Critical Thinking: Saudi Arabia’s Currency and the U.S. Dollar

While Saudi Arabia seeks to diversify its economy, the Saudi economy is dominated by the petroleum sector. In addition, the Saudi Arabian Riyal (SAR) is pegged to the U.S. Dollar.

In a critical essay, indicate the main considerations Saudi Arabia faces from a currency perspective (e.g., currency values, interest rates, inflation, and trade issues) that ensue given two scenarios:

The first scenario is a dramatically declining world oil price.

The second scenario is a dramatically increasing world oil price.

Analyze the results you expect from each scenario.

Module 11: Exchange Rate Determination
1. Foreign Currency Exchange Rates
The exchange rate between any two currencies is the price of one currency in relation
to the other.
In the short term, and in the long term, the exchange rate between any two currencies
is a basic economic supply and demand equilibrium problem. The demand for foreign
exchange expresses the quantity of foreign exchange that will be purchased at a range
of prices, or exchange rates. The supply of foreign exchange is the amount of foreign
exchange that will be offered to the market at various exchange rates.
Exchange rates fluctuate daily. Appreciation is an increase of one currency’s value in
terms of another, while depreciation is a decrease of one currency’s value in terms of
another. As with all supply and demand schedules, the equilibrium exchange rate is
established at the point of intersection between the supply and demand schedules and
specifies the quantity of foreign exchange that will be bought and sold and the
exchange rate, or price. For a nation as a whole, the demand for foreign exchange
corresponds to the debit items on the country’s balance of payments and the supply
for foreign exchange corresponds to the credit items.
Exchange rates fluctuate based on any factor—economic or otherwise—that affects
the supply or demand for a country’s currency. For example, the release of bad
economic data or the election of a politician considered to be irresponsible can cause
the demand for the country’s currency to decrease, which decreases the equilibrium
exchange rate.
For more on foreign exchange, watch this video.
https://www.youtube.com/watch?time_continue=26&v=FDiOxHTvkKU
Any comparison of the values of two currencies is complicated by the fact that in
addition to the exchange rate between the two currencies (the price of each in terms
of the other), the exchange rates between any currency and other important
currencies in the world are not consistent.
To make direct comparisons between the values of two currencies requires reference
to each currency’s exchange rate index or effective exchange rate. The latter shows
how strong a domestic currency is against a basket of other currencies. The nominal
exchange rate index of a currency is the average value of the currency, not adjusted
for changes in price levels in the home country and its trading partners.
The conventional analysis pays attention to the effect of the effective exchange rates
on GDP through trade balance. For example, an appreciation of the effective exchange
rates leads to a decrease in net exports (the appreciation reduces exports and
increases imports) which has a contractionary effect on the economy. However,
another effect should be also considered: the increase in supply due to a decrease in
the price of the imported intermediate goods. If the latter effect is greater than the
contractionary effect, the overall effect on the economy could be expansionary.
Furthermore, Anaya and Hasenclever (2018) argued that because of the financial
globalization economies are connected not only by trade flows but also by foreign
assets. For example, an appreciation of the currency could lead to an acceleration of
bank flows (Bruno & Shin, 2015).
2. Foreign Currency Exchange Rate Transactions
There are several primary types of exchange rate transactions. Click on the items
below to learn more.
Exchange arbitrage
Exchange arbitrage is the concurrent purchase and sale of a currency in different
foreign exchange markets in order to profit from exchange rate differentials in the two
locations. Arbitragers are speculators out to make a profit, but their activities—in
theory and in practice—keep exchanges rates from diverging from their proper
equilibrium points and so provide discipline to currency markets, making economic
activity more efficient. On the other hand, like all speculation, arbitrage can create
instability when markets do not function per classical economic assumptions.
forward market
The forward market allows buyers and sellers in international trade markets to lock in
an exchange rate in advance of a contracted transaction, so both can hedge against
the risk of unanticipated fluctuations in spot rates. Carbaugh (2019) pointed out that
such hedging itself exacts a cost. Therefore, many international traders—particularly
large ones—prefer to cover exchange rate risk using their own assets.
market speculation
Foreign exchange market speculation is an attempt to earn profits by anticipating
future prices of currencies and trading on those expectations. Unlike arbitrage
speculators who attempt to exploit momentary differences in exchange rates that exist
at the same moment, exchange speculators purchase, hold, and sell foreign exchange,
hoping to “buy low and sell high.” In economic theory, currency speculation plays a
similar role to other market activity, imposing discipline on exchange rates and hence
making economic activity more efficient. However, in recent years the currency
speculation market, which like other financial markets has greatly expanded and
increased its velocity during the past decade or so, has been a key component in
bringing about sudden, extreme, and destructive changes in exchange rates.
3. Foreign Currency Exchange Rate
Determinations
Four generally accepted economic fundamentals constitute long-term supply and
demand for currency (and thus are the determinants of the fundamental equilibrium
path). These four are described here:
Relative Price Levels
If price levels rise more quickly in country A than they do in country B, then country A consumers will face
falling prices for country B products. This increases the demand for country B currency and causes country
B currency to appreciate, relatively speaking.
Relative Productivity Levels
As a country becomes more productive, its currency appreciates because its products become relatively
less expensive, increasing the demand for the country’s currency abroad (and vice versa).
Domestic or Foreign Goods
Preferences for domestic or foreign goods arise based on increased demand for a country’s exports
causing the country’s currency to appreciate as overseas demand for its currency increases.
Trade Barriers
Trade barriers involve tariffs and quotas imposed on imports. These cause the currency of the country
imposing the barriers to appreciate as the price of imports increases, reducing the demand for foreign
currency.
For more on demand and supply, watch this video.

INTERNATIONAL
ECONOMICS
SEVENTEENTH EDITION
ROBERT J. CARBAUGH
© 2019 Cengage. All rights reserved.
1
Chapter 12
Exchange
Rate
Determination
© 2019 Cengage. All rights reserved.
2
Chapter Outline
What Determines Exchange Rates?
Determining Long-Run Exchange Rates
Inflation Rates, Purchasing Power Parity, and
Long-Run Exchange Rates
Determining Short-Run Exchange Rates: The
Asset-Market Approach
Exchange-Rate Overshooting
Forecasting Foreign-Exchange Rates
© 2019 Cengage. All rights reserved.
3
What Determines Exchange
Rates? (1 of 3)
Factors that cause the supply-and-demand
schedules of currencies to change
• Market fundamentals (economic variables)
• Productivity, inflation rates, real-interest rates,
consumer preferences, and government trade
policy
• Market expectations
• News about future market fundamentals
• Traders’ opinions about future exchange rates
© 2019 Cengage. All rights reserved.
4
What Determines Exchange
Rates? (2 of 3)
• Factors affecting exchange rates
• Short run: transfers of assets
• Differences in real-interest rates and shifting
expectations of future exchange rates
• Medium run: cyclical factors
• Fluctuations in economic activity
• Long run: flows of goods, services, and
investment capital
• Inflation rates, investment profitability, consumer
tastes, productivity, and government trade policy
© 2019 Cengage. All rights reserved.
5
What Determines Exchange
Rates? (3 of 3)
© 2019 Cengage. All rights reserved.
6
Determining Long-Run Exchange
Rates (1 of 5)
Exchange rate changes
• Reactions of traders in foreign-exchange
market to changes in four key factors:
•
•
•
•
Relative price levels
Relative productivity levels
Preferences for domestic or foreign goods
Trade barriers
© 2019 Cengage. All rights reserved.
7
Determining Long-Run Exchange
Rates (2 of 5)
TABLE 12.1 Determinants of the Dollar’s Exchange Rate in the Long Run
Factor*
Change
Effect on the Dollar’s
Exchange Rate
U.S. price level
Increase
Decrease
Depreciation
Appreciation
U.S. productivity
Increase
Decrease
Appreciation
Depreciation
U.S. preferences
Increase
Decrease
Depreciation
Appreciation
U.S. trade barriers
Increase
Decrease
Appreciation
Depreciation
*Relative to other countries. The analysis for a change in one determinant assumes that the other
determinants are unchanged.
© 2019 Cengage. All rights reserved.
8
Determining Long-Run Exchange
Rates (3 of 5)
• Relative Productivity Levels
• Increase in U.S. price level leads to increase
in demand for foreign currency, decrease in
supply of foreign currency, and depreciation of
dollar
• Decrease in U.S. price level leads to
decrease in demand for foreign currency,
increase in supply of foreign currency, and
appreciation of dollar
© 2019 Cengage. All rights reserved.
9
Determining Long-Run Exchange
Rates (4 of 5)
• Preferences for Domestic or Foreign
Goods
• Increased demand for U.S. exports and
appreciation of dollar
• Increased demand for U.S. imports and
depreciation of dollar
• U.S. imposes trade barriers
• Appreciation of dollar
© 2019 Cengage. All rights reserved.
10
Determining Long-Run Exchange
Rates (5 of 5)
© 2019 Cengage. All rights reserved.
11
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (1 of 13)
Law of One Price
• Identical goods should be sold everywhere at
same price when converted to common
currency, assuming it is costless to ship goods
between nations, there are no barriers to
trade, and markets are competitive
• Prevailing market-exchange rate is the true
equilibrium rate
© 2019 Cengage. All rights reserved.
12
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (2 of 13)
• Burgeromics: The Big Mac Index and the
Law of One Price
• Attempt to measure the true equilibrium value
of a currency based on one product, the Big
Mac
• Can be used to determine extent to which
market-exchange rate differs from true
equilibrium-exchange rate
• Big Mac prices show law of one price does
not hold across countries
© 2019 Cengage. All rights reserved.
13
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (3 of 13)
TABLE 12.2 Big Mac Index, 2017
Price of Big Mac
in Local Currency
Price of Big Mac
in U.S. Dollars*
Local Currency Overvaluation (+)
Undervaluation (−) (percent)
$5.06
$5.06
—
Switzerland (franc)
6.50
6.35
25.5
Norway (krone)
49.0
5.67
12.1
Sweden (krona)
48.0
5.26
4.0
Canada (dollar)
5.98
4.51
−10.9
Euro Area (euro)
3.88
4.06
−19.7
China (yuan)
19.6
2.83
−44.1
Mexico (peso)
49.0
2.23
−55.9
Country/Currency
United States (dollar)
*At market exchange rate, January 12, 2017. The price in each country is based on the average of four cities.
Source: From “Big Mac Currencies,” The Economist, available at http://www.economist.com.
© 2019 Cengage. All rights reserved.
14
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (4 of 13)
• Purchasing Power Parity
• Theory that exchange rates adjust to make
goods and services cost same everywhere
• Application of law of one price
© 2019 Cengage. All rights reserved.
15
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (5 of 13)
• Purchasing Power Parity
• If the rate of inflation is much higher in one
country
• Its money has lost purchasing power over
domestic goods
• Currency should depreciate to restore parity
with prices of goods abroad
© 2019 Cengage. All rights reserved.
16
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (6 of 13)
TABLE 12.3 The Law of One Price Applied to a Single
Product—Steel
According to the law of one price, if the yen price of steel increases by
10 percent and the dollar price of steel remains constant, the yen will
depreciate by 10 percent against the dollar to ensure that price is the
same in both countries.
Dollar Price of a
Ton of Steel
Exchange Rate:
Yen per Dollar
50,000 yen
500
100
55,000
500
110
Yen Price of a Ton of Steel
© 2019 Cengage. All rights reserved.
17
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (7 of 13)
• Purchasing Power Parity(cont’d)
• Trade flows are mechanism that makes a
currency depreciate or appreciate
• Changes in relative national price levels
determine changes in exchange rates over
long term
© 2019 Cengage. All rights reserved.
18
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (8 of 13)
• Purchasing Power Parity (cont’d)
• Foreign-exchange value of currency tends to
appreciate or depreciate at rate equal to
difference between foreign and domestic
inflation
• Changes in relative national price levels
• Determine changes in exchange rates, long term
© 2019 Cengage. All rights reserved.
19
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (9 of 13)
• Purchasing Power Parity (cont’d)
• A currency is expected to depreciate by
amount equal to the excess of domestic
inflation over foreign inflation
• A currency is expected to appreciate by
amount equal to excess of foreign inflation
over domestic inflation
© 2019 Cengage. All rights reserved.
20
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (10 of 13)
• Purchasing Power Parity (cont’d.)
• Used to predict long-term exchange rates
• P – price indexes of U.S. and Switzerland
• 0 – base period
• 1 – period 1
• S0 – equilibrium exchange rate in base period
• S1 – estimated target at which actual rate should be
in the future
S1 = S0
PUS1 PUS0
PS1 PS0
© 2019 Cengage. All rights reserved.
21
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (11 of 13)
• Purchasing Power Parity (cont’d.)
• Exchange-rate movements may be influenced by
investment flows
• Problems
• Choosing appropriate price index to be used in
price calculations
• Determining equilibrium period to use as base
© 2019 Cengage. All rights reserved.
22
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (12 of 13)
• Purchasing Power Parity (cont’d.)
• Government policy may interfere with operation of
theory
• Forecasting exchange rates appropriate in long
run; poor forecasters in short run
© 2019 Cengage. All rights reserved.
23
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (13 of 13)
© 2019 Cengage. All rights reserved.
24
Determining Short-Run Exchange Rates:
The Asset-Market Approach (1 of 9)
Foreign-exchange market activity
• Dominated by investors in assets
• Treasury securities, corporate bonds, bank
accounts, stocks, and real property
Asset-market approach
• Investors decide between domestic and
foreign investments based on
• Relative levels of interest rates
• Expected changes in exchange rate itself over
term of investment
© 2019 Cengage. All rights reserved.
25
Determining Short-Run Exchange Rates:
The Asset-Market Approach (2 of 9)
TABLE 12.4 Determinants of the Dollar’s Exchange Rate against the
Pound in the Short Run
Change in Determinant*
Repositioning of International
Financial Investment
Effect on Dollar’s
Exchange Rate
Increase
Toward dollar-denominated assets
Appreciates
Decrease
Toward pound-denominated assets
Depreciates
Increase
Toward pound-denominated assets
Depreciates
Decrease
Toward dollar-denominated assets
Appreciates
Appreciate
Toward dollar-denominated assets
Appreciates
Depreciate
Toward pound-denominated assets
Depreciates
U.S. Interest Rate
British Interest Rate
Expected Future Change in the
Dollar’s Exchange Rate
*The analysis for a change in one determinant assumes that the other determinants are unchanged.
© 2019 Cengage. All rights reserved.
26
Determining Short-Run Exchange Rates:
The Asset-Market Approach (3 of 9)
• Relative Levels of Interest Rates
• Level of nominal interest rate is first
approximation of rate of return on assets that
can be earned in a particular country
• Differences in level of nominal interest rates
between economies
• Likely to affect international investment flows as
investors seek highest rate of return
© 2019 Cengage. All rights reserved.
27
Determining Short-Run Exchange Rates:
The Asset-Market Approach (4 of 9)
• Relative Levels of Interest Rates (cont’d)
• If interest rates in U.S. > rates abroad
• Increase in demand for dollars
• Dollar appreciation
• If interest rates in U.S. < rates abroad • Decrease in demand for dollars • Dollar depreciation • Real-interest rate • Nominal-interest rate minus inflation rate © 2019 Cengage. All rights reserved. 28 Determining Short-Run Exchange Rates: The Asset-Market Approach (5 of 9) © 2019 Cengage. All rights reserved. 29 Determining Short-Run Exchange Rates: The Asset-Market Approach (6 of 9) TABLE 12.5 Nominal and Real Interest Rates, April 2017 Country Nominal Interest Rate* (percent) Inflation Rate** (percent) Real Interest Rate (percent) Greece 6.7 0.8 5.9 Russia 8.1 4.5 3.6 South Africa 8.8 5.7 3.1 Indonesia 7.0 4.3 2.7 United States 2.2 2.4 −0.2 Canada 1.5 1.9 −0.4 Euro Area 0.2 1.6 −1.4 Venezuela 10.4 56.2 −45.8 *Rates are for 10-year government bonds. **Measured by the Consumer Price Index for the latest three months. Source: From The Economist, “Economic and Financial Indicators,” April 22, 2017. See also International Monetary Fund, International Financial Statistics, and World Bank, Data and Statistics, available at www.data.worldbank.org. © 2019 Cengage. All rights reserved. 30 Determining Short-Run Exchange Rates: The Asset-Market Approach (7 of 9) • Expected Change in the Exchange Rate • Future expectations of appreciation of dollar can be self-fulfilling for today’s value of the dollar © 2019 Cengage. All rights reserved. 31 Determining Short-Run Exchange Rates: The Asset-Market Approach (8 of 9) © 2019 Cengage. All rights reserved. 32 Determining Short-Run Exchange Rates: The Asset-Market Approach (9 of 9) • Diversification, Safe Havens, & Investment Flows • Relative levels of interest rates strongly impact investment flows • Other factors affecting investment flows among economies • Size of stock of assets denominated in a particular currency in investor portfolios may induce change in investor preferences for diversification purposes • Safe-haven effect: investors may be willing to sacrifice return for safe repository for their funds © 2019 Cengage. All rights reserved. 33 Exchange-Rate Overshooting (1 of 4) Exchange-Rate Overshooting • Short-run response (depreciation or appreciation) to change in market fundamentals is greater than its long-run response • Changes in market fundamentals exert a disproportionately large short-run impact on exchange rates © 2019 Cengage. All rights reserved. 34 Exchange-Rate Overshooting (2 of 4) • Exchange-Rate Overshooting (cont’d) • Helps explain why exchange rates depreciate or appreciate so sharply from day to day • Volatility of exchange rates intensified by overshooting © 2019 Cengage. All rights reserved. 35 Exchange-Rate Overshooting (3 of 4) • Exchange-Rate Overshooting (cont’d) • Overshooting explained by: • Tendency of elasticities to be smaller in short run than in long run • Ex. (Figure 12.6): Increased demand for pounds leads to initial pound appreciation (dollar depreciation); with U.S. prices lower, quantity of pounds supplied increases over time, dampening the initial pound appreciation • Exchange rates tend to be more flexible than many other prices, which are often written into long-term contracts © 2019 Cengage. All rights reserved. 36 Exchange-Rate Overshooting (4 of 4) © 2019 Cengage. All rights reserved. 37 Forecasting ForeignExchange Rates (1 of 9) Forecasting exchange rates • Very tricky, especially in short run • Necessary for exporters, importers, investors, bankers, and foreign-exchange dealers • Choosing currency in which to make deposits requires idea of what currency’s value will be • Decisions about foreign investment necessitate awareness of where exchange rates will move over time • Need for exchange rate forecasting resulted in emergence of consulting firms © 2019 Cengage. All rights reserved. 38 Forecasting ForeignExchange Rates (2 of 9) • Judgmental forecasts • Subjective or common sense models require • Wide array of political and economic data • Interpretation of these data in terms of timing, direction, and magnitude of exchange-rate changes • Projections based on thorough examination of individual nations • Based on economic indicators, political factors, technical factors, psychological factors © 2019 Cengage. All rights reserved. 39 Forecasting ForeignExchange Rates (3 of 9) • Technical forecasts • Involve use of historical exchange-rate data to estimate future values • Ignore economic and political determinants of exchange-rate movements • Founded on idea that “history repeats itself” • Used to analyze short-run movements of exchange rates © 2019 Cengage. All rights reserved. 40 Forecasting ForeignExchange Rates (4 of 9) TABLE 12.7 Exchange Rate Forecasters Forecasting Organization Methodology Horizon Global Insights Econometric 24 months JPMorgan Chase Judgmental Under 12 months Econometric Over 12 months Econometric Over 12 months Technical Under 12 months Technical Under 12 months Econometric Over 12 months Judgmental 8 months Econometric 12 months Bank of America Goldman Sachs UBS Global Asset Management Source: Data collected by author. © 2019 Cengage. All rights reserved. 41 Forecasting ForeignExchange Rates (5 of 9) © 2019 Cengage. All rights reserved. 42 Forecasting ForeignExchange Rates (6 of 9) • Fundamental Analysis • Opposite of technical analysis • Considers economic variables likely to affect supply and demand of a currency • Uses statistical estimations of economic theories • Attempts to incorporate fundamental variables that underlie exchange-rate movements • Interest rates, balance of trade, productivity, inflation rates © 2019 Cengage. All rights reserved. 43 Forecasting ForeignExchange Rates (7 of 9) • Limitations of econometric models used to forecast exchange rates • Rely on predictions of key economic variables for which reliable information may be hard to obtain • Some factors affecting exchange rates cannot easily be quantified • Precise timing of factor’s effect on currency’s exchange rate may be unclear • Currency traders generally prefer technical to fundamental analysis; most forecasters use combination of fundamental, technical, judgmental analysis © 2019 Cengage. All rights reserved. 44 Forecasting ForeignExchange Rates (8 of 9) • Econometric models best suited for forecasting long-run trends in the movement of an exchange rate • Models do not generally provide foreign currency traders precise price information regarding when to purchase or sell a particular currency • Currency traders generally prefer technical to fundamental analysis; most forecasters use combination of fundamental, technical, judgmental analysis © 2019 Cengage. All rights reserved. 45 Forecasting ForeignExchange Rates (9 of 9) • Exchange-Rate Misalignment • Deviation of exchange rate from fundamental value • Has implications for country’s trade position and job creation • Undervalued currency gives country trade advantage at expense of trading partners • Undervaluation widely considered unfair; however, there’s no sure way to estimate correct value of currency and thus determine extent of undervaluation © 2019 Cengage. All rights reserved. 46 INTERNATIONAL ECONOMICS 13th Edition Robert J. Carbaugh Professor of Economics Central Washington University Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. This is an electronic version of the print textbook. Due to electronic rights restrictions, some third party content may be suppressed. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. The publisher reserves the right to remove content from this title at any time if subsequent rights restrictions require it. For valuable information on pricing, previous editions, changes to current editions, and alternate formats, please visit www.cengage.com/highered to search by ISBN#, author, title, or keyword for materials in your areas of interest. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. International Economics, 13th Edition Robert J. Carbaugh Vice President of Editorial, Business: Jack W. Calhoun Vice President/Marketing: Bill Hendee Publisher: Joe Sabatino Executive Editor: Michael Worls Supervising Developmental Editor: Katie Yanos Executive Marketing Manager: Keri Witman Associate Marketing Manager: Betty Jung Content Project Management: PreMediaGlobal Manager of Technology, Editorial: Emily Gross Media Editor: Deepak Kumar Senior Manufacturing Coordinator: Sandee Milewski Production Service: PreMediaGlobal Copyeditor: Jonathan Moore Senior Art Director: Michelle Kunkler Cover Designer: Rose Alcorn Main Image: © Manuel Velasco/ iStockphoto Secondary Image: © byphotography/ Shutterstock Permissions Acquisitions Manager, Text: Mardell Glinski Schultz Permissions Acquisitions Manager, Images: Deanna Ettinger © 2011, 2005 South-Western, a part of Cengage Learning ALL RIGHTS RESERVED. 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Contents in Brief PREFACE ................................................................................................................................................................ xv CHAPTER 1 The International Economy and Globalization.....................................................1 29 PART 1 International Trade Relations CHAPTER 2 CHAPTER 3 Foundations of Modern Trade Theory: Comparative Advantage ............31 Sources of Comparative Advantage ....................................................................... 69 4 CHAPTER 5 Tariffs................................................................................................................................... 111 Nontariff Trade Barriers.............................................................................................. 155 6 Trade Regulations and Industrial Policies ......................................................... 187 7 CHAPTER 8 Trade Policies for the Developing Nations ...................................................... 231 Regional Trading Arrangements............................................................................ 271 9 International Factor Movements and Multinational Enterprises ........... 309 10 International Monetary Relations 341 The Balance of Payments.......................................................................................... 343 11 CHAPTER 12 Foreign Exchange ......................................................................................................... 369 Exchange-Rate Determination ................................................................................ 405 CHAPTER CHAPTER CHAPTER CHAPTER PART 2 CHAPTER CHAPTER 13 Mechanisms of International Adjustment......................................................... 433 CHAPTER 14 CHAPTER 15 Exchange-Rate Adjustments and the Balance of Payments.................... 441 Exchange-Rate Systems and Currency Crises ................................................. 461 16 CHAPTER 17 Macroeconomic Policy in an Open Economy................................................. 495 International Banking: Reserves, Debt, and Risk ........................................... 513 CHAPTER CHAPTER GLOSSARY........................................................................................................................................................... 535 INDEX .................................................................................................................................................................. 547 iii Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Contents Preface ........................................................................................ xv CHAPTER 1 The International Economy and Globalization ....................................... 1 Globalization of Economic Activity .................. 2 Waves of Globalization ................................. 3 First Wave of Globalization: 1870–1914 ......... 4 Second Wave of Globalization: 1945–1980 ...... 4 Latest Wave of Globalization ...................... 5 The United States as an Open Economy ........... 7 Trade Patterns ......................................... 7 Labor and Capital ................................... 10 Why Is Globalization Important? .................. 11 The Global Recession of 2007–2009 ........... 12 Globalization: Increased Competition From Abroad ................................................. 16 Bicycle Imports Force Schwinn to Downshift .. 16 PART 1: International Trade Relations CHAPTER Dell Sells Factories in Effort to Slash Costs .... 17 Common Fallacies of International Trade ........ 18 Does Free Trade Apply to Cigarettes? ............. 19 Is International Trade an Opportunity or a Threat to Workers? .............................. 20 Backlash Against Globalization ..................... 22 Terrorism Jolts the Global Economy .............. 24 Competition in the World Steel Industry ................................................ 25 The Plan of this Text .................................. 26 Summary ................................................. 26 Key Concepts & Terms ............................... 27 Study Questions ........................................ 27 29 2 Foundations of Modern Trade Theory: Comparative Advantage ............ 31 Historical Development of Modern Trade Theory ............................................ 31 The Mercantilists .................................... 31 Why Nations Trade: Absolute Advantage ...... 32 Why Nations Trade: Comparative Advantage ............................................. 34 David Ricardo ......................................... 36 Production Possibilities Schedules .................. 37 Trading Under Constant-Cost Conditions ....... 38 Basis for Trade and Direction of Trade ........ 38 Production Gains from Specialization ........... 39 Consumption Gains from Trade .................. 40 Distributing the Gains from Trade .............. 42 Equilibrium Terms of Trade ...................... 43 Babe Ruth and the Principle of Comparative Advantage ........................... 44 Terms-of-Trade Estimates .......................... 44 Dynamic Gains From Trade ......................... 45 How Global Competition Led to Productivity Gains for U.S. Iron Ore Workers ................. 46 v Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. vi Contents Changing Comparative Advantage ................. Trading Under Increasing-Cost Conditions ...... Increasing-Cost Trading Case ..................... Partial Specialization ............................... The Impact of Trade on Jobs ........................ Comparative Advantage Extended to Many Products and Countries ............................... More Than Two Products ......................... More Than Two Countries ........................ Exit Barriers ............................................. Empirical Evidence on Comparative Advantage ................................................ CHAPTER 47 49 50 52 52 53 54 55 55 56 Does Comparative Advantage Apply in the Face of Job Outsourcing? ............................. 58 Advantages of Outsourcing ........................ 58 Outsourcing of Boeing 787 Dreamliner Triggers Machinist’s Strike ........................ 60 Outsourcing and the U.S. Automobile Industry ................................................ 61 Burdens of Outsourcing ............................ 61 Some U.S. Manufacturers Prosper by Keeping Production in the United States .................. 62 Summary ................................................. 63 Key Concepts & Terms ............................... 64 Study Questions ........................................ 64 3 Sources of Comparative Advantage .................................................... 69 Factor Endowments as a Source of Comparative Advantage .............................. 69 The Factor-Endowments Theory .................. 70 Visualizing the Factor-Endowment Theory .................................................. 72 Applying the Factor-Endowment Theory to U.S.-China Trade ................................ 73 Factor-Price Equalization .......................... 74 Who Gains and Loses From Trade? The Stolper-Samuelson Theorem ................. 76 Globalization Drives Changes for U.S. Automakers ..................................... 78 Is International Trade a Substitute for Migration? ........................................ 80 Specific Factors: Trade and the Distribution of Income in the Short Run ....................... 81 Does Trade Make the Poor Even Poorer? ........ 82 Does a “Flat World” Make Ricardo Wrong? ................................................. 84 Skill as a Source of Comparative Advantage .... 85 Increasing Returns to Scale and Comparative Advantage ................................................ 87 External Economies of Scale and Comparative Advantage ................................................ 89 Overlapping Demands as a Basis for Trade ...... 90 Intra-industry Trade ................................... 91 Technology as a Source of Comparative Advantage: The Product Cycle Theory ............ 93 Radios, Pocket Calculators, and the International Product Cycle ....................... 95 Dynamic Comparative Advantage: Industrial Policy ........................................ 96 Government Subsidies Support Boeing and Airbus ............................................... 98 Government Regulatory Policies and Comparative Advantage .............................. 99 Transportation Costs and Comparative Advantage ............................................... 101 Trade Effects ........................................ 101 Falling Transportation Costs Foster Trade Boom ......................................... 103 Rising Energy Costs Hinder Trade Flows .................................................. 104 Terrorist Attack Results in Added Costs and Slowdowns for U.S. Freight System: A New Kind of Trade Barrier? ................. 105 Summary ................................................ 107 Key Concepts & Terms .............................. 108 Study Questions ....................................... 108 Copyright 2010 Cengage Learning. 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Contents CHAPTER vii 4 Tariffs ............................................................................................. 111 The Tariff Concept ................................... 112 Types of Tariffs ........................................ 113 Specific Tariff ....................................... 113 Ad Valorem Tariff ................................. 114 Compound Tariff .................................. 114 Effective Rate of Protection ......................... 115 Tariff Escalation ....................................... 117 Outsourcing and Offshore-Assembly Provision ................................................ 119 Dodging Import Tariffs: Tariff Avoidance and Tariff Evasion .................................... 120 Ford Strips Its Wagons to Avoid High Tariff .......................................... 120 Smuggled Steel Evades U.S. Tariffs ............. 121 Postponing Import Tariffs .......................... 122 Bonded Warehouse ................................ 122 Foreign-Trade Zone ............................... 122 FTZ’s Benefit Motor Vehicle Importers ....... 124 Tariff Effects: An Overview ......................... 124 Tariff Welfare Effects: Consumer Surplus and Producer Surplus ................................ 125 Tariff Welfare Effects: Small-Nation Model ..... 127 Trade Protectionism Intensifies as Global Economy Falls into Recession ...................................... 128 CHAPTER Tariff Welfare Effects: Large-Nation Model ..... 131 The Optimum Tariff and Retaliation ......... 134 Gains from Eliminating Import Tariffs ................................................. 135 How a Tariff Burdens Exporters ................... 135 Steel Tariffs Buy Time for Troubled Industry .................................................. 138 Tariffs and the Poor .................................. 139 Arguments for Trade Restrictions ................. 140 Job Protection ....................................... 141 Protection Against Cheap Foreign Labor ..... 142 Fairness in Trade: A Level Playing Field ..... 143 Maintenance of the Domestic Standard of Living ............................................. 144 Equalization of Production Costs .............. 145 Infant-Industry Argument ....................... 145 Noneconomic Arguments ......................... 145 Petition of the Candle Makers ................. 147 The Political Economy of Protectionism ...... 147 A Supply and Demand View of Protectionism ....................................... 149 Summary ................................................ 150 Key Concepts & Terms .............................. 151 Study Questions ....................................... 151 5 Nontariff Trade Barriers ................................................................... 155 Import Quota .......................................... Trade and Welfare Effects ....................... Allocating Quota Licenses ........................ Quotas Versus Tariffs ................................ Tariff-Rate Quota: A Two-Tier Tariff ............ Sugar Tariff-Rate Quota Bittersweet for Consumers ...................................... Export Quotas .......................................... 155 156 159 159 161 162 163 Japanese Auto Restraints Put Brakes on U.S. Motorists ...................................... 164 Domestic Content Requirements .................. 165 Subsidies ................................................. 166 Domestic Production Subsidy ................... 166 How “Foreign” Is Your Car? .................... 168 Export Subsidy ..................................... 169 Dumping ................................................ 170 Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. 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Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. viii Contents Forms of Dumping ................................ 170 International Price Discrimination ............ 170 Antidumping Regulations ........................... 173 Smith Corona Finds Antidumping Victories Are Hollow .............................. 174 Canadians Press Washington Apple Producers for Level Playing Field .............. 174 Swimming Upstream: The Case of Vietnamese Catfish ................................ 175 Is Antidumping Law Unfair? ....................... 176 Should Average Variable Cost Be the Yardstick for Defining Dumping? .............. 176 CHAPTER Should Antidumping Law Reflect Currency Fluctuations? ........................................ 177 Are Antidumping Duties Overused? ........... 178 Other Nontariff Trade Barriers .................... 178 Government Procurement Policies ............. 179 U.S. Fiscal Stimulus and Buy American Legislation ........................................... 180 Social Regulations .................................. 180 Sea Transport and Freight Regulations ....... 182 Summary ................................................ 183 Key Concepts & Terms .............................. 184 Study Questions ....................................... 184 6 Trade Regulations and Industrial Policies .......................................... 187 U.S. Tariff Policies Before 1930 .................... 187 Smoot-Hawley Act .................................... 188 Reciprocal Trade Agreements Act ................. 190 General Agreement on Tariffs and Trade ....... 190 Trade Without Discrimination ................. 191 Promoting Freer Trade ........................... 192 Predictability: Through Binding and Transparency ................................. 193 Multilateral Trade Negotiations ................ 193 World Trade Organization .......................... 195 Settling Trade Disputes ........................... 196 Does the WTO Reduce National Sovereignty? ......................................... 197 Should Retaliatory Tariffs Be Used for WTO Enforcement? ............................... 198 Does the WTO Harm the Environment? ....................................... 199 Burning Rubber: Obama’s Tire Tariff Ignites Chinese Officials ......................... 201 From Doha To Hong Kong: Failed Trade Negotiations ............................................ 202 Trade Promotion Authority (Fast-Track Authority) ............................... 203 Safeguards (The Escape Clause): Emergency Protection From Imports ............................ 203 U.S. Safeguards Limit Surging Imports of Textiles from China ............................ Countervailing Duties: Protection Against Foreign Export Subsidies ............................ Lumber Duties Hammer Home Buyers ....... Antidumping Duties: Protection Against Foreign Dumping ..................................... Remedies Against Dumped and Subsidized Imports ................................ U.S. Steel Companies Lose an Unfair Trade Case and Still Win ........................ Section 301: Protection Against Unfair Trading Practices ...................................... Protection of Intellectual Property Rights ....... Trade Adjustment Assistance ....................... Will Wage and Health Insurance Make Free Trade More Acceptable to Workers? ............. Industrial Policies of the United States ........... Export Promotion and Financing .............. Industrial Policies of Japan .......................... Strategic Trade Policy ................................ Economic Sanctions .................................. Factors Influencing the Success of Sanctions ......................................... 205 206 207 207 209 211 212 213 215 216 218 219 220 221 223 225 Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Contents Economic Sanctions and Weapons of Mass Destruction: North Korea and Iran ............ 225 Do Automaker Subsidies Weaken the WTO? ............................................ 227 CHAPTER ix Summary ................................................ 227 Key Concepts & Terms .............................. 228 Study Questions ....................................... 229 7 Trade Policies for the Developing Nations ......................................... 231 Developing-Nation Trade Characteristics ........ 231 Tensions Between Developing and Advanced Nations .................................................. 233 Trade Problems of the Developing Nations ..... 234 Unstable Export Markets ......................... 234 Falling Commodity Prices Threaten Growth of Exporting Nations ................... 235 Worsening Terms of Trade ...................... 236 Limited Market Access ............................ 238 Agricultural Export Subsidies of Advanced Nations ................................. 240 Stabilizing Primary-Product Prices ................ 241 Production and Export Controls ................ 241 Buffer Stocks ........................................ 242 Multilateral Contracts ............................ 243 Does the Fair-Trade Movement Help Poor Coffee Farmers? ............................. 244 The Opec Oil Cartel .................................. 245 Maximizing Cartel Profits ....................... 245 OPEC as a Cartel .................................. 247 Are International Labor Standards Needed to Prevent Social Dumping? ........ 248 Aiding the Developing Nations .................... 249 The World Bank ................................... 249 International Monetary Fund ................... 251 Generalized System of Preferences ............. 252 CHAPTER Does Aid Promote Growth of Developing Nations? ............................... 253 How to Bring Developing Nations in From the Cold ...................................... 253 Economic Growth Strategies: Import Substitution Versus Export-Led Growth ................................................... 255 Import Substitution ............................... 255 Import-Substitution Laws Backfire on Brazil ............................................. 256 Export-Led Growth ................................ 257 Is Economic Growth Good for the Poor? ............................................. 259 Can All Developing Nations Achieve Export-Led Growth? ............................... 259 East Asian Economies ................................ 260 Flying-Geese Pattern of Growth ................ 261 China’s Transformation to Capitalism ........... 262 China’s Export Boom Comes at a Cost: How to Make Factories Play Fair .............. 264 Does Foreign Direct Investment Hinder or Help Economic Development? ...................................... 265 India: Breaking Out of the Third World ........ 266 Summary ................................................ 268 Key Concepts & Terms .............................. 269 Study Questions ....................................... 269 8 Regional Trading Arrangements ....................................................... 271 Regional Integration Versus Multilateralism ......................................... 271 Types of Regional Trading Arrangements .......................................... 272 Missing Benefits: The United States Falls Behind on Trade Liberalization ....................................... 274 Impetus for Regionalism ............................. 275 Copyright 2010 Cengage Learning. 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Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. x Contents Effects of a Regional Trading Arrangement ..... 275 Static Effects ........................................ 276 Did the United Kingdom (UK) Gain from Entering the European Union? .................. 278 Dynamic Effects .................................... 278 The European Union ................................. 280 Pursuing Economic Integration ................. 280 French and Dutch Voters Sidetrack Integration .......................................... 282 Agricultural Policy ................................. 283 Economic Costs and Benefits of a Common Currency: The European Monetary Union ...... 286 Optimum Currency Area ........................ 287 Europe as a Suboptimal Currency Area ...... 288 Challenges for the EMU .......................... 289 The Euro, Ten Years Later: How Has It Performed? ....................................... 290 Does the Eurozone Need a Bailout Fund? .... 290 North American Free Trade Agreement ......... 292 CHAPTER NAFTA’s Benefits and Costs for Mexico and Canada ......................................... 293 NAFTA’s Benefits and Costs for the United States ........................................ 294 NAFTA and Trade Diversion: Textiles and Apparel ......................................... 297 Is NAFTA an Optimum Currency Area? ..... 298 From NAFTA to CAFTA ........................... 299 Free Trade Area of the Americas .................. 300 Asia-Pacific Economic Cooperation ............... 302 Transition Economies ................................ 302 The Transition Toward a Market-Oriented Economy ............................................. 303 Russia and the World Trade Organization ........................................ 305 Summary ................................................ 306 Key Concepts & Terms .............................. 307 Study Questions ....................................... 308 9 International Factor Movements and Multinational Enterprises ........... 309 The Multinational Enterprise ....................... 309 Motives for Foreign Direct Investment .......... 311 Demand Factors ................................... 312 Do U.S. Multinationals Exploit Foreign Workers? .................................. 313 Cost Factors ......................................... 314 Supplying Products to Foreign Buyers: Whether to Produce Domestically or Abroad ............................................... 315 Direct Exporting versus Foreign Direct Investment/Licensing .............................. 315 Foreign Direct Investment versus Licensing ............................................. 316 Country Risk Analysis ............................... 318 International Trade Theory and Multinational Enterprise ............................. 319 Japanese Transplants in the U.S. Automobile Industry .................................................. 320 International Joint Ventures ........................ 321 Welfare Effects ...................................... 323 Multinational Enterprises as a Source of Conflict ............................................... 325 Employment ......................................... 325 Technology Transfer ............................... 326 National Sovereignty .............................. 328 Balance of Payments .............................. 329 Transfer Pricing .................................... 329 Does the U.S. Tax Code Send American Jobs Offshore? ...................................... 330 International Labor Mobility: Migration ......... 331 The Effects of Migration ......................... 331 Immigration as an Issue ......................... 334 Does U.S. Immigration Policy Harm Domestic Workers? ................................ 336 Do Immigrants Really Hurt American Workers’ Wages? ................................... 337 Summary ................................................ 337 Key Concepts & Terms .............................. 338 Study Questions ....................................... 338 Copyright 2010 Cengage Learning. 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Contents PART 2: International Monetary Relations CHAPTER xi 341 10 The Balance of Payments ................................................................. 343 Double-Entry Accounting ........................... 343 International Payments Process ............... 345 Balance-of-Payments Structure ..................... 346 Current Account ................................... 346 Capital and Financial Account ................. 347 Statistical Discrepancy: Errors and Omissions ...................................... 349 U.S. Balance of Payments ........................... 350 The Paradox of Capital Flows from Developing to Industrial Countries ............................................. 352 What Does a Current Account Deficit (Surplus) Mean? ....................................... 354 Net Foreign Investment and the Current Account Balance ................................... 354 Impact of Capital Flows on the Current Account ................................... 355 CHAPTER Is a Current Account Deficit a Problem? ..... 356 Business Cycles, Economic Growth, and the Current Account ........................ 357 Economic Downturn of 2007–2009: Effect on Foreign Investment in the United States ............................... 358 How the United States Has Borrowed at Very Low Cost .................................. 359 Do Current Account Deficits Cost Americans Jobs? .................................... 360 Can the United States Continue to Run Current Account Deficits Indefinitely? ........ 361 Balance of International Indebtedness ............ 363 United States as a Debtor Nation .............. 365 Summary ................................................ 365 Key Concepts & Terms .............................. 366 Study Questions ....................................... 366 11 Foreign Exchange ........................................................................... 369 Foreign-Exchange Market ........................... 369 Types of Foreign-Exchange Transactions ............................................ 371 Interbank Trading ..................................... 373 Reading Foreign-Exchange Quotations ........... 375 Forward and Futures Markets ...................... 377 Foreign-Currency Options .......................... 379 Exchange-Rate Determination ...................... 380 Demand for Foreign Exchange .................. 380 Weak Dollar Is a Bonanza for European Tourists ................................. 381 Supply of Foreign Exchange ..................... 381 Equilibrium Rate of Exchange .................. 382 Indexes of the Foreign-Exchange Value of the Dollar: Nominal and Real Exchange Rates ........................................ 383 Arbitrage ................................................ 385 The Forward Market ................................. 387 The Forward Rate ................................. 387 Relation Between the Forward Rate and Spot Rate ...................................... 388 Managing Your Foreign Exchange Risk: Forward Foreign-Exchange Contract .......... 389 How Markel Rides Foreign-Exchange Fluctuations ......................................... 391 Volkswagen Hedges Against Foreign-Exchange Risk ............................ 392 Does Foreign-Currency Hedging Pay Off? .............................................. 392 Exchange-Rate Risk: The Hazard of Investing Abroad .................................. 394 Interest Arbitrage ...................................... 394 Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. xii Contents Uncovered Interest Arbitrage .................... 395 Covered Interest Arbitrage ....................... 396 Foreign-Exchange Market Speculation ........... 397 How to Play the Falling (Rising) Dollar ................................................. 399 Foreign Exchange Trading as a Career .................................................. 399 CHAPTER Foreign Exchange Traders Hired by Commercial Banks, Companies, and Central Banks ................................ Currency Markets Draw Day Traders ........ Summary ................................................ Key Concepts & Terms .............................. Study Questions ....................................... 400 400 401 402 402 12 Exchange-Rate Determination .......................................................... 405 What Determines Exchange Rates? ............... 405 Determining Long-Term Exchange Rates ....... 407 Relative Price Levels ............................... 408 Relative Productivity Levels ...................... 408 Preferences for Domestic or Foreign Goods ................................................. 408 Trade Barriers ...................................... 410 Inflation Rates, Purchasing Power Parity, and Long-Term Exchange Rates ................... 410 Law of One Price .................................. 410 The “Big Mac” Index and the Law of One Price ............................................ 411 Purchasing Power Parity ......................... 412 Determining Short-Term Exchange Rates: The Asset-Market Approach ........................ 415 Inflation Differentials and the Exchange Rate ...................................... 416 Relative Levels of Interest Rates ................ 417 Expected Change in the Exchange Rate ....... 420 CHAPTER Diversification, Safe Havens, and Investment Flows .................................. 421 The Ups and Downs of the Dollar ................ 421 The 1980s ............................................ 421 The 1990s ............................................ 422 The First Decade of the 2000s .................. 423 Exchange-Rate Overshooting ....................... 423 Forecasting Foreign-Exchange Rates .............. 425 Judgmental Forecasts .............................. 426 Technical Forecasts ................................ 426 Fundamental Analysis ............................ 428 International Comparisons of GDP: Purchasing Power Parity ......................... 429 Comercial Mexicana Gets Burned By Speculation ..................................... 430 Summary ................................................ 430 Key Concepts & Terms .............................. 431 Study Questions ....................................... 431 13 Mechanisms of International Adjustment .......................................... 433 Price Adjustments ..................................... Gold Standard ...................................... Quantity Theory of Money ...................... Current-Account Adjustment ................... Financial Flows and Interest-Rate Differentials ............................................. Income Adjustments .................................. 434 434 434 435 436 438 Disadvantages of Automatic Adjustment Mechanisms ............................................ Monetary Adjustments ............................... Summary ................................................ Key Concepts & Terms .............................. Study Questions ....................................... 439 439 440 440 440 Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Contents CHAPTER xiii 14 Exchange-Rate Adjustments and the Balance of Payments ................. 441 Effects of Exchange-Rate Changes on Costs and Prices ....................................... 441 Japanese Firms Outsource Production to Limit Effects of Strong Yen ................. 444 Cost-Cutting Strategies of Manufacturers in Response to Currency Appreciation .............. 445 Appreciation of the Yen: Japanese Manufacturers ...................................... 445 Appreciation of the Dollar: U.S. Manufacturers ...................................... 447 Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach .......... 447 J-Curve Effect: Time Path of Depreciation ...... 451 Exchange Rate Pass-Through ....................... 453 CHAPTER Partial Exchange Rate Pass-Through .......... 453 Invoice Practices ................................... 454 Market Share Considerations ................... 454 Distribution Costs ................................. 455 Why a Dollar Depreciation May Not Close the U.S. Trade Deficit ..................... 456 The Absorption Approach to Currency Depreciation ............................................ 456 The Monetary Approach to Currency Depreciation ............................................ 458 Summary ................................................ 458 Key Concepts & Terms .............................. 459 Study Questions ....................................... 459 15 Exchange-Rate Systems and Currency Crises ..................................... 461 Exchange-Rate Practices ............................. 461 Choosing an Exchange Rate System: Constraints Imposed by Free Capital Flows .................... 462 Fixed Exchange-Rate System ....................... 464 Use of Fixed Exchange Rates .................... 464 Par Value and Official Exchange Rate ........ 465 Exchange-Rate Stabilization ..................... 466 Devaluation and Revaluation ................... 467 Bretton Woods System of Fixed Exchange Rates ..................................... 469 Is China a Currency Manipulator? ........................................ 470 Floating Exchange Rates ............................. 471 Achieving Market Equilibrium .................. 471 Trade Restrictions, Jobs, and Floating Exchange Rates ..................................... 473 Arguments for and Against Floating Rates ...................................... 473 Managed Floating Rates ............................. 474 Managed Floating Rates in the Short and Long Terms ................................... 475 Exchange-Rate Stabilization and Monetary Policy .................................... 476 Is Exchange-Rate Stabilization Effective? ..... 478 The Crawling Peg ..................................... 479 Currency Crises ........................................ 480 Sources of Currency Crises ....................... 482 Speculators Attack East Asian Currencies .... 484 Capital Controls ....................................... 484 Should Foreign-Exchange Transactions Be Taxed? ........................................... 485 Increasing the Credibility of Fixed Exchange Rates ........................................ 486 Currency Board .................................... 487 For Argentina, No Panacea in a Currency Board .................................... 489 Dollarization ........................................ 489 The Global Economic Crisis of 2007–2009 ........................................... 492 Summary ................................................ 493 Key Concepts & Terms .............................. 494 Study Questions ....................................... 494 Copyright 2010 Cengage Learning. 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Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. xiv Contents CHAPTER 16 Macroeconomic Policy in an Open Economy ..................................... 495 Economic Objectives of Nations ................... 495 Policy Instruments .................................... 496 Aggregate Demand and Aggregate Supply: A Brief Review ......................................... 496 Monetary and Fiscal Policy Respond to Financial Turmoil in the Economy ............ 497 Monetary and Fiscal Policy in a Closed Economy ....................................... 498 Monetary and Fiscal Policy in an Open Economy ........................................ 500 Does Crowding Occur in an Open Economy? .................................... 501 Effect of Fiscal and Monetary Policy Under Fixed Exchange Rates ............................. 502 Effect of Fiscal and Monetary Policy Under Floating Exchange Rates ......................... 503 CHAPTER Macroeconomic Stability and the Current Account: Policy Agreement Versus Policy Conflict ......................................... 504 Inflation With Unemployment ..................... 505 International Economic-Policy Coordination ........................................... 506 G-20 Agrees to Cooperate on Global Economic Policy: International Policy Coordination ........................................ 507 Policy Coordination in Theory .................. 508 Does Policy Coordination Work? ............... 509 Summary ................................................ 510 Key Concepts & Terms .............................. 511 Study Questions ....................................... 511 17 International Banking: Reserves, Debt, and Risk ................................. 513 Nature of International Reserves .................. 513 Demand for International Reserves ............... 514 Exchange-Rate Flexibility ........................ 514 Other Determinants ............................... 516 Supply of International Reserves ................... 517 Foreign Currencies .................................... 517 Should SDRs Replace the Dollar as the World’s Reserve Currency? ................ 518 Gold ...................................................... 521 International Gold Standard .................... 521 Gold Exchange Standard ......................... 522 Demonetization of Gold .......................... 523 Special Drawing Rights .............................. 524 Facilities for Borrowing Reserves .................. 524 IMF Drawings ...................................... General Arrangements to Borrow .............. Swap Arrangements ............................... International Lending Risk .......................... The Problem of International Debt ............... Dealing with Debt-Servicing Difficulties ........................................... Reducing Bank Exposure to DevelopingNation Debt ............................................ Debt Reduction and Debt Forgiveness ........... The Eurodollar Market ............................... Summary ................................................ Key Concepts & Terms .............................. Study Questions ....................................... 525 525 526 526 527 528 529 530 531 532 532 533 Glossary .................................................................................... 535 Index ........................................................................................ 547 Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Preface My belief is that the best way to motivate students to learn a subject is to demonstrate how it is used in practice. The first twelve editions of International Economics reflected this belief and were written to provide a serious presentation of international economic theory with an emphasis on current applications. Adopters of these editions strongly supported the integration of economic theory with current events. The thirteenth edition has been revised with an eye toward improving this presentation and updating the applications as well as toward including the latest theoretical developments. Like its predecessors, this edition is intended for use in a one-quarter or one-semester course for students who have no more of a background than the principles of economics. This book’s strengths are its clarity, organization, and applications, which demonstrate the usefulness of theory to students. The revised and updated material in this edition emphasizes current applications of economic theory and incorporates recent theoretical and policy developments in international trade and finance. International Economics Themes This edition highlights six current themes that are at the forefront of international economics: • • The Global Economic Downturn of 2007–2009 • Anatomy of the economic crisis—Ch. 1 • Trade protectionism intensifies as economies fall into recession—Ch. 4 • U.S. fiscal stimulus and “Buy American” legislation—Ch. 5 • Do government subsidies to automakers weaken the World Trade Organization?—Ch. 6 • Falling commodity prices squeeze the economies of developing nations—Ch. 7 • Does the U.S. tax code send American jobs offshore?—Ch. 9 • The paradox of capital flows from developing countries to advanced countries—Ch. 10 Globalization of economic activity • Waves of globalization—Ch. 1 • Has globalization gone too far?—Ch. 1 • Putting the H-P Pavilion together—Ch. 1 • Soaring transportation costs hinder globalization—Ch. 3 • Constraints imposed by capital flows on the choice of an exchange rate system—Ch. 15 xv Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. xvi Preface • • • • Free trade and the quality of life issues • Does the principle of comparative advantage apply in the face of job outsourcing?—Ch. 2 • Boeing outsources work, but protects its secrets—Ch. 2 • Does trade make the poor even poorer?—Ch. 3 • Does wage insurance make free trade more acceptable to workers?—Ch. 6 • The environment and free trade—Ch. 6 Trade conflicts between developing and advanced nations • Is international trade a substitute for migration?—Ch. 3 • Economic growth strategies—import substitution versus export-led growth—Ch. 7 • Does foreign aid promote the growth of developing countries?—Ch. 7 • How to bring developing countries in from the cold—Ch. 7 • The Doha Round of multilateral trade negotiations—Ch. 6 • China’s export boom comes at a cost: how to make factories play fair—Ch. 7 • Do U.S. multinationals exploit foreign workers?—Ch. 9 Liberalizing trade: the WTO versus regional trading arrangements • Does the WTO reduce national sovereignty?—Ch. 6 • Regional integration versus multilateralism—Ch. 8 • Is Europe really a common market?—Ch. 8 • French and Dutch Voters Sidetrack European Integration—Ch. 8 • From NAFTA to CAFTA—Ch. 8 • Will the Euro Fail?—Ch. 8 The dollar as a reserve currency • Paradox of foreign debt: how the United states has borrowed without cost—Ch. 10 • Why a dollar depreciation may not close the U.S. trade deficit—Ch. 14 • Preventing currency crises: currency boards versus dollarization—Ch. 15 • China lets Yuan rise against dollar—Ch. 15 • Should the Special Drawing Right replace the dollar as the world’s reserve currency?—Ch. 17 Besides emphasizing current economic themes, the thirteenth edition of this text contains many new contemporary topics such as outsourcing and the U.S. auto industry, U.S. safeguards limit imports of textiles from China, bailout fund for the Eurozone, bike imports force Schwinn to downshift, and currency markets draw day traders. Faculty and students will appreciate how this edition provides a contemporary approach to international economics. Organizational Framework: Exploring Further Sections Although instructors generally agree on the basic content of an international economics course, opinions vary widely about which arrangement of material is appropriate. This book is structured to provide considerable organizational flexibility. The topic of international trade relations is presented before international monetary relations, but the order can be reversed by instructors who choose to start with monetary theory. Instructors can begin with Chapters 10–17 and conclude with Chapters 2–9. Those who do not wish to cover all the material in the book can easily omit all or parts of Chapters 6–9 and Chapter 13, and Chapters 15–17 without loss of continuity. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Preface xvii The thirteenth edition streamlines its presentation of theory so as to provide greater flexibility for instructors. This edition uses online Exploring Further sections to discuss more advanced topics: They can be found at www.cengage.com/ economics/Carbaugh. By locating the Exploring Further sections online rather than in the textbook, as occurred in previous editions, more textbook coverage can be devoted to contemporary applications of theory. The Exploring Further sections consist of the following: • • • • • • • • • • • • • • • • • Comparative advantage in money terms—Ch. 2 Indifference curves and trade—Ch. 2 Offer curves and the equilibrium terms of trade—Ch. 2 The specific-factors theory—Ch. 3 WTO Makes Ruling on Boeing-Airbus Aircraft Subsidy Dispute—Ch. 3 Offer curves and tariffs—Ch. 4 Tariff-rate quota welfare effects—Ch. 5 Export quota welfare effects—Ch. 5 Welfare effects of strategic trade policy—Ch. 6 Government procurement policy and the European Union—Ch. 8 Economies of scale and NAFTA—Ch. 8 Can the Euro Survive?—Ch. 8 Techniques of foreign-exchange market speculation—Ch. 11 A primer on foreign-exchange trading—Ch. 11 Fundamental forecasting—regression analysis—Ch. 12 Income adjustment mechanism—Ch. 13 Exchange rate pass-through—Ch. 14 Supplementary Materials International Economics Web Site (www.cengage.com/economics/Carbaugh) In this age of technology, no text package would be complete without Web-based resources. An international economics website is offered with the thirteenth edition. This site, www.cengage.com/economics/Carbaugh, contains many useful pedagogical enrichment features including NetLink Exercises, which draw upon the expanded NetLinks feature at the end of each chapter. While the NetLinks direct the student to an appropriate international economics website to gather data and other relevant information, the NetLink Exercises allow students to access these Web sites to answer pertinent and practical questions that relate to international economics. As an added enrichment feature, a Virtual Scavenger Hunt engages and encourages students to search for international economics answers at various Internet Web sites. PowerPoint Slides The thirteenth edition also includes PowerPoint slides created by Andreea Chiritescu of Eastern Illinois University. These slides can be easily downloaded from the Carbaugh Web site (www.cengage.com/economics/Carbaugh). The slides offer professors flexibility in enhancing classroom lectures. Slides may be edited to meet individual needs. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. xviii Preface Instructor’s Manual To assist instructors in the teaching of international economics, I have written an Instructor’s Manual with Test Bank that accompanies the thirteenth edition. It contains: (1) brief answers to end-of-chapter study questions; (2) multiple-choice questions for each chapter; and (3) true-false questions for each chapter. The Instructor’s Manual with Test Bank is available for download for qualified instructors from the Carbaugh Web site (www.cengage.com/economics/Carbaugh). Study Guide To accompany the thirteenth edition of the international economics text, Professor Jim Hanson of Willamette University has prepared an online Study Guide for students. This guide reinforces key concepts by providing a review of the text’s main topics and offering practice problems, true-false and multiple-choice questions, and short-answer questions. Acknowledgments I am pleased to acknowledge those who aided me in preparing the current and past editions of this textbook. Helpful suggestions and often detailed reviews were provided by: • • • • • • • • • • • • • • • • • • • • • • • • • • • • Burton Abrams, University of Delaware Richard Adkisson, New Mexico State University Richard Anderson, Texas A&M Brad Andrew, Juniata College Richard Ault, Auburn University Mohsen Bahmani-Oskooee, University of Wisconsin—Milwaukee Kevin Balsam, Hunter College Kelvin Bentley, Baker College Online Robert Blecker, Stanford University Scott Brunger, Maryville College Jeff W. Bruns, Bacone College Roman Cech, Longwood University John Charalambakis, Asbury College Mitch Charkiewicz, Central Connecticut State University Xiujian Chen, California State University, Fullerton Miao Chi, University of Wisconsin—Milwaukee Howard Cochran, Jr., Belmont University Charles Chittle, Bowling Green University Christopher Cornell, Fordham University Elanor Craig, University of Delaware Manjira Datta, Arizona State University Ann Davis, Marist College Firat Demir, University of Oklahoma Gopal Dorai, William Paterson College Veda Doss, Wingate University Seymour Douglas, Emory University G. Rod Erfani, Transylvania University Carolyn Fabian Stumph, Indiana University-Purdue University Fort Wayne Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Preface xix • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • Farideh Farazmand, Lynn University Daniel Falkowski, Canisius College Patrice Franko, Colby College Emanuel Frenkel, University of California—Davis Norman Gharrity, Ohio Wesleyan University Sucharita Ghosh, University of Akron Jean-Ellen Giblin, Fashion Institute of Technology (SUNY) Leka Gjolaj, Baker College Thomas Grennes, North Carolina State University Darrin Gulla, University of Kentucky Li Guoqiang, University of Macau (China) William Hallagan, Washington State University Jim Hanson, Willamette University Bassam Harik, Western Michigan University John Harter, Eastern Kentucky University Seid Hassan, Murray State University Phyllis Herdendorf, Empire State College (SUNY) Pershing Hill, University of Alaska-Anchorage David Hudgins, University of Oklahoma Ralph Husby, University of Illinois-Urbana/Champaign Robert Jerome, James Madison University Mohamad Khalil, Fairmont State College Wahhab Khandker, University of Wisconsin—La Crosse Robin Klay, Hope College William Kleiner, Western Illinois University Anthony Koo, Michigan State University Faik Koray, Louisiana State University Peter Karl Kresl, Bucknell University Fyodor Kushnirsky, Temple University Edhut Lehrer, Northwestern University Jim Levinsohn, University of Michigan Benjamin Liebman, St. Joseph’s University Susan Linz, Michigan State University Andy Liu, Youngstown State University Alyson Ma, University of San Diego Mike Marks, Georgia College School of Business John Muth, Regis University Al Maury, Texas A&I University Jose Mendez, Arizona State University Mary Norris, Southern Illinois University John Olienyk, Colorado State University Shawn Osell, Minnesota State University—Mankato Terutomo Ozawa, Colorado State University Peter Petrick, University of Texas at Dallas Gary Pickersgill, California State University, Fullerton William Phillips, University of South Carolina John Polimeni, Albany College of Pharmacy and Health Sciences Rahim Quazi, Prairie View A&M University Chuck Rambeck, St. John’s University Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. xx Preface • • • • • • • • • • • • • • • • • • • • • • • James Richard, Regis University Daniel Ryan, Temple University Manabu Saeki, Jacksonville State University Nindy Sandhu, Claifornia State University, Fullerton Jeff Sarbaum, University of North Carolina, Greensboro Anthony Scaperlanda, Northern Illinois University Juha Seppälä, University of Illinois Ben Slay, Middlebury College (now at PlanEcon) Gordon Smith, Anderson University Robert Stern, University of Michigan Paul Stock, University of Mary Hardin-Baylor Laurie Strangman, University of Wisconsin—La Crosse Manjuri Talukdar, Northern Illinois University Nalitra Thaiprasert, Ball State University William Urban, University of South Florida Jorge Vidal, The University of Texas Pan American Adis M. Vila, Esq., Winter Park Institute Rollins College Jonathan Warshay, Baker College Darwin Wassink, University of Wisconsin—Eau Claire Peter Wilamoski, Seattle University Harold Williams, Kent State University Chong Xiang, Purdue University Hamid Zangeneh, Widener University I would like to thank my colleagues at Central Washington University—Tim Dittmer, David Hedrick, Koushik Ghosh, Tyler Prante, Peter Saunders, Thomas Tenerelli, Chad Wassell—for their advice and help while I was preparing the manuscript. I am also indebted to Shirley Hood who provided advice in the manuscript’s preparation. It has been a pleasure to work with the staff of South-Western—Mike Worls, Katie Yanos and Lena Mortis—who provided many valuable suggestions and assistance in seeing this edition to its completion. Thanks also go to Jennifer Ziegler and Jean Buttrom, who orchestrated the production of this book in conjunction with Mary Stone, project manager at PreMediaGlobal. I also appreciate the meticulous efforts that Jonathan Moore did in the copyediting of this textbook. Moreover, Keri Witman and Betty Jung did a fine job in advertising and marketing the thirteenth edition. Finally, I am grateful to my students, as well as the faculty and students at other universities, who provided helpful comments on the material contained in this new edition. I would appreciate any comments, corrections, or suggestions that faculty or students wish to make so I can continue to improve this text in the years ahead. Please contact me! Thank you for permitting this text to evolve to a thirteenth edition. Bob Carbaugh Department of Economics Central Washington University Ellensburg, Washington 98926 Phone: (509) 963–3443 Fax: (509) 963–1992 Email: Carbaugh@cwu.edu Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. TheInternationalEconomy and Globalization CHAPTER 1 I n today’s world, no nation exists in economic isolation. All aspects of a nation’s economy—its industries, service sectors, levels of income and employment, and living standard—are linked to the economies of its trading partners. This linkage takes the form of international movements of goods and services, labor, business enterprise, investment funds, and technology. Indeed, national economic policies cannot be formulated without evaluating their probable impacts on the economies of other countries. The high degree of economic interdependence among today’s economies reflects the historical evolution of the world’s economic and political order. At the end of World War II, the United States was economically and politically the most powerful nation in the world, a situation expressed in the saying, “When the United States sneezes, the economies of other nations catch a cold.” But with the passage of time, the U.S. economy has become increasingly integrated into the economic activities of foreign countries. The formation in the 1950s of the European Community (now known as the European Union), the rising importance in the 1960s of multinational corporations, the market power in the 1970s enjoyed by the Organization of Petroleum Exporting Countries (OPEC), and the creation of the euro at the turn of the twenty-first century have all resulted in the evolution of the world community into a complicated system based on a growing interdependence among nations. Recognizing that world economic interdependence is complex and its effects uneven, the economic community has taken steps toward international cooperation. Conferences devoted to global economic issues have explored the avenues through which cooperation could be fostered between industrial and developing nations. The efforts of developing nations to reap larger gains from international trade and to participate more fully in international institutions have been hastened by the impact of the global recession, industrial inflation, and the burdens of high-priced energy. Over the past 50 years, the world’s market economies have become increasingly interdependent. Exports and imports as a share of national output have risen for most industrial nations, while foreign investment and international lending have 1 Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 2 The International Economy and Globalization expanded. This closer linkage of economies can be mutually advantageous for trading nations. It permits producers in each nation to take advantage of the specialization and efficiencies of large scale production. A nation can consume a wider variety of products at a cost less than that which could be achieved in the absence of trade. Despite these advantages, demands have grown for protection against imports. Protectionist pressures have been strongest during periods of rising unemployment caused by economic recession. Moreover, developing nations often maintain that the so-called liberalized trading system called for by industrial nations serves to keep the developing nations in poverty. Economic interdependence also has direct consequences for a student taking an introductory course in international economics. As consumers, we can be affected by changes in the international values of currencies. Should the Japanese yen or British pound appreciate against the U.S. dollar, it would cost us more to purchase Japanese television sets or British automobiles. As investors, we might prefer to purchase Swiss securities if Swiss interest rates rise above U.S. levels. As members of the labor force, we might want to know whether the president plans to protect U.S. steelworkers and autoworkers from foreign competition. In short, economic interdependence has become a complex issue in recent times, often resulting in strong and uneven impacts among nations and among sectors within a given nation. Business, labor, investors, and consumers all feel the repercussions of changing economic conditions and trade policies in other nations. Today’s global economy requires cooperation on an international level to cope with the myriad issues and problems. Globalization of Economic Activity When listening to the news, we often hear about globalization. What does this term mean? Globalization is the process of greater interdependence among countries and their citizens. It consists of the increased interaction of product and resource markets across nations via trade, immigration, and foreign investment—that is, via international flows of goods and services, of people, and of investments in equipment, factories, stocks, and bonds. It also includes non-economic elements such as culture and the environment. Simply put, globalization is political, technological, and cultural, as well as economic. In terms of people’s daily lives, globalization means that the residents of one country are more likely now than they were 50 years ago to consume the products of another country, to invest in another country, to earn income from other countries, to talk by telephone to people in other countries, to visit other countries, to know that they are being affected by economic developments in other countries, and to know about developments in other countries. What forces are driving globalization?1 The first and perhaps most profound influence is technological change. Since the industrial revolution of the late 1700s, technical innovations have led to an explosion in productivity and slashed transportation costs. The steam engine preceded the arrival of railways and the mechanization of a growing number of activities hitherto reliant on muscle power. Later discoveries 1 World Trade Organization, Annual Report, 1998, pp. 33–36. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 1 3 and inventions such as electricity, the telephone, the automobile, container ships, and pipelines altered production, communication, and transportation in ways unimagined by earlier generations. More recently, rapid developments in computer information and communications technology have further shrunk the influence of time and geography on the capacity of individuals and enterprises to interact and transact around the world. For services, the rise of the Internet has been a major factor in falling communication costs and increased trade. As technical progress has extended the scope of what can be produced and where it can be produced, and advances in transport technology have continued to bring people and enterprises closer together, the boundary of tradable goods and services has been greatly extended. Also, continuing liberalization of trade and investment has resulted from multilateral trade negotiations. For example, tariffs in industrial countries have come down from high double digits in the 1940s to about five percent in the early 2000s. At the same time, most quotas on trade, except for those imposed for health, safety, or other public policy reasons, have been removed. Globalization has also been promoted through the widespread liberalization of investment transactions and the development of international financial markets. These factors have facilitated international trade through the greater availability and affordability of financing. Lower trade barriers and financial liberalization have allowed more and more companies to globalize production structures through investment abroad, which in turn has provided a further stimulus to trade. On the technology side, increased information flows and the greater tradability of goods and services have profoundly influenced production location decisions. Businesses are increasingly able to locate different components of their production processes in various countries and regions and still maintain a single corporate identity. As firms subcontract part of their production processes to their affiliates or other enterprises abroad, they transfer jobs, technologies, capital, and skills around the globe. How significant is production sharing in world trade? Researchers have estimated production sharing levels by calculating the share of components and parts in world trade. They have concluded that global production sharing accounts for about 30 percent of the world trade in manufactured goods. Moreover, the trade in components and parts is growing significantly faster than the trade in finished products, highlighting the increasing interdependence of countries through production and trade.2 Waves of Globalization In the past two decades, there has been pronounced global economic interdependence. Economic interdependence occurs through trade, labor migration, and capita...