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1 Introduction l

What Is International Economics About? 3

The Gains from Trade 3 The Pattern^f Trade 4 Protectionism 5

' The Balance of Payments". 6 Exchange-Rate Determination 6 International Policy Coordination 7 The International Capital Market 7

International Economics: Trade and Money 8


)( 2 Labor Productivity and Comparative Advantage:

The Ricardian Model 11 '

A One-Factor Economy 12 f

Production Possibilities 12

Relative Prices and Supply 13 »

Trad| in a One-Factor World 13

Determining the Relative Price after Trade 15 The Gains from Trade 17

A Numerical Example 18

Misconceptions about Comparative Advantage 20

Productivity and Competitiveness 20 The Sweatshop Labor Argument 21 Unequal Exchange 22

Comparative Advantage with Many Goods 22

Setting up the Model 22

Relative Wages and Specialization 23


Adding Transport Costs and Nontraded Goods 26 Empirical Evidence on the Ricardian Model 28 Summary 29

*Key Terms 30 ^Problems 30 *Further Reading 32

APPENDIX: A Ricardian Model with Very Many Goods 33

Technology and Specialization 33 Demand and Equilibrium 34 The Gains from Trade 35

An Application: Productivity Growth 36

3 Specific Factors and Income Distribution 38

The Specific Factors Model 39

Assumptions of the Model 39 Production Possibilities 40

Prices, Wages, and Labor Allocation 43

Relative Prices and the Distribution of Income 47

International Trade in the Specific Factors Model 49

Resources and Relative Supply 49 Trade and Relative Prices 50 The Pattern of Trade 51

Income Distribution and the Gains from Trade 53 The Political Economy of Trade: A Preliminary View 55

' Optimal Trade Policy 55

BOX: Specific Factors and the Beginnings' of Trade Theory 56

Income Distribution and Trade Politics 57

Summary 58

APPENDIX: Further Details on Specific Factors 61

Marginal and Total Product 61

Relative Prices and the Distribution of Income 62

4 Resources and Trade: The Heckscher-Ohlin Model 64

A Model of a Two-Factor Economy 65

a Assumptions of the Model 65 Production Possibilities 66

" "" • - -Goods Prices and Factor Prices 67 Allowing Substitution between Inputs 70

Effects of International Trade between Two-Factor Economies 71

Relative Prices and thePattern of Trade 72 Trade and the Distribution of Income 73 Factor Price Equalization 74

CASESTUDY: Pollution Rights as a Resource 75


Empirical Evidence on the Heckscher-Ohlin Model 77

Testing the Heckscher-Ohlin Model 77 Implications of the Tests 78

Summary 79

APPENDIX: The Heckscher-Ohlin Model with Variable Coefficients 83

Choice of Technique 83

Goods Prices and Factor Prices 84 Allocation of Resources 85

5 The Standard Trade Model 87

A Standard Model of a Trading Economy 88

Production Possibilities and Relative Supply 88 Relative Prices and Demand 89

The Welfare Effect of Changes in the Terms of Trade 92 Determining Relative Prices 92

Economic Growth: A Shift of the RS Curve 92

Growth and the Production Possibility Frontier 93 Relative Supply and the Terms of Trade 94 Internation^tEffects of Growth 95

CASE STUDY: Foreign Growth and the U.S. Terms of Trade 96 International Transfers of Income: Shifting the RD Curve 98

The Transfer Problem 98

Effects of a Transfer on the Terms of Trade 99

Presumptions about the Terms of Trade Effects of Transfers 100

CASE STUDY: The Transfer Problem for the United States 102 Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD 102

Relative Demand and Supply Effects of a Tariff 103 Effects of an Export Subsidy 104

Implications of Terms of Trade Effects: Who Gains and Who Loses? 104

Summary 106

APPENDIX: Representing International Equilibrium with Offer Curves 110

Deriving ^Country's Offer Curve 110

International-Equilibrium 112 •• /

6 Economies of Scale, Imperfect Competition, and International

Tracle 113

~ Economies of Scale and International Trade: An Overview 114

Economies of Scale and Market Structure 115 The Theory of Imperfect Competition 116

Monopoly: A Brief Review 117 Monopolistic Competition 119

Limitations of the Monopolistic Competition Model 124

Monopolistic Competition and Trade 124

' The Effects of Increased Market Size 125

Gains from an Integrated Market: A Numerical Example 125 Economies of Scale and Comparative Advantage 128


The Significance of Intraindustry Trade 130 Why Intraindustry Trade Matters 131

CASE STUDY: Intraindustry Trade in Action: The North American Auto Pact 133 Dumping 134

The Economics of Dumping 134

BOX: Reverse Dumping 136

CASE STUDY: Antidumping as Protectionism 137

Reciprocal Dumping 138 " • .

BOX: A Concrete Example of Dumping 138 External Economies and International Trade 139 BOX: Examples of External Economies 140

External Economies and the Pattern of Trade 140 Trade and Welfare with External Economies 142 Dynamic Increasing Returns 143

Summary 145

APPENDIX: Determining Marginal Revenue 148

7 International Factor Movements 149

International Labor Mobility 150

A One-Good Model without Factor Mobility 150 International Labor Movement 152

Extending the Analysis 153

BOX: International Labor Mobility in Practice: "Guest Workers" in Europe 154 International Borrowing and Lending 155

• Intertemporal Production Possibilities and Trade 155 The Real Interest Rate 156

Intertemporal Comparative Advantage 157

BOX: Changes in the Pattern of Capital Movements in the 1980s 158 Direct Foreign Investment and Multinational Firms 159

The Theory of Multinational Enterprise 159 Multinational Firms in Practice < 161

CASE STUDY: Foreign Direct Investment in the United States 163 BOX: Japan in the Entertainment Business 165 ,t Summary 165 •

APPENDIX: More on Intertemporal Trade 169


8 Regional Economic Issues 173

What is a Country? 174

How Governments Create National Economies 175 From International to interregional Trade 178

BOX: Food Fights in Europe 178 Comparing Regions and Nations 179

-I Specialization and Trade 179 ; Factfrr Mobility 181

Problems of Regional Economics 182


BOX: Anatomy of a Declining Region 183

Agglomeration and Uneven Development 184

Summary 187


9 The Instruments of Trade Policy 195

Basic Tariff Analysis 195

Supply, Demand, and Trade in a Single Industry 196 Effects of a Tariff 197

Measuring the Amount of Protection 199

Costs and Benefits of a Tariff 201

Consumer and Producer Surplus 201 Measuring the Costs and Benefits 203

Other Instruments of Trade Policy 206

Export Subsidies: Theory 206

CASE STUDXpEurope's Common Agricultural Policy 207

Import Quotas: Theory 208

CASE STUDY: An Import Quota in Practice: U.S. Sugar 209

Voluntary Export Restraints 210

BOX: The Case of the Forbidden Phone Booths 211

CASE STUDY: A Voluntary Export Restraint in Practice: Japanese Autos 212

Iiocal Content Requirements 212

BOX: What's a Domestic Car? 213

CASE STUDY: A Local Content Scheme: The Oil Import Quota in the 1960s 214

Other Trade Policy Instruments 215

Summary 215

APPENDIX I: Tariff Analysis in General Equilibrium 219

A Tariff in a Small Country 219 f A Tariff in a Large Country 221 '

APPENDIX IlfTariffs and Import Quotas in the Presence of Monopoly 225

The Model with Free Trade 223 / The Model with a Tariff 224

The Model with an Import Quota 224 Comparing a Tariff and a Quota 225

10 The Political Economy of Trade Policy 227

The Case for Free Trade 228

Free Trade and Efficiency 228 Additional Gains from Free Trade 229 Political Argument for Free Trade 230

National Welfare Arguments against Free Trade 230 CASE STUDY: The Gains from "1992" 230


The Domestic Market Failure Argument against Free Trade 232 How Convincing Is the Market Failure Argument? 234

Income Distribution and Trade Policy 236

Weighted Social Welfare 236 Conservative Social Welfare 236 Collective Action 237

Who Gets Protected? 238

International Negotiations and Trade Policy 238

The Advantages of Negotiation 239

International Trade Agreements: A Brief History 241

BOX: Environmentalism or Protectionism? 242

Stresses on the Trading System 243 Preferential Trading Agreements 245

BOX: Do Trade Preferences Have Appeal? 246 BOX: The Oilseed Dispute 247

CASE STUDY: Recent Regional Trading Agreements 247 Summary 249

APPENDIX: Proving that the Optimum Tariff Is Positive 253

Demandjand Supply 253 The Tariff and Prices 253

The Tariff and Domestic Welfare 254

11 Trade Policy in Developing Countries 256

.Trade Policy to Promote Manufacturing 257

Why Manufacturing Is Favored: The Infant Industry Argument 257 How Manufacturing Is Favored: Import-Substituting Industrialization 259

Results of Favoring Manufacturing: Problems of Import-Substituting Industrialization 261 Another Way to Favor Manufacturing: Industrialization through Exports 262

BOX: Trade Liberalization and Economic Growth: The Case of China 263 Problems of the Dual Economy ^ 264

The Symptoms of Dualism 264

CASE STUDY: Economic Dualism in India 265

Dual Labor Markets and Trade Policy 266 ' Trade Policy as a Cause of Economic Dualism 268

^Negotiations between Developing and Advanced Countries: The North-South * Debate 268

Are Poor Nations Exploited? 269

The Role of Foreign Capital and Multinational Firms in Development 270

Raising the Export Prices of Developing Countries: Commodity Export Cartels 271

CASE STUDY: OPEC 272 Summary 273

12 Industrial Policy in Advanced Countries 277

Popular Arguments for Industrial Policy 278

Encouraging Industries with High Value Added Per Worker 278 Encouraging Linkage Industries 279


Promoting Industries with Future Growth Potential 280

Countering the Effects of Other Countries' Industrial Policies 280

Sophisticated Arguments for Industrial Policy 282

Technology and Externalities 282

Imperfect Competition and Strategic Trade Policy 284

Industrial Policy in Practice 287

The Industrial Policy of Japan 287 Industrial Policy in Other Countries 289

BOX: The HDTV Debate 290 Case Studies of Industrial Policy 292

CASE STUDY: Japanese Targeting of Steel (1960-Early 1970s) 292 CASE STUDY: European Support of Aircraft in the 1970s and 1980s 294 CASE STUDY: Japanese Targeting of Semiconductors (Mid-1970s to Date) 295 Summary 296



13 National Income Accounting and the Balance of Payments 301

The National Income Accounts 303

National Product and National Income 303

Capital Depreciation, International Transfers, and Indirect Business Taxes 305 Gross Domestic Product 305

National Income Accounting in a Closed Economy 306

Consumption 306 Investment 306

Government Purchases 307

The National Income Identity for a Closed Economy 307

An Imaginary Closed Economy 308

Implications for National Saving 308 . . '

National Income Accounting for an Open Economy 309

The National Income Identity for an Open Economy 309 The Current Account and Foreign Indebtedness 311 Saving and the Current Account 312

Private and Government Saving 313

CASE STUDY: Do Government Budget Deficits Worsen the Current Account? 314 The Balance of Payment Accounts 317

The Current Account, Once Again 318 The Capital Account 320

The Statistical Discrepancy 321 Official Reserve Transactions 321

BOX: The'Mystery of the Missing Surplus 322

CASE STUDY: Is the United States the World's Biggest Debtor? 325 Summary 327


14 Exchange Rates and the Foreign Exchange Market:

An Asset Approach 332

Exchange Rates and International Transactions 333

Domestic and Foreign Prices 333 Exchange Rates and Relative Prices 336

The Foreign Exchange Market 337

The Actors 337

BOX: Making the Most of a Cheap Dollar 338

Characteristics of the Market 340 Spot Rates and Forward Rates 341 Foreign Exchange Swaps 343 Futures and Options 343

BOX: How Multinationals Manage Their Foreign Exchange Risks 341 The Demand for Foreign Currency Assets 344

Assets and Asset Returns 345 Risk and Liquidity 347 Interest Rates 347

Exchange Rates and Asset Returns 348 A Simple Rule 349

Return, Risk, and Liquidity in the Foreign Exchange Market 351

Equilibrium in the Foreign Exchange Market 352

Interest Parity: The Basic Equilibrium Condition 352

How Changes in the Current Exchange Rate Affect Expected Returns 353 The Equilibrium Exchange Rate 356

Interest Rates, Expectations, and Equilibrium 357

The Effect of Changing Interest Rates on the Current Exchange Rate 357

BOX: The Perils of Forecasting Exchange Rates 359

The Effect of Changing Expectations on the Current Exchange Rate 360

Summary 360

APPENDIX: Forward Exchange Rates and Covered Interest Parity 365


15 Money, Jnterest Rates, and Exchange Rates 368


Money Defined: A Brief Review 369

Money as a Medium of Exchange 369 j . Money as a Unit of Account 369

« Money as a Store of Value 370 What Is Money? 370

How the Money Supply Is Determined 370

The Demand for Money by Individuals 371

Expected Return 371 Risk 372

Liquidity 372

, Aggregate Money Demand 372

I The Equilibrium Interest Rate: The Interaction of Money Supply and Demand 374

Equilibrium in the Money Market 374 Interest Rates and the Money Supply 376 Output and the Interest Rate 377


The Money Supply and the Exchange Rate in the Short Run 378

Linking Money, the Interest Rate, and the Exchange Rate 379 U.S. Money Supply and the Dollar/DM Exchange Rate 381 German Money Supply and the Dollar/DM Exchange Rate 382

Money, the Price Level, and the Exchange Rate in the Long Run 383

Money and Money Prices 384

The Lbng-Run Effects of Money Supply Changes 385 Empirical Evidence on Money Supplies and Price Levels 386

BOX: Money as a Weapon of War 387

Money and the Exchange Rate in the Long Run 388

Inflation and Exchange Rate Dynamics 388

Short-Run Price Rigidity versus Long-Run Price Flexibility 389

BOX: Money Supply Growth and Hyperinflation in Bolivia 390

Permanent Money Supply Changes and the Exchange Rate 392 Exchange Rate Overshooting 395

Summary 395

16 Price Levels and the Exchange Rate in the Long Run 398

The Law of One Price 399 Purchasing Power Parity 400

• The Relationship BetweenPPP and the Law of One Price 400 Absolute PPP and Relative PPP 401

A Long-Run Exchange Rate Model Based on PPP 402 The Fundamental Equation of the Monetary Approach 402 Ongoing Inflation, Interest Parity, and PPP 404

The Fisher Effect 405

Empirical Evidence on PPP and the Law of One Price 408 BOX: Some Meaty Evidence on the Law of One Price 412 Explaining the Problems with PPP 414

Trade Barriers and Nontradables 414 Departures from Free Competition ,415

International Differences in Price Level Measurement 416

PPP in the Short Run and in the Long Run 416 „

CASE STUDY: Why Price Levels Are Lower in Poorer Countries 417

Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates 419

The Real Exchange Rate 419

Demand, Supply, and the Long-Run Real Exchange Rate 421

BOX: Productivity Growth and the Real Dollar/Yen Exchange Rate 422

Nominal and Real Exchange Rates in Long-Run Equilibrium 424

International Interest Rate Differences and the Real Exchange Rate 427 Real Interest Parity 428

Summary 429

17 Output/and the Exchange Rate in the Short Run 435

Determinants of Aggregate Demand in an Open Economy 436

Determinants of Consumption Demand 436 Determinants of the Current Account 437


How Real Exchange Rate Changes Affect the Current Account 438 How Disposable Income Changes Affect the Current Account 438

The Equation of Aggregate Demand 439

The Real Exchange Rate and Aggregate Demand 439 Real Income and Aggregate Demand 439

How. Output Is Determined in the Short Run 440

Output Market Equilibrium in the Short Run: The DD Schedule 441

Output, the Exchange Rate, and Output Market Equilibrium 442 Deriving the DD Schedule 443

Factors That Shift the DD Schedule 443

Asset Market Equilibrium in the Short Run: The AA Schedule 446

Output, the Exchange Rate, and Asset Market Equilibrium 447 Deriving the AA Schedule 448

Factors That Shift the AA Schedule 449

Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together 450

Temporary Changes in Monetary and Fiscal Policy 451

Monetary Policy 452 Fiscal Policy 453 ^

Policiefto Maintain Full Employment 454 Some Problems of Policy Formulation 455

Permanent Shifts in Monetary and Fiscal Policy 456

A Permanent Increase in the Money Supply 456

Adjustment to a Permanent Increase in the Money Supply 457 A Permanent Fiscal Expansion 458

Macroeconomic Policies and the Current Account 460

CASE STUDY: U.S. Monetary and Fiscal Policy in Action, 1979-1983 462 Gradual Trade Flow Adjustment and Current Account Dynamics 464

The J-Curve 464

The Beachhead Effect 466

Exchange Rate Pass-Through and Inflation 466

Summary 467 j

APPENDIX I: The IS-LM Model and the DD-AA Model 472

APPENDIX II: The Marshall-Lerner Condition and Empirical Estimates of Trade Elasticities 476 ^

18 Fixed Exchange Rates and Foreign Exchange Intervention 479

Why Study Fixed Exchange Rates? 480

Central Bank Intervention and the Money Supply 481

The Central Bank Balance Sheet 481

The Central Bank Balance Sheet and the Money Supply 482 Foreign Exchange Intervention and the Money Supply 483 | Sterilization 484

l The Balance of Payments and the Money Supply 485

How the Central Bank Fixes the Exchange Rate 486


Money Market Equilibrium under a Fixed Exchange Rate 486 A Diagrammatic Analysis 487

Stabilization Policies with a Fixed Exchange Rate 489

Monetary Policy 489 Fiscal Policy 491

Changes in the Exchange Rate 492

Adjustment to Fiscal Policy and Exchange Rate Changes 493

Balance of Payments Crises and Capital Flight 494 Managed Floating and Sterilized Intervention 496

Perfect Asset Substitutability and the Ineffectiveness of Sterilized Intervention 497 Foreign-Exchange Market Equilibrium under Imperfect Asset Substitutability 498 The Effects of Sterilized Intervention with Imperfect Asset Substitutability 499 Evidence on the Effects of Sterilized Intervention 500

The Signaling Effect of Intervention 501

Reserve Currencies in the World Monetary System 501

The Mechanics of a Reserve Currency Standard 502

BOX: Games Governments Play 503

The Asymmetric Position of the Reserve Center 503

The Gold Standard 504

The Mechajiks of a Gold Standard 504

Symmetric Monetary Adjustment under a Gold Standard 505

BOX: Intervention Arrangements in the European Monetary System 506

Benefits and Drawbacks of the Gold Standard 506 The Gold Exchange Standard 508

Summary 508 / ^

APPENDIX I: Equilibrium in the Foreign Exchange Market with Imperfect Asset Substitutability 513 '

Demand 513 • Supply 514

Equilibrium 514

APPENDIX II: The Monetary Approach to the Balance of Payments 516 APPENDIX III: The Timing of Balance of Payments Crises 518




19-The International Monetary System, 1870-1973 523

Macroeconomic Policy Goals in an Open Economy 524

Internal Balance: Full Employment and Price Level Stability 524 External Balance: The Optimal Level of the Current Account 525

International Macroeconomic Policy under the Gold Standard, 1870-1914 528

Origins of the Gold Standard 528

i External Balance under the Gold Standard 529 ' The Price"-Specie-Flow Mechanism 529

The Gold Standard "Rules of the Game": Myth and Reality 531 Internal Balance under the Gold Standard 531


BOX: Hume versus the Mercantilists 532 The Interwar Years, 1918-1939 533

The German Hyperinflation 533 The Fleeting Return to Gold 533

International Economic Disintegration 534

The Bretton Woods System and the International Monetary Fund 535

Goals and Structures of the IMF 536 Convertibility , 537

Internal and External Balance under the Bretton Woods System 538

The Changing Meaning of External Balance 538 Speculative Capital Flows and Crises 539

Analyzing Policy Options under the Bretton Woods System 540

Maintaining Internal Balance 541 Maintaining External Balance 541

Expenditure-Changing and Expenditure-Switching Policies 542

The External Balance Problem of the United States 544

CASE STUDY: The Decline and Fall of the Bretton Woods System 546

The Calm before the Storm: 1958-1965 546

The Vietnam Military Buildup and the Great Society: 1965-1968 547 From-iHe Gold Crisis to the Collapse: 1968T1973 547

Worldwide Inflation and the Transition to Floating Rates 550 Summary 554

' ' " ' ^ \

20 Macroeconomic Policy and Coordination Under Floating Exchange

• Rates 558

The Case for Floating Exchange Rates ' 559

Monetary Poliqy Autonomy 559 Symmetry 560

Exchange Rates as Automatic Stabilizers 561

The Case against Floating Exchange Rates 563

Discipline 564 /

Destabilizing Speculation and Money Market Disturbances 564 Injury'to International Trade and Investment 565 •» Uncoordinated Economic Policies 566

The Illusion of Greater Autonomy 566

^CASE STUDY: Exchange Rate Experience between the Oil Shocks, 1973-1980 567

The First Oil Shock and Its Effects, 1973-1975 567

~" Rambouillet and Jamaica: Revising the IMF's Charter, 1975-1976 571 The Weak Dollar, 1976-1979 571

The Second Oil Shock, 1979-1980 573

A Two-Country Model of Macroeconomic Interdependence under a Floating Rate 574 CASE STUDY: Disinflation, Recovery, and Global Slump, 1980-1993 577

Disinflation and the 1981-1983 Recession 577

\ Fiscal Policies, the Current Account, and the Resurgence of Protectionism 579

! From the Plaza to the Louvre and Beyond: Trying to Manage Exchange Rates 582 Global Slump Once Again 584

What Has Been Learned Since 1973? 586


Symmetry 588

The Exchange Rate as an Automatic Stabilizer 589 Discipline 590

Destabilizing Speculation 590

International Trade and Investment 591 Policy Coordination 592

Directions for Reform 593 Summary 593

APPENDIX: International Policy Coordination Failures 597

21 Optimum Currency Areas and the European Experience 600

Why Has Europe Favored Mutually Fixed Exchange Rates? 601

European Currency Reform Initiatives, 1969-1978 601

The European Monetary System: From 1979 to the Present 603 German Monetary Dominance and Credibility Theory of the EMS 606

BOX: The EMS Currency Grid 608

Problems with Germany's Dominant Position 609 The EC "1£92" Initiative 610 "

The Theory of Optimum Currency Areas 611

Economic Integration and the Benefits of a Fixed Exchange Rate Area: The GG Schedule 611

Economic Integration and the Costs of a Fixed Exchange Rate Area: The LL Schedule 611

The Decision to Join a Currency Area: Putting the GG and LL Schedules Together 615 What is an Optimum Currency Area? 617

CASE STUDY: Is Europe an Optimum Currency Area? 617

The Extent of Intra-European Trade 618 How Mobile is Europe's Labor Force? 618 Other Considerations 619

BOX: Can Europe Learn Lessons from America's Fiscal Federalism? 620

Summing Up 621

European Monetary Union 622 '* CASE STUDY: How European Macroeconomic Tensions Helped Derail

Maastricht 623

German Reunification 624

Public Opinion and the Maastricht Treaty 625 Black Wednesday 626

Continuing Crisis 626

Summary 627

APPENDIX: How German Reunification May Have Deepened the European Recession of the Early 1990s 631

22 The Global Capital Market: Performance and Policy Problems 634

The International Capital Market and the Gains from Trade 635


Risk Aversion 636

Portfolio Diversification as a Motive for International Asset Trade 637 The Menu of International Assets: Debt versus Equity 638

International Banking and the International Capital Market 639

The Structure of the International Capital Market 639 Offshore Banking and Offshore Currency Trading 640

Eurodollars and Other Eurocurrencies 642

How Big Is the Eurocurrency Market? 642 How Eurocurrencies Are Created 643 The Growth of Eurocurrency Trading 646 The Importance of Regulatory Asymmetries 647 Eurocurrencies and Macroeconomic Stability 649

BOX: Of Samurai and Sushi: Opening Japan's Financial Markets 651 Regulating International Banking 652

The Problem of Bank Failure 652

Difficulties in Regulating International Banking 654 International Regulatory Cooperation 655

BOX: The Banco Ambrosiano Collapse 656 CASE STUDY: The BCCI Affair 657

How Well Has the International Capital Market Performed? 658

The Extent of International Portfolio Diversification 659 The Extent of Intertemporal Trade 660

Onshore-Offshore Interest Differentials 660

The Efficiency of the Foreign Exchange Market 661

.Summary 665

23 Developing Countries: Debt, Stabilization, and Reform 670

Income and Wealth in the World Economy 671 Macroeconomic Features of Developing Countries 671

Undeveloped Financial Markets t 672

Government's Pervasive Role /673 Inflation-and the Government Budget 674

Pegged Exchange Rates, Exchange Controls, and Inconvertible Currencies 674

BOX: How Important Is Seigniorage? 676

_ The Structure of Developing Country Exports 677

Developing Country Borrowing and Debt 678

' • The Economics of Borrowing by Developing Countries 678 Alternative Forms of Capital Inflow 679

Government and Publicly Guaranteed Borrowing 680

CASE STUDY: Orthodox and Heterodox Stabilization Programs in Latin America 681 Developing Country Borrowing in Historical Perspective 683

Capital Flows to Developing Countries before 1914 683 • The Interwar Period and Its Aftermathf 1918-1972 684

1 Borrowing after 1973: Oil Shocks and Floating Interest Rates 686

1 BOX: The Paris Club 687

Origins of the Developing Country Debt Crisis 689


Developing Countries in the Worldwide Recession 691 Mexico: The Beginning of the Crisis 692

The Debt Crisis in Other Countries 693

The Economics of Sovereign Default 694

The Costs of Sovereign Default 694 The Benefit of Sovereign Default 695 When^Does a Debtor Choose to Default? 696

Managing the Debt Crisis 696

The First Phase: Concerted Lending 697 The Role of the IMF 698

The Second Phase: Trying to Muddle Through 698

BOX: Debts of the Eastern Bloc 699

The Brady Plan 701

Market-Based Debt Reduction 703

Third-Party Buybacks 703 Debt Forgiveness 704

Is the Debt Crisis Over? 704

The Effects of the Brady Plan 705 Renewed Capital Inflows 705 The Road Ahead 706

Summary 707

24 International Economic Problems of Former Communist

Countries 711

Trade in Eastern Europe before 1989 712

-CMEA Trade under Communism 712

The Management of Trade within the Soviet Union 716 The Management of Trade among CMEA Nations 717

The Adjustment Problem in Eastern Europe 718

The Decline in Intra-CMEA Exports, 719 The Terms of Trade Shock 720 / How SevercWas the Shock? 721 Policy Options 722 y The Case for Policy Coordination 723

The Coordination Problem in the Soviet Union 725

Priclfe Controls, Central Planning, and Interregional Trade 725

Monetary Problems within the Former Soviet Union 728 Prospects for the Former Communist Countries 729 Summary 730

Mathematical Postscripts 735

Postscript^ Chapter 3: THE SPECIFIC FACTORS MODEL 737

Factor Prices, Costs, and Factor Demands 737

Factor Price Determination in the Specific Factors Model 739 Effects of a Change in Relative Prices 741


Postscript to Chapter 4: THE FACTOR-PROPORTIONS MODEL 742

The Basic Equations in the Factor-Proportions Model 742 Goods Prices and Factor Prices 743

Factor Supplies and Outputs 743

Postscript to Chapter 5: THE TRADING WORLD ECONOMY 744

Supply, Demand, and Equilibrium 744 World Equilibrium 744

Production and Income 744 Income, Prices, and Utility 745

Supply, Demand, and the Stability of Equilibrium 746 Effects of Changes in Supply and Demand 748 The Method of'Comparative Statics 748 Economic Growth 748

The Transfer Problem 750 A Tariff 750



An Analytical Derivation of the Optimal Portfolio 754 A DiagtfaThmatic Derivation of the Optimal Portfolio 755 The Effects of Changing Rates of Return 758







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