit further her comparative advantages

through increased specialisation;

to reduce the need to fight continual battles to counter U.S.

protectionist measures and maintain market access, and improve the

mechanisms through which disputes may be settled; and

to counter the development of an undesirable “hub and spoke”

trading system under which the U.S. has bilateral free trade

agreements with several partners that do not share free trade

agreements with each other; having entered a free trade area with the

U.S., Canada had little choice but to be a partner in the expansion to

NAFTA, because otherwise its attractiveness as an investment

location would have been reduced.

The key provisions of NAFTA include:

eliminating all tariffs on trade in goods among the three

countries, while clarifying “rules of origin”;

liberalising trade in services (including transportation,

communications, and financial services);

providing greater access to government procurement contracts;

providing protection for investors against discriminatory

practices by imposing “national treatment” standards;

reducing restrictions on foreign direct investment in most

sectors (exclusions include airlines and communications in the U.S.,

petroleum in Mexico, cultural industries in Canada);

easing restrictions in a limited way on inter-country labour

mobility for white collar jobs; no easing for blue collar jobs;

improving protection of intellectual property rights;

recognising the right of each country to adopt health, safety

and environmental standards within its own territory;

allowing for the continuation of various “supply management”

programs;

establishing a dispute settlement mechanism; however, no

agreement was struck on what constitutes a countervailable subsidy

under each country’s trade remedy laws (e.g., softwood lumber

dispute).

To counter the concerns of loss of sovereignty, one notes that:

much of the foreign control of Canada’s manufacturing

industry occurred as a result of the Canadian tariff as subsidiaries

were created by foreign multinationals to avoid tariff protection on

production directed at Canadian consumers;

Canada is already constrained in meeting its taxation and

regional development objectives by her close integration into the

world (or New York) capital market;

Canada’s social welfare programs were not on the table when

either the U.S./Canada free trade agreement or NAFTA were

negotiated.

Ross Perot’s “giant sucking sound” prediction of substantial losses

of U.S. jobs to low wage workers in Mexico does not seem to have

materialised. More generally, labour market adjustments have not

been as wrenching, or costly, as some had feared.

Sectoral considerations: agriculture, energy, forest products,

minerals, automobiles and parts, precision instruments, electronic

equipment, consumer products.

Non-discriminatory pricing, proportional market access rules, and

resource-sharing principles: the energy sector

Contingent protection: anti-dumping and countervailing duties: the

softwood lumber dispute

Summary data on Canadian trade patterns: implications of the

gravity model: borders still matter

Trade and mobility implications of 9/11/2001, terrorism, and

homeland security

Exchange rate regimes and the currency issue: would the Euro

experiment make any sense for NAFTA?

Two basic propositions about foreign exchange rate changes

Short-run movements in foreign exchange rates are intimately

related to interest rate differentials among countries, while long-run

movements are intimately related to anticipated differences in rates

of price inflation.

Proposition One:

Other things being equal, the short-run effects of an increase

(decrease) in the domestic money supply (Ms) will be to lower (raise)

domestic interest rates (R) and to put upwards (downwards) pressure

on the price of foreign exchange (E); that is, the domestic currency

will tend to depreciate (appreciate) in market value.

Proposition Two:

In the longer term, a sustained increase (decrease) in the domestic

money supply (Ms) will increase (decrease) the domestic price level

(P) and lead to an expectation that the domestic currency will

depreciate (appreciate) in value; that is, that the price of foreign

exchange (E) will rise (fall).

In consequence, the real exchange rate (P*E/P) will tend to return to

its initial value, given the foreign price level (P*), because the

movements in P and E will tend to offset each other. “Mean

reversion” in the real exchange rate in response to monetary changes

embodies the concept of relative purchasing power parity.

The Case for Flexible Exchange Rates

Monetary policy autonomy (instrument restoration)

Symmetry in adjustment processes

(a) reserve currency countries

(b) deficit countries versus surplus countries

Exchange rates as automatic stabilisers

(a) insulation from foreign shocks

(b) easing the pain from required changes in the real

exchange rate (avoiding the need for wage deflation)

The Case for Fixed Exchange Rates

Imposition of monetary discipline

Insulation from domestic shocks by pegging to an island of

stability (appropriate and inappropriate pegs)

Lower transactions costs for the trade sector

National Income Accounting and the Balance of Payments

Borrowers and lenders:

Trade balance Net debt service Net capital Net int’l

Receipts Inflows Indebtedness

Immature debtor - - + increasing

Mature debtor + - - decreasing

Net foreign

Wealth

Immature creditor + + - increasing

Mature creditor - + + decreasing

Savings, investment and global imbalances

Foreign Exchange Market

Three kinds of exchange rate risk:

(a) transactions exposure

(b) translation exposure

(c) economic exposure

Forward exchange rates and hedging

Covered (or hedged) interest parity condition

(1+R) = E(f) (1+R*) / E

Asset market equilibrium and the foreign exchange market

Uncovered interest parity condition

(1+R) (1+q) = E(e) (1+R*) / E, or

E = E(e) (1+R*) / (1+R) (1+q).

Exchange rate (un)predictability

The Concept of the Real Exchange Rate

Proposition One: Ms changes affect R and, thus, E

Capital flight: E(e) falls or q rises, leading to either E down, or R* up, or both.

Proposition Two: E adjusts to compensate for differential inflation

Prices and the exchange rate: mean reversion of P*E/P

Exchange rate movements in response to monetary and real shocks

The real exchange rate and the current account balance

Fiscal policy and the current account balance

Developing Countries and the World Debt Problem

d(D/Y)/dt = (R – G) (D/Y) – B/Y,

where D/Y is the ratio of external debt (D) to output (Y), B/Y is the ratio of the trade

balance (exports less imports) to output, R is interest rate on debt, and G is growth rate.

Major Canadian Trading Partners, 1926-2003: Share of Total Trade (Exports plus

Imports)

From Brander, Government Policy Toward Business, Table 9.1, p. 185

1926 1955 1970 1985 1990 1995 2000 2003

USA 49 67 67 75 72 76 76 73

Japan 0 1 5 5 5 5 3 3

China 0 0 0 0 0 1 2 3

United Kingdom 28 13 7 3 3 2 2 2

Other 23 19 21 17 20 17 17 19

Canadian Trade Flows by Product Class, 2003

From Brander, Government Policy Toward Business, Table 9.2, p. 186

Exports Imports

Machinery and equipment 22.2% 28.7%

Automotive products 21.8 22.3

Industrial goods and materials 16.6 19.1

Energy products 15.1 5.7

Forest products 8.6 0.9

Agricultural and fish products 7.3 6.3

Consumer goods 4.3 13.5

Other goods 4.0 3.4

Total 100.0% 100.0%

Canada’s Balance of Payments (International Transactions Statement), 2004

Billions of dollars

Current Account

Exports of goods $429 Imports of goods $363 Net goods exports $66

Exports of services 62 Imports of services 74 Net services exports - 12

Investment income Investment income Net investment

receipts 38 payments 63 income - 25

Total receipts 529 Total payments 500 Current a/c balance 29

Capital Account

Investment inflows Investment outflows

portfolio $55 portfolio $19 Net portfolio inflows $36

direct 8 direct 62 Net direct inflows - 54

Total inflows 63 Total outflows 81 Capital a/c balance - 18

Sources of foreign Uses of foreign Official settlements

exchange $592 exchange $581 balance* $11

*The official settlements balance indicates an increase in Canada’s holdings of foreign

exchange reserves. (It is assumed that there are no errors and omissions.)

Compensation in 26 countries: Ratios of CEO Pay to Manufacturing Employee Pay

Derived from Hill, Global Business Today, Table 16.3, p. 548. These data, for 2003-4,

relate to companies with annual sales of about $500 million.

Japan 9.5 Taiwan 14.5 Korea 14.8

Belgium 16.0 France 17.2 Sweden 17.6

Netherlands 18.3 New Zealand 19.5 Switzerland 19.8

Germany 21.3 China (Shanghai) 21.6 Spain 21.8

Australia 22.0 Italy 23.7 Canada 24.5

United Kingdom 27.9 China (Hong Kong) 35.7 United States 44.0

Venezuela 40.8 Argentina 45.7 Malaysia 49.9

Singapore 54.9 India 56.7 Brazil 61.5

Mexico 63.1 South Africa 72.2

Although there may be few firms with annual sales of $500 million in several of the

developing countries, these data nevertheless suggest that income inequality is greater in

many developing countries than in many Western countries, particularly including

European countries, while (from these data) the most egalitarian society appears to be Japan

(where labour turn-over is also traditionally slower). However, income distribution in the

United States appears to be less equal than that in other advanced countries, while there

may be some spill-over implications of this phenomenon to other English-speaking

countries.