1 introduction what is international economics about

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  • TRADE FINANCE - INTRODUCTION What is trade finance?
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1. INTRODUCTION
WHAT IS INTERNATIONAL ECONOMICS ABOUT
International economics uses the same fundamental methods of analysis as other
branches of economics, because the motives and behavior of individuals and firms are the same
in international trade as they are in domestic transactions. When a bottle of Spanish wine appears
on a London table, the sequence of events that brought it there is not very different from the
sequence that brings a California bottle to a table in New York-and the distance traveled is much
less! Yet, international economies involve new and different concerns, because international
trade and investment occur between independent nations. Spain and the United Kingdom are
sovereign states; California and New York are not. Spain's wine shipments to the United
Kingdom can be disrupted if the British government sets a quota that limits imports; Spanish
wine can become suddenly cheaper to British wine drinkers if the foreign-exchange value of
Spain's peseta falls against that of Britain's pound sterling. Neither of these events can happen
within the United States, where the Constitution forbids restraints on interstate trade and there is
only one currency.
The subject matter of international economics, then, consists of issues raised by the
special problems of economic interaction between sovereign states. Seven themes recur
throughout the subject: the gains from trade, the pattern of trade, protectionism, the balance of
payments, exchange-rate determination, international policy coordination, and the international
capital market.
The Gains from Trade
Everyone knows that some international trade is beneficial-nobody would suggest that
Norway should grow its own oranges. Many people, however, are skeptical about the benefits of
trading for goods that a country could produce for itself. Shouldn't Americans buy American
goods whenever possible to help save U .S. jobs? Probably the most important insight in all of
international economics is the idea that there are gains from trade-that is, that when countries
sell goods and services to one another, this is almost always to their mutual benefit. The range of
circumstances under which international trade is beneficial is much wider than most people
appreciate. For example, many U.S. businessmen fear that if Japanese productivity overtakes that
of the United States, trade with Japan will damage the U. S. economy because none of our
industries will be able to compete. U.S. labor leaders charge that the United States is hurt by
trade with less advanced countries, whose industries are less efficient than ours but who can
sometimes undersell U.S. producers because they pay much lower wages. Yet the first model of
trade in this book (Chapter 2) demonstrates that two countries can trade to their mutual
advantage even when one of them is more efficient than the other at producing everything and
producers in the less efficient economy can compete only by paying lower wages. Trade
provides benefits by alIowing countries to export goods whose production makes relatively
heavy use of resources that are 10calIy abundant while importing goods whose production
ma! countries to specialize in produc ing narrower ranges of goods, alIowing them to gain greater
efficiencies of largescale production (Chapter 6). Nor are the benefits limited to trade in tangible
goods: international migration and international borrowing and lending are also forms of
mutualIy beneficial trade, the first a trade of labor for goods and services, the second a trade of
current goods for the promise of future goods (Chapter 7). FinalIy, international exchanges of
risky assets such as stocks and bonds can benefit all countries by allowing each country to
diversify its wealth and reduce the variability of its income (Chapter 20). These invisible forms
of trade yield gains as real as the trade that puts fresh fruit from Latin America in Toronto
markets in February.
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The Pattern of Trade
Economists cannot discuss the effects of international trade or recommend changes in
government policies toward trade with any confidence unless they know that their theory is good
enough to explain the international trade that is actually observed. Thus attempts to explain the
pattern of international trade-who sells what to whom-have, been a major preoccupation of
international economists.
Some aspects of the pattern of trade are easy to understand. Climate and resources
clearly explain why BraziI exports coffee and Saudi Arabia exports oiI. Much of the pattern of
trade is more subtle, however. Why does Japan export automobiles, while the United States
exports aircraft? In the early nineteenth century English economist David Ricardo offered an
explanation of trade in terms of international differences in labor productivity, an explanation
that remains a powerful insight (Chapter 2). In the twentieth century, however, alternative
explanations have also been proposed. One of the most infiuential, but still controversial, views
links trade patterns to an interaction between the relative supplies of national resources such as
capital, labor, and land on one side and the relative use of these factors in the production of
different goods on the other. We present this theory in Chapter 4. Recent efforts to test the
implications of this theory, however, appear to show that it is less valid than many had
previously thought. More recently stilI, some international economists have proposed theories
that suggest a substantial random component in the pattern of international trade, theories that
are developed in Chapter 6.
Protectionism
If the idea of gains from trade is the most important theoretical concept in international
economics, the seemingly etern al battle between Free Trade and Protection is its most important
policy theme. Since the emergence of modem nation-states in the sixteenth century, governments
have worried about the effect of international competition on the prosperity of domestic
industries and have tried either to shield industries from foreign competition by placing limits on
imports or to help them in world competition by subsidizing exports. The single most consistent
mission of international economics has been to analyze the effects of these so-called protectionist
policies-and usually, though not always, to criticize protectionism and show the advantages of
freer international trade.
The protectionist issue is especially intense in the United States because of the trends
illustrated by Figure 1-1. Since W orld War II the United States has advocated free trade in the
world economy, viewing international trade as a force not only for prosperity but also for world
peace. With the growing role oftrade in the U.S. economy from 1965 to 1980, however, many
industries found that for the first time they were facing foreign competition in their home
markets. Some of them found the foreign competition too much to handle and appealed for
protection. During the 1970s these demands were opposed by other U.S. industries that were
benefiting from increased export sales. In the 1980s, however, as exports plunged, the mood of
Congress shifted toward protectionism. The Reagan administration resisted this political pressure
but made a series of concessions, limiting imports of Japanese automobiles, European steel,
Canadian lumber, and many other goods. Congress recently passed a major new piece of
legislation, the Omnibus Trade and Competitiveness Act of 1988, which significantly toughens
U.S. trade policy. Although the opposition of most international economists to protection
remains as strong as ever, there seems to be a real possibility that over the next few years the
United States will move sharply away from its fourdecade-Iong commitment to the principle of
free trade.
As befits both the historical importance and the current relevance of the protectionist
issue, roughly a quarter of this book is devoted to this subject. Over the years, international
economists have developed a simple yet powerful analytical framework for determin ing the
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effects of government policies that affect international trade. This framework not only predicts
the effects oftrade policies, it allows cost-benefit analysis and defines criteria for determining
when government intervention is good for the economy. We present this framework in Chapters
8 and 9, and use it to discuss a number of policy issues in those chapters and in the following
two.
In the real "(orld, however, governments do not necessarily do what the costbenefit
analysis of economists tells them they should. This does not mean that analysis is useless.
Economic analysis can help make sense of the politics of international trade policy, by showing
who benefits and who loses from such government actions as quotas on imports and subsidies to
exports. The key insight of this analysis is that conflicts of interest within nations are usually
more important in determin ing trade policy than conflicts of interest between nations. Chapters 3
and 4 show that trade usually has very strong effects on income distribution within countries,
while Chapters 9, 10, and 11 reveal that the relative power of different interest groups within
countries, rather than some measure of overall national interest, is often the main determin ing
factor in government policies toward international trade.
The Balance of Payments
In 1987 both Japan and Brazii ran large trade surpluses-that is, each sold more goods to
the rest of the world than it bought in return. Japan's surplus of $96 billion brought complaints
from many other countries that Japan was gaining at their expense; Brazil's surplus of$12 billion
(which represented a much larger fraction ofthe country's national income) brought complaints
from the Brazilians that they were being unfairly treated. What does it mean when a country runs
a trade surplus or a trade deficit? To make sense of numbers like the trade deficit,)t is essential to
place them in the broader context of the whole of a nation' s international transactions.
The record of a country's transactions with the rest of the world is called the balance of
payments. Explaining the balance of payments, and diagnosing its significance, is a main theme
of international economics. It emerges in a variety of specific contexts: in discussing
international capital movements (Chapter 7), in relating international transactions to national
income accounting (Chapter 12), and in discussing virtually every aspect of international
monetary policy (Chapters 16 through 21). Like the problem of protectionism, the balance of
payments has become a central issue for the United States because the nation has run huge trade
deficits in every year since 1982.
Exchange-Rate Determination
In February 1985, one U.S. dollar traded on international markets for 260 Japanese yen;
in January 1988, a dollar was worth only 123 yen. This change had effects that reached far
beyond financial markets. In February 1985, the average Japanese worker in manufacturing was
paid a wage in yen that, converted into dollars at the prevailing rate of exchange, was only about
half that of his U.S. counterpart. Three years later Japanese wages were about the same as U.S.
wages. With their labor cost advantage vis-a-vis the United States gone, and in the face of
competition from low-wage competitors like Korea and Taiwan, Japanese manufacturers were
initially forced into layoffs that drove the Japanese unemployment rate to its highest level since
the 1950s, after which they began investing heavily in acquiring production facilities in other
countriesespecially in the U.S.
One of the key differences between international economics and other areas of
economics is that countries have different currencies. It is usually possible to convert one
currency into another (though even this is illegal in some countries), but as the example of the
dollar-yen exchange rate indicates, relative prices of currencies may change over time,
sometimes drastically.
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The study of exchange-rate determination is a relatively new part of international
economics, for historical reasons. For most of the past century, exchange rates have been fixed
by government action rather than determined in the marketplace. Before World War I the values
of the world's major currencies were fixed in terms of gold, while for a generation after World
War II the values of most currencies were fixed in terms of the U. S. dollar. The analysis of
international monetary systems that fix exchange rates remains an important subject, especially
since a return to fixed rates in the fu ture
Remains a real possibility. Chapters 17 and 18 are devoted to the working of fixedrate
systems, and Chapter 19 to the debate over which system is better. For the time being, however,
some of the world's most important exchange rates fluctuate minute by minute and the role of
changing exchange rates remains at the center of the international economics story. Chapters 13
through 16 focus on the modem theory of floating exchange rates.
International Policy Coordination
The international economy comprises sovereign nations, each free to choose its own
economic policies. Unfortunately, in an integrated world economy one country's economic
policies usually affect other countries as well. When West Germany rai sed taxes and interest
rates in 1981, all of Europe went into a recession; when the United States imposed a tariff on
imports of lumber during 1986, the Canadian lumber industry experienced a crisis. Differences
in goals between countries of ten lead to conflicts of interest. Even when countries have similar
goals, they may suffer losses if they fail to coordinate their policies. A fundamental problem in
international economics is how to produce an acceptable degree ofharmony among the
international trade and monetary policies of different countries without a world government that
tel!s countries what to do.
For the last forty years international trade policies have been governed by an
international treaty known as the General Agreement on Tariffs and Trade, and massive
internationalnegotiations involving dozens of countries at a time have been held. We discuss the
rationale for this system in Chapter 9 and look at whether the current rules of the game for
international trade in the world economy can or should survive.
While cooperation on international trade policies is a wel!-established tradition,
coordination of international macroeconomic policies is a newer and more uncertain topic. Only
in the last few years have economists formulated at all precisely the case for macroeconomic
policy coordination. Nonetheless, attempts at international macroeconomic coordination are
occurring with growing frequency in the real world. Both the theory of international
macroeconomic coordination and the developing experience are reviewed in Chapters 18 and 19.
The International Capital Market
During the 1970s banks in advanced countries lent tens of billions of dollars to firms
and governments in poorer nations, especially in Latin America. In 1982, Mexico announced that
it could no longer pay the money it owed without special arrangements that allowed it to
postpone payments and borrow back part of its interest; soon afterward Brazi!, Argentina, and a
number of smal!er countries found themselves in the same situation. While combined efforts of
banks, governments, and countries avoided a world financial crisis in 1982, the debt difficulties
of less-developed countries remained in a state of periodic crisis through 1990. The debt problem
brought to the public's attention the growing importance of the international capital market.
In any sophisticated economy there is an extensive capital market: a set of arrangements
by which individuals and firms exchange money now for promises to pay in the future. The
growing importance of international trade since the 1960s has been accompanied by a growth in
the international capital market, which links the capital markets of individual countries. Thus in
the 1970s oil-rich Middle Eastern nations placed their oii revenues in banks in London or New
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York, and these banks in turn lent money to governments and corporations in Asia and Latin
America. During the 1980s Japan converted much of the money it earned from its booming
exports into investments in the United States, including the establishment of a growing number
of U.S. subsidiaries of J apanese corporations.
International capital markets differ in important ways from domestic capital markets.
hey must cope with special regulations that many countries impose on foreign investment; they
also sometimes offer opportunities to evade regulations placed on domestic markets. Since the
I960s, huge international capital markets have arisen, most notably the remarkable London
Eurodollar market, in which billions of dollars are exchanged each day without ever touching the
United States.
Some special risks are also associated with international capital markets. One risk is
that of currency fluctuations: if the dollar falls suddenly against the Japanese yen, Japanese
investors who bought U.S. bonds suffer a capitalloss-as many discovered in 1985-1988. Another
risk is that of national default: a nation may simply refuse to pay its debts (perhaps because it
cannot), and there may be no effective way for its creditor to bring it to court. This remains a real
possibility for the nations of Latin America; if all of them were to refuse payment; major U.S.
banks would Iose heavily.
The growing importance of international capital markets, and their new problems,
demand greater attention than ever before. This book devotes two chapters to issues arising from
international capital markets: one on the functioning of global as set markets (Chapter 20) and
one on the international debt problem (Chapter 21).
INTERNATIONAL ECONOMICS: TRADE AND MONEY
The economics of the international economy can be divided into two broad subfields:
the study of international trade and the study of international money. International trade analysis
focuses primarily on the real transactions in the international economy, that is, on those
transactions that involve a physical movement of goods or a tangible commitment of economic
resources. International monetary analysis focuses on the monetary side of the international
economy, that is, on financial transactions such as foreign purchases of U. S. dollars. An
example of an international trade issue is the conflict between the United States and Europe over
Europe's subsidized exports of agricultural products; an example of an international monetary
issue is the dispute over whether the foreign-exchange value of the dollar should be allowed to
float freely or be stabilized by government action.
In the real world there is no simple dividing line between trade and monetary issues.
Most international trade involves monetary transactions, while, as the examples in this chapter
already suggest, many monetary events have important consequences for trade. Nonetheless, the
distinction between international trade and international money is useful. The first half of this
book covers international trade issues. Part One (Chapters 2 through 7) develops the analytical
theory of international trade, and Part Two (Chapters 8 through 11) applies trade theory to the
analysis of government policies toward trade. The second half of the book is devoted to
international monetary issues. Part Three (Chapters 12 through 17) develops international
monetary theory, and Part Four (Chapters 18 through 21) applies this analysis to international
monetary policy.
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2. THE RICARDIAN MODEL
1. In this chapter we examined the Ricardian model, the simplest model that shows how
differences between countries give rise to trade and gains from trade. In this model labor is the
only factor of production and countries differ only in the productivity of labor in different
industries.
2. In the Ricardian model, countries will export goods that their labor produces relatively
efficiently, and import goods that their labor produces relatively inefficiently. In other words, a
country's production pattern is determined by comparative advantage.
3. That trade benefits a country can be shown in either of two ways. First, we can think of
trade as an indirect method of production. Instead of produc ing a good for itself, a country can
produce another good and trade it for the desired good. The simple model shows that whenever a
good is imported it must be true that this indirect "production" requires less labor than direct
production. Second, we can show that trade enlarges a country's consumption possibilities,
implying gains from trade.
4. The distribution of the gains from trade depends on the relative prices of the goods
countries produce. To determine these relative prices it is necessary to look at the relative world
supply and demand for goods. The relative price implies a relative wage rate as well.
5. The proposition that trade is beneficial is unqualified. That is, there is no requirement
that a country be "competitive" or that the trade be "fair." In particular, we can show that three
cominonly held beliefs about trade are wrong. First, a country gains from trade even if it has
lower productivity than its trading partner in all industries. Second, trade is beneficial even if
foreign industries are competitive only because of low wages. Third, trade is beneficial even if a
country's exports embody more labor than its imports.
6. Extending the one-factor, two-good model to a world of many commodities does not
alter these conclusions. The only difference is that it becomes necessary to focus directly on the
relative demand for labor to determine relative wages rather than to work via relative demand for
goods. Also, a many-commodity model can be used to illustrate the important point that
transportation costs can give rise to a situation in which some nontraded goods exist.
7. While some of the predictions of the Ricardian model are clearly unrealistic, its basic
prediction-that countries will tend to export goods in which they have relatively high
productivity-has been confirmed by a number of studies.
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