Elements of International Economics-Springer-Verlag Berlin Heidelberg (2004)

Elements of International Economics
Springer-Verlag Berlin Heidelberg GmbH

Giancarlo Gandolfo
Elements
of International
Economics
With 41 Figures
and 9 Tables
i Springer
Professor Dr. Giancarlo Gandolfo
University of Rome La Sapienza
Faculty of Economics
Via del Castro Laurenziano 9
00161 Roma, Italy
[email protected]
ISBN 978-3-642-05935-3 ISBN 978-3-662-07005-5 (eBook)

DOI 10.1007/978-3-662-07005-5
Bibliographic information published by Die Deutsche Bibliothek

Die Deutsche Bibliothek lists this publication in the Deutsche Nationalbibliografie;
detailed bibliqgraphic data available in the internet at http://dnb.ddb.de
This work is subject to copyright. An rights are reserved, whether the whole or part of the mate-
rial is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recita-
tion, broadcasting, reproduction on microfilm or in any other way, and storage in data banks.
Duplication of this publication or parts thereof is permitted only under the provisions of the
German Copyright Law of September 9, 1965, in its current version, and permission for use must
always be obtained from Springer-Verlag Berlin Heidelberg GmbH.
Violations are liable for prosecution under the German Copyright Law.
springeronline.com
© Springer-Verlag Berlin Heidelberg 2004
Originally published by Springer-Verlag Berlin Heidelberg New York in 2004
Softcover reprint ofthe hardcover lst edition 2004
The use of general descriptive names, registered names, trademarks, etc. in this publication does
not imply, even in the absence of a specific statement, that such names are exempt from the
relevant protective laws and regulations and therefore free for general use.
Cover design: Erich Kirchner, Heidelberg
SPIN 10990643 42/3130 - 5 4 3 210 - Printed on acid-free paper
To the memory of my parents
Edgardo Gandolfo
There Chiarotti
Preface
Modern economies become more and more open and the external sector of an
economy becomes more and more important. This textbook aims at clarify-
ing how an open economy functions, in particular at explaining the determi-
nants of international fiows of commodities and financial assets. It also aims
at examining the effects of these fiows on the domestic and international econ-
omy and the possible policy acti.ons at the national and international level.
Particular attention will be paid to the problems of international economic
integration at both the commercial and monetary level.
Students will be able to read and interpret the balance of payments of
a country, evaluating the various types of balance, to explain the behaviour
of commercial fiows in the light of the theories studied, to analyze fiows of
financial assets according to interest-rate differentials and other elements, to
study the forces that determine exchange rates and cause currency crises,
to understand the reasons behind international economic integration such
as the European Union, to evaluate the effects of national and international
policies.
A peculiarity of this textbook is that it tries to bridge the gap between un-
dergraduate and graduate texts in international economics without being too
bulky. Drawing on my two graduate texts, International Trade Theory and
Policy (Springer Verlag, 1998) and International Finance and Open-Economy
Macroeconomics (Springer Verlag, 2002), I have written a concise textbook,
where the treatment is at a level suitable for undergraduate courses without
sacrificing the topics treated in graduate textbooks (for example, an elemen-
tary introduction to the modern approach to international macroeconomics,
namely the intertemporal approach, is given).
I am grateful to Marianna Belloc, Andrea Bubula, Giuseppe De Arcange-
lis, Daniela Federici, Alberto Felettigh, Michael D. Goldberg, Lelio Iapadre,
Manuela Nenna, Francesca Sanna Randaccio for useful comments on earlier
drafts. The boxed inserts that now and then appear in the text have been
mainly prepared by Daniela Federici and partly by Manuela Nenna.
The University of Rome "La Sapienza" provided the ideal environment for
the development and testing of the material contained in this book: I have,
in fact, used it both for courses given in English to undergraduate students
coming from all parts of Europe under the Socrates/Erasmus programme,
VII
VIII
and for courses given to Italian undergraduates in the Faculty of Economics.

None of the persons and institutions mentioned has any responsibility for
possible deficiencies that might remain.
Giancarlo Gandolfo (http://gandolfo.org)

University of Rome 1 "La Sapienza", February 2004
Contents
1 Introduction 1
1.1 International Economics as a DistinctSubject 1
1.2 Structure of the Book . . . . . . . . . . . . . . 3
1.2.1 International Finance . . . . . . . . . . 3
1.2.2 The Theory and Policy of International Trade 4
1.2.3 Small and Large Open Economies . . . . . . . 5
I The Basics 7
2 The Foreign Exchange Market 9
2.1 Introduction: The Exchange Rate 9
2.1.1 The Real Exchange Rate. 11
2.1.2 The Effective Exchange Rate 13
2.2 The Spot Exchange Market .. 14
2.3 The Forward Exchange Market .. . 17
2.3.1 Introduction . . . . . . . . . . 17
2.3.2 Various Covering Alternatives; Forward Premium and
Discount . . . . . . . . . . . . . . . . . . . 19
2.4 The Transactors in the Foreign Exchange Market 22
2.4.1 Speculators . . . . . . 23
2.4.2 Non-Speculators.... 24
2.4.3 Monetary Authorities . 24
2.5 Currency Derivatives 24
2.5.1 Futures . . . . . . 25
2.5.2 Options . . . . . . 26
2.5.3 Swap Transactions 27
2.6 Eurodollars and Xeno-Currencies 29
2.7 Selected Further Reading . . . . . 30
3 Exchange-Rate Regimes and the International Monetary

System 31
3.1 The Two Extremes . . . . . 31
3.2 The Bretton Woods System 32
IX
X Contents
3.2.1 The Monetary Authorities' Intervention 33

3.3 Other Limited-Flexibility Systems . . . . . . . . 35
3.4 The Curreilt Nonsystem . . . . . . . . . . . . . 36
3.5 Key Events in the Postwar International Monetary System 38
3.5.1 Collapse of Bretton Woods. 38
3.5.2 Petrodollars....... 41
3.5.3 Demonetization of Gold .. 41
3.5.4 EMS and EMU. . . . . . . 43
3.5.5 The International Debt Crisis 43
3.5.6 The Asian and Other Crises 43
3.6 International Organisations 43
3.6.1 The IMF. . . . . 43
3.6.2 The World Bank .. 45
3.6.3 GATT and WTO . . 46
3.6.4 The Bank for International Settlements. 47
3.7 Suggested Further Reading. . . . . . . . . . . . 48
4 International Interest-Rate Parity Conditions 49

4.1 Covered Interest Parity (CIP) . . . . . . . . . 49
4.2 Uncovered Interest Parity (DIP) . . . . . . . . 51
4.3 Uncovered Interest Parity with Risk Premium 52
4.4 Real Interest Parity . . . . . . . . . . . . . . . 52
4.5 Efficiency of the Foreign Exchange Market . . 53
4.6 Perfeet Capital Mobility, Perfect Asset Substitutability, and
Interest Parity Conditions . 54
4.7 Suggested Further Reading . . . . . . . . . . . . . . . . . . .. 56
5 The Balance of Payments 57

5.1 Balance-of-Payments Accounting and Presentation . 57
5.1.1 Introduction........ 57
5.1.2 Standard Components . . . . . . . . . . 59
5.1.2.1 Current Account . . . . . . . . 59
5.1.2.2 Capital and Financial Account 60
5.2 The Meaning of Surplus, Deficit, and Equilibrium in the
Balance of Payments . . . . . . . . . . . 63
5.3 Some Important Accounting Relations 65
5.4 Suggested Further Reading. . . . . . . . 70
11 International Finance and Open-Economy

Macroeconomics 71
6 The Basic Models: Elasticities, Multiplier, Mundell-Fleming 73
6.1 The Elasticity Approach . . . . . . . . . . . . . . . . . . . .. 73
Contents XI
6.1.1 Critical Elasticities and the Marshall-Lerner Condition 74

6.2 The Multiplier Approach . . . . . . . . . 78
6.2.1 Balance-of-Payments Adjustment 81
6.3 Elasticities and Multipliers. . 84
6.4 The Mundell-Fleming Model. . . . . . . 85
6.4.1 Fixed Exchange Rates . . . . . . 85
6.4.1.1 Graphie Representation of the Equilibrium
Conditions . . . . . . . . . . . . . . . . . . . 86
6.4.1.2 Simultaneous Real, Monetary and External
Equilibrium; Stability .. . . 90
6.4.2 Flexible Exchange Rates . . . . . . . . 93
6.4.3 Capital Mobility and Economic Policy 95
6.4.4 Some Observations on the Model 98
6.5 Suggested Further Reading. . . . . . . . . 99
7 The Monetary and Portfolio Approaches 101

7.1 The Monetary Approach. . . . . . . . . . . 101
7.1.1 The Basic Propositions and Implications . 102
7.1.2 A Simple Model . . . . 104
7.1.3 Concluding Remarks . . . . 105
7.2 The Portfolio Approach . . . . . . 106
7.2.1 AGraphie Representation . 108
7.2.2 Monetary Policy, Port folio Equilibrium, and Capital
Flows . . . . . . . . 110
7.3 Suggested Further Reading. . . . . . . . . . . . . . . . . 111
8 Capital Movements, Speculation, and Currency Crises 113

8.1 Long-Term Capital Movements . . . . . . . . . . . . . 113
8.1.1 Multinational Enterprises and Foreign Direct
Investment. . . . . . . . . . . . . . . . . . . . 115
8.2 Short-Term Capital Movements and Foreign Exchange
Speculation . . . . . . . . . . . . . . . . . . . . . 116
8.2.1 Flexible Exchange Rates and Speculation . 118
8.3 Speculative Attacks and Currency Crises 119
8.3.1 The Bipolar View . . . 123
8.4 Suggested Further Reading. . . 124
9 Exchange-Rate Determination 125

9.1 The Purchasing-Power-Parity Theory . . . . . . . . . . . . . . 125
9.2 The Traditional Flow Approach . . . . . . . . . . . . . . .. 127
9.3 The Modern Approach: Money and Assets in Exchange-Rate
Determination . . . . . . . . . 128
9.3.1 Introductory Remarks . 128
9.3.2 The Monetary Approach . 129
XII Contents
9.3.2.1 Sticky Prices, Rational Expectations, and

Overshooting of the Exchange-Rate . . . . . . 130
9.3.3 The Portfolio Approach . . . . . . . . . . . . . . . . . 131
9.3.3.1 Interaction Between Current and Capital
Accounts . . . . . . . . . . . . . . 132
9.4 The Exchange Rate in Macroeconometric Models . 134
9.5 Fixed Vs Flexible Exchange Rates. . 138
9.5.1 The Traditional Arguments .. . 138
9.5.2 The Modern View. . . . . . . . . 141
9.5.2.1 Money Demand Shock . 141
9.5.2.2 Aggregate Demand Shock . 142
9.5.2.3 Aggregat«;! Supply Shock . . 142
9.5.2.4 Conclusion . 143
9.6 Suggested Further Reading. . . . . . . . . . 143
10 The Intertemporal Approach to the Balance of Payments 145

10.1 Introduction: The Absorption Approach . . . . . . . . . . . . 145
10.2 Intertemporal Decisions, the Current Account, and Capital
Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
10.2.1 The Feldstein-Horioka Puzzle . . . . . . . . . . . 152
10.3 Intertemporal Approaches to the Real Exchange Rate. . 153
10.4 Suggested Further Reading . . . . . . . . . . . . . . . . . 154
11 International Monetary Integration and European Monetary

Union 155
11.1 Introduction . . . . . . . . . . . . . . . . . . 155
11.2 The Theory of Optimum Currency Areas . . 156
11.2.1 The Traditional Approach . . 157
11.2.2 The Cost-Benefit Approach . 159
11.2.3 The new Theory . . . . . . . 162
11.2.4 Optimum for whom? . . . . . 163
11.3 The Common Monetary Policy Prerequisite, and the
Inconsistent Triad . . . . . . . . . . 164
11.4 The Single-Currency Problem . . . . . . . 166
11.5 The European Monetary Union . . . . . . . 168
11.5.1 The European Monetary System .. 168
11.5.2 The Maastricht Treaty and the Gradual Approach to
EMU. . . . . . . . . . . . . . . . . . . .170
11.5.3 The Institutional Aspects . . . . . . . . 172
11.5.3.1 The ECB's Monetary Policy . . 174
11.5.4 The Maastricht Criteria . . . . . . . . . 175
11.5.5 The new Theory of Optimum Currency Areas
and EMU. . . . . . . . . .178
11.5.6 The Euro and the Dollar . . . . . . . . . . . . . 180
Contents XIII
11.6 Suggested Further Reading . · 183
12 Problems of the International Monetary System 185

12.1 Introduction . . . . . . . . . . . . . . . . . . . . . · 185
12.2 International Policy Coordination . . . . . . . . . . . . . . . . 186
12.2.1 Policy Optimization, Game Theory, and International
Coordination . . . . . . . . . . . . . . . . . . . . . . . 186
12.2.2 The Problem of the Reference Model and the Obstacles
to Coordination . . . . . . . . . . . 191
12.3 The International Debt Crisis . . . . . . . . . 193
12.4 Growth-Oriented Adjustment Programs . . . · 196
12.5 Proposals for the International Management
of Exchange Rates . . . . . . . . . . . . . . · 199
12.5.1 Introduction . . . . . . . . . . ... . · 199
12.5.2 McKinnon's Global Monetary Objective · 199
12.5.3 John Williamson's Target Zones . .200
12.5.4 The Tobin Tax .. . · 201
12.6 Suggested Further Reading . . . . . . . . .203
III International Trade Theory and Policy 205

13 The Orthodox Theory: Comparative Cost, Factor
Endowments, Demand 207
13.1 Comparative Costs and International Trade: The Ricardian
Theory. . . . . . . . . . . . . . . . 207
13.1.1 AGraphie Representation . . . . . . . . 210
13.2 The Heckscher-Ohlin Model . . . . . . . . . . . 212
13.2.1 Basic Assumptions and their Meaning . 212
13.2.2 Proof of the Fundamental Theorem . 214
13.3 The Neoclassical Theory . . . . . . . . 218
13.3.1 A Digression on Walras' Law ... . 220
13.3.2 International Trade . . . . . . . . . . 221
13.4 Offer Curves and International Equilibrium . . 223
13.5 The Gains from Trade . . . . . . . . . . . . . 225
13.6 The Four Core Theorems . . . . . . . . . . . . 227
13.6.1 The Factor-Price-Equalization Theorem . 227
13.6.2 The Stolper-Samuelson Theorem . . . . . 229
13.6.3 The Rybczynski Theorem . . . . . . . . . 230
13.7 International Factor Mobility and Trade in Factors . 232
13.8 The Specific Factors Model. . 233
13.9 Suggested Further Reading. . . . . . . . . . . . . . . 235
XIV Contents
14 Tariffs, and Non-Tariff Barriers 237

14.1 Introduction . . . . . . . . . .237
14.2 Effects of a Tariff . . . . . . . . .238
14.3 The Social Costs of a Tariff .. .240
14.4 Quotas and Other Non-Tariff Barriers . .242
14.4.1 Quotas . . . . . . . . . . . . . . .243
14.4.2 International Cartels . . . . . . .245
14.4.3 Other Impediments to Free Trade .250
14.5 Suggested Further Reading . . . . . . . . .252
15 Free Trade vs Protection, and Preferential Trade

Cooperation 253
15.1 The Optimum Tariff .253
15.2 The Infant Industry . .255
15.3 Distortions . . . . . . .256
15.4 The Theory of Second Best .257
15.5 Preferential Trading Cooperation .259
15.5.1 The Various Degrees of Cooperation .259
15.5.2 The Effects of a Customs Union . . . .260
15.5.3 How can we Measure the Effects of Integration? . 263
15.6 The Main Cases of Preferential Trading Cooperation. . 264
15.6.1 The European Common Market (now European Union) 264
15.6.2 NAFTA . . . . 264
15.6.3 MERCOSUR . 265
15.6.4 ASEAN . . . . 265
15.6.5 FTAA . . . . . 266
15.7 Suggested Further Reading . . 266
16 The new Protectionism 267

16.1 Why the new Protectionism? . . . . . . . . . . . . . 267
16.2 Voluntary Export Restraints and Import Expansion . 268
16.3 Subsidies. . . . . . . . . . . . . . . . . . . . . . . . 270
16.4 The Political Economy of Protectionism . . . . . . . 272
16.4.1 The Demand for and Supply of Protection . . 273
16.5 Administered and Contingent Protection, and Fair Trade . 275
16.5.1 Dumping and Antidumping . 277
16.5.2 Countervailing Duty . 280
16.5.3 Safeguard Actions. . . 280
16.6 Suggested Further Reading . . 282
17 The new Theories of International Trade 283

17.1 Introduction . . . . . . . . . . . . . 283
17.2 Classification of the new Theories . 286
17.3 Precursors . . . . . . . . . . . . . . 288
Contents xv
17.3.1 Availability . . . . .288
17.3.2 Technology Gaps . .289
17.3.3 The Product Cycle .290
17.3.4 Income Effects: Linder's Theory . . 291
17.3.5 Intra-industry Trade: First Explanations .292
17.4 Neo-Heckscher-Ohlin Theories . . . . . . . . . . .295
17.5 Monopolistic Competition and International Trade .297
17.6 Oligopoly and International Trade . .299
17.6.1 Introduction . . . . . . . . . . . .299
17.6.2 Homogeneous Commodities .. .300
17.6.3 Vertically Differentiated Goods .302
17.6.4 Horizontally Differentiated Goods .303
17.7 Strategie Trade Policy . . . .305
17.8 Suggested Further Reading . . . . . . . . . .307
18 Growth, Trade, Globalization 309

18.1 Endogenous Growth and International Trade . . . . . . . . . . 309
18.1.1 A Small Open Economy with Endogenous Technical
Progress . . . . . . . . . . . . . . . . . . . . . . . 310
18.1.2 Endogenous Growth, North-South Trade and
Imitation: A new Version of the Product Cycle . 312
18.2 Globalization and the new Economic Geography . . . . . 315
18.2.1 Transport Cost, Location Theory, and Comparative
Advantage . . . . . . . . . . . . . . . . . . . . . . 316
18.2.2 Economic Geography, Globalization, and Trade . 318
18.3 Suggested Further Reading . . . . . . . . . . . . . . . . 321
Index 323
List of Figures 337
List of Tables 339
List of Boxes 341

Chapter 1
Introduction
1.1 International Economics as a Distinct

Subject
While several specialistic fields of economics have been developed as distinct
branches of general economic theory only in relatively recent times, the pres-
ence of a specific treatment of the theory of international economic transac-
tions is an old and consolidated tradition in the economic literature. Various
reasons can be advanced to explain the need for this specific treatment, but
the main ones are the following.
The first is that factors of production are generally less mobile between
countries than within a single country. Traditionally, this observation has
been taken as a starting point for the development of a theory of interna-
tional trade based on the extreme assumption of perfect national mobility and
perfect international immobility of the factors of production, accompanied
by the assumption of perfect mobility (both within and between countries )
of the commodities produced, exception being made for possible restrictive
measures on the part of governments.
The second is the fact that the mere presence of different countries as
distinct political entities each with its own frontiers gives rise to aseries of
problems which do not occur in general economics, such as the levying of
duties and other impediments to trade, the existence of different national
currencies whose relative prices (the exchange rates) possibly vary through
time, etcetera.
Aß in any other discipline, also in international economics we can distin-
guish a theoretical and a descriptive part. The former is further divided into
the theory 0/ international trade and international monetary economics. All
these distinctions are of a logical and pedagogical nature, but of course both
the descriptive and the theoretical part, both the trade and the monetary
branch, are necessary for an understanding of the international economic
relations in the real world.
1
2 Chapter 1. Introduction
The descriptive part, as the name clearly shows, is concerned with the
description of international economic transactions just as they happen and
of the institutional context in which they take place: flows of goods and
financial assets, international agreements, international organizations like the
International Monetary FUnd, the World 'Irade Organization, the European
Union, and so forth.
The theoretical part tries to go beyond the phenomena to seek general
principles and logical frameworks which can serve as a guide to the under-
standing of actual events (so as, possibly, to influence them through policy
interventions). Like any economic theory, it uses for this purpose abstractions
and models, often expressed in mathematical form. The theoretical part can
be further divided, as we said above, into trade and monetary theory each
containing aspects of both positive and normative economicsj although these
aspects are strictly intertwined in our discipline, they are usually presented
separately for didactic convenience.
A few words are now in order on the distinction between international
trade theory and international finance.
International finance (also called international monetary economics) is
often identified with open-economy macroeconomics or international macroe-
conomics because it deals with the monetary and macroeconomic relations
between countries. Although there are nuances in the meaning of the various
labels, we shall ignore them and take it that our field deals with the problems
deriving from balance-of-payments disequilibria in a monetary economy, and
in particular with the automatie adjustment mechanisms and the adjust-
ment policies concerning the balance of paymentsj with the relationships
between the balance of payments and other macroeconomic variablesj with
the various exchange-rate regimes and exchange-rate determinationj with
international financial markets and the problems of the international mon-
etary systems such as currency crises, debt problems, international policy
coordinationj with international monetary integration such as the European
Monetary Union.
The theory 0/ international trade (which has an essentially microeco-
nomic nature) deals with the causes, the structure and the volume of in-
ternational trade (that is, which goods are exported, which are imported,
and why, by each country, and what is their amount)j with the gains from
international trade and how these gains are distributedj with the determina-
tion of the relative prices of goods in the world economyj with international
specializationj with the effects of tariffs, quotas and other impediments to
tradej with the effects of international trade on the domestic structure of
production and consumptionj with the effects of domestic economic growth
on international trade and vice versaj and so on. The distinctive feature of
the theory of international trade is the assumption that trade takes place in
the form of barter (or that money, if present, is only a veil having no influ-
ence on the underlying real variables but serving only as a reference unit,
1.2. Structure of the Book 3
the numeraire). A by-no-means secondary consequence of this assumption is

that the international accounts of any country vis-a-vis all the others always
balance: that is, no balance-of-payments problem exists.
This part of international economics was once also called the pure theory
of international trade, where the adjective "pure" was meant to distinguish
it from monetary international economics.
1.2 Structure of the Book

This book is divided into three parts.
Part I deals with the basics, which are theory independent, such as the
market for foreign exchange (including currency derivatives and euromarkets)
and the various exchange-rate regimes, the international interest-rate parity
conditions, the definition and accounting rules of the balance of payments,
the main international organizations. In this part there is also a treatment of
the relationships between the balance of payments and the other macroeco-
nomic (real and financial) variables from an accounting point of view, which
is indispensable to fit the balance of payments in the context of the whole
economic system and to illustrate the meaning of several widely used identi-
ties (for example, that the excess of national saving over national investment
equals the country's current account). The accounting framework that we
propose will render us invaluable services in the course of the examination of
the various models.
Part 11 treats international finance, while Part 111 deals with the theory
and policy of international trade.
1.2.1 International Finance

In the field of international monetary economics we can distinguish two dif-
ferent views. On the one hand there is the "old" or traditional view, which
considers the balance of payments as a phenomenon to be studied as such, by
studying the specific determinants of trade and financial flows. On the other
hand there is the "new" or modern view, that considers trade and financial
flows as the outcome of intertemporally optimal saving-investment decisions
by forward-Iooking agents. More precisely, since the excess of national sav-
ing over national investment equals the country's current account (see Sect.
5.3), the idea is to concentrate on the determination of such an excess via an
intertemporal optimization; the current account (and the matching capital
flows) will be a consequence. This view has not yet succeeded in making its
way either in general textbooks (some recent texts in international economics
do not even mention it) or in the minds of policy makers.
One of the aims of this part of the book is to introduce, alongside with
the treatment of the traditional models and their policy implications, some
aspects of the new international macroeconomics which cannot be neglected

at the undergraduate level.
In treating the traditional approaches to balance-of-payments adjustment
we shall distinguish between ftow approaches (which include the elasticity
and multiplier approaches, and the Mundell-Fleming model) and stock ap-
proaches (which include the monetary approach to the balance of payments
and the portfolio-balance modeW, because strikingly different results may
occur according as we take the macroeconomic variables involved as being
pure flows, or as flows only deriving from stock adjustments.
To clarify this distinction let us consider, for example, the flow of im-
ports of consumption commodities, which is part of the flow of national
consumption. Suppose that the agent decides how much to spend for current
consumption by simply looking at the current flow of income, ceteris paribus.
This determines imports as a pure flow. Suppose, on the contrary, that the
agent first calculates the desired stock of wealth (based on current values of
interest rates, income, etc.) and then, looking at the existing stock, decides
to adjust the latter toward the former, thus determining a flow of saving
(or dissaving) and consequently the flow of consumption. This determines
imports as a flow deriving from a stock adjustment.
We shall then examine foreign exchange speculation and currency crises,
the determination of the exchange rate, and the debate on fixed versus flexi-
ble exchange rates. The modern intertemporal approach is treated in Chap.
10. Chapter 11 deals with international monetary integration, and in partic-
ular with the European Monetary Union. The concluding chapter of part I
(Chap. 12) examines the main current problems of the international mone-
tary system.
1.2.2 The Theory and Policy of International Trade

In the traditional or orthodox theory of international trade it is possible
to distinguish three main models aimed at explaining the determinants of
international trade and specialization:
1) the classical (Torrens-Ricardo) theory, according to which these deter-
minants are to be found in technological differences between countries;
2) the Heckscher-Ohlin theory, which stresses the differences in factor
endowments between different countries;
3) the neoclassical theory'(which has had a longer gestation: traces can
be found in J .S. Mill; A. Marshall takes it up again in depth, and numerous
modern writers bring it to a high level of formal sophistication), according to
which these determinants are to be found simultaneously in the differences
between technologies, factor endowments, and tastes of different countries.
The last element accounts for the possible presence of international trade,
lWe shall not deal with integrated stock-flow models, given their difliculty.
1.2. Structure of the Book 5
even if technologies and factor endowments were completely identical between

countries.
From the chronological point of view, model (2) post-dates model (1), while
model (3), as we said, has had a longer gestation and so has been developing
in parallel to the others.
To avoid misunderstandings it must be stressed that the Heckscher-Ohlin
theory is also neoclassical (in the sense in which the neoclassical vision is
different from the classical one), as it accepts all the logical premises of, and
follows the, neoclassical methodology. As a matter of fact the Heckscher-
Ohlin model can be considered as a particular case of the neoclassical one in
which internationally identical production functions and tastes are assumed.
This loss in degree of generality is, according to some authors, the price that
has to be paid if one wishes to obtain definite conclusions about the structure
of the international trade of a country.
We shall subsequently deal with the problems of commercial policy, in-
cluding the debate between free trade and protectionism. The new pro tec-
tionism, whereby protection is based on non-tariff instruments and comes
about through administrative procedures or lobbying activities, is also ex-
amined.
The two fundamental assumptions of the orthodox theory are perfeet
competition and product homogeneity. The new theories of international
trade drop these assumptions and analyse international trade in a context of
imperfect competition andj or product differentiation.
We conclude this part with a treatment of the relations between interna-
tional trade and economic growth, of the "new" economic geography, and of
the notion of globalization.
1.2.3 Small and Large Open Economies

In our treatment we shall use both one-country and two-country models.
With the expression one-country or small-country model (also called SOE,
small open economy) we refer to a model in which the rest of the world is
taken as exogenous, in the sense that what happens in the country under
consideration (call it country 1) is assumed to have a negligible infiuence
(since this country is small relative to the rest of the world) on the rest-of-
the-world variables (income, price level, interest rate, etc.). This means that
these variables can be taken as exogenous in the model.
With the expression two-country or large-country model we refer to a
model in which the effect on the rest-of-the-world's variables of country l's
actions cannot be neglected, so that the rest of the world has to be explicitly
included in the analysis (as country 2). It follows that, through the channels
of exports and imports of goods and services, and capital movements, the
economic events taking place in a country have repercussions on the other
country, and vice versa.
Consider, for example, the imposition of a tariff on imports by a country.

The demand for imports decreases. If the country is a SOE, this decrease
will have no appreciable effect on the world market, so that the world price
will not change. But if the country is large, the reduction of its imports will
influence world demand and price. Another example is the case of a cyclical
depression in country 1, with a consequent reduction in income, demand,
and hence in imports. If the country is a SOE, there will be no appreciable
consequence on the world market. But if the country is large, the decrease in
its imports, that is in country 2's exports to country 1, will cause a decrease
in country 2's income, with achain of further repercussions.
Part I
The Basics
Chapter 2
The Foreign Exchange Market
2.1 Introduction: The Exchange Rate

As soon as one comes to grips with the actual problems of international
monetary economics it becomes indispensable to account for the fact that
virtually every country (or group of countries forming a monetary union)
has its own monetary unit (currency) and that most international trade is
not bart er trade but is carried out by exchanging goods for one or another
currency. Besides, there are international economic transactions of a purely
financial character, which, therefore, involve different currencies.
From all the above the necessity arises of a foreign exchange market,
that is, of a market where the various national currencies can be exchanged
(bought and sold) for one another. The foreign exchange market, like any
other concept of market used in economic theory, is not a precise physical
place. It is actually formed (apart from institutional characteristics which
we shall not go into) by banks, brokers and other authorized agents (who are
linked by telephone, telex, computer, etc.), to whom economic agents apply
to buy and sell the various currencies; thus it has an international rather than
national dimension, although in the actual quotation of the foreign exchange
rates it is customary to refer to typical places (financial centres) such as New
York, London, Paris, Zurich, Milan, Tokyo, Frankfurt, etc.
We must now define the concept of (foreign) exchange rate. It is a
price, and precisely the price of one currency in terms of another. Since two
currencies are involved, there are two different ways of giving the quotation
of foreign exchange. One is called the price quotation system, and defines
the exchange rate as the number of units of domestic currency per unit of
foreign currency (taking the USA as the horne country, we have, say, $1.621
per British pound, $0.00868 per Japanese yen, $1.069 per euro, etc.); this
amounts to defining the exchange rate as the price of foreign currency in
terms of domestic currency.
The other one is called the volume quotation system, and defines the
9
10 Chapter 2. The Foreign Exchange Market
exchange rate as the number of units of foreign currency per unit of domestic
currency and is, obviously, the reciprocal of the previous one (again taking
the USA as the horne country, we would have 0.61690 British pounds per US
dollar, 115.20737 Japanese yens per US dollar, 0.93545 euros per US dollar,
etc.); with this definition the exchange rate is the price of domestic currency
in terms of foreign currency.
We shall adopt the price quotation system, and a good piece of advice
to the reader is always to ascertain which definition is being (explicitly or
implicitly) adopted, to avoid confusion. The same concept, in fact, will be ex-
pressed in opposite ways according to the definition used. Let us consider for
example the concept of "depreciation of currency x" (an equivalent expres-
sion from the point of view of country x is an "exchange rate depreciation").
This means that currency x is worth less in terms of foreign currency, namely
that a greater amount of currency x is required to buy one unit of foreign
currency, and, conversely, that a lower amount of foreign currency is required
to buy one unit of currency x. Therefore the concept of depreciation of cur-
rency x is expressed as an increase in its exchange rate if we use the price
quotation system (to continue with the example of the US dollar, we have,
say, $1.65 instead of $1.621 per British pound, etc.) and as a decrease in
its exchange rate, if we use the volume quotation system (0.60606 instead of
0.61690 British pounds per US dollar, etc.). By the same token, expressions
such as "a fall in the exchange rate" or "currency x is falling" are ambiguous
if the definition used is not specified. Similar observations hold as regards
an exchange rate appreciation (currency x is worth more in terms of foreign
currency).
It should now be pointed out that, as there are various monetary instru-
ments which can be used to exchange two currencies, the respective exchange
rate may be different: the exchange rate for cash, for example, may be dif-
ferent from that for cheques and from that for bank transfer orders.
These differences depend on various elements, such as the costs of trans-
ferring funds, the carrying costs in a broad sense (if bank keeps foreign cur-
rency in the form of banknotes in its vaults rather than in the form of demand
deposits with a foreign bank, it not only loses interest but also has to bear
custody costs). These differences are however very slight, so that henceforth
we shall argue as if there were only one exchange rate for each foreign cur-
rency, thus also neglecting the bid-offer spread, that is, the spread which
exists at the same moment and for the same monetary instrument, between
the buying and selling price of the same currency in the foreign exchange
market.
To conclude this introductory section, we must explain another difference:
that between the spot and the forward exchange rate. The former is that
applied to the exchange of two currencies on the spot, that is, for immediate
delivery. In practice the currencies do not materially pass from hand to hand
except in certain cases, such as the exchange of banknotes; what usually
2.1. Introduction: The Exchange Rate 11
takes place is the exchange of drawings on demand deposits 1 denominated in

the two currencies.
The forward exchange rate is that applied to the agreement for a future
exchange of two currencies at an agreed date (for instance, in three months'
time). In other words, we are in the presence of a contract which stipulates
the exchange of two currencies at a prescribed future date but at a price (the
forward exchange rate) which is fixed in advance (as is the amount) at the
moment of the stipulation of the contract. When the contract expires (or, to
be exact, two days before the expiry date) it automatically becomes a spot
contract, but of course the price remains that fixed at the moment of the
stipulation.
The forward exchange rate is quoted for various delivery dates (one week;
1-,3-, 6-months; etc.; rarely for more than one year ahead) and for the main
currencies: not all currencies, in fact, have a forward market. The spot and
the forward market together constitute the foreign exchange market.
Since the exchange rate is, as we have seen, aprice which is quoted on
a market, the problem comes immediately to mind of whether the exchange
rate (spot and forward) is determined in accordance with the law of supply
and demand, much as the price of a commodity is determined on the rela-
tive market. The problem is very complicated, as it involves the whole of
international monetary theory and also depends on the institutional setting;
therefore we shall deal with it later, after having introduced the necessary
notions (for a general treatment see Chap. 9).
2.1.1 The Real Exchange Rate

In general, real magnitudes are obtained from the corresponding nominal
magnitudes eliminating the changes solely due to price changes, which can
be done in a variety of ways. In the case of exchange rates the question
is however more complicated' due to the fact that the exchange rate is in-
trinsically a nominal concept, which is not obtained (as is instead the case
with nominal income or other nominal magnitudes which have a c1ear-cut
price/quantity decomposition) multiplying a physical quantity by its price.
The real exchange rate, like the nominal one, is a relative price, but there
is no agreement on which relative price should be called "the" real exchange
rate, since currently there are several definitions, a few of which are given
here.
The oldest notion of real exchange rate, and the one which is often (incor-
rectly) identified with "the" real exchange rate, is probably the ratio of the
general price levels at horne and abroad expressed in a common monetary
ITo avoid confusion, the reader should note that demand deposit is here taken to mean
a deposit with a bank from which money can be drawn without previous notice and on
which cheques can be drawn (synonyms in various count ries are: current account deposit,
checking deposit, sight deposit).
unit, or the nominal exchange rate adjusted for relative prices between the
countries under consideration:
(2.1)
or
(2.2)
where Ph, PI are the domestic and foreign price levels in the respective curren-
eies. Prom the economic point of view, it is easy to see that in (2.1) domestic
and foreign prices have been made homogeneous by expressing the latter in
domestic currency before taking their ratio, whilst in (2.2) they have been
made homogeneous by expressing the former in foreign currencyj the ratio is
of course the same.
According to another definition, the real exchange rate is the (domestic)
relative price of tradable and nontradable goods,
pT
rR = NT' (2.3)
P
The rationale of this definition is that, in a two-sector (tradables-nontradables)
model, the balance of trade depends on PT/PNT because this relative price
measures the opportunity cost of domestically producing tradable goods, and
the balance of trade depends on the excess supply of tradables.
A widely held opinion is that the real exchange rate ShOlUd give a measure
of the external competitiveness of a country's goods (if non-traded goods are
also present, only tradables should be considered), but even if we so restrict
the definition, it is by no means obvious which index should be taken. In the
simple exportables-importables model of trade the real exchange rate reduces
to the notion of terms 0/ trade defined in the theory of international trade,
namely
Px
rR = 1f = - ,
rpm
(2.4)
where Px represents export prices (in terms of domestic currency), Pm import

prices (in terms of foreign currency), and r the nominal exchange rate of the
country under consideration.
Prom the point of view of the consumer, 1f represents the relative price
of foreign and domestic goods on which (in accordance with standard con-
sumer's theory) demand will depend. Prom the point of view of the country
as a whole, 1f represents the amount of imports that can be obtained in ex-
change for one unit of exports (or the amount of exports required to obtain
one unit of imports). Therefore an increase in 1f is also defined as an improve-
ment in the terms of trade, as it means that a greater amount of imports
can be obtained per unit of exports (or, equivalently, that a smaller amount
2.1. Introduction: The Exchange Rate 13
of exports is required per unit of imports). It should also be noted that it is

irrelevant whether 7f is defined as above or as
1
-Po;
7f=~ (2.5)
Pm'
since the two formulae are mathematically equivalent.
The terms of trade 7f can serve both the domestic and the foreign con-
sumer (country) for the relevant price-comparison, because in (2.4) the prices
of domestic and foreign goods are expressed in domestic currency, while in
(2.5) they are expressed in foreign currency.
It is dear that, since exports are part of domestic output, Po; = Ph, and
similarly Pm = Pj, so that (2.4) and (2.1) coincide.
Another definition of real exchange rate uses the ratio of unit labour costs
at home (Wh) to unit labour costs abroad (Wj ), expressed in a common
monetary unit through the nominal exchange rate (r),
(2.6)
With this definition an increase (decrease) in rR means a deterioration (im-

provement) in the external competitiveness of domestic goods. In fact, ce-
teris paribus, an increase in domestic with respect to foreign unit labour costs
(Wh/Wj increases) is reflected (in both perfectly and imperfectly competitive
markets) in an increase in the relative price of domestic with respect to for-
eign goods. The same result is obtained when, at given Wh/Wj , the exchange
rate appreciates (i.e., the nominal exchange rate r decreases). Sometimes the
real exchange rate is defined as the reciprocal of the above expression, namely
rR = rWi/Wh, in which case an increase in rR means an improvement in the
external competitiveness of domestic goods, etcetera.
2.1.2 The Effective Exchange Rate

While the exchange rate involves two currencies only, it may be desirable to
have an idea of the overall external value of a currency, namely with respect
to the rest of the world (or a subset of it, for example the industrialized coun-
tries) and not only with respect to another country's currency. The presence
of floating exchange rates makes it difficult to ascertain the behaviour of the
external value of a currency. In fact, in a floating regime a currency may si-
multaneously depreciate with respect to one (or more) foreign currency and
appreciate with respect to another (or several others).
In such a situation it is necessary to use an index number, in which the
bilateral exchange rates of the currency under consideration with respect
to all other currencies enter with suitable weights. This index is called an
effective exchange rate. Let us begin with the nominal effective exchange
rate, which is given by the formula
n n
rei = L Wjrji, L Wj = 1, (2.7)
j=l,#i j=l,#i
where
r ei = nominal effective exchange rate of currency i,
rji = nominal exchange rate of currency i with respect to currency j,
Wj = weight given to currency j in the construction of the index; by
definition, the sum of the weights equals one.
Usually the effective exchange rate is given as an index number with a
base of 100 and presented in such a way that an increase (decrease) in it
means an appreciation (depreciation) of the currency under consideration
with respect to the other currencies as a whole. This implies that rji is
defined using the volume quotation system.
Unfortunately it is not possible to determine the weights unambiguously:
this is an ambiguity inherent in the very concept of index number. Many
effective exchange rates thus exist in theory; usually, however, the weights
are related to the share of the foreign trade of country i with country j in
the total foreign trade of country i. Effective exchange rates are computed
and published by the IMF, central banks and private institutions.
If we carry out the same operation defined by Eq. (2.7) using real rather
than nominal bilateral exchange rates we shall of course obtain areal effec-
tive exchange rate. This will give a measure of the overall competitiveness
of domestic goods on world markets rather than with respect to another
country's goods.
2.2 The Spot Exchange Market

Given n currencies, n - 1 bilateral (spot) ex~hange rates of each one vis-a-vis
all the others will be defined, thus n(n - 1) exchange rates in total. The spot
exchange market, however, by way of the so-called arbitrage on currencies, enables
one to determine all the exchange rates by knowing only (n - 1) of them. In other
words, arbitrage succeeds in causing actual exchange rates to practically coincide
with the values which satisfy certain simple mathematical relations which, from
the theoretical point of view, exist between them. Arbitrage on foreign currencies
can be defined as the simultaneous buying and selling of foreign currencies to
profit from discrepancies between exchange rates existing at the same moment in
different financial centres.
Let us first consider the mathematical relations and then the arbitrage activity.
To begin with, the exchange rate of currency i for currency j and the exchange
rate of currency j for currency i (of course expressed using the same quotation
system) are--theoretically-the reciprocal of each other: this enables us to reduce
2.2. The Spot Exchange Market 15
the exchange rates from n(n - 1) to n(n - 1)/2. If we denote by Tji the exchange
rate of currency i (i = 1,2, ... , n) with respect to currency j (j = 1,2, ... , njj f. i)
in the ith financial centre, that is, given the definition adopted, the number of
UIutS of currency i exchanged for one unit of currency j (price of currency j in
terms of currency i)2, the consistency condition requires that
(2.8)
where k and s are any two currencies. In fact, the consistency condition (also called
neutmlity condition) means that by starting with any given quantity of currency k,
exchanging it for currency S and then exchanging the resulting amount of currency
S for currency k, one must end up with the same initial quantity of currency k.
More precisely, starting with x units of currency k and selling it in financial centre
s for currency s we obtain XTks units of currency Sj if we then seIl this amount of
currency S in financial cent re k for currency k we end up with (XTks) Tsk units of
currency k. The consistency condition x = (XTks) Tsk must therefore holdj if we
divide through by x and rearrange terms we obtain Eq. (2.8). From this equation
it immediately follows that
(2.9)
which is our initial statement.

If, for example, the exchange rate between the yen (''i) and the US dollar ($) is
115.20737 in Tokyo (~115.20737 per $1), mathematically the $/~ exchange rate in
New York is 0.00868 ($0.00868 per Japanese yen). What ensures that the exchange
rate between the two currencies in New York is 0.00868-given the exchange rate
of 115.20737 between them in Tokycr-is indeed arbitrage, which in such cases is
called two-point arbitrage, as two financial centres are involved. Let us assume,
for example, that while the ~ /$ exchange rate in Tokyo is 115.20737, the exchange
rate in New York is $0.009 for ~l. Then the arbitrageur can buy ~ with $ in
Tokyo and seIl them for $ in New York, thus obtaining a profit of $0.00032 per~,
which is the difference between the selling ($0.009) and buying ($0.00868) dollar
price of one ~.
It should also be noted that, since everything occurs almost instantaneously
and simultaneously on the computer, telephone, telex, or other such means of
communication, this arbitrage does not tie up capital, so that no cost of financing
is involved and, also, no exchange risk is incurredj the cost is the fee for the
utilization of the telephone or other lines.
In this way opposite pressures are put on the yen in Tokyo and in New York.
The additional demand for yen (supply of dollars) in Tokyo brings about an ap-
preciation of the yen with respect to the dollar there, and the additional supply of
yens (demand for dollars) in New York brings about a depreciation ofthe yen with
respect to the dollar there, that is, an appreciation of the dollar with respect to
2The reader should note that the order of the subscripts is merely conventional, so
that many authors (as here) use Tji to denote the price of currency j in terms of currency
i, whereas others follow the reverse order and use Tij to denote the same concept. It is
therefore important for the reader to carefully check which convention is adopted.
the yen. This continues as long as arbitrage is no longer profitable, that is, when
the exchange rates between the two currencies in the two financial centres have
been brought to the point where they satisfy the condition of neutrality.
In practice this condition is never exactly satisfied, because of possible friction
and time-Iags (such as, for example, transaction costs, different business hours,
different time zones, etc.), but in normal times the discrepancies are so small as
to be negligible for all purposes.
After exarnining the relations between the bilateral exchanges rates, we must
now introduce the notion of indirect or cross (exchange) rate. The cross rate
of currency i with respect to currency j indicates how many units of currency
exchange indirectly (this is, through the purchase and sale of a third currency, m)
for one unit of currency j. More precisely, with one unit of currency j one can
purchase Tjm units of currency m in financial centre jj by selling this amount of
currency m for currency i in financial cent re i at the exchange rate Tmi, one obtains
TjmTmi units of currency i. The indirect rate between currency i and currency j
is thus TjmTmi. The consistency (or neutrality) condition obviously requires that
the indirect and direct rates should be equal, and as the direct rate of currency i
with respect to currency j is Tji, the mathematical relation which must hold is
(2.10)
for any triplet of (different) indexes i,j,m. This condition can also be written-
recalling that, from (2.9), we have Tji = I/Tij,T mi = I/Tim-as
(2.11)
If, for example, the US dollar/euro rate in new York is 1.069 dollars per one
euro, and the yen/dollar exchange rate in Tokyo is 115.20737 yen per one dollar in
Tokyo, then the euro/yen cross rate in Tokyo is 115.20737 x 1.069 = 123.1566785
yen per one euro. It is still arbitrage, this time in the form of three-point or
triangulaT aTbitrage (as th!ee currencies are involved), which equalizes the direct
and indirect exchange rate.
The considerations made above on the almost instantaneousness and negligible
cost of the various operations also explain why these will continue until the direct
and indirect exchange rates are brought into line, so as to cause the profit to
disappear. This will, of course, occur when, and only when, the direct exchange
rate between any two currencies coincides with all the possible cross rates between
them. In practice this equalization is never perfect, for the same reasons as in the
case of two-point arbitrage, but here too we can ignore these discrepancies.
It can readily be checked that the cross rates between any pair of currencies
(i,j) are n-2: in fact, as there are n currencies, it is possible to exchange currencies
i and j indirectly through any one of the other (n - 2) currencies. And, since all
these cross rates must equal the only direct rate between currencies i and j, it can
easily be shown that it is sufficient to know the n - 1 direct rates of one currency
vis-a-vis all the others to be able to determine the fuH set of (direct) exchange
rates among the n currencies. Let us in fact assume that we know the n - 1 direct
rates of one currency, say currency 1, vis-a-vis all the others: that is, we know the
2.3. The Forward Exchange Market 17
rates r2l,r3l, ... ,rnl. From Eq. (2.10) we have, letting i = 1,

(2.12)
for any pair of different subscripts j, m. From Eq. (2.12) we immediately get
(2.13)
whence, account being taken of Eq. (2.10),
(2.14)
Now, since the rates rjl and rml are known by assumption, from Eqs. (2.13) and
(2.14) it is possible to determine all the direct exchange rates between all pairs
of currencies (m, j) and therefore the full set of bilateral exchange rates. This
completes the proof of the statement made at the beginning of this section.
2.3 The Forward Exchange Market

2.3.1 Introduction
The main nmction of the forward exchange market is to allow economic
agents engaged in international transactions (whether these are commercial
or financial) to cover themselves against the exchange risk deriving from
possible future variations in the spot exchange rate. If, in fact, the spot
exchange rate were permanently and rigidly fixed, the agent who has in the
future to make or receive a payment in foreign currency (or, more generally,
who has liabilities andjor assets in foreign currency) does not incur any
exchange risk, as he already knows how much he will pay or receive (or,
more generally, the value of his liabilities and assets) in terms of his own
national currency. But when exchange rates are bound to change through
time, as is usually the case, an exchange rate risk arises.
From the point of view of the agent who has to make a future payment
in foreign currency (for example, an importer who will have to pay in three
months' time for the goods imported now) , the risk is that the exchange rate
will have depreciated at the time of the payment, in which case he will have
to pay out a greater amount of domestic currency to purchase the required
amount of foreign currency. From the point of view of the agent who is to
receive a future payment in foreign currency (for example, an exporter who
will be paid in three months time for the goods exported now) the risk is
that the exchange rate will have appreciated at the time of the payment, in
which case he will get a smaller amount of domestic currency from the sale
of the given amount of foreign currency.
Naturally the agent who has to make a future payment in foreign currency
will benefit from an appreciation of the domestic currency and, similarly, a
depreciation will benefit the agent who is to receive a future payment in
foreign currency. But, if we exclude the category of speculators, the average

economic agent is usually risk averse, in the sense that, as he is incapable
of predicting the future behaviour of the exchange rate and considers future
appreciations and depreciations to be equally likely, he will assign a greater
weight to the eventuality of a loss than a gain deriving from future variations
in the exchange rate.
The average operator, therefore, will seek cover against the exchange risk,
that is, he will hedge 3 . In general, hedging against an asset is the activity of
making sure to have a zero net position (that is, neither a net asset nor a net
liability position) in thatasset. As we are considering foreign exchange, to
hedge means to have an exact balance between liabilities and assets in foreign
currency (of course, this exact balance must hold for each foreign currency
separately considered), that is, in financial jargon, to have no open position
in foreign exchange, neither a lang position (more assets than liabilities in
foreign currency) nor a shart position (more liabilities than assets in foreign
eurrency). A particular case of a zero net position in foreign exchange is,
of course, to have zero assets and zero liabilities. This can be obtained, for
example, by stipulating all contracts in domestic currency. But this hardly
solves the problem, because for the other party the contract will then be
necessarily in foreign currency, and this party will have to hedge.
Now, one way to cover against the exchange risk is through the forward
exchange market. The agent who has to make a payment in foreign currency
at a known future date can at onee purchase the necessary amount of foreign
currency forward: since the price (the forward exchange rate) is fixed now,
the future behaviour of the spot exchange rate is irrelevant for the agentj
the liability position (the obligation to make the future payment) in foreign
currency has been exact1y balanced by the asset position (the claim to the
given amount of foreign exchange at the maturity of the forward contract).
Similarly, the agent who is to receive a payment in foreign curreney at a
known future date can at once sell the given amount of foreign currency
forward.
There are, however, other ways of hedgingj the main possibilities will be
briefly examined and then compared.
3Some writers distinguish between covering and hedging. Covering (by means of for-
ward exchange) is an arrangement to safeguard against the exchange risk on a payment
of adefinite amount to be made or received on a definite date in connection with a self-
liquidating commercial or financial transaction. Hedging (by means of forward exchange)
is an arrangement to safeguard against an indefinite and indirect exchange risk arising
from the existence of assets or liabilities, whose value is liable to be affected by changes in
spot rates. More often, however, no distinction is made and hedging (in the broad sense)
is taken to include all operations to safeguard against the exchange risk, however it arises.
2.3.2 Various Covering Alternatives; Forward Premium

and Discount
Let us consider the case of an economic agent who has to make a payment
at a given future date, for example an importer of commodities (the case
of the agent who is to receive a future payment is a mirror-image of this).
Let us also list the main opportunities for cover, inc1uding the forward cover
mentioned above. The possibilities are these:
(a) The agent can buy the foreign exchange forward. In this case he will
not have to pay out a single cent now, because the settlement of the forward
contract will be made at the prescribed future date.
(b) The agent can pay immediately, that is, purchase the foreign exchange
spot and settle his debt in advance. To evaluate this alternative we must
examine its costs and benefits. On the side of costs we must count the
opportunity cost of (domestic) funds, that is, the fact that the economic
agent forgoes the domestic interest rate on his funds for the delay granted
in payment (if he owns the funds) or has to pay the domestic interest rate
to borrow the funds now (if he does not own the funds). For the sake of
simplicity, we ignore the spread between the lending and borrowing interest
rates, so that the costs are the same whether the agent owns the funds or not.
On the side of benefits, we have the discount that the foreign creditor (like
any other creditor) allows because of the advance payment; this discount will
be related to the foreign interest rate (the creditors domestic interest rate).
For the sake of simplicity, we assurne that the percentage discount is equal
to the full amount of the foreign interest rate and that the calculation is
made by using the exact formula x[1j(1 + i f )] instead of the approximate
commercial formula x - ifx = x(1 - if), where x is the amount of foreign
currency due in the future and i, is the foreign interest rate (referring to the
given period of time).
(c) The agent can immediately buy the foreign exchange spot, invest it
in the foreign country from now till the maturity of the debt and pay the
debt at maturity (spot covering). The costs are the same as in the previous
case; on the side of benefits we must count the interest earned by the agent
by investing the foreign exchange abroad.
In practice things do not go so smoothly (think, for example, of foreign
drafts which are discounted and rediscounted, etc.), but at the cost of some
simplification they can be fitted into these three alternatives.
In the case of an agent who is to receive a payment in the future the alter-
natives are: (a) sell the foreign exchange forward; (b) allow a discount to the
foreign debtor so as to obtain an advance payment, and immediately sell the
foreign exchange spot; (c) discount the credit with a bank and immediately
seIl the foreign exchange spot.
In order to compare these three alternatives, besides the domestic and
foreign interest rates, we must also know the exact amount of the divergence
between the forward exchange rate and the (current) spot exchange rate.
For this we need to define the concept of forward premium and discount.
A forward premium denotes that the currency under consideration is more
expensive (of course in terms of foreign currency) for future delivery than
for immediate delivery, that is, it is more expensive forward than spot. A
forward discount denotes the opposite situation, i.e. the currency is cheaper
forward than spot. The higher or lower value of the currency forward than
spot is usually measured in terms of the (absolute or proportional) deviation
of the forward exchange rate with respect to the spot exchange rate.
We observe, incidentally, that in the foreign exchange quotations the for-
ward exchange rates are usually quoted implicitly, that is, by quoting the
premium or discount, either absolute or proportional. When the forward ex-
change rate is quoted explicitly as a price, it is sometimes called an outright
forward exchange rate. We also observe, as a matter of terminology, that
when the spot price of an asset exceeds (falls short of) its forward price, a
backwardation (contango, respectively) is said to occur.
This is one of the cases where it is most important to have a dear idea of
how exchange rates are quoted (see Sect. 2.1). If the price quotation system
is used, the higher value of the currency forward than spot means that the
forward exchange rate is lower than the spot exchange rate, and the lower
value of a currency forward than spot means that the forward exchange rate
is higher than the spot rate. But if the volume quotation system is used the
opposite is true: the higher (lower) value of a currency on the forward than
on the spot foreign exchange market means that the forward exchange rate is
higher (lower, respectively) than the spot rate. If, say, the $ in New York is
more expensive forward than spot with respect to the euro, this means that
fewer dollars are required to buy the same amount of euros (or, to put it the
other way round, that more euros can be bought with the same amount of
dollars) on the forward than on the spot exchange market, so that if the USA
uses the price quotation system, in New York the $/euro forward exchange
rate will be lower than the spot rate, whereas if the USA used the other
system, the opposite will be true.
Therefore in the case 'of the prke quotation system the forward premium
will be measured by a negative nillnber (the difference forward minus spot
exchange rate is, in fact, negative) and the forward discount by a positive
number. This apparently counterintuitive numerical definition (intuitively it
would seem more natural to associate premium with a positive number and
discount with a negative one) is presumably due to the fact that this ter-
minology seems to have originated in England, where the volume quotation
system is used, so that by subtracting the spot from the forward exchange
rate one obtains a positive (negative) number in the case of a premium (dis-
count). Be this as it may, having adopted the price quotation system and
letting r denote the generic spot exchange rate and r F the corresponding
forward rate of a currency, the proportional difference between them,
(2.15)
gives a measure of the forward premium (if negative) and discount (if posi-
tive). As there are different maturities for forward contracts, in practiee the
proportional difference (2.15) is given on aper annum basis by multiplying it
by a suitable factor (if, for example, we are considering the 3-month forward
rate, the approximate factor is 4) and as a percentage by multiplying by 100.
The reason why the forward margin (a margin is a premium or a discount)
is expressed in this proportional form is that, in this way, we give it the
dimension 0/ an interest rate and can use it to make comparisons with the
(domestic and foreign) interest ratesj expression (2.15) is, in fact, sometimes
called an implicit interest rate in the forward transaction.
So equipped, we can go back to compare the various alternatives of the
agent who has to make a future payment (the case of the agent who has
to receive a future payment is perfectly symmetrie). We first show that
alternatives (b) and (c) are equivalent. We have already seen that the costs
are equivalentj as regards the benefits, we can assurne that the discount made
by the foreign creditor for advance payment (case b) is percentually equal to
the interest rate that our debtor might earn on foreign currency invested in
the creditors country (case c). More precisely, let ih and i f be the horne and
the foreign interest rate respectively, referring to the period considered in the
transaction (if, for example, the delay in payment is three months, these rates
will refer to a quarter), and x the amount of the debt in foreign currency.
With alternative (b), thanks to the discount allowed by the foreign creditor,
it is sufficient to purchase an amount x / (1 + i f) of foreign currency now. The
same is true with alternative (c), because by purchasing an amount x / (1 + i f )
of foreign currency now and investing it in the creditor's country for the given
period at the interest rate i f, the amount [x / (1 + i f )]( 1 + i f) = x will be
obtained at the maturity of the debt. The purchase of this amount of foreign
currency spot requires the immediate outlay of an amount r[x/(l + if)] of
domestic currency.
Therefore, if we consider the opportunity cost of domestie funds (interest
foregone on owned funds, or paid on borrowed funds), referring to the period
considered, the total net cast of the operation in cases (b) and (c), referring
to the maturity date of the debt, is obtained by adding this opportunity cost
to the sum calculated above. Thus we have
(2.16)
Let us now consider case (a): the agent under consideration will have to
pay out the sum r F x in domestic currency when the debt falls due. It is
then obvious that alternative (a) will be better than, the same as, or worse
than the other one [since (b) and (c) are equivalent, there are actually two
alternatives] according as
rx (1 + Zh
< --.-
rF x:> . ). (2.17)
1 + zf
If we divide through by rx we have
(2.18)
whence, by subtracting unity from both sides,

F ..
r - r < Zh - zf
-r-:> 1+if ·
(2.19)
On the left-hand side we meet our old friend, the forward margin; the
numerator of the fraction on the right-hand side is the interest (rate) dif-
ferential between the domestic and the foreign economy. Formula (2.19) is
often simplified by letting 1 + if ~ 1, but this is legitimate only when if
is very small (for a precise determination of the degree of approximation,
see Sect. 4.1). The condition of indifference between the alternatives then
occurs when the forward margin equals the interest rate differential.
It is interesting to observe that an absolutely identical condition holds in
the case of covered interest arbitrage, that will be treated in Chap. 4, Sect.
4.l.
We conclude the section by observing that in the forward exchange market
the same type of arbitrage operations on foreign exchange takes place as
described in relation to the spot market (see Sect. 2.2), so that the direct
and indirect (or cross) forward rates come to coincide.
2.4 The Transactors in the Foreign Exchange

Market
It is as well to point out at the beginning that the classification of the various
transactors will be made on a junctional rather than personal or institutional
basis. In fact, the same economic agent can be a different transactor at differ-
ent times or even simultaneously belong to different functional categories of
transactors: for example, importers and exporters who change the timing of
their payments and receipts to get the benefit of an expected variation in the
exchange rate are simultaneously traders and speculators. If, for example,
a depreciation is expected, and traders do not hedge on the forward market
but, on the contrary, pay in advance for the goods they are due to receive in
the future (as importers) and delay the collection of payment for the goods
2.4. The Transactors in the Foreign Exchange Market 23
already delivered (as exporters), then we are in the presence of speculative

activity (speculative exploitation by traders of the leads and lags of trade).
A possible classification is based on three categories (within which it is
possible to perform further subdivisions ): non-speculators, speculators, and
monetary authorities. To put this classification into proper perspective, a
digression on speculative activity is in order.
2.4.1 Speculators
In general, speculation can be defined as the purchase (sale) of goods, assets,
etc. with a view to re-sale (re-purchase) them at a later date, where the
motive behind such action is the expectation of a gain deriving from a change
in the relevant prices relatively to the ruling price and not a gain accruing
through their use, transformation, transfer between different markets, etc.
In general, the agent who expects an increase in the price of an asset is
called a bult, whereas a bear is one who expects a decrease in the price of an
asset. Therefore, if we denote by r the expected future spot exchange rate,
a bull in foreign currency (r > r) will normally buy foreign currency (have
a long position) and a bear (r < r) will normally sell foreign currency (have
a short position). Both deliberately incur an exchange risk to profit from
the expected variation in the exchange rate. This risk is usually accounted
for by introducing a risk premium, which will be the greater, the greater
the dispersion of expectations and the size of commitments. More precisely,
consider for example a bull, whose expected speculative capital gain in per-
centage terms is given by (r - r)jr. Although the interest rate gain (from
placing the funds abroad) and loss (forgone domestic interest) are negligible
in speculative activity, they have to be taken into account for a precise eval-
uation, hence the bull will speculate if (f - r)/r + 8 + i f > i h , where 8 is
the risk premium. Similar considerations show that the bear will speculate if
(r - r)jr + 0 + ij < ih. No incentive to speculate in either direction will exist
when
r-r
- - + 0 + ij = i h. (2.20)
r
This is speculation on spot foreign exchange, besides which a forward ex-
change speculation also exists. The latter derives from a divergence between
the current forward rate and the expected spot rate of a currency. If the ex-
pected spot rate is higher than the current forward rate, it is advantageous
for the speculator to buy foreign currency forward, as he expects that, when
the forward contract matures, he will be able to seIl the foreign currency spot
at a price (the expected spot rate) higher than the price that he knows he
will pay for it (the current forward rate). In the opposite case, namely if the
expected spot rate is lower than the current forward rate, it is advantageous
for the speculator to sen foreign currency forward, in the expectation of being
able to buy it, at delivery time, at a price (the expected spot rate) lower than
the price that he knows he will be paid for delivering it (the current forward
rate).
We have talked of delivery etcetera. In practice, the parties of a forward
exchange speculative transaction settle the difference between the forward
exchange rate and the spot exchange rate existing at maturity, multiplied by
the amount of currency contemplated in the forward contract. It should also
be noted that, in principle, forward speculation does not require the availabil-
ity offunds (neither command over cash nor access to credit facilities) at the
moment the contract is stipulated, by the very nature of the forward contract
(both payment and delivery are to be made at a future date). In practice
banks often require the transactor in forward exchange to put down a given
percentage of the contract as collateral; this percentage depends, amongst
other things, on the efficiency and development of the forward market, and
on possible binding instructions of central banks.
2.4.2 Non-Speculators
A second functional category is that of non-speculators. This category in-
cludes exporters and importers of goods and services, businesses which carry
out investment abroad, individual or institutional savers who wish to di-
versify their portfolios between national and foreign assets on the basis of
considerations of risk and yield (excluding speculative gains), arbitrageurs,
etcetera. Non-speculators are more precisely defined by exclusion, i.e., those
agents who are neither speculators nor monetary authorities.
2.4.3 Monetary Authorities

Finally we have the monetary authorities. These are the institutions (usually
the central bank, but also exchange equalization agencies where they exist as
bodies juridically separate from the central bank) to which the management
of the international reserves of the relative country is attributed. Monetary
authorities can intervene in the foreign exchange market both by buying and
selling foreign currencies in exchange for their own, and by taking various
administrative measures (such as exchange controls).
2.5 Currency Derivatives

The enormous growth of what are known as derivative instruments has also
involved foreign exchange transactions. We shall give abrief introduction
to the main types of currency derivative instruments, which are the same
as those involving other assets (futures, options, and swaps). Standardized
derivatives contracts are traded on organized exchanges, such as the CBOE
2.5. Currency Derivatives 25
(Chicago Board Options Exchange), the LIFFE (London International Fi-

nancial Futures Exchange), the MATIF (Marche A Terme International de
France), etcetera. However, trading can also occur outside of the major
exchanges in what is known as the OTC (Over-The-Counter) market, an
expression which means that banks and other financial institutions design
contracts tailor-made to satisfy the specific needs of their clients.
2.5.1 Futures
A currency futures contract is an agreement between two counterparties to

exchange a specified amount of two currencies at a given date in the future at
an exchange rate which is pre-determined at the moment of the contract. The
definition looks the same as that given in previous sections of currency for-
ward contract. What are then the differences? They are mainly of practical
type, as summarized in the following list.
1) In forward contracts the amount to be exchanged can be any, as de-
termined by the mutual agreement of the two parties, while currency futures
contracts are for standardized amounts.
2) Forward contracts are essentially over-the-counter instruments with
the exchange taking place direct1y between the two parties, while currency
futures are traded on an Exchange. Hence the next difference (point 3)
follows.
3) Forward contracts involve a counterparty risk, while futures are guar-
anteed by the Exchange.
4) Forward contracts are relatively illiquid assets, because forward con-
tract obligations cannot be easily transferred to a third party. On the con-
trary, the standardized nature of futures means that they can be easily sold
at any time prior to maturity to a third party at the prevailing futures price.
5) Forward contracts cover over 50 currencies, while futures cover only
major currencies.
The asset (in this case the currency) to be delivered in fulfilment of the
contract is called the underlying. In futures contract involving physical assets
(gold or other commodities) the physical delivery of the commodity would be
cumbersome, hence most parties enter into what is known as reversing trade.
This means that they willliquidate their position at the clearing house just
prior to maturity so that they neither have to actually receive or actually pay
the underlying. Reversing trade is also applied in around 99% of currency
futures contracts.
Apart from these practical differences, currency futures can be used for
the same purposes of currency forwards for hedging (see above, Sect. 2.3.2)
and speculating (see below, Sect. 2.4.1).
2.5.2 Options
A currency option is a contract that gives the purchaser the right (but not
the obligation) to buy or seIl a currency at a predetermined price (exchange
rate) sometime in the future. Hence options are a much more complicated
instrument than forwards and futures. They also have a precise terminology,
which is the following.
The party selling the option is called the writer, while the purchaser is
the holder. A call option gives the holder the right to purchase the currency
involved, while a put option gives the right to sell the currency. The currency
in which the option is granted is called the underlying currency, while the
currency in which the price will be paid is the counter currency. For example,
if the contract specifies the right to seIl euro1, 000, 000 at $1.05/euro1, the
euro is the underlying currency while the dollar is the counter currency. The
price at which the underlying currency can be bought or sold is the strike (or
exercise) price. The price that the holder pays to the writer for an option
is known as the option premium. The date at which the contract expires is
called the expiry date or maturity date. Finally, a distinction is made between
the American option (the right to buy or sell the currency at the given price
can be exercised any time up to the maturity date) and the European option
(the right can be exercised only on the maturity date).
There are two main differences between options and forward or futures
contracts, which both derive from the fact that the option gives the holder a
right but not an obligation.
The first is that the option provides the agent interested in hedging with
a more flexible instrument, because it enables him to fix a maximum payable
price (the sum of the option premium plus the exercise price) while leaving
him free to take advantage of favourable movements in the exchange rate.
With a forward or futures contract the hedger is obliged to respect the con-
tract in any case, also when the spot exchange rate at maturity is more
favourable than the forward rate agreed upon when the contract was signed.
On the contrary, with an option the holder can decide not to exercise the
right if the spot exchange rate at the expiry date is more favourable than
that the exercise price, account being taken of the option premium.
Suppose, for example, that a US company has to make a payment of
.LI million in sixth months' time, and that the forward/futures exchange
rate is $1.50/1:1. Alternatively, the company can buy a call option with an
exercise price of $1.50/1:1 for 8 cents per pound (the option premium). At
maturity, if the spot exchange rate is higher than $1.50/.LI, the US firm will
exercise the option. This is in any case cheaper than buying pounds spot,
but of course more expensive than would have been with the forward/futures
contract, given the option premium. If the spot exchange rate is lower than
$1.50/1:1, the firm will not exercise the option and buy pounds spot. The
cost will again be higher than with a forward/futures contract, but only if
2.5. Currency Derivatives 27
the spot exchange rate is higher than $1.42/.LI, because adding the option
premium (8 cents per pound) the price paid will be higher than $1.50/ .n. If
the spot exchange rate is lower than $1.42/ f.l, the option will have provided
a cheaper means of hedging than a forward/futures contract.
The second difference concerns the asymmetry in the risk-return char-
acteristics of the contract. With a forward/futures contract, for every cent
the spot exchange rate at the date of expiry is above (below) the exchange
rate established in the forward/futures contract, the buyer makes (loses) a
cent and the seller loses (makes) acent. This means a perfect symmetry.
On the contrary, with an options contract, the maximum loss of the option
holder equals the option premium, which is also the maximum gain for the
option writer, but there is unlimited potential gain for the option holder and,
correspondingly, unlimited potential loss for the option writer. This feature
makes options very attractive for speculators, because speculative holders can
combine limited losses (the premium paid) with unlimited potential profit.
2.5.3 Swap Transactions

The presence of the forward exchange market beside the spot exchange mar-
ket, allows hybrid spot and forward transactions such as swap contracts. The
swap contracts we are dealing with take place between private agents and are
different from swap agreements between central banks, in which the latter
exchange their respective currencies between themselves (by crediting the re-
spective accounts held with one another: for example, the Bank of England
credits the European Central Bank's account with 100 million pounds, and
the European Central Bank credits the Bank of England's account with 151.6
million euros), usually with the obligation to make a reverse operation after
a certain period of time.
A swap is a transaction in which two currencies are exchanged in the spot
market and, simultaneously, they are exchanged in the forward market in the
opposite direction. At first sight the swap contract would not seem to have
wide potential use: on the contrary, its market is more important than the
outright forward exchange market, second only to that for spot exchange.
The swap market is currently organized by the ISDA (International Swap
Dealers Association).
An obvious example of swap transaction is that deriving from covered
interest arbitrage operations (see Sect. 4.1). If we assume, for instance,
that the condition for an outward arbitrage occurs, the arbitrageur will buy
foreign exchange spot and simultaneously sell it forward. More precisely,
since the arbitrageur covers not only the capital but also the accrued interest
against the exchange risk, the quantity of foreign currency sold forward will
exceed the quantity of it bought spot by an amount equal to the interest on
the latter accrued abroad.
Another example is related to the cash management of multinational
corporations. Suppose that a parent company in the US has an excess of

liquidity in dollars, which is likely to persist for three months, whereas a
subsidiary in England has a temporary shortage of liquidity in pounds, which
is likely to last for three months. In such a situation the parent company can
sell dollars for pounds spot and lend these to the subsidiary, at the same time
selling pounds for dollars forward so as to cover the repayment of the debt
by the subsidiary. This is a swap transaction in the pound/dollar market.
A swap agreement can also be used by firms to raise finance more cheaply
than would otherwise be the case. Suppose that a European company wants
to raise yen funds while a Chinese company wants to raise euro funds. Ad-
ditionally suppose that Japanese investors are not very desirous to invest
in European companies but are eager to invest in Chinese companies, while
European investors are not very keen to lend to Chinese companies but are
willing to invest in a European company. Then it may be advantageous (in
term of cheaper conditions, such as a lower interest rate to be offered to in-
vestors) that the Chinese company raises funds in yen, while the European
company raises funds in euros; the companies then swap the funds raised and
the corresponding obligations. The result is that both companies obtain the
funds they need at cheaper cost than they had directly raised the funds.
Swap transactions are also carried out by banks themselves, to eliminate
possible mismatches in the currency composition of their assets and liabilities.
A bank, for example, may have-for a time horizon of three months-a
$50 million excess of dollar loans over dollar deposits, and, simultaneously,
an excess of deposits in pounds over loans in pounds of equivalent value.
In such a situation the bank can sell the excess of pounds for $50 million
spot and simultaneously buy the same amount of pounds for dollars three
months forward so as to cover against the exchange risk. Alternatively, the
bank could have lent the pound equivalent of $50 million, and borrowed $50
million, in the interbank money market.
Swap transactions involve two exchange rates (the spot and the forward
rate); in practice a swap rate is quoted, which is a price difference, namely,
the difference between the spot and forward rates quoted for the two trans ac-
tions which form the swap transaction (this difference is quoted in absolute
rather than percentage terms).
A swap agreement is basically the same as a forward/futures contract,
from which it differs for various practical aspects:
1) most forward/futures contracts are for a year or less, while swap con-
tracts are often for long periods, from 5 to 20 years and possibly longer.
This makes them more attractive to firms which have long-run obligations
in foreign currency.
2) Futures have an active secondary market, which is not the case for
swaps. Since swap agreements, as all contracts, can only be cancelled with
the consent of both parties, a party who wants to get rid of a swap may not
be able to do so.
2.6. Eurodollars and Xeno-Currencies 29
3) Futures are standarclized contracts, while swaps can be tailored to meet

the needs of the dient.
4) Futures contracts are guaranteed by the futures Exchange, while swap
agreements present the risk that one of the parties will not fulfil its obliga-
tions.
2.6 Eurodollars and Xeno-Currencies

The description of foreign exchange transactions given in the previous sections is
the traditional one. The situation has, however, been complicated by the develop-
ment, since the late 1950s, of an international money market of a completely new
type: the sQ---{;alled Eurodollar system, subsequently extended to other currencies.
In the traditional system, economic agents can obtain loans, hold deposits,
etc., in a currency, say currency j, only with country j's banks so that, for exam-
pIe, a German resident can hold dollar deposits only with the US banking system.
Eurodollars are, on the contrary, dollar deposits with European banks. The Eu-
rodollar market began in fact with dollar deposits placed with European banks
and used by these to grant loans in dollars. By European banks we mean banks
"resident" in Europe (in accordance with the definition of resident which will be
examined in Sect. 5.1). Thus a European bank can also be a subsidiary of a US
bank.
Note that, in general, a European bank can also accept deposits and grant loans
denominated in currencies other than the dollar (and, of course, different from the
currency of the country where the bank is resident); so that the denomination Eu-
rocurrencies was coined (these include the Eurodollar, Eurosterling, Euroyen, etc.).
Still more generally, since similar operations can be carried out by banks outside
Europe (Asiadollars, etc.), the general denomination Xeno-currencies (from the
Greek xenos = foreigner) has been suggested by F. Machlup to indicate deposits
and loans denominated in currencies other than that of the country in which the
bank is located. An equivalent denomination is cross-border bank assets&liabilities.
As regards the Eurodollar market, various reasons have been put forward to
explain its birth. According to some, the origin lies in an initiative of the Soviet
Union which, during the Korean war, fearing that its dollar deposits in the US
might be frozen by the US government, found it convenient to shift these dollar
accounts to Europe, largely to London. Others believe that the initiative was taken
by London banks which, in order to avoid the restrietions on the credit to foreign
trade imposed in the UK in 1957, induced the official agencies of the Soviet Union
to deposit their dollar holdings in London by granting favourable interest rates.
Still another factor is believed to be the US Federal Reserve System's Regulation
Q, which fixed the rates of interest paid on time deposits, but which did not apply
to time deposits owned by nonresidents. Thus New York banks began to compete
for nonresidents deposits, the interest rates on these rose about 0.25% above the
ceiling in 1958-9, and London banks were induced to bid for dollar deposits which
in turn they re-Ient to New York banks. A practical factor may also have had
its importance: due to the difference in time zones, European and US banks are
open simultaneously only for a short time in the day, so that Europeans who had
to borrow or lend dollars found it convenient to do this directly in London rather
than in New York through a London bank.
Be this as it may, the enormous growth of the Xeno-currency markets has
complicated the international financial market: let it suffice to think of the greater
complexity of interest arbitrage operations and of the birth of new types of interna-
tional banking transactions. As regards these, they can be classified in four main
types: onshore-foreign, offshore-foreign, offshore-internal, and offshore-onshore.
The first word of each pair refers to the currency in which the bank is transact-
ing: if it is that of the country in which the bank is resident the transaction is
onshore, whilst if it is the currency of another country the transaction is offshore.
The second word refers to the residence of the customer (borrower or lender): the
customer is internal if resident in the same country as the bank, foreign if resident
in a country different from that where the bank is resident and also different from
the country which issues the currency being transacted; in fact, the customer is
onshore if resident in the country issuing the currency.
Before the birth of Xeno-currencies, international banking transactions were
entirely of the onshore-foreign type: an example of an onshore-foreign deposit is a
deposit in dollars placed with ehase Manhattan, New York, by a non-US resident.
The growth of offshore deposits related to Xeno-currencies has given rise to the
multiplication of the three other types of international banking transactions.
An example of an oiJshore-foreign deposit is a deposit in euros placed with a
Swiss bank by a Japanese resident.
An example of an oiJshore-internal deposit is a deposit in US dollars placed
with a Dutch bank by a Dutch resident.
Finally, an example of an oJJshore-onshore deposit is a deposit in US dollars
placed by a US resident with a Japanese bank.
When international capital flows where to some extent subject to controls
(this was the normal situation during the Bretton Woods system, and also after
its collapse several countries maintained capital controls), a specific analysis of
Xeno-markets, by their very nature exempt from national controls (a situation
that worried central bankers very much), was very important. But in the early
1990s completely free international mobility of capital became the rule rather than
the exception, hence this importance no longer exists.
2.7 Selected Further Reading

Davis, E.P., 1992, Euromarkets, in The New Palgrave Dictionary of Money and
Finance, Macmillan: London.
Steinherr, A., 1998, Derivatives: The Wild Beast of Finance, New York: Wiley.
Exchange rate quotations can be found in all financial newspapers, such as The
Wall Street Journal and The Financial Times.
Chapter 3
Exchange-Rate Regimes and

the International Monetary
System
In theory a large number of exchange-rate regimes are possible, because be-

tween the two extremes of perfectly rigid (or fi,xed) and perfectly (freely)
flexible exchange rates there exists a range of intermediate regimes of limited
flexibility. A detailed treatment is outside the scope of the present work,
so that we shall briefly deal with the main regimes, beginning by the two
extremes. Our treatment will be purely descriptive, with no discussion of
the pros and cons of the various regimes, for which see Sect. 9.5.
3.1 The Two Extremes

One extreme is given by perfectly and freely flexible exchange rates. This
system is characterized by the fact that the monetary authorities do not
intervene in the foreign exchange market. Therefore the exchange rate (both
spot and forward) of the currency with respect to any foreign currency is left
completely free to fluctuate in either direction and by any amount on the
basis of the demands for and supplies of foreign exchange coming from all
the other operators. The other extreme is given by rigidly fixed exchange
rates. Here various cases are to be distinguished. The first and oldest is
the gold standard, where each national currency has a precisely fixed gold
content (for our purposes it is irrelevant whether gold materially circulates
in the form of gold coins or whether circulation is made of paper currency
which can be immediately converted into gold on demand). In this case the
exchange rate between any two currencies is automatically and rigidly fixed
by the ratio between the gold content of the two currencies (which is called
the mint parity).
Conceptually similar to the gold standard is the gold exchange standard,
31
32 Chapter 3. Exchange-Rate Regimes and the International Monetary System
in which, without itself buying and selling gold, a country stands ready to buy
or sell a particular foreign currency which is fully convertible into gold. This
system enables the international economy to economize gold with respect to
the gold standard, because the ultimate requests for conversion into gold of
the convertible foreign currency are normally only a fraction of the latter.
It must be emphasized that, for this system to be a true gold exchange
standard, the convertibility of the foreign currency must be free and full, so
that it can be demanded and obtained by any agent. In this case the system
is equivalent to the gold standard.
If, on the contrary, the convertibility is restricted, for example solely to
the requests from central banks, we are in the presence of a limping gold
exchange standard, in which case the automatic mechanisms governing the
gold standard no longer operate, and the concept itself of convertibility has
to be redefined: now convertibility simply means that private agents have the
right to freely exchange the various currencies between each other at fixes
rates. When convertibility into gold is completely eliminated, even between
central banks, we have a pure exchange standard, in which a country buys
and sells foreign exchange (or a stipulated foreign currency) at fixed rates.
Other fixed exchange rate arrangements include a) situations where coun-
tries have no national currency, either because they belong to a currency
union or because they have formally adopted the currency of some other
country (so called dollarization, but the foreign currency may be other than
the dollar), and b) currency boards. The main characteristics of a currency
board arrangement are: 1) the board stands ready to exchange domestic cur-
rency for the foreign reserve currency at a fixed rate; 2) to ensure the rigidity
of this rate, the board is required to hold liquid financial assets in the reserve
currency at least equal to the value of the domestic currency in circulation.
Hence in this system there can be no fiduciary issue of domestic money.
Arrangements a) and b) are usually described as "hard pegs".
3.2 The Bretton Woods System

The exchange rate system that was put into being after the end of World
War II and which is called the Bretton Woods system (after the name of
the New Hampshire town where the negotiations took place and where the
final agreement was signed in 1944), belonged to the category of the limping
gold exchange standard with important modifications. To synthesize to the
utmost, each country declared a par value or parity of its own currency in
terms of gold, from which the bilateral parities automatically derived. How-
ever, at that time, the only currency convertible into gold at the fixed price
of $35 per ounce of gold was the US dollar, which in this sense became the
key currency. The convertibility of the other currencies into dollars qualified
the system as a gold exchange standard, limping because the convertibility
3.2. The Bretton Woods System 33
of dollars into gold was restrieted to the requests from central banks.
The member countries were required to stand ready to maintain the de-
clared parity in the foreign exchange market by buying and selling foreign ex-
change (usually dollars, which thus became the main intervention currency);
more precisely, the actual exchange rate could vary only within the so-called
support (or intervention) points, which were initially set at 1 percent above
or below parity.
The modifications consisted in the fact that parity, notwithstanding the
obligation to defend it, was not immutable, but could be changed in the case
of "fundamental disequilibrium" in accordance with certain rules: changes
up to 10% could be made at the discretion of the country, whilst for greater
changes the country had first to notify the IMF (the International Monetary
Fund, which is one of the international organizations set up by the Bretton
Woods agreement) and obtain its assent.
The obligation to maintain the declared parity together with the possibil-
ity of changing it gave the system the name of adjustable peg. The idea behind
it was a compromise between rigidly fixed and freely flexible exchange rates,
and it is clear that the greater or lesser extent to which it approached either
system depended essentiallyon the interpretation of the rules for changing
parity. The prevailing interpretation was restrietive, in the sense that parity
was to be defended at all costs and changed only when it was unavoidable.
3.2.1 The Monetary Authorities' Intervention

In any case, the defence of a given parity requires a continuous intervention
of the monetary authorities in the foreign exchange market: the authorities
stand ready to meet both the market excess demand for foreign exchange
and the market excess supply when these arise. The alternative to this in-
tervention is to act on other macroeconomic variables of the system, so as
to eliminate or reduce the excess demand, or to introduce administrative
controls on foreign exchange. In the latter case, the foreign exchange is ra-
tioned by the monetary authorities and economic agents cannot freely engage
in international transactions. Excluding this case, what happens is that if,
for example, at the given parity the mmket demarid forforeign exchange is
higher than the supply by a certain amount, the monetary authorities must
intervene by supplying the market with that amount, because if they did
not do so, the pressure of excess demand for foreign exchange would cause
a depreciation in the exchange rate. And vice versa in the case of an excess
supply of foreign exchange on the market.
To put this in graphie form, let us consider Fig. 3.1, where a simple
partial equilibrium analysis of the foreign exchange market has been depicted,
on the assumption that the supply of foreign exchange is a well-behaved
(increasing) function of its price (the exchange rate) and the demand for
foreign exchange is a decreasing function of the exchange rate. In reality
these demands and supplies are not necessarily weH behaved, and depend on
a lot of other factors, which will determine shifts in the schedules, but we
shaH ignore these complications. We further assume that the market behaves
as aH other markets, i.e., the price (in our case the price of foreign currency is
the exchange rate) tends to increase (decrease) if there is an excess demand
(excess supply) in the market.
S(r)
D(r)
foreign exchange
Figure 3.1: Monetary authorities' intervention to peg the exchange rate
Let us now suppose that the exchange rate has to be pegged at T' whilst
the market is in equilibrium at Te. In the absence of official intervention, the
exchange rate would move towards Te, driven by the excess supply of foreign
exchange. To prevent this from happening, the monetary authorities must
absorb, as residual buyers, the excess supply A' B' (providing the market
with the corresponding amount of domestic currency). If, on the contrary,
the exchange rate were to be pegged at T", to prevent it from depreciating
towards Tein response to the pressure of excess demand for foreign exchange,
the monetary authorities would have to meet (as residual seHers) the excess
demand, by supplying an amount A" B" of foreign currency to the market
(absorbing from the market the corresponding amount of domestic currency).
It should be pointed out that, as the schedules in question represent
fiows, the monetary authorities must (ceteris paribus ) go on absorbing A' B',
or supplying A" B", of foreign exchange peT unit of time. This may weH give
rise to problems, especially in the case T", because by continuously giving
up foreign exchange the monetary authorities run out of reserves. These
3.3. Other Limited-Flexibility Systems 35
problems will be dealt with in Parts II and following.

So much as regards the spot exchange market. As regards the forward
market, the Bretton Woods system did not contemplate a similar obligation
to intervene.
The Bretton Woods system collapsed with the declaration of the legal (de
jure) inconvertibility into gold of the US dollar on August 15, 1971. It was de
jure, but the dollar had actually been inconvertible (de facto inconvertibility)
for several years. The amount of dollars officially held by non-US central
banks was, in fact, much greater than the official US gold reserve, and the
system was able to keep going only because these central banks did not
actually demand the conversion of dollars into gold. Therefore a de facto
"dollar standard" prevailed.
3.3 Other Limited-Flexibility Systems

The Bretton Woods system could also be classified as a limited-flexibility
system. Conventional fixed pegs arrangements still exist in several countries,
whereby the country pegs its currency at a fixed rate to another currency or a
basket of currencies, with or without fluctuation margins around the central
rate (parity). There are three other main types of intermediate systems:
(a) Crawling Peg (also called gliding parities; sliding parities; shiftable
parities). The currency is gradually and periodically adjusted vis-a-vis a
single currency or a basket. The crawl is viewed as baekward looking when it
is set to generate inflation-adjusted changes in the currency, and as forward
looking when the parity is adjusted at a preannounced fixed rate.
This system can give rise to several variants, according to (i) the rules
for changing the parity, and (ii) the indicators that have to be monitored in
order to ascertain the need for a parity change. On the basis of (i) we have
the diseretionary variant (whether to change the parity is entirely at the dis-
cretion of the monetary authorities), the automatie variant (the monetary
authorities are obliged to change the parity if, and only if, certain indicators
reach certain criticallevels), the presumptive variilnt(the signals of the in-
dicators are a presumption that the monetary authorities should change the
parity but have no obligation to do so).
As regards the indicators, among the many which have been suggested,
we can mention: disequilibrium in the balance of payments; change in inter-
national reserves; relative inflation rates; a moving average of the previous
spot exchange rates.
(b) Wider Band (also called widened band). The basic idea is to broaden
the band of permitted variation in the exchange rate around parity (i.e. the
range between the intervention points, which should be officially declared),
while maintaining a fixed but adjustable parity. The main variants con-
cern the rules for changing the parity. One variant proposes that the parity
(and with it the entire band) should be gradually changed, according to

the same rules as for the crawling peg (this case is defined as a "crawling
band" or "gliding band"). Another variant proposes, on the contrary, discrete
jumps (like the adjustable peg) but with a delayed official declaration of the
change. More precisely, when-as a consequence of an irreversible move of
the exchange rate to either of the margins of the band-the need for a parity
change arises, the monetary authorities should change it, but announce the
change only after a certain period of time, taking care so to define the new
parity as to make the old margin (where the exchange rate was stuck) fall
inside the new band. The delay in the announcement (which is meant to
have an anti-speculative purpose) has suggested the name "delayed peg" for
this variant.
(c) M anaged or Dirty Float. In this system the exchange rates are flexible,
so that no officially declared parities exist, but the monetary authorities
intervene more or less intensely to manage the float. A practically infinite
range of alternatives exists as regards the criteria for this management. At
one end of the spectrum, official intervention may be limited to smoothing out
exchange-rate movements (leaning against the wind): this is the case nearest
to the freely flexible regime. At the other end of the spectrum, monetary
authorities may pursue a very active intervention policy with the aim of
driving the exchange rate towards what they consider an appropriate value
(target approach): in this case managed floating will resemble a pegged-rate
system. An appropriate exchange rate may be estimated by the authorities
as an equilibrium exchange rate or as an exchange rate consistent with their
general economic policy objectives. In any case the member countries of
the IMF have agreed (Second Amendment to the Articles of Agreement of
the Fund, which came into force in March, 1978) to adhere to certain general
principles in their interventions in the exchange markets, amongst which that
of not manipulating exchange rates in order to prevent effective balance of
payments adjustment or in order to gain an unfair competitive advantage
over other members. The Fund, according to this Amendment, shall exercise
firm surveillance over the exchange rate policies of members, which must
consult with the Fund in establishing these policies.
The conventional fixed peg (including the adjustable peg), the crawling
peg, the wider band, and the crawling band arrangements are called "soft
pegs", as opposed to "hard pegs" (see above, Sect. 3.1).
3.4 The Current Nonsystem

After the collapse of the Bretton Woods system, no other replaced it, if by
system we mean a coherent set of rules (rights and obligations) and a precise
exchange rate regime universally adopted. Williamson (1976) aptly coined
the name "nonsystem" to denote such a situation, still in force. In fact,
3.4. The Current Nonsystem 37
the situation at the moment of going to the press, is that each country can
choose the exchange-rate regime that it prefers and notify its choice to the
IMF, so that various regimes coexist. Some countries peg their exchange
rate to a reference currency (usually thedollar, but also the euro and other
currendes) with zero or very narrow margins; naturally they will follow the
reference currency's regime with respect to the other countries.
EXCHANGE RATE ARRANGEMENTS
(in percent of IMF membership)
Hard Pegs Regimes 25.8, of which: Dollarization 4.3, Currency union 17.2,
Currency board 4.3
Soft Pegs Regimes 30.1, of which: Fixed peg to a currency 16.7, Fixed peg to a
basket 5.4, Horizontal band 2.7, Crawling peg 2.2, Crawling band 3.1
Floating Regimes 44.1, of which: Tightly managed float 8.6, Other managed
float 14.0, Independently floating 21.5
The classification system is based on the members' actual, de facto regimes that may
differ from their officially announced arrangements. The scheme ranks exchange rate
regimes on the basis of the degree of flexibility of the arrangements.
Source: IMF, Annual Report on Exchange Arrangements and Exchange Restric-
tions, 2003.
Then there are other countries which peg their currency to a compos-
ite currency such as, for example, the IMF's Special Drawing Right (SDR).
A composite currency, also called a "basket-currency" is an artifidal cur-
rency consisting of predeterminOO amounts of various currencies. The Special
Drawing Right issued by the International Monetary FUnd (see below) is a
basket-currency whose composition (revised in 2001; the basket composition
is revisOO every five years) is 45% US dollar, 29% euro, 15% Japanese yen,
11 % pound sterling. Another example of a basket-currency was the ECU
(European Currency Unit).
Groups of countries enter into monetary agreements to form currency
areas (by maintaining fixed exchange rates among themselves), or monetary
unions with a common currency, such as the European Monetary Union.
Further, the situation is continually changing, hence the reader had bet-
ter to consult the Annual Report on Exchange Arrangements and Exchange
Restrictions publishOO by the International Monetary FUnd to know the up-
datOO situation. In the box we report the situation as of 2003.
We conclude this section by stressing again that we have deliberately ab-
stained from giving a comparative evaluation of the various exchange-rate
regimes. The reason is that such an evaluation requires familiarity with
notions (adjustment processes of the balance of payments, macroeconomic
equilibrium in an open economy, etc.), which will be dealt with in the follow-
ing chapters. Thus the comparative evaluation of the different exchange-rate
regimes, which has 100 to hot debates in the literature, has to be deferrOO
(see Sect. 9.5).
3.5 Key Events in the Postwar International

Monetary System
Among the main events in the postwar international monetary system are
the following (in chronological order):
(a) the de jure inconvertibility into gold of the US dollar in 1971 and
the subsequent abandonment of the par value by all major currencies, which
adopted a managed float system (the collapse of the Bretton Woods system);
(b) the acquisition of enormous dollar surpluses by the oil exporting coun-
tries and the consequent "recycling problem";
(c) the demonetization of gold and the legalization of the float;
(d) the creation of the European Monetary System and the European
Monetary Union;
(e) the international debt crisis;
(f) the Asian and other crises.
Any choice of a limited number of events is inevitably arbitrary and may
reflect the idiosyncrasies of the writer. While pleading guilty, we believe that
most events listed above would be considered by most writers as key events
in the international monetary system. A very brief treatment of each of these
(or reference to other parts of the book, in which an event has already been
previously treated) will now be given.
3.5.1 Collapse of Bretton Woods

The events that are identified with the collapse of the Bretton Woods system
have already been described above. We only add that where the Jamaica
Agreement of January 1976 contemplated the possibility of returning to a
generalized regime of "stable but adjustable" par values, the reference was
not to an adjustable peg of the Bretton Woods type, which has proved to
be no longer viable, but to a regime which should ensure a better flexibility
than the adjustable peg. Thus the problem of the choice of the appropriate
exchange-rate regime is far from obsolete,and we refer the reader to Sect.
9.5 for a discussion of the various possible alternatives.
It is now as well to examine the causes of the collapse of the Bretton
Woods regime. In this system the country at the centre of the system, or
dominant country (the United States) guaranteed the convertibility of its
currency into gold at a fixed price. The other participating countries, in
turn, guaranteed the convertibility of their currencies into dollars at a fixed
exchange rate. Hence the system was, in fact, a gold exchange standard of
the limping type (since the convertibility of dollars into gold was limited to
central banks). It should be noted that generalised convertibility was fully
actuated only in 1959, so that the life span of the regime was a dozen years.
There is no doubt that the Bretton Woods regime of convertibility and fixed
3.5. Key Events in the Postwar International Monetary System 39
exchange rates was dose to a regime with a single world currency. And,
in fact, it brought about great benefits, amongst which the impetus to the
growth of international trade. We must then ask ourselves why it didn't last
longer.
The answer to this question is generally based on the so called 'friffin
dilemma. In a growing world with growing trade, there is a growing world
demand for money for trans action purposes. In the system under consider-
ation, this amounts to a growing demand for international reserves, that is
for dollars, which can be acquired only by running balance-of-payments sur-
pluses, exduding of course the USo In fact, given the international consistency
condition
the nth country (the US) has to incur a balance-of-payments deficit for the
"n-l
rest-of-the-world to acquire dollars, namely B n < 0 for L..,i=l Bi > O. But
this process poses the problem of the convertibility of dollars into gold. Since
the gold stock owned by the US cannot grow at the same rate as the growth of
dollars held by the rest-of the-world central banks, there is a loss of confidence
in the ability of the US to guarantee convertibility. If, on the other hand,
the United States brought their balance of payments into equilibrium, the
international monetary system would suffer from a liquidity shortage, with
the possible collapse of international trade. Hence the dilemma: if the US
allow the increase in international liquidity through deficits in their balance
of payments, the international monetary system is bound to collapse for a
confidence crisis; if, on the other hand, they do not allow such an increase,
the world is condemned to deflation.
In addition to the 'friffin dilemma, two other concurring causes are brought
into play: the rigidity of the system and the "seignorage" problem. The rigid-
ity 0/ the system was due to the fact that the idea of "fixed but adjustable"
exchange rates (adjustable peg) was interpreted, as observed in Sect. 3.2, in
the restrictive sense. That is to say, the parity was to be defended by all
means, and was to be changed only when any further defence turned out to
be impossible. Hence the external adjustment could not come about through
reasonably frequent exchange-rate variations, but through deflationary poli-
eies.
The seignorage problem was related to the reserve-currency role of the
dollar. This enabled the US to acquire long-term assets to carry out direct
investment abroad in exchange for short-term assets (the'dollars). These dol-
lars were usually invested by the rest-of-the-world central banks in short-term
US 'freasury bills, that carried a relatively low interest and whose purchas-
ing power was slowly but steadily eroded by US inflation. This problem was
much feit by several countries (especially by France under De Gaulle) and,
though not being an essential cause, certainly weakened the will to save the
system when it came under pressure.
The Triffin dilemma is the commonly accepted explanation of the collapse

of the Bretton Woods system. But there is an alternative explanation, put
forth by De Grauwe (1996, Chap. 4). This explanation is based on Gresham's
law ("bad money drives out good money"). This law, originally stated for
abimetallic standard (gold-silver, etc.), can be applied to any monetary
system based on the use of two moneys whose relative price (or conversion
rate) is officially fixed by the authorities, who commit themselves to buying
and selling the moneys at the official price. If one of the two currencies
becomes relatively abundant, its price in the private market will tend to
decrease: economic agents will then buy it there and sell it to the authorities
at the official price, which is higher. In the same way they obtain the scarce
currency from the authorities at a cheaper price than in the private market.
This means that the scarce currency will go out of the monetary circuit to be
used for non-monetary purposes (hoarding etc.). Only the abundant currency
will remain in use in the monetary circuit.
Now, if we apply this law to the gold-dollar system, it can be seen that the
increase in dollars was not matched by an increase in the gold stock, and that
the official price was losing credibility. In fact, while the purchasing power of
dollars (in terms of goods and services) was decreasing because of inflation,
it remained fixed in terms of gold. Thus the so-called "gold pool" , made up
of the central banks of the most industrialised countries, that acted buying
and selling gold in the private market with the aim of stabilizing its price
at the official level, was faced with increasing gold demand from the private
sector at the given official price ($ 35/oz.). The ensuing gold loss compelled
the gold pool to discontinue any intervention and leave the private price free,
maintaining the official price for transactions between central banks only.
The August 1971 official declaration of inconvertibility of the dollar was just
the de jure acknowledgment of a de facto situation, namely the functioning
of the system as a dollar standard.
If one accepts this analysis, the corollary follows that, even if the Triffin
dilemma were hypothetically solved, the working of Gresham's law would not
make it advisable a "return to gold" (as some still advocate).
Whichever explanation is accepted for the collapse of Bretton Woods,

the following fundamental point should be stressed: to base the international
monetary system on fixed exchange rates is tantamount to assuming that
the world as whole is an optimum currency area. If this assumption is not
true (and it does not seem that the Bretton Woods system was an optimum
currency area for all participants), then the system is bound to collapse.
3.5. Key Events in the Postwar International Monetary System 41
3.5.2 Petrodollars
The repeated increases in oil prices 1 charged since October 1973 by the oil
producing and exporting countries united in the OPEC cartel (Organization
of Petroleum Exporting Countries), gave rise to serious balance-of-payments
problems in the importing countries and to the accumulation of huge dollar
balances (also called petrodollars) by these countries, as oil was paid in dol-
lars. In 1974 the (flow) financial surplus of the OPEC countries was about $
56 billion, which mirrored an equal overall deficit of the oil importing coun-
tries vis-a-vis OPEC countries. About two-thirds of this deficit concerned
industrial countries, the remaining third the non-oil-producing developing
countries (also called the "Fourth World"). The problem of financing the
oil deficits was particularly acute given the suddenness and the amount of
the price increases, and was solved by means of the so-called recycling pro-
cess, through which the oil surpluses of the OPEC countries were lent back
(indirectly) to the deficit countries. The recycling process operated mostly
through market mechanisms, both international (the Eurodollar market) and
national (the US and UK financial markets), and for the rest through ad hoc
mechanisms. Since the OPEC countries invested their petrodollar surpluses
in the Eurodollar market and in the US and UK financial markets, the deficit
countries could borrow the dollars that they needed by applying to the Eu-
rodollar market and to the US and UK financial markets. The ad hoc mech-
anisms concerned both bilateral agreements between an oil importing and
an oil exporting country, and agreements brought into being by international
organizations. The latter included the IMF's "oil facility" brought into being
in 1974 (and discontinued in 1976) and financed by borrowing agreements be-
tween the IMF and other countries (mostly oil producing countries) with the
aim of granting loans, with certain conditions, to countries facing balance-
of-payments disequilibria due to oil deficits. The agreements also included
borrowing facilities created within the EEC and OECD organisations.
The recycling process was of course a short-run solution as it did not solve
the problem of the elimination of the oil surpluses and deficits. This can be
examined in the context of the theory of cartels (see Chap. 14, Sect. 14.4.2).
3.5.3 Demonetization of Gold

The problem of the function of gold in the international monetary system
and of its price was finally solved by the Jamaica Agreement of 1976, which
ITo set the problem into proper perspective it should be pointed out that these increases
occurred after a long period of low oll prices, which, though stable in nominal terms, had
actually been decreasing in real terms. Many people wonder therefore whether a more far
sighted policy (on the part of all those concerned), of gradual price increases in the period
before 1973, might not have avoided the problems created by the huge and sudden 1973
price increase.
mIed the demonetization of gold, thus removing the privileged status that
gold had previously enjoyed, with the ultimate aim of making it like any
other commodity.
The Bretton Woods Agreement gave gold a central place in the inter-
national monetary system, as was elear from the obligation on the part of
members to pay out twenty-five per cent of their IMF quota in gold and to
declare the par value of their currencies in terms of gold or, alternatively,
in terms of the US dollar (which was the same thing, since the dollar was
convertible into gold at the irrevocably fixed price of $ 35 per ounce). The
maintenance of this official price of gold was an easy matter until the end
of the fifties. But in 1960 problems began to arise because of the fact that
the free market price of gold, quoted in some financial centres (mainly Lon-
don), began to diverge from the official price, mostly because of speculative
hoarding. To counter this, the central banks of eight countries, by the Basle
Agreements of 1961 and 1962, constituted the so-called Gold Pool, which-
by using the gold provided by the central banks themselves-had the task of
intervening on the free market to stabilize the gold price, by buying (selling)
gold when its price fell (rose) beyond certain limits with respect to the official
price. In this way a single price of gold prevailed. But in 1968 the Gold Pool
was discontinued, because of huge losses of gold due to increasing speculative
pressures on the market, and the two-tier market for gold was established:
the official market for the transactions between central banks, at the agreed
price of $ 35 per ounce, and the free market, where the price was formed
by the free interplay of supply and demand; the central banks agreed not to
intervene on the free market.
The increase in the official price of gold to $ 38 and then to $ 42.44
did not solve the problem of the gold-reserve freeze, due to the fact that no
central bank was willing to meet its international payments by releasing gold
at the official price when the market price was much higher. Partial solutions
were found within the EEC (1974), with the settlement in gold of payment
imbalances at an official gold price related to the market price. However, the
general problem of the function of gold remained, and there were two main
schools of thought.
The first aimed at maintaining the monetary function of gold as the
paramount international means of payment and suggested the revaluation
of its official price to bring it elose to the market price. The second aimed
at eliminating this function so aB to allow the emergence of international
fiduciary means of payments, as had happened in the individual national
economic systems (where the link with gold hadlong been eliminated and re-
placed by fiduciary money). The second school prevailed, and this is reflected
in the Kingston (Jamaica) Agreement of January 1976, which contemplated,
amongst other,
(1) The elimination of the function of gold as numeraire of the system,
i.e. as common denominator of par values of currencies.
3.6. International Organisations 43
(2) The abolition of the official price of gold.

(3) The abolition of any obligation on the part of member countries to
malm payments to the FUnd in gold, in particular as regards quota increases
and interest payments.
3.5.4 EMS and EMU

The European Monetary System and the European Monetary Union will be
treated in Chap. 11, to which we refer the reader.
3.5.5 The International Debt Crisis

This will be treated in Chap. 12, to which we refer the reader.
3.5.6 The Asian and Other Crises

These will be treated in Chap. 8, to which we refer the reader.
3.6 International Organisations

The international organisations dealing with economic matters are numerous,
but here we shall only examine the International Monetary FUnd, the World
Bank, the World Trade Organization, the Bank for International Settlements.
The American and British governments, in the hope of avoiding the inter-
national economic disorder that had followed World War I, in the early 1940s
took the initiative of assembling governments and experts to design rules and
institutions for post-World War II monetary and financial relations. The
agreements that emerged were adopted by 44 nations at a conference held
in Bretton Woods (new Hampshire) in July 1944. The system that was set
up took the name of Bretton Woods system and has been described above.
Although this system collapsed in 1971, the institutions that were created
at the Bretton Woods conference still exist, and are the IMF (International
Monetary Fund) and the IBRD (International Bank for Reconstruction and
Development, commonly known as the World Bank); these were joined a few
years later by the GATT (General Agreement on Tariffs and Trade), which
developed into the WTO (World Trade Organization).
3.6.1 The IMF

The International Monetary FUnd (http://imf. org) began operations in Wash-
ington, DC in May 1946 with 39 members; it now has 183 members. On
joining the IMF each member country contributes a certain sum of money
called a quota subscription, which is determined by the IMF itself on the ba-
sis of the country's wealth and econornie performance. Quotas are reviewed
every five years and can be lowered or raised on the basis of the needs of the
IMF and the econornic situation of the member. In 1946, the 39 members
paid in the equivalent of $7.6 billion; by 2001, the 183 members had paid in
the equivalent of about $269 billion, and there is a proposal to raise quotas
to a still higher value.
Quotas serve various purposes:
1) they eonstitute the resources from which the IMF draws to make loans
to members in financial diffieulty;
2) they are the basis for deterrnining how much a member can borrow
from the IMF, or receives from the IMF in periodic allocations of special
assets known as SDRs (Special Drawing Rights; see above, Sect. 3.4);
3) they deterrnine the voting power of the member.
The highest link of the chain of eommand in the Fund is the Board of
Governors and Alternate Governors (one Governor and one Alternate per
member). These persons are ministers of finance or heads of central banks,
and meet onee a year. The day-to-day management of the Fund is delegated
to the Executive Board chaired by the Managing Direetor. The Executive
Board at the moment consists of 24 persons, eight of whom represent in-
dividual countries (China, France, Germany, Japan, Russia, Saudi Arabia,
the United Kingdom, the United States), while the remaining sixteen repre-
sent groups of countries. By tradition, the Managing Director is a non-US
national, while the President of the World Bank is a US national.
The IMF performs three main functions in the interest of an orderly
functioning of the international monetary system:
1) Surveillance. After the dernise of the Bretton Woods system it seemed
that the preerninent role of the IMF would disappear. This has not hap-
pened, as under the current system the IMF has been entrusted with the
exarnination of all aspects of any member's economy that are relevant for
that member's exchange rate and with the evaluation of the economy's per-
formance for the entire membership. This entails more scope for the IMF
to monitor members' policies. The activity we are describing is called by
the IMF "surveillance" over members' exchange policies, and is carried out
through periodie consultations conducted in the member country.
2) Financial assistance. This is perhaps the most visible activity to the
general public: as of July 1998, for example, the IMF had committed about
$35 billion to Indonesia, Korea and Thailand to help them with their finan-
cial crisis (the Asian crisis) and around $21 billion to Russia to support its
econornic program. The general rules for obtaining financial assistance from
the fund are the following:
i) a member country with a payments problem can immediately withdraw
from the IMF the 25 percent of its quota. Once this was called the gold
tranche position, because it had to be paid in gold to the Fund. After the
demonetization of gold this percentage has to be paid in SDRs or convertible

currencies.
ii) if this is not sufficient, the member can request more from the FUnd,
up to a cumulative maximum of three times what it paid in as a quota.
This limit does not apply to loans under special facilities, such as the SRF
(Supplemental Reserve Facility) and the CCL (Contingent Credit Line). The
SRF was created in December 1997 to cope with the Asian crisis; under this
facility the Fund can make short-term loans in huge amounts at penalty
rates to countries in crisis, subject to the condition that certain economic
policies be foIlowed. The CCL was created in April 1999 to provide "sound"
countries with a line of credit (at penalty rates in case of use) that they
can draw on in the event they are hit by contagion from an external crisis.
To qualify for a CCL the country must foIlow good macroeconomic policies,
have a strong financial sector , and meet (or be moving towards meeting)
international standards in several areas. The idea behind CCL is to provide
a kind of insurance for countries with good policies rather than assisting
countries that are already in trouble, and thus stimulating other countries to
pursue good policies
The main difference between i) and ii) is that the withdrawal of 25% of the
quota is a right of the member, since it requires no assent from the Fund.
On the contrary, further loans under ii) are conditional, i.e., the IMF extends
them only provided that the member agrees to undertake domestic policy
actions in accordance with the FUnd's recommendations (see Chap. 14, Sect.
14.3).
3) Technical Assistance. Members (for example developing countries,
countries moving from planned to market economy such as Russia, Eastern
European countries, etc.), may sometimes lack expertise in highly techni-
cal areas of central banking and public finance, and thus turn to the IMF
for technical assistance, including advice by Fund's experts, training of the
member's officials in Washington or locaIly, etcetera.
3.6.2 The World Bank

The International Bank for Reconstruction and Development, commonly
know as World Bank (http://worldbank.org), provides loans and develop-
ment assistance to creditworthy poor countries as weIl as to middle-income
countries. Its organization is conceptuaHy similar to that of the IMF: it is
owned by more than 180 member countries which are shareholders with vot-
ing power proportional to the members' capital subscriptions, that in turn
are based on each country's economic strength.
Each member appoints a Governor and an Alternate Governor, who meet
once a year. The day-to-day management of the World Bank is carried out
by a Board consisting of 24 Executive Directors chaired by a President (by
tradition anational of the United States). Five Executive Directors represent
individual countries (France, Germany, Japan, the United Kingdom and the
United States) while the remaining 19 represent groups of countries.
While the task of the IMF is to promote a weH functioning and orderly
international monetary system, the main task of the World Bank is to pro-
mote growth of poorer countries. Contrary to the IMF, whose resources are
the members' quotas, the World Bank raises almost all its funds in finan-
cial markets by selling bonds and other assets. Its average annualloans are
around $30 billion.
Over the years the World Bank has become a group, consisting of five
institutions: the IBRD proper, the IDA (International Development Asso-
ciation, whose assistance is focused on the poorest countries), IFC (Inter-
national Finance Corporation, which provides finance for business ventures
in developing countries), MIGA (Multilateral Investment Guarantee Agency,
which covers foreign investors in developing countries against non-commercial
risks) , and ICSID (International Center for Settlement of Investment Dis-
putes, which arbitrates disputes between foreign investors and the country
where they have invested).
The IMF in providing financial assistance, and the World Bank in pro-
viding development assistance, have in mind a model. The model on which
the IMF-WB growth-oriented adjustment programs are based will be treated
in Chap. 12, Sect. 12.4.
3.6.3 GATT and WTO

GATT (General Agreement on Tariffs and Trade) was established in 1947 on
a provisional basis with the aim of providing an international forum for ne-
gotiating tariff reductions, agreeing on world trade disciplines, solving trade
disputes. Provisional because GATT was meant to pave the way for a spe-
cialized agency of the United Nations, the ITO (International Trade Organi-
zation), to be established shortly afterwards. This did not take place because
the national ratification of the ITO charter proved impossible in some coun-
tries (amongst which the United States). Thus provisionality lasted for 47
years, until WTO (World Trade Organization, http://wto.org) was estab-
lished.
GATT has promoted international trade liberalization in several ways. It
has outlawed the use in general of import quotas, and established the exten-
sion to all members of the MFN (Most Favoured Nation) treatment. Under
Article I of GATT (also called the MFN clause), members have committed
themselves to give to the products of other members a treatment no less
favourable than that granted to the products of any other country. Thus,
no country can give special advantages to another country or discriminate
against it. GATT has also provided a negotiating framework for tariff re-
ductions through multilateral trade negotiations or "trade rounds" , the last
and most extensive being the Uruguay round (1986-93). These negotiations
have involved not only tariffs, but also subsidies and countervailing measures,
anti-dumping, teehnieal barriers to trade, government procurement, and so
on.
The original agreement (ealled GATT 1947) was amended and updated
in 1994 (GATT 1994). GATT 1994 is an integral part of WTO, which was
established on 1st January 1995.
As the names say, WTO is an organization, while GATT 1947 was an
agreement. This is not only a semantie differenee or a juridical subtlety: an
agreement is simply a set of mIes with no legal institutional foundation; a
(permanent) organization is an institution with legal personality and its own
secretariat and powers. This implies, amongst other, that the WTO dispute
settlement system is faster and more automatie, and the implementation of
its deeisions on disputes is more easily assured. From the economie point of
view, WTO has a greater seope than GATT, for GATT mIes applied solely
to trade in merchandise, while WTO in addition to goods also covers trade in
services (GATS, General Agreement on Trade in Services) as weIl as trade-
related aspects of intelleetual property (TRIPS, Trade-Related aspects of
Intellectual Property rights). Member countries are requested to make their
trade policies transparent by notifying the WTO ab out laws in force and
measures adopted, and the secretariat issues regular reports on countries'
trade policies.
GATT, and now WTO, are sometimes deseribed as free-trade institutions.
This is not entirely eorrect, if only because tariffs (and, in limited circum-
stances, other forms of protection) are permitted. The basic aim of GATT
and WTO mIes is to secure open, fair and undistorted competition in inter-
national trade. Rules on non-diserimination (such as the MFN dause and the
national treatment principle, whieh eondemns diserimination between foreign
and national goods in terms of taxation and regulation, onee the applicable
border measures have been satisfied), as weIl as those on dumping and subsi-
dies (governments are allowed to impose compensating duties on these forms
of unfair eompetition), are designed to bring about fair conditions of trade.
3.6.4 The Bank for International Settlements

The Bank for International Settlements (BIS, http://bis.org) was established
in Basle in 1930 under the Hague Agreements as an international organisation
whose functions centred on the collection, administration and distribution of
the annuities payable as reparations by Germany following the First World
War - hence the name of the Bank - as weIl as on the servicing of the external
loans eontracted to finance them. From the outset, however, the BIS has
served as a forum to facilitate eooperation among central banks. This role
has undergone eonstant transformation as the requirements for international
monetary cooperation have changed over the years.
Today, the Bank's activities are focused on the following two areas:
1) The BIS assists central banks and other financial authorities in their
efforts to promote greater monetary and financial stability. This assistance
takes two forms:
1a) Direct contributions to international cooperation. The BIS provides
an institutional framework for cooperation in the monetary and financial area
and serves as a meeting place mainly for central banks, but also for other
financial and regulatory authorities.
1b) Services to committees established by central bank Governors over the
course of the past decades, and support to a number of other groupings with
secretariats at the BIS. The most important committees are, in chronolog-
ical order of establishment, the Markets Committee (1962), the Committee
on the Global Financial System (1971), the Basle Committee on Banking
Supervision (1974) and the Committee on Payment and Settlement Systems
(1990).
2) It acts as a bank, almost exclusively for central banks, providing ser-
vices related to their financial operations. Trustee and collateral agency
functions are also part of these services. In addition to its central bank
customers, the BIS also acts as a banker to, and manages funds for, a num-
ber of international financial institutions. The Bank's Statutes do not allow
the Bank to open current accounts in the name of, or make advances to,
governments.
Three decision-making bodies are relevant within the Bank's governance
structure: the General Meeting of member central banks (currently 51), the
Board of Directors and the Management of the Bank, headed by a General
Manager. Decisions taken at each of these levels concern the running of
the Bank and as such are mainly of an administrative and financial nature,
related to its banking operations, the policies governing internal management
of the BIS and the allocation of budgetary resources to the different business
areas.
3.7 Suggested Further Reading

De Grauwe, P., 1996, International Money: Postwar Trends and Theories,
2nd edition, Oxford: Oxford University Press.
Eichengreen, B. 1996, Globalizing Capital: A History 0/ the International
Monetary System, Princeton: Princeton University Press.
Kenen, P.B., F. Papadia and F. Saccomanni (eds.), 1994, The International
Monetary System, Cambridge (UK): Cambridge University Press.
Williamson, J., 1976, The Benefits and Costs of an International Nonsys-
tem, in: E.M. Bernstein et al., Reftections on Jamaica, Essays in In-
ternational Finance No. 115, International Finance Section, Princeton
University.
Chapter 4
International Interest-Rate
Parity Conditions
The relations between interest rates (domestic and foreign) and exchange
rates (spot and forward) that were already mentioned in Chap. 2, are very
important and frequently used in international finance. Hence, we give here a
general overview, with additional important considerations on the efficiency
of the foreign exchange market and on capital mobility.
4.1 Covered Interest Parity (CIP)

In general, interest arbitrage is an operation that aims to benefi.t from the
short-term employment of liquid funds in the financial centre where the yield
is highest: we are in the presence of economic agents engaged in purely
financial operations. AB, however, these agents are not speculators, they will
cover themselves against exchange risk (by having recourse to the forward
exchange market), hence the denomination of covered interest arbitrage.
Let us consider, for example, an agent who has to place a certain amount
of domestic currency short-term, and assume that the interest rates are in-
dependent of the amount of funds placed or that this amount is not so huge
as to give its owner the power to infiuence market interest rates significantly,
so that we can reason at the unit level. For each unit of domestic currency
placed at horne short-term, the agent will obtain, after the stipulated period
has elapsed, the amount (1 + i h), where ih is referred to this same period.
Alternatively, the agent can buy foreign currency spot and place it abroad
for the same period of time: as (1/r) of foreign currency is obtained per
unit of domestic currency, the amount (1/r)(1 + i f ) of foreign currency will
be obtained at the end of the period, where if is the foreign interest rate
referring to this same period. To eliminate any exchange risk, the agent can
now seIl that amount of foreign currency forward: thus he will obtain, after
the stipulated period has elapsed, the amount rF(l/r)(l + if) of domestic
49
50 Chapter 4. International Interest-Rate Parity Conditions
currency with no exchange risk.

Now, if, for the sake of simplicity, we assume that the costs of the oper-
ations are equal, it is obvious that the agent will place the funds at home or
abroad according aS (1 + ih) ~ r F(l/r)(l + i/)' whilst he will be indifferent
in the case of equallty. Since as can be easily checked the same conditions
hold when the arbitrageur does not own the funds but has to borrow them,
or when the funds are in foreign currency, it follows that funds will flow in
(inward arbitrage), have no incentive to move, flowout (outward arbitrage)
according as
(4.1)
If we divide through by (1 + i I) and exchange sides, this condition can
be written as
r F < 1 + ih
(4.2)
-:;::> l+i/
whence, by subtracting one from both sides,
F ..
r - r < '/,h - '/,1
-r-:> l+i l · (4.3)
Note that this inequality coincides with the inequallty concerning the various
covering alternatives of commercial traders, see Eq. (2.19), of course when
both refer to the same period of time.
The condition of equallty in (4.2) or in (4.3), that iswhen funds have
no incentive to move from where they are placed, is called the neutrality
condition and the forward rate is said to be at interest parity or simply
that covered interest parity (CIP) prevails, and the corresponding forward
exchange rate is called the parity forward rate. When there is a difference
between the forward margin and the interest rate differential such that funds
tend to flow in (out), we say that there is an intrinsie premium (discount)
for the domestic currency.
The equations that define CIP
rF 1 + ih rF - r ih - i1
(4.4)
r 1+i/ --r- = 1 + i1 '
can be written in alternative specifications, that are often used in the litera-
ture, which are obtained by an approximation!
(4.5)
lAs can easily be checked, i;~; = (ih -i,) - (ih -i,)~. Hence the approximation
error of using ih - i, in the place of i;:;ii/
is very small, since it is given by - (i h - i,) ~,
which is of the second order of magnitude.
4.2. Uncovered Interest Parity (UIP) 51
i.e. the interest differential equals the forward margin, or the domestic inter-
est rate equals the foreign interest rate plus the (positive or negative) forward
margin. These equations are also referred to as the covered interest parity
conditions.
4.2 Vncovered Interest Parity (VIP)

Let us consider an agent who holds deterministic (or certain) exchange-rate
expectations, namely is sure of the exactness of his expectations about the
future value of the spot exchange rate. Alternatively we can assume that the
agent is risk neutral, namely is indifferent to seeking forward cover because,
unlike arbitrageurs, only cares about the yield of his funds and not about
the risk. Suppose that such an agent has to place a certain amount of funds
short-term, that we assume to be denominated in domestic currency (if they
are denominated in foreign currency the result will not change). He will
consider the alternative between:
a) investing his funds at horne (earning the interest rate ih), or
b) converting them into foreign currency at the current spot exchange
rate r, placing them abroad (earning the interest rate i f ), and converting
them (principal plus interest accrued) back into domestic currency at the
end of the period considered, using the expected spot exchange rate (r) to
carry out this conversion.
The agent will be indifferent between the two alternatives when
(4.6)
where the interest rates and expectations are referred to the same time hori-
zon. If the two sides of Eq. (4.6) are not equal, the agent can earn a profit
by shifting funds in or out of the country according as the left-hand side of
Eq. (4.6) is greater or smaller than the right-hand side.
If we divide both members of (4.6) by (1 + if), we get
1 + ih r
--=-
1 + if r'
whence, subtracting one from both members,
~h - ~f r- r
--=-- (4.7)
1 + if r
From these relations we obtain, by the same approximation as in the previous

section,
. . r-r ih=i,+--.
r-r (4.8)
zh-~' = --,
r r
This condition, according to which the interest differential is equal to the

expected variation in the spot exchange rate or, equivalently, the domestic
interest rate equals the foreign interest rate plus the expected variation in
the exchange rate, is called the uncovered interest parity (UIP) condition.
4.3 Uncovered Interest Parity with Risk

Premium
Both deterministic expectations and risk neutrality are rather strong assump-
tions, so that in the normal case of agents who are uncertain about the future
value of the exchange rate and/or are risk averse, a risk coefficient or risk
premium has to be introduced. The reasoning is the same as that used in
relation to foreign-exchange speculators-see Sect. 2.4.1, in particular Eq.
(2.20). Thus we have
. . r- r
Zh=Z/+--+u,
~
(4.9)
r
where {) is the risk coefficient or risk premium, expressed in proportional or
percentage terms like the other variables appearing in the equation. It is not
surprising that (4.9) is equal to (2.20): the motivations are different, but the
underlying economic calculations are the same. In fact, for speculators the
main element of profit is the expected change in the exchange rate, and the
interest rates enter the picture rationally to compare the alternatives. For
financial investors the main element of profit is the interest differential, and
the expected variation in the exchange rate enters the picture rationally to
compare the alternatives. The final result is in any case the same.
4.4 Real Interest Parity

The interest rates so far considered are nominal rates. It may however be
interesting to reason in terms of real interest rates. According to the well-
known Fisher definition, real and nominal interest rates are related by the
expected inflation rate (naturally referred to the same time horizon as the
interest rates). More precisely,
(4.10)
where iRh is the real interest rate and Wh - Ph)/Ph is the expected inflation
rate. A similar definition holds for the rest-of-the-world real interest rate,
namely
(4.11)
4.5. Effideney of the Foreign Exchange Market 53
Let us now consider the uncovered interest parity condition (4.8), that we
report here for the reader's convenience,
. . r-r
~h = ~i + --,
r
and assume that the expected variation in the exchange rate equals the dif-
ference between the expected inflation rates in the two countries, namely
Pi -Pi
(4.12)
r Ph Pi
If we now substitute the expected variation in the exchange rate, as given by

Eq. (4.12), into the UIP condition, and use the definitions (4.10) and (4.11),
we get the relation
(4.13)
which is caHed real interest parity. It should be noted that, if we accept
the orthodox neoc1assical theory, according to which the real interest rate
equals the marginal productivity of capital, Eq. (4.13) is equivalent to the
equalization of the price of the factor capital (the factor-price equalization
theorem, weH known in the theory of international trade: see Sect. 13.6.1).
It is then interesting to observe that, if we assume from the beginning that
factor-price equalization holds (i.e., Eq. (4.13) becomes our initial assump-
tion), then-by reasoning backwards-we prove Eq. (4.12) as a result of the
analysis.
4.5 Efficiency of the Foreign Exchange

Market
According to the generaHy accepted definition by Fama, a market is efficient
when it fully uses all available information or, equivalently, when current
prices fully reflect all available information and so there are no unexploited
profit opportunities (there are various degrees of efficiency, but they need
not concern us here). Then, by definition, in an efficient foreign exchange
market both covered and uncovered interest parity must hold.
We have in fact seen (Sect. 4.1) that, if there is a discrepancy between the
two sides of the CIP equation, it will be possible to make profits by shifting
funds at home or abroad, according to the sign of the discrepancy. But, if
we assume perfect capital mobility (so that no impediments exist to capital
flows), such a profit opportunity cannot exist if the market is efficient.
Similarly, a risk-neutral agent will be able to make profits by shifting
funds at home or abroad, as the case may be, if the UIP condition (4.8) does
not hold. If the agent is risk averse or has uncertain expectations, we shall
have to consider the possible discrepancy between the two sides of Eq. (4.9).
This last observation also holds for speculators, as we have seen above.
If we assurne the interest rates as given, in the foreign exchange market
the variables that must reflect the available information are the spot (both
current and expected) and forward exchange rate. Hence, since both CIP
and UIP hold if the market is efficient, we have
whence
(4.14)
from which
(4.15)
namely the forward exchange rate and the expected spot exchange rate (both
referred to the same time horizon) coincide. In a stochastic context it turns
out that the forward exchange rate is an unbiased and efficient predictor of
the future spot exchange rate.
In the case ofrisk premium, using (4.5) and (4.9) we get
r F -r - -r
r
--=--+<5, (4.16)
r r
namely the forward margin is equal to the sum of the expected variation in
the spot exchange rate and the risk coefficient. In terms of levels we have
rF = r+RP, (4.17)
where RP = 8r is the risk premium in levels.
4.6 Perfeet Capital Mobility, Perfeet Asset

Substitutability, and Interest Parity
Conditions
From the theoretical point of view the verification of the interest parity con-
ditions requires perfeet capital mobility, by which we mean that asset holders
are completely free instantaneously to move their funds abroad or to repatri-
ate them. Imperfect capital mobility could derive, e.g., from administrative
obstacles such as controls on capital movements, from high trans action costs,
and so on. Asset holders can thus instantaneously realize the desired port-
folio composition by moving their funds. An equivalent way of saying this is
that the speed of adjustment of the actual to the desired portfolio is infinite,
4.6. Perfect Capital Mobility, Perfect Asset Substitutability, and Interest Parity 55
so that the adjustment of the actual to the desired portfolio is instantaneous.

It follows that the current portfolio is always equal to the desired one.
Perfect capital mobility thus implies covered interest parity: the domes-
tic interest rate is equal to the foreign interest rate plus the forward margin.
It does not, however, necessarily imply uncovered interest parity, unless a
further assumption is introduced: the assumption of perfeet substitutability
between domestic and foreign assets. This means that assets holders are in-
different as to the composition (in terms of domestic and foreign bonds) of
their portfolios so long as the expected yield of domestic and foreign bonds
(of equivalent characteristics such as maturity, safety, etc.) is identical when
expressed in a common numeraire. Taking for example the domestic cur-
rency as numeraire, the expected yield of domestic bonds is the domestic
interest rate, while the expected yield of foreign bonds is the foreign interest
rate, to which the expected variation in the exchange rate must be added
algebraically (to account for the expected capital gains or losses when the
foreign currency is transformed into domestic currency). But this is exactly
the uncovered interest parity condition.
When domestic and foreign assets are not perfect substitutes, UIP cannot
hold, but uncovered interest parity with risk premium will hold. The fac-
tors that, besides exchange risk, make domestic and foreign bonds imperfect
substitutes are, amongst others, political (or country) risk, the risk of de-
fault, the risk of the introduction of controls on capital movements, liquidity
considerations, and so on.
It is now as weIl to clarify a point. Perfect capital mobility plus perfeet
asset substitut ability imply, as we have just seen, that both CIP and UIP
hold, namely ih = i f +(r F - r) Ir = i f + (f - r) Ir. It is however often
stated that perfect capital mobility plus perfect asset substitut ability imply
that the domestic interest rate cannot deviate from the foreign interest rate,
Le. i h = i f. This is not automatically true, unless further assumptions
are made. More precisely, the additional property of (nominal) interest rate
equalization requires that the agents involved expect the future spot exchange
rate to remain equal to its current value (statie expeetations). This amounts
to assuming f = t and so, since there is no perceived exchange risk, the
forward exchange rate is also equal to the current spot exchange rate, r F = r.
In the case of fixed exchange rates for this to hold it is sufficient that the
various agents are convinced of the fixity of the exchange rate: the current
spot exchange rate, in other words, is eredible. In the case of flexible exchange
rates, static expectations are a bit less plausible. However, they remain valid
in the case of agents who do not hold any particular expectation about the
future spot exchange rate, i.e. hold appreciations and depreciations in the
exchange rate as equally likely. If so, the best forecast is exactly f = r. More
technically, this means that agents implicitly assume a (driftless) random
walk, namely a relation of the type f = r + €, where € is a random variable
with zero mean, constant finite variance, and zero autocovariance.
The distinction between perfect capital mobility and perfect asset sub-
stitutability (advocated by Dornbusch and Krugman, 1976) is not generally
accepted. Other authors (for example Mundell, 1963, p. 475), in fact, in-
clude in the notion of perfect capital mobility not only instantaneous portfolio
adjustment, but also perfect asset substitutability. We believe that the dis-
tinction between the two notions is important and useful, therefore we shall
keep it.

Dornbusch, R and P. Krugman, 1976, Flexible Exchange Rates in the Short
Run, Brookings Papers on Economic Activity, No. 3, 537-575.
Froot, K.A. and RH. Thaler, 1990, Foreign Exchange, Journal 01 Economic
Perspectives 4 (3), 179-92.
Mundell, RA., 1963, Capital Mobility and Stabilization Policy under Fixed
and Flexible Exchange Rates, Canadian Journal 01 Economics and Po-
litical Science 29, 475-485.
Chapter 5
The Balance of Payments
5.1 Balance-of-Payments Accounting and

Presentation
5.1.1 Introduction
Before coming to grips with the theories of commercial and financial fiows,
we must have a clear idea of what a balance of payments is and be able to
understand the content of the statistical data presented therein. Although
the various national presentations look different, all obey a common set of
accounting rules and definitions, which can be given a general treatment. Fur-
thermore, where possible, the IMF (International Monetary Fund) publishes
the balances of payments of all member countries in a standardized presen-
tation (see the IMF's publications Balance 0/ Payments Statistics Yearbook
and International Financial Statistics) in accordance with the classification
scheme of the Fund's Balance 0/ Payments Manual. This contains the rec-
ommended concepts, rules, definitions, etc., to guide member countries in
making their regular reports on the balance of payments, as stipulated in the
Fund's Articles of Agreement; at the time of writing the latest edition is the
fifth (henceforth referred to as the Manual).
We shall first explain the general principles, and then treat the standard
classification scheme.
In synthesis, the balance of payments of a country is a systematic record
of all economic transactions which have taken place during a given period of
time between the residents of the reporting country and residents of foreign
countries (also called, for brevity, "nonresidents", "foreigners", or "rest of
the world"). This record is normally kept in terms of the domestic currency
of the compiling country.
Since the balance of payments refers to a given time period, it is a flow
concept.
It should be pointed out that the concept of resident does not coincide
57
58 Chapter 5. The Balance of Payments
with that of citizen, though a considerable degree of overlapping normally

exists. In fact, as regards individuals, residents are the persons whose general
centre of interest is considered to rest in the given economy, that is, who
consume goods and services, participate in production, or engage in other
economic activities in the territory of an economy on other than a temporary
basis, even if they have a foreign citizenship. On the basis of this definition,
for example, migrants are to be considered as residents of the country in
which they work, even if they maintain the citizenship of the country of
origin.
The Fund's Manual indicates a set of rules to solve possible doubtful cases
concerning both individuals and non-individuals.
Let us now come to the accounting principles of the balance of payments.
(a) The first basic principle is that, as all accounting documents, the bal-
ance of payments is kept under standard double-entry bookkeeping. Therefore
each international trans action of the residents of a country will result in two
entries that have exactly equal values but opposite signs: a credit (+) and
adebit (-) entry in that country's balance of payments. The result of this
accounting principle is that the total value of debit entries necessarily equals
the total value of credit entries (so that the net balance of all the entries is
necessarily zero), that is, the balance of payments always balances.
Naturally, the credit and debit entries are not arbitrary but must follow
precise rules. "Under the conventions of the system, a compiling economy
records credit entries (i) for real resources denoting exports and (ii) for fi-
nancial items reflecting reductions in an economy's foreign assets or increases
in an economy's foreign liabilities. Conversely, a compiling economy records
debit entries (i) for real resources denoting imports and (ii) for financial items
reflecting increases in assets or decreases in liabilities. In other words, for
assets-whether real or financial-a positive figure (credit) represents a de-
crease in holdings, and a negative figure (debit) represents an increase. In
contrast, for liabilities, a positive figure shows an increase, and a negative
figure shows a decrease. Transfers are shown as credits when the entries to
which they provide the offsets are debits and as debits when those entries
are credits" (from the Manual, p. 7).
Note that under this rule an increase in foreign liabilities of the country
(the sale of domestic securities to non residents gives rise to such an increase)
gives rise to a credit entry, while an increase in foreign assets (the purchase
of foreign securities by residents gives rise to such an increase) gives rise to a
debit entry. A decrease in foreign assets is treated like an increase in foreign
liabilities, and a decrease in foreign liabilities is treated like an increase in
foreign assets.
The convention concerning the recording of finandal items implies that
a capital outftow is a debit in the capital account, as it gives rise to an
5.1. Balance-of-Payments Accounting and Presentation 59
increase in foreign assets, or to a decrease in foreign liabilities, of the country;

sirnilarly, a capital inflow is a credit in the capital account, as it gives rise to
an increase in foreign liabilities or a decrease in foreign assets.
(b) The second basic principle concerns the timing of recording, that is,
the time at which transactions are deemed to have taken place. In general,
various rules are possible; the principle adopted by the Fund's Manual is
the change of ownership principle. By convention, the time of change of
ownership is normally taken to be the time that the parties concerned record
the transaction in their books.
(c) The third basic principle is that of the uniformity of valuation of

exports and imports. Commodities must be valued on a consistent basis,
and .this may give rise to problems if, for example, the exporting country
values exports on a f.o.b. (free on board) basis, whilst the importing country
values the same commodities as imports on a c.iJ. (cost, insurance, and
Jreight) basis. The Fund suggests that all exports and imports should be
valued f.o.b. to achieve uniforrnity of valuation.
The standard presentation of the balance of payments consists of two
sections. Section I is called the current account: it includes all real transfers
involving a quid pro quo, and all unrequited transfers. Section 11 is called the
capital and financial account: it shows changes of ownership and other speci-
fied changes in an economy's foreign financial assets and liabilities (including
changes in the country's international reserves).
5.1.2 Standard Components

We shall examine here the main standard components of the two sections
(current account, and capital and financial account) into which a standard
balance of payments is divided.
5.1.2.1 Current Account

The current account includes goods, services, and unilateral transfers.
A) Goods and Services
A.l) Exports and Imports of Goods. These are also called the ''visible''
items of trade (the invisible items being the services)
A.2) Exports and Imports of Services, also called the "invisible" items
of trade. They include both services proper and items classified under this
heading for convenience. Insurance and freight charges for goods, passenger
transportation, film rentals, banking comrnissions, fees and royalties for the
use of intangible property or rights (patents, trademarks, copyright, etc.),
and so on, are clearly payments for services. For convenience's sake tourist
expenditures, even if they partly consist of the purchase of commodities, are

included here in their totality.
B) Factor income
The Manual suggests that factor incomes (labour income and investment
income) be included in aseparate sub-account of the current account. As
regards labour income, care must be taken to check the residence. The
labour income item records income earned by residents working abroad for
nonresidents and income earned by nonresidents working in the domestic
country for residents. Therefore, migrants' remittances do not belong to
this category. Migrants, in fact, are no longer considered as residents of the
country of origin, but as residents of the country in which they work, so that
any remittance to the country of origin of amigrant cannot be considered as
the quid pro quo for services of domestic factors abroad (from the point of
view of the receiving country), nor as the quid pro quo for services of foreign
factors (from the point of view of the paying country). These remittances
are therefore to be considered as unrequited transfers.
As regards investment income, while the purchase of a foreign bond is
recorded in the capital account, interest received from the bond is recorded
here.
G) Unrequited or Unilateral Transfers
These are divided into two groups, according to the nature of the oper-
ator: private or official. In the case of the former the main item consists
of migrants remittances; the latter includes voluntary subsidies to defence
budgets, government contributions to international organizations for admin-
istrative expenses, war reparations, etc. An innovation of the fifth edition
of the Manual is to include in this account current transfers only. Capital
transfers (e.g., transfer of ownership of a fixed asset, forgiveness of a liability
by a creditor, etc., of course when no counterpart is received in return) should
be included in the capital and financial account, to which we now turn.
5.1.2.2 Capital and Financial Account

This account (which once was called the capital account) includes all changes
in the country's foreign financial assets and liabilities (including reserve as-
sets, on which see below), or, as they are also called, all capital movements. It
is divided into: A. Gapital account, and B. Financial account. The capital ac-
count contains a11 unilateral capital transfers as weH as the purchase and sale
of immaterial capital or intangible assets (patents, licences, author's rights,
etc.); note that income from immaterial capital (for example, the payment
of author's rights) is not included here, but in the factor income account (see
above). The financial account includes all the rest, and is what was formerly
called the capital account. To avoid confusion we shall continue using the
old terminology. In general several classification criteria can be used:
1) the nature of the operation, or type of capital: direct investment,
5.1. Balance-of-Payments Accounting and Presentation 61
portfolio investment, reserves, other capital. The main feature of direct in-
vestment is taken to be the fact that the direct investor seeks to have, on
a lasting basis, an effective voice in the management of a nonresident en-
terprise; this gives rise to accounting conventions which will be examined in
Sect. 16.1. Portfolio investment covers investment in financial assets (bonds,
corporate equities other than direct investment, etc.). On reserves see below.
"Other capital" is a residual category.
2) The length of the operation: long-term and short-term capital. The
convention adopted is based on the original contractual maturity of more
than one year (long term) and one year or less (short-term). Assets with
no stated maturity (e.g. corporate equities, property rights) are also consid-
ered as long-term capital. The initial maturity convention may give rise to
problems: for example the purchase of, say, a foreign bond with an original
maturity of three years, but only 6 months to maturity when the purchase
is made, is nonetheless recorded as a long-term capital movement. The in-
evitable convention derives from the fact that usually no data are available
on the time to maturity of securities when international transactions occur.
3) The nature of the operator: private and official, the latter possibly
divided in general government, central monetary institutions (central banks
etc.) and other official institutions.
The Manual adopts the first criterion, and categorizes between: 1. Direct
investment, 2. Portfolio investment, 3. Other investment, 4. Reserve assets.
Within these categories further subdivisions are present, which use the other
criteria.
"Reserves" is a junctional category comprising all those assets available
for use by the central authorities of a country in meeting balance of payments
needsj this availability is not linked in principle to criteria of ownership or
nature of the assets. In practice, however, the term reserves is taken to
include monetary gold, special drawing rights (SDRs) in the FUnd, reserve
position in the FUnd, foreign exchange and other claims available to the
central authorities for the use described above.
To conclude this section we point out that, in addition to the balance of
payments, there also exists the balance oj indebtedness (also called by the
Manual the international investment position). In general, the balance of
indebtedness records the outstanding claims of residents on nonresidents and
the outstanding claims of nonresidents on residents at a given point in time,
such as the end of the year. Therefore this balance is concerned with stocks,
unlike the balance of payments, which refers to flows.
Various balances of indebtedness can be reported according to the claims
considered. One is that which considers only the stock of foreign assets and
liabilities of the central authorities; another considers the direct investment
position, etcetera.
Clandestine capital movements By clandestine capital movements we

mean capital flows that take place outside legal channels for various purposes.
For example if in a country there are exchange controls and controls on capital
movements, clandestine capital movements provide a way to evade these controls.
But clandestine capital movements can take place even if there is perfect capital
mobility, for example to create slush funds to be used for a range of illegal activities
such as money laundering, bribery, terrorism, etcetera. These activities are not
limited to "ships in the night" operations (inflows and outflows of goods through
illegal pI aces of entry, or shipment of banknotes) but also include illegal trade
through legal checkpoints or, more generally, illegal transactions through legal
channels (such as misinvoicing, direct compensation, etc.). The former type does
not appear in the balance of payments, but the latter does, insofar as it gives
rise to inexact entries in the balance of payments and/or to entries in the wrong
accounts.
Merchandise trade can serve as a channel for clandestine outward capital move-
ments. To achieve this, imports will be overinvoiced, or exports underinvoiced. In
the former case the foreign exporter, who receives a greater amount than the true
value of the goods, will credit the difference to, say, a secret account that the
domestic importer holds abroad. In the latter case the foreign importer, who has
to pay a lower amount than the true value of the goods, will credit the difference
to, say, the account that the domestic exporter secretly holds abroad. These dif-
ferences are (clandestine) capital movements, which of course are not recorded as
such in the capital account, since they are hidden in merchandise trade.
Clandestine capital movements can also be hidden in other current account

items, such as travel, labour income and workers' remittances. As regards travel,
foreign tourists coming to visit the country may purchase the domestic currency
on the black market. This will give rise to a decrease in the credit entries recorded
in the travel item in the current account.
As regards labour income and workers' remittances, the best known device is
that of direct compensation through an illegal organisation. Let us consider Mr.
Y, a worker who has (temporarily or definitively) come to work in country 2 from
country 1, and who wishes to send (part of) his earnings to his relatives in country
1. Mr. Y can either use the official banking, post al and other authorised channels
(in which case there will be arecord in the balance of payments), or give the
money to the organisation's representative in country 2, who offers hirn perhaps
more favourable conditions, or immediate delivery, or hidden delivery (Mr. Y may
be an illegal migrant and doesn't want to be discovered). The money remains in
country 2 to be used by the organisation, and the organisation's representative
in country 2 only has to instruct his counterpart in country 1 to pay the agreed
amount to Mr. Y's relatives out of the organisation's funds held in country 1.
In conclusion, no money has moved, but a clandestine capital outflow from

country 1 will have taken place; this will be reflected in lower credit entries in the
labour income and migrants' remittances items.
5.2. The Meaning of Surplus, Deficit, and Equilibrium in the Balance of Payments 63
5.2 The Meaning of Surplus, Deficit, and

Equilibrium in the Balance of Payments
Since all economic transactions between residents and nonresidents are re-
ported under double-entry bookkeeping, the balance of payments always bal-
ances. It is therefore a concept of (economic) equilibrium to which one refers
when one talks of equilibrium and disequilibrium of the balance of payments.
In order to avoid terminological confusion, we shall use the term equilibrium
to denote economic equilibrium, and balance to denote accounting identities.
We shall also use the terminology surplus and deficit to qualify a disequilib-
rium of the balance of payments.
An appropriate definition of deficit and surplus is important for economic
analysis and policy, and requires the classification of all the standard com-
ponents of the balance of payments into two categories. The first includes
all those items whose net sum constitutes the surplus (ifpositive), the deficit
(if negative) or indicates equilibrium (if zero); the second includes all the re-
maining items, whose net sum is necessarily the opposite of the former (since
the grand total must, as we know, be zero) and is sometimes said to "finance"
or "settle" the imbalance. If we imagine all the standard components being
arranged in a column in such a way that all the components included in the
first category are listed first, then the balance of payments may be visual-
ized as being separated into the two categories by drawing a horizontal line
between the last component of the first category and the first component of
the second category (hence the accountant's terminology to draw the line).
Therefore the transactions whose net sum gives rise to a surplus or deficit
(or indicates equilibrium, if zero) are said to be above the line, whilst the
remaining ones are said to be below the line.
However, in most treatments the term "balance of payments" is still used
both in the sense of the complete accounting statement (treated in the pre-
vious section) and in the sense of the net sum of the items included in the
first category, hence the usual terminology "balance-of-payments surplus"
and "balance-of-payments deficit" .
To recapitulate: we shall say that the balance of payments is in equilib-
rium when the net sum of the items above the line is zero, in disequilibrium
when this net sum is different from zero, showing a surplus if positive, a
deficit if negative.
All this is very fine, but how are we to divide the items into the two
categories, i.e. how shall we draw the line? This is the crucial point to give
an operational content to the concepts we have been talking about.
The typical balances generally considered are few in number (although
individual countries may build other types for the examination of some par-
ticular aspect of international economic relationships). We give a list in
increasing order of coverage.
1) Trade Balance. As the name indicates, this is the balance between

exports and imports of goods or commercial balance. The trade balance in
the strict sense or in the broad sense (i.e. taken to include also invisible
trade, in which case it is now more usual to speak of balance on goods and
services) was that considered by mercantilists and by the traditional theory
of the processes of adjustment of the balance of payments.
2) Balance on Goods and Services. In addition to visible trade, also
invisibles are put above the line. This balance measures the net transfer of
real resources between an economy and the rest of the world.
3) Current (Account) Balance. This is obtained by adding net unilateral
transfers to the balance on goods and services, and represents the trans ac-
tions that give rise to changes in the economy's stock of foreign financial
items.
4) Balance on Current Account and Long-Term Capital, also called Basic
Balance. This includes the flow of long-term capital above the line, besides
the items of the current account balance. It is intended to be a rough indi-
cator of long-term trends in the balance of payments.
5) Overall Balance. This considers all components except changes in
reserve assets to be above the line. The idea behind it is to provide a measure
of the residual imbalance that is financed through the use and acquisition of
reserves. Conventionally, the net errors and omissions item is included above
the line. The obvious reason is that the use and acquisition of reserves is
usually known and measured with a high degree of accuracy, so that errors
and omissions must pertain to items above the line.
In any case, whichever type of balance one uses, a necessary constraint
or international consistency condition is
(5.1)
namely the balance of payments of all countries (of course the same type
of balance, and expressed in a common monetary unit) must algebraically
sum up to zero. This follows from the fact that the surplus of one country
must necessarily be matched by a corresponding deficit of one or more other
countries, provided that no reserve creation takes place (more generally, the
sum of the balances of payments of all countries, Le., the world balance of
payments, equals the increase in net world reserves: see Mundell, 1968).
From Eq. (5.1) it follows that only n - 1 balances of payments can be
independently determined. For example, a maximum of n - 1 countries can
independently set balance-of-payments targets: the nth country has to accept
the outcome or the system will be inconsistent.
5.3. Some Important Accounting Relations 65
5.3 Some Important Accounting Relations

In this section we draw from national economic accounting and ßow-of-funds anal-
ysis some elementary accounting relations among the main macroeconomic (real
and financial) aggregates in an open economy in order to fit the balance of pay-
ments into the context of the whole economic system.
We have built a framework-which, though very simplified, is sufficient to
include the basic elements-in which there are only five sectors and six markets
or transaction categories (real resources and financial assets). This framework is
exhaustive, in the sense that it includes all transactors and transactions. In other
words, all transactors are included in one of the sectors and all the transactions
they carry out are included in one of the categories. It should also be pointed
out that this accounting framework records flows, which can be-according to the
distinction introduced in Sect. 1.2.1-pure ßows or ßows deriving from a stock
adjustment. In this second case they will be denoted by the symbol tl prefixed to
the symbol indicating the stock: for example, if N9 is the stock of public debt, its
variation will be denoted by tlN9.
The framework under consideration can be represented schematically in a table
(see Table 5.1), where the columns refer to sectors and the rows to markets. The
subscript/superscript indicates the holding/issuing sector respectively. A tilde
("') means that the entry is assumed absent for simplicity's sake, while a dash (-)
means that there can be no entry for logical reasonSj a capital delta (tl) means a
variation.
Let us begin by clarifying the meaning of the sectors.
The private sector includes all transactors who do not belong to any other
sector. The adjective "private" must not, therefore, be interpreted as the opposite
of "public" in a juridical sense. For example, public enterprises which seIl to the
public most of the goods or services they produce are included here (unless they
are banks). The private sector therefore includes the producing and household
sectors.
The government sector refers to the geneml government and includes all de-
partments, establishments, and agencies of the country's central, regional, and
local governments (excluding the central bank if this is institutionally part of the
government and not an independent body). The banking sector includes com-
mercial banks, savings banks and all financial institutions other than the central
bank.
The centml bank includes, besides the central bank, the exchange stabilization
fund, if this exists as an institutionally separate body.
The rest-of-the-world sector includes all nonresidents.
Let us now turn to an examination of the categories of transactions or markets.
Goods and services includes all transactions on goods and services (produc-
tion, exchange and transfers) and gives rise to the real market. Then there are
the markets concerning national or domestic money, distinguished into monetary
base (also called high-powered money, primary money, etc.) and bank deposits.
Table 5.1: An accounting matrix for real and financial flows

Market Sector
Private Govern- Banking Central Rest of ROW
ment Bank the World TOTALS
Goods
and
services I-S G-T CA 0
Domestic
monetary
base ßHp ßHb ßHc 0
Domestic
bank
deposits ßDp ßDb ßDf 0
Domestic
securities ßNp ßN9 ßNb ßNc ßNf 0
Foreign
money ßRp ßRJ, ßRc ßRf 0
Foreign
securities ßFp ßFb ßFc ßFf 0
COLUMN
TOTALS 0 0 0 0 0
Generally the monetary base is the liability of the central bank and consists of
coin, banknotes and the balances which the banks keep with the central bank. As
regards bank deposits, it is outside the scope of the present work to discuss whether
only demand deposits or also time deposits (and other types of deposits or financial
assets) are to be considered as money. In any case what is not included as money
here, comes under the heading of the national (or domestic) securities item, which
includes, besides securities proper, any form of marketable debt instrument. As
regards joreign money, we do not make the distinction between monetary base
and bank deposits, since all the foreign sectors (including the central bank and the
banking sector) have been consolidated into a single sector (the rest-of-the-world
or foreign sector), and for residents foreign exchange in either of its forms (cash or
deposits) is foreign money. There are, finally, joreign securities, for which similar
considerations hold as for domestic ones.
The table can be read along either the rows or the columns: in any case, as
this is an accounting presentation, the algebraic sum of the magnitudes in any row
is zero, as is the algebraic sum of the magnitudes in each column. It should be
noted that the items have an intrinsic sign.

More precisely, the fact that the row totals are zero reflects the circumstance
that, as the magnitudes considered represent excess demands (positive or negative:
a negative excess demand is, of course, an excess supply) by the single sectors
for the item which gives the name to the row, the total quantity of it actually
exchanged is necessarily the same both from the point of view of demand and from
the point of view of supply. In other words, the ex post total amount demanded
and the ex post total amount supplied are necessarily equal, as they are one and
the same thing. It should be stressed that this is a mere fact of accounting, which
must not be confused with the equilibrium of the market where the item is being
transacted, or equality between ex ante magnitudes.
The equality to zero of the column totals reflects the budget constraint of each
transactor, that is, the fact that total receipts and total outlays must necessarily
coincide, where receipts and outlays are of course taken to include the change in
financialliabilities and assets. Thus an accounting link is established between real
and financial flows, according to which for any transactor the excess of investment
over saving coincides with the change in his net liabilities (i.e. the change in
liabilities net of the change in assets). Since the budget constraint must hold for
each transactor it will hold for their aggregate, i.e. for the sector.
This said, we shall present a few of the accounting relations that can be drawn
from the matrix (for a full treatment see Gandolfo, 2002). We begin with the first
row, which gives
(1 - S) + (G - T) + CA = 0, (5.2)
which states that the algebraic sum of the private sector's excess demand for goods
and services (measured by the difference between investment and saving) plus the
public sector's excess demand (measured by the difference between government
expenditure and revenue, the latter being measured by taxes net of transfer pay-
ments) plus the foreign sector's excess demand (measured by the difference between
exports and imports of goods and services plus unilateral transfers) must be zero.
If we recall that C + S = Yd by definition, where C, Yd are the private sector's
consumption and disposable income, it follows that 1 - S = (1 +C) - Yd. Therefore,
(I - S) is indeed the private sector's excess demand for goods and services, while
(G - T) is the excess demand of the government (budget deficit), and CA the
excess demand of the rest of the world (if we neglect unilateral transfers, this is
net exports). These excess demands can be either positive or negative: a negative
excess demand of the foreign sector, for example, means that the current account
balance shows a deficit.
One of the implications of (5.2) is that it is not possible for the three excess
demands to have the same sign: for example, it is not possible simultaneously
to have a positive excess demand of the private sector (1 > S), a budget deficit
(G > T) and a current account surplus (CA> 0).
If we remember that the private sector's disposable income is given by national
income minus taxes net of transfer payments, i.e. Yd = Y - T, whence S = Y - T-
C, and if we define a new aggregate called national absorption (or expenditure) A

as the sum C + I + G , we can rewrite (5.2) as
CA=Y -A, (5.3)

namely the current account equals the difference between national income and
absorption. Alternatively, if we aggregate the private and public sector and define
national excess demand for goods and services as IN - SN = (I - S) + (G - T)
we have
(5.4)
which states that the current account equals the difference between national saving
and investment.
Let us now consider the first column, namely the budget constraint of the
private sector,
(5.5)
which states that the difference between private saving and investment gives rise
to a change (ß) in the stock of private net financial wealth where Wp (money,
bonds, etc.). An excess of saving over investment means that the private sector
spends less than its disposable income, hence an increase in its wealth (ßWp > 0),
while ß Wp < 0 means that the private sector spends more than its disposable
income. In fact, given that (see above) S = Yd - C = Y - T - C, and defining a
new aggregate called "absorption" of the private sector Ap as the sum C + I, so
that S - I = Yd - A p , we can rewrite (5.5) as
(5.6)
namely the change in the private sector's stock of wealth equals the difference
between disposable income and absorption. This also called the net acquisition
of jinancial assets (NAFA) or the jinancial surplus (that of course can be either
positive or negative) of the private sector.
The government budget constraint tells us that
G-T=-ßN9, (5.7)
which states that the government budget deficit (excess of expenditure over re-
ceipts) is financed by issuing government bonds (a negative excess demand, that
is an excess supply, equal to -ßN9). This embodies the assumption that the
monetary financing of the public deficit is forbidden.
The various row and column constraints can be combined to derive other mean-
ingful constraints. Taking for example the last column (the rest-of-the-world bud-
get constraint), using the fifth and sixth rows, and rearranging terms, we get
Equation (5.8) is simply the expression of the ovemll balance 01 payments (B)
already examined in Sect. 5.2. In fact, CA is the current account balance and the
expression in braces is the autonomous-capital balance, consisting of the change in
domestic assets (deposits, !:l.D j , and securities, !:l.Nj) owned by non residents plus
the change in foreign assets (money, !:l.R, and securities, !:l.F) owned by residents,
who are subdivided into private sector (hence !:l.Rp + !:l.Fp ) and banking sector
(hence !:l.~ + !:l.Fb); note that the minus sign before the square bracket reflects
the accounting convention illustrated in Sect. 5.1. The offsetting item is given
by the change in official international reserves (!:l.R) in the wide sense, subdivided
into liquid assets (foreign money, !:l.R,;) and medium/long term assets (foreign
securities, !:l.Fe) owned by the central bank. Hence the identity
B=!:l.R, (5.9)
which states that the overall balance of payments coincides with the change in
international reserves.
Another derived identity is obtained aggregating the columns "Banking" and
"Central Bank" , which gives the budget constraint of the aggregate banking sector
from which, rearranging terms,
Let us now observe that from the second row of Table 5.1 we have
and from the third we get
Therefore, if we define
!:l.R = !:l.R,; + !:l.Fe,

!:l.Q = !:l.~+!:l.Nb+!:l.Fb+!:l.Ne,
!:l.M = !:l.Dp + !:l.Dj + !:l.Hp ,
we obtain the identity
!:l.M -!:l.Q=!:l.R=B, (5.10)
which states that the balance of payments (change in international reserves ) equals
the change in the money stock (!:l.M: M2 definition) minus the change in all
other financial assets (!:l.Q) held by the aggregate banking sector. In the foreign
exchange market, in fact, agents purchase foreign currency giving up domestic
currency (which reduces the amount of the latter in circulation), and supply foreign
exchange acquiring domestic currency (which increases the amount of the latter
in circulation). If these operations do not exactly offset each other, their balance,
namely the overall balance of payments, implies a net change in the domestic
quantity of money. lf the monetary authorities wish to offset such a change (i.e.,
to "sterilize" the external component of liquidity, namely the effect of the balance
of payments on the money supply), they can act on the internal component of
liquidity, for example by open market operations. In terms of accounting identities,
this means that the monetary authorities can act on ßQ in such a way that
ßR+ßQ=O.
We would like to emphasize, in conclusion, that all these relations, being mere
accounting relations, are always valid ex post, but cannot tell us anything on the
causal relations between the variables considered, which require the consideration
of behavioural functions of the various agents.

Gandolfo, G., 2002, International Finance and Open-Economy Macroeconomics,
Berlin Heidelberg New York: Springer-Verlag, Chap. 6.
IMF (International Monetary Fund), 1948, Balance 0/ Payments Manual, 1st edi-
tion; 2nd edn. 1950; 3rd edn. 1961; 4th edn. 1977; 5th edn. 1993.
IMF, Balance 0/ Payments Yearbook (yearly); International Financial Statistics
(monthly).
M1llldell, R.A., 1968, International Economics, New York: Macmillan, Chap.
10.
The data contained in the publications of the IMF are also available on line in
the IMF's site (http://imf.org) against payment of a fee. Other sources of online
data at the international level are:
-the World Bank (http://worldbank.org), free
-the World Trade Organization (http://wto.org), free
-the Organization for Economic Cooperation and Development
(http://oecd.org), against payment of a fee
-the Bank for International Settlements (http://bis.org), free
-the statistical office of the European Union (http://europa.eu.int/eurostat),
partly free
-the European Central Bank (http://ecb.int), free
Part 11
International Finance and

Open-Economy
Macroeconomics
Chapter 6
The Basic Models: Elasticities,

Multiplier, Mundell-Fleming
In this chapter we shall deal with the adjustment processes of the balance of
payments based on flows. We shall first examine the balance on goods and
services, then introducing capital movements. In Sections 3.1 through 3.5,
"balance of payments" is synonomous with "balance on goods and services" .
6.1 The Elasticity Approach

This approach purports to examine the effects of exchange-rate changes on
the balance of payments. The adjustment of the balance of payments through
exchange-rate changes relies upon the effect of the relative price of domestic
and foreign goods (considered as not perfectly homogeneous) on the trade
flows with the rest of the world. This relative price, or (international) terms
of trade, is defined by
Px
71"=-, (6.1)
rpm
where Px represents export prices (in terms of domestic currency), Pm import
prices (in terms of foreign currency), and r the nominal exchange rate of the
country under consideration. The meaning of 71" has already been examined
in Eq. (2.4).
The idea behind this adjustment process is that a change in the relative
price of goods, ceteris paribus, brings about a change in the demands for
the various goods by both domestic and foreign consumers, thus inducing
changes in the fiows of exports and imports which will hopefully adjust a
disequilibrium in the payments balance considered.
The terms of trade may vary both because of a change in the prices Px and
Pm expressed in the respective national currencies, and because r changes.
The analysis with which we are concerned in this chapter focuses on the
73
74 Chapter 6. The Basic Models: Elasticities, Multiplier, Mundell-Fleming
changes in r and so asslllIles that Px and Pm as weH as aH other variables

that might influence the balance of payments, are constant. It is, therefore,
a partial equilibrilllIl analysis, in which the ceteris paribus dause is imposed
when the exchange rate varies. It is important to observe at this point that
the problem of the effects of exchange-rate changes does not vary whether
we consider a free movement of the exchange rate in a flexible exchange
rate regime or a discretionary or managed movement in an adjustable peg
or other limited-flexibility regime (see Sect. 3.3). In the latter case (Le.
the case of a policy-determined change), we are in the presence, in H.G.
Johnson's (1958) terminology, of an expenditure switching policy, that is of
a policy aiming at restoring balance-of-payments equilibrilllIl by effecting a
switch of expenditure (by residents and foreigners) between domestic and
foreign goods. By contrast, if we consider a deficit, an expenditure reducing
policy involves measures inducing a decrease in residents' total expenditure
(and thus in that part of it which is directed to foreign goods, i.e. imports)
by monetary or fiscal restriction.
6.1.1 Critical Elasticities and the Marshall-

Lerner Condition
To begin with, we observe that the ceteris paribus dause enables us to con-
sider exchange-rate variations as the sole cause of changes in export and
import flows. A depreciation in the exchange rate (Le., a depreciation of
the domestic currency) at unchanged domestic and foreign prices in the re-
spective currencies, in fact, makes domestic goods cheaper in foreign markets
and foreign goods more expensive in the domestic market. The opposite is
true for an appreciation. Thus we can say, on the basis of conventionalde-
mand theory, that the quantity of exports varies in the same direction as the
exchange rate (an increase in the exchange rate, that is a depreciation, stim-
ulates exports and a decrease, that is an appreciation, lowers them) whilst
the quantity of imports varies in the opposite direction to the exchange rate.
Strictly speaking, this is true as regards the foreign demand for domestic
goods (demand for exports) and the domestic demand for foreign goods (de-
mand for imports). Tobe able to identify the demand for exports with
exports and the demand for imports with imports, we need the further as-
slllIlption that the relevant supplies (supply of domestic goods by domestic
producers to meet foreign demand, and of foreign goods by foreign producers
to meet our demand) are perfectly elastic. If not, we would have to introduce
the supply elasticities, making the model much more complicated
However, the fact that the quantity of exports varies in the same direction
as the exchange rate whilst the quantity of imports varies in the opposite
direction to it is not sufficient to allow us to state that suitable exchange-
rate variations (a depreciation in the case of a deficit, an appreciation in the
6.1. The Elasticity Approach 75
case of a surplus) will equilibrate the balance of payments. The balance of

payments is, in fact, expressed in monetary terms, and it is not certain that
a movement of the quantities of exports and imports in the right direction
ensures that their value also changes in the right direction. The change in
receipts and outlays depends on the elasticities, as the student knows from
microeconomics.
We define the exchange-rate elasticity of exports, TJx, and of imports, TJm,
as any price-elasticity, that is as the ratio between the proportional change
in quantity and the proportional change in price (here represented by the
exchange rate). Thus, letting x and m denote the quantities of exports and
imports respectively, we have
_ b.m/m b.m r
TJm = - b.r/r = - b.r m' (6.2)
where b. as usual denotes a change, and the minus sign before the second
fraction serves to make it a positive number (b.m and b.r have, in fact,
opposite signs because of what we said at the beginning, so that the fraction
by itself is negative).
Since each country normally records its balance of payments in terms of
domestic currency, we consider the payments balance in domestic currency
(6.3)
where the value of imports in terms of foreign currency (Pm, we remember,
is expressed in foreign currency) has to be multiplied by the exchange rate
to transform it into domestic currency unitsj as Px is expressed in terms of
domestic currency, the value of exports, PxX, is already in domestic currency
units.
To examine the effects of a variation in the exchange rate, let us consider
a depreciation by a small amount, say b.r. Correspondingly, exports and
imports change by b.x > 0 and by b.m < O. The new value of the balance of
payments is then
(6.4)
and by subtracting the previous value B as given by Eq. (6.3) we obtain the
change in the balance of payments
f:::..B = Pxb.x - Pmmb.r - Pmr f:::..m - Pmb.r b.m.
Since b.r, b.m are small magnitudes, their product is of the second order of
smalls and can be neglected. Collecting Pmmb.r we obtain
b.B = Pxb.x - Pmmf:::..r - Pmrb.m =

b.X-Px- - 1 - -
Pmmf:::..r [- b.m -- r] .
b.r P:rnm f:::..r m
We now multiply and divide the first fraction in square brackets by r/x,
whence
It follows that
IlB = Pmmllr [(IlX~) ~~ _

Ilr x r Pmm
1 _ Ilm
Ilr m
!-.] ,
and so, given the definitions of the elasticities (6.2), we obtain
IlB PxX - 1 +""m ] .

= Pmmllr [""x-- (6.5)
rpmm
Since Ilr > 0, the sign of IlB will depend on the sign of the expression in
square brackets, hence an exchange-rate depreciation (Ilr > 0) will improve
the balance of payments (IlB > 0) when
Pxx
--""x+""m> 1. (6.6)
rpmm
If we consider a situation near equilibrium, such that PxX '::= rpmm, the
condition becomes
""X +""m > 1, (6.7)
namely a depreciation will improve the balance of payments if the sum of
the export and import elasticities is greater than unity. Inequality (6.7) is
variously called the Marshall-Lerner condition 1 , or the Bickerdicke-Robinson
condition, or the critical elasticities condition.
Let us note that a depreciation is unlikely to occur when the balance
of payments is near equilibrium. On the contrary, it will normally occur
when the balance of payments shows a deficit (which is the case in which an
exchange-rate depreciation normally comes ab out , either spontaneously or
through discretionary intervention by the monetary authorities). A deficit
means rpmm > PxX, and we should apply the more general condition (6.6),
which is more stringent than (6.7). In fact, since pxx/rpmm < 1, the value of
""X will be multiplied by a factor smaller than one, hence it may well happen,
if the sum of the elasticities is just above unity and the deficit is huge, that
condition (6.6) is not satisfied.
In order to translate this analysis into practical policy recommendations
(i.e., that a way of coping with a trade-balance deficit is to devalue the ex-
change rate, or let it depreciate) we must be sure that the critical elasticities
condition is satisfied. In the past there was a heated debate between elasticity
IThe most frequent denomination is, by far, Marshall-Lerner condition. However, some
authors maintain that such adenomination is wrong: see, e.g., MundeIl (2001), Sect. VI;
Gandolfo, 2002, p. 24.
6.1. The Elasticity Approach 77
pessimism (elasticities are too low) and optimism (elasticities are sufficiently
high). Recent studies (Hooper et al., 2000; Gagnon, 2003) show that price
elasticities for imports and exports generally satisfy the Marshall-Lerner con-
dition.
BOX 6.1 Does a devaluation help? The J curve
In November 1967, the pound sterling was devalued (from 2.80 dollars per pound
to 2.50 dollars per pound) due to balance-of-payments difficulties. According to the
estimates of the time, the elasticities were sufficiently high to satisfy the Marshall-
Lerner condition. However, the devaluation was followed bya trade deficit which
lasted untill970. The terminology J curve was coined in relation to this phenomenon
(NIESR 1968, p. 11). The J curve can be explained by introducing adjustment lags,
and, more precisely, by distinguishing various periods following the devaluation in
which the effects of the devaluation itself take place. These are, in the terminology
of Magee (1973), the currency-contmct period, the pass-through period, and the
quantity-adjustment period.
The currency-contmct period is defined as that short period of time immediately
following the exchange-rate variation in which the contracts stipulated before the
variation mature. During this period both prices and quantities are predetermined.
Normally both the export and import contracts stipulated before the devaluation
are expressed in foreign currency. In fact, in the expectation of a possible devalua-
tion, both domestic and foreign exporters will try to avoid an exchange-rate loss by
stipulating contracts in foreign currency. Now, as a consequence of the devaluation,
the domestic-currency value of both imports and exports will increase by the same
percentage as the devaluation, so that as the pre-devaluation value of imports was
higher than that of exports, the deficit will increase.
The pass-through period is defined as that short period of time following the
exchange-rate variation in which prices can change (as they refer to contracts agreed
upon after the exchange rate has varied), but quantities remain unchanged due to
rigidities in the demand for and/or supply of imports and exports. Consider, for
example, the case of a devaluation with a demand for imports by residents of the de-
valuing country and a demand for the devaluing country's exports by the rest of the
world which are both inelastic in the short-run. The domestic-currency price of im-
ports increases as a consequence of the devaluation but the demand does not change,
so that the outlay for imports increases. The foreign-currency price of exports de-
creases as a consequence of the devaluation, but the demand does not change, so
that the foreign-currency receipts will decrease and their domestic-currency value
will not change. Therefore the domestic-currency balance deteriorates (again a per-
verse effect).
Finally, we come to the quantity-adjustment period, in which both quantities and
prices can change. Now, if the suitable conditions on the elasticities are fulfilled, the
balance of payments ought to improve. This is undoubtedly true from the viewpoint
of comparative statics, but from the dynamic point of view it may happen that
quantities do not adjust as quickly as prices, owing to reaction lags, frictions etc.,
so that even if the stability conditions occur the balance of payments may again
deteriorate before improving towards the new equilibrium point.
In addition to these lags, there may be other elements which cause the devaluation
not to be fully passed through to prices. For example, in an imperfectly competitive
setting, part of the devaluation may be absorbed (in the short run) by foreign
producers and domestic importers (in order to avoid losing market shares), so that
the domestic price of imports rises by less than the percentage of the devaluation.
The J-curve phenomenon is by now a weil established fact: see, e.g., Bahmani-
Oskooee et a1. (1999, 2003), Hacker and Hatemi (2003), LaI (2002).
It is important to point out that the satisfaction of the Marshall-Lerner

condition ensures that, following a devaluation, the balance of payments
will improve in the new equilibrium position that the system will reach af-
ter all the adjustments have worked themselves out. This does not exclude
the eventuality that the balance of payments may deteriorate in the course of
the adjustment process because of effects of the exchange-rate devaluation on
domestic prices and income and other effects. All these effects may in fact
immediately after the devaluation cause a temporary balance-of-payments
deterioration (which is often referred to as the perverse effeä of the devalu-
ation) before the final improvement.
This phenomenon (see box 6.1) is called in the literature the J curve, to
denote the time path of the payments balance, which initially decreases
(deteriorates) and subsequently increases (improves) to a level higher than
the one prior to devaluation, thus resembling a J slanted to the right in a
diagram in which time is measured on the horizontal axis and the balance of
payments on the vertical one.
6.2 The Multiplier Approach

The extension of the closed-economy multiplier to an open economy will
be carried out in the case of a small open economy (SOE). This is the so-
called multiplier without foreign repercussions, which implies that exports
are entirely exogenous. In other words, we are in the context of a one-
country model (see Sect. 1.2.3). In fact, the SOE assurnption means that
what occurs in the country under consideration has negligible effects on the
rest of the world. In particular, any variation in the country's imports-
that are the rest-of-the-world exports do not have appreciable effects on the
rest-of-the-world income and hence on its imports, which are the country's
exports. It follows that the exports of a SOE can be considered exogenous
in the model.
The model used is the standard Keynesian textbook model with the in-
clusion of the foreign sector; the equations are as folIows:
C = Co + by, 0< b < 1, (6.8)

[ = [0 + hy, 0< h < 1, (6.9)
m = mo+J.ty, 0< J.t < 1, (6.10)
x = xo, (6.11)
y = C+[ +x-m. (6.12)
The equations represent, in this order: the consumption function (Co is the
autonomous component, b is the marginal propensity to consume, and y is
national income), the investment function (the autonomous cornponent is [0,
and h is the marginal propensity to invest), the import function (mo is the
6.2. The Multiplier Approach 79
autonomous component, and /-L is the marginal propensity to import), the

export function (the absence of foreign repercussions, as we said above, is
reflected in the fact that exports are entirely exogenous), the determination
of national income.
The meaning of Eq. (6.12) is simple: in an open economy, total demand
for domestic output is no longer C + 1, but C + 1 - m + x which is composed
of C + 1 - m (aggregate demand for domestic output by residents) and x
(demand for domestic output by nonresidents). In fact, in C + 1 both home
and foreign goods and services are now included, and the demand for foreign
goods and services by residents in our simplified model is m: therefore, by
subtracting m from C + 1 we obtain the demand for domestic output by
residents. Govemment expenditure is not explicitly included in Eq. (6.12)
because it can be considered as present in the autonomous components of
the appropriate expenditure functions.
Equation (6.12) can be written in several alternative forms. For example,
if we shift C and m to the left-hand side and remember that y - Cis, by
definition, saving (S), we have
S+m=1+x, (6.13)
which is the extension to an open economy of the well-known S = 1 closed-
economy condition. From (6.13) we obtain
S-1 = x-m, (6.14)

1 - S = m-x, (6.15)
that is, the excess of exports over imports is equal to the excess of saving
over investment, namely the excess of imports over exports is equal to the
excess of investment over saving.
Equations (6.8)-(6.12) form a complete system by means of which the
foreign multiplier can be analyzed. Since, however, we are interested in
balance-of-payments adjustment, we add the equation which defines the bal-
ance of payments B (since prices and the exchange rate are rigid, they can
be normalized to one):
B=x-m. (6.16)
The problem we are concerned with is to ascertain whether, and to
what extent, balance-of-payments disequilibria can be corrected by income
changes. Suppose, for example, that a situation of equilibrium is altered by
an increase in exports, so that B shifts to a surplus situation. What are
the (automatie) corrective forces that tend to re-equilibrate the balance of
payments? The answer is simple: via the multiplier the increase in exports
brings about an increase in income, which in turn determines an induced
increase in imports via the marginal propensity to import. This increase in
imports tends to offset the initial increase in exports, and we must ascertain
whether the former increase exactly matches the latter (so that the balance of
payments returns to an equilibrium situation) or not. In the second case the
situation usually depicted is that the balance of payments will show a sur-
plus, although smal1er than the initial increase in exports: in other words, the
induced change in imports will not be sufficient to re-equilibrate the balance
of payments. However, we shal1 see presently that the contrary case (that is,
when induced imports increase more than the initial increase in exports) as
well as the borderline case cannot be excluded on apriori grounds.
To rigorously analyse these and similar problems the first step is to find
the formula for the multiplier. If we substitute from Eqs. (6.8)-(6.11) into
Eq. (6.12) and solve for y, we obtain
1
y= 1 b h (Co+lo-mo+xo), (6.17)
- - +J.L
where of course
1-b-h+J.L>0 (6.18)
for the solution to be economically meaningful. If we then consider the
variations (denoted by 6.), we get
1
6.y = 1- b - +J.L
h(6.Co + 6.10 - 6.mo + 6. xo). (6.19)
Note that if we assume no induced investment, the multiplier is reduced to

the familiar formula 1/(8 + J.L), where 8 = 1 - b is the marginal propensity
to save. Also observe that, as in all multiplier analyses, the autonomous
components are included in the multiplicand (where 6.mo appears) whereas
the coefficients concerning the induced components enter into the multiplier
(where J.L is included).
The open-economy multiplier is smaller than that for the closed economy
[l/(b+h)]-of course ifwe assume that b and h are the same in both the closed
and the open economy-because of the additionalleakage due to imports.
From (6.18) we obtain
b+h < 1 + J.L, (6.20)

or
b+h-J.L < 1. (6.21)
Condition (6.20) means that the marginal propensity to spend, (b + h),
must be smaller than one plus the marginal propensity to import. Condition
(6.21) means that the marginal propensity to spend on domestic output by
residents, (b + h - J.L), must be smaller than one.
To clarify the meaning of b + h - J.L, consider a unit increment in income,
which causes an increment in the induced components of the various expen-
diture functions. The increment in consumption and investment is b + hand
contains both national and foreign goods. The part pertaining to the latter
is thus apart of the total increment b + h, and coincides, in our pure flow
model, with J.L.
Algebraically, let the subscripts d and f denote domestic and foreign
goods (and services) respectively; then
b = bd + bf , (6.22)
h hd + hf , (6.23)
and in our simplified model
(6.24)
Therefore
(6.25)
measures the marginal propensity to spend on domestic output by residents.
6.2.1 Balance-of-Payments Adjustment

Let us now consider the balance of payments. By substituting from Eqs.
(6.10) and (6.11) into Eq. (6.16) and considering the variations we have
(6.26)
which states that the change in the balance of payments is equal to the
exogenous change in exports minus the change in imports, the latter being
partly exogenous (~mo) and partly induced (J.L~Y, where ~y is given by the
multiplier formula (6.19) found above).
Here we have all that is needed to analyse the balance-of-payments ad-
justment problem. Consider for example the case of an exogenous increase
in exports.
By assumption, no other exogenous change occurs, so that ~Co = ~Io =
~mo = 0, and the equations of change become
1
~B = ~xo - J.L~Y, ~y = 1- b h
- +J.L
ßXo,
whence
1
ßB ~xo - J.L b h ~xo
1- - +J.L
I-b-h
1 - b - h +J.L ~xo, (6.27)
82 Chapter 6. The Basic Models: Elasticities, Multiplier, MundeIl-Fleming
BOX 6.2 The empirical relevance of the multiplier

It might seem that the foreign trade multiplier which, together with the elasticity
approach, forms the core of the traditional theory, must nowadays be considered
not only theoretically obsolete, but also of little help in analyzing actual problems,
such as fiscal-policy international transmission. In fact, the effects of fiscal policy
on incomes in a multiple-country world are analysed by using linked econometdc
models of the count ries concerned and simulating the change in fiscal policy.
The complexity of these models might lead one to think that no hope exists for the
poor old foreign multiplier, so why bother studying it.
WeIl, twenty-five years aga Deardoff and Stern (1979) set forth the opposite view,
namely that (p. 416) "the linked econometric models, as a group, do not appreciably
add to our knowledge about fiscal-policy transmission beyond what is suggest by
our calculations using a simple and relatively naive model": meaning that based on
the foreign multiplier! In fact, these authors compared the results obtained from
simulations of several linked econometric models (a linked econometric model is a
set of econometric models of different countries linked together via the respective
foreign sectorsj for a description see Sect. II of their paper) with those calculated
using the naive multiplier. The surprising outcome was that most results obtained
by these naive calculations fell between the simulation extremes.
This exercise was repeated by Ferrara (1984) and Rotondi (1989) for different peri-
ods, who obtained similarly good results. Of course, as Deardoff and Stern note, the
comparison of fiscal-policy multipliers leaves open the question whether the linked
models can provide useful information on other issues. In our opinion the results of
these exercises are not to be seen from a negative view-point (Le., as a symptom of
the limited contributions of the linked multi-country models to our understanding
of the problem at hand) but rather from a positive one, that is as an indication
of the usefulness of the foreign multiplier at least to obtain a first, rough idea of
fiscal-policy transmission by simple, "back-of-the-envelope" calculations.
which expresses the final change in the balance of payments. The reader will
note that the simple mathematical procedure followed is nothing more than
the algebraic transposition of the verbal reasoning made above; but it enables
us to find the precise conditions under which the adjustment is incomplete,
complete, or more than complete. These conditions are easily derived from
(6.27).
If the marginal propensity to spend is smaller than one, b + h < 1, then
1 - b - h > 0 and so ßB > 0; furthermore, since 1 - b - h < 1 - b - h + p"
the fraction in the right-hand-side of (6.27) is smaller than one, whence
ßB < ßxo. The conc1usion is that adjustment is incomplete: the induced
increase in imports is not great enough to match the initial exogenous increase
in exports, so that the balance of payments will show a surplus (ßB > 0),
although smaller than the initial one (tlB < ßxo).
Figure 6.1 gives a graphic representation of the situation. If we con-
sider Eq. (6.14) we can draw the (x - m) schedule-that is, the balance-
of-payments schedule-and the (8 - I) schedule, both as functions of Y;
equilibrium will obtain at the intersection of these schedules.
In Fig. 6.1, the (x - m) schedule is downward sloping because we are
subtracting an ever greater amount of imports from an exogenously given
amount of exports (x - m = Xo - mo - J.LY). The positive intercept reflects
x-mt
S-1
Figure 6.1: Exogenous increase in exports, the multiplier, and the balance of
payments
the assumption that the autonomous component of imports is smaller than

exports; this assumption is necessary to ensure that it is in principle possible
to reach balance-of-payments equilibrium at a positive level of income. The
(8 - 1) schedule is increasing, on the assumption that the marginal propensity
to spend is smaller than one [8 - 1 = (1 - b - h)y - (Co + 10 )], The fact
that the two schedules intersect at a point lying on the y axis reflects the
assumption, already made above, that in the initial situation the balance of
payments is in equilibrium.
An increase in exports shifts the (x - m) schedule to (x' - m); the new
intersection occurs at E' where the balance of payments shows a surplus BE'.
This is smaller than the initial increase in exports, measured by the vertical
distance between (x' - m) and (x - m), for example by AE.
As we said above, the case of underadjustment examined so far is not
the only one possible. From Eq. (6.27) we see that adjustment is complete
(6.B = 0) when 1 - b - h = 0, that is when the marginal propensity to
spend equals one. In this borderline case the induced increase in imports
exact1y offsets the initial exogenous increase in exports. But the case of
overadjustment is also possible: when the marginal propensity to spend is
greater than one, then 1 - b - h < 0, and 6.B < 0, that is, the induced
increase in imports is greater than the initial exogenous increase in exports.
From the economic point of view it is easy to understand why this is so:
the greater the marginal propensity to spend, the greater ceteris paribus the
multiplier; this means a higher income increase given the exogenous increase
in exports, and finally, a greater increase in induced imports.
In terms of Fig. 6.1, the case of overadjustment implies that the (8 -
1) schedule is downward sloping (as shown by the broken line); the slope,
however, must be smaller in absolute value than the slope of the (x - m)
schedule for stability to obtain: in fact, from Eq. (6.20) we get (b+h-1) < j.t.
Therefore, overadjustment cannot be ruled out on the basis of considerations

of stability.
It is true that if the country is stable in isolation, b + h < 1 and only
underadjustment can occur. But since we are dealing with an open economy,
what matters is that it is stable qua open economy, and to impose the con-
dition that it should also be stable in isolation seems unwarranted. Thus,
on theoretical grounds we must accept the possibility of overadjustment (as
weH as the borderline case of exact adjustment), and the assertion that the
multiplier is incapable of restoring equilibrium in the balance of payments is
not correct.
6.3 Elasticities and Multipliers

It is possible to perform an integration between the two mechanisms (the
elasticity and the multiplier approaches) in a broader framework in which
the adjustment can simultaneously come from both the exchange rate and
income. The simplest model (a reduced version of Laursen and Metzler,
1950) to show this consists of two simple equations, concerning real and
balance-of-payments equilibrium:
y = C(y, r) + I(y, r) + x(r) - rpmm(y, r),

(6.28)
B = x(r) - rpmm(y, r) = o.
It can be seen that the various macroeconomic variables are functions of both
national income and the exchange rate (except for exports, which depend,
in addition to the exchange rate, on foreign income, here taken as exogenous
thanks to the SOE assumption).
The main result of this model is that the critical elasticities condition,
although necessary, is not sufficient to ensure the adjustment of the balance
of payments: for an exchange rate depreciation to improve the balance of
payments the sum of the elasticities must be greater than a critical value
which is greater than one.
The economic reason for this result is intuitive. Let us assume, for exam-
pIe, that the balance of payments is in deficit. The exchange rate depreciates
and, assuming that the traditional critical elasticities condition occurs, the
deficit is reduced. However, the depreciation increases total demand for da-
mestic output; this causes an increase in income and so imports increase,
thus opposing the initial favourable effect of the depreciation on the balance
of payments: this effect must therefore be more intense than it had to be in
the absence of income effects, Le. the sum of the elasticities must be higher
than in the traditional case.
The model under consideration still remains in the context of current
account adjustment. Given the ever increasing importance of capital move-
6.4. The Mundell-Fleming Model 85
ments, we now turn to a model in which capital flows are explicitly intro-
duced.
6.4 The Mundell-Fleming Model

The analysis carried out in the previous sections was concerned with the
"real" side of the economy and the balance of payments, as only the market
for goods and services and the relative international flows were considered.
The introduction of monetary equilibrium, interest rates, and international
flows of capital was first carried out through the extension to an open econ-
omy of the closed-economy Keynesian model as synthesized in the I S - LM
analysis. This extension was independently accomplished by Mundell and
Fleming in the early 1960s (Mundell, 2001).
We shall first examine the case of fixed exchange rates and then flexible
exchange rates.
6.4.1 Fixed Exchange Rates

The model can be reduced to three equations, one which expresses the deter-
mination of national income in an open economy (equilibrium in the goods
market or real equilibrium), one which expresses the equilibrium in the money
market (monetary equilibrium) and the third which expresses balance-of-
payments equilibrium (external balance). Since prices and exchange rate are
fixed, both can be normalized to unity. This simply means that a suitable
choice can be made of the units of measurement so that real and nominal
magnitudes coincide. We also consider a one-country model.
Let us begin with real equilibrium. Exports are now exogenous by hy-
pothesis (as the rate of exchange is fixed and repercussions are ignored),
while aggregate expenditure depends (negatively) on the interest rate and
(positively) on income, as we know from closed-economy IS-LM analysis.
We thus have the equation for real equilibrium
y = A(y, i) + Xo - m(y, i), (6.29)
where i denotes the interest rate. Since national expenditure or absorption

(A = C + I) includes both domestic and foreign commodities, the intro duc-
tion of the interest rate as an explanatory variable in A logically implies its
introduction as an explanatory variable into the import function with the
same qualitative effects. It should also be noted that the effect of an income
variation on aggregate demand (marginal propensity to aggregate demand)
is greater in absolute value than the marginal propensity to import, since
imports are only part of aggregate demand. The difference between the
marginal propensity to aggregate demand and the marginal propensity to
import is the marginal propensity to spend on domestic goods on the part of
residents (for brevity's sake we shall call it marginal propensity to domestic

expenditure), that can be safely assumed to be smaller than one.
We then have the usual equation for monetary equilibrium
M = L(y,i), (6.30)
where M indicates the money stock and L the demand for money, that
depends positivelyon income and negativelyon the interest rate.
The balance of payments includes not only imports and exports of goods,
but also capital movements. Net capital flows (inflows less outflows) are
expressed as an increasing function of the interest differential. It is in fact
clear that the greater the domestic interest rate with respect to the foreign
rate, the greater, ceteris paribus, will be the incentive to capital inflows and
the less to outflows, as we have seen in Chap. 4. Sinee this is a one-country
model, the foreign interest rate is exogenous, so that the movement of capital
is ultimately a function of the domestic interest rate). We can therefore write
the following equation for the equilibrium in the balance of payments
B = Xo - m(y,i) + K(i) = 0, (6.31)
°
where K(i) ~ indicates the net private capital inflow (outflow). Let us
note, in passing, that the condition that the overall balance of payments is
in equilibrium (external equilibrium) is equivalent to the condition that the
stock of international reserves is stationary, as shown in Sect. 5.3.
The system, composed of the three equations studied so far, is determined
if the unknowns are also three in number: it is therefore necessary to consider
M also as an unknown, in addition to y and i. We shall discuss this fact at
length in Sect. 6.4.1.2.
It is convenient at this point to pass to a graph of the equilibrium condi-
tions, which will be of considerable help in the subsequent analysis.
6.4.1.1 Graphie Representation of the Equilibrium Conditions

If we plot in the (y, i) plane all the combinations of the interest rate and
income which ensure real equilibrium, we obtain a curve (which as usual for
simplicity we shall assume to be linear: this is also true for curves, which we
shall come across later) whieh corresponds, in an open economy, to the I S
schedule for a closed economy.
The characteristic of this curve, which as we have just seen, is a locus
of equilibrium points, is that it is downward sloping. In fact, if income
is higher, aggregate expenditure and imports are likewise higher, but by a
smaller amount (given a marginal propensity to domestic expenditure smaller
than one). Thus it is necessary to have a lower value for the rate of interest
(so that there will be a further increase in domestic expenditure) to maintain
real equilibrium.
s
y
Figure 6.2: Mundell-Fleming under fixed exchange rates: the real equilibrium
schedule
Furthermore, the I S curve has the property that at all points above it
there will be a negative excess demand, while at all points below it the excess
demand for goods will be positive.
Consider in fact any point A' above the I S curve. Here the rate of interest
is greater than at point A, while income is the same. Point A is a point of
real equilibrium, being on the I S schedule. If, income being equal, the rate
of interest is greater, domestic demand will be less, so that at A' there will
be negative excess demand (excess supply). In the same way, it can be
demonstrated that at A" there is positive excess demand.
Let us now examine the monetary equilibrium schedule. Given that the
demand for money is an (increasing) function of income and a (decreasing)
function of the interest rate, there will be a locus of the combinations of these
two variables which make the total demand for money equal to the supply,
which is represented by the familiar schedule, LM in Fig. 6.3.
The LM curve is increasingj in fact, given a certain supply of money, if
income is higher the demand for money will also be higher: in consequence,
it is necessary to have a higher value for the interest rate, so as to reduce
the demand for money itself, to maintain the equality between demand and
supply. Furthermore the LM schedule has the property that, at all points
above it, there is negative excess demand for moneyj while at all points below
it, there is positive excess demand. Consider for example any point above
LM, for example, A'j there the rate of interest is higher, income being equal,
than at point A on LM. At A', therefore, there is a lower demand for money
than at A. Since at A the demand for money equals the supply and given
that at A' the demand for money is lower than at A, it follows that at A'
the demand for money is less than the supply. In the same way, it is possible
to show that at any point below the LM schedule (for example at A") the
-------------,A'
I
Figure 6.3: Mundell-Flerning under fixed exchange rates: the monetary equi-
librium schedule
Figure 6.4: Shifts in the monetary equilibrium schedule
demand for money is greater than the supply.

The LM schedule undergoes shifts as the supply of money varies and, to
be precise, it moves to the left (for example to L' M' in Fig. 6.4) if the supply
of money is reduced, and to the right (for example to L" M") if the supply
of money increases.
In fact, to each given value of income must correspond a lower rate of
interest, ifthe money supply is higher, so that the greater demand for money
will absorb the greater supply so as to maintain equilibrium between demand
and supply of money; in consequence, LM must shift downwards and to the
right. Similarly, it is possible to demonstrate that LM shifts upwards and
to the left if the supply of money is reduced. Thus there is a very precise
position for the LM schedule for each level of money supply in the diagram.
The new schedule to be considered in the open-economy extension of
the IS-LM model is the external equilibrium schedule. Equilibrium of the
B'
Figure 6.5: Mundell-Fleming under fixed exchange rates: the external equi-
librium schedule
balance of payments occurs when the algebraic sum of the current account
balance and the capital movements balance is nil. As exports have been
assumed exogenous and imports a function of incomeand the interest rate,
and the capital movements balance as a function of the interest rate, it is
possible to show in a diagram all the combinations of the interest rate and
income which ensure balance-of-payments equilibrium, thus obtaining the
BB schedule (Mundell called it the F F schedule, but there is no standardized
denomination: BB, BP, FX, NX are all used in the literature).
This schedule is upward sloping: in fact, as exports are given, greater
imports correspond to greater income and therefore it is necessary to have
a higher interest rate (which tends on the one hand to put a brake on the
increase in imports and on the other to improve the capital account) in order
to maintain balance-of-payments equilibrium.
We observe that the slope of BB depends, ceteris paribus, on the respon-
siveness of capital fiows to the interest rate, Le, on the degree of international
capital mobility. The higher the mobility of capital, the fiatter the BB sched-
ule. In Fig. 6.5, the degree of capital mobility underlying schedule B' B' is
higher than that underlying schedule BB. In fact, if consider for example
the external equilibrium point H, a higher income (for example, Y2 instead of
Yd will mean a balance-of-payments deficit. This requires-as we have just
seen-a higher value of the interest rate to maintain external equilibrium.
Now, the more reactive capital fiows to the interest rate, the lower the re-
quired interest rate increase. Given Y2 the interest rate will have to be i 2 in
the case of BB, and only i3 in the case of B' B', In the limit, namely in the
case of perfect capital mobility, the BB schedule will become a horizontal
straight line parallel to the Y axis.
Furthermore, the BB schedule has the property that at all points above it
there is a surplus in the balance of payments, while at all points below it there
is a deficit. In fact, consider any point A' above the line BB. At A', while
income is the same, the interest rate is greater than at A, where the balance
of payments is in equilibrium. Thus, as imports are a decreasing function of
the interest rate and as the capital account balance is an increasing function
of the rate itself, at A' imports will be lower and the capital account balance
will be higher-ceteris paribus-than at A, so that if at A the balance of
payments is in equilibrium, at A' there must be a surplus.
In the same way, it is possible to show that at all points below BB (see,
for example, point A") there will be a balance-of-payments deficit.
6.4.1.2 Simultaneous Real, Monetary and External Equilibrium;

Stability
The three schedules 18, BB, and LM so far separately examined, can now
be brought together in a single diagram. Given three straight lines, they will
not intersect at the same point except by chance. Consider first of all the
18 and BB schedules (Fig. 6.6a). They intersect at a point E, where real
equilibrium and balance-of-payments equilibrium are simultaneously estab-
lished with values YE for income and i E for the interest rate. Now consider
schedule LM.
y y
a) b)
Figure 6.6: Mundell-Fleming under fixed exchange rates: macroeconomic

equilibrium
There are two possibilities:

(i) if the quantity of money is considered as given, it is altogether excep-
tional for the corresponding LM schedule to pass through point E. And if the
LM schedule does not pass through E, it follows that monetary equilibrium
does not correspond to real and balance-of-payments equilibrium;
(ii) if, on the other hand, the quantity of money is considered to be vari-
able, then, in principle, it is always possible to find a value for the quantity of
money itself such that the corresponding LM schedule will also pass through
point E. In this case-see Fig. 6.6b-we have the simultaneous occurrence
of real, balance of payments, and monetary equilibrium.
But, one might ask, do any forces exist which tend to cause the necessary
shifts in the LM schedule? The answer to this question cannot be given in
isolation, but requires a general analysis of the dynamics of the disequilibria
in the system, that is, of the behaviour of the system itself when one or more
of the equilibrium conditions are not satisfied. For this purpose it is necessary
to make certain assumptions regarding the dynamic behaviour of the relevant
variables: money supply, income and interest rate. The assumptions are as
follows:
(a) the money supply varies in relation to the surplus or deficit in the
balance of payments and, precisely, increases (decreases) if there is a surplus
(deficit). This assumption implies that the monetary authorities do not in-
tervene to sterilize (see Sect. 5.3) the variations in the quantity of money
determined by disequilibria in the balance of payments: in fact, given Eq.
(5.10), we have b.M = B when the other items are set to zero.
(b) Income varies in relation to the excess demand for goods and, to be
exact, it increases (decreases) according to whether this excess demand is
positive (negative). This is the assumption usually made in the context of
Keynesian-type models.
(c) The rate of interest varies in relation to the excess demand for money
and, more precisely, it increases (decreases) if this excess demand is positive
(negative). This is a plausible hypothesis within the context of an analysis
of the spontaneous behaviour of the system. In fact, if the interest rate is,
in a broad sense, the price of liquidity, an excess demand for liquidity causes
an increase on the market in this price and vice versa. The mechanism,
commonly described in textbooks, is the following: an excess demand for
money-that is, a scarcity of liquidity-induces holders of bonds to offer
them in exchange for money: this causes a fall in the price of bonds, and
thus an increase in the interest rate (which is inversely related to the price
of bonds).
Having made these behavioural hypotheses, it will be seen that the system
is stable and will therefore tend to eliminate disequilibria, that is to say, it
will tend to reach the point of simultaneous real, monetary and balance-
of-payments equilibrium, if the marginal propensity to domestic expenditure
is less than one (as already previously assumed) and ij, in addition, the
marginal propensity to import is below a certain critical value.
A simple case of disequilibrium and the related adjustment process can
be analysed intuitivelyon the basis of Fig. 6.7. Assume, for example, that
the system is initially at point A. At that point there is real and monetary
equilibrium, but not equilibrium of the balance of payments: more exactly,
i
B
o y
Figure 6.7: Mundell-Fleming under fixed exchange rates: dynamic analysis

of the adjustment process
as point A lies below the B B schedule, there is a deficit. Point A is thus a

partial or temporary point of equilibrium.
It is necessary here to distinguish two possible cases: if the monetary
authorities were to intervene in order to sterilize the payments imbalances,
the money supply would remain constant and the economic system would
remain at A; naturally, a reduction in the stock of international reserves
would correspond to the continued balance-of-payments deficit (except in
the case of a country with areserve currency). This situation could not
be sustained indefinitely, since the authorities would eventually run out of
international reserves. However, we have assumed-hypothesis (a)-that an
intervention of this kind would not take place, so that the supply of money
diminishes and the LM schedule moves upwards and to the left, for example
from LoMo to LIMI . Then at A there is a (positive) excess demand for
money, so that-hypothesis (c)-the interest rate increases. The increase in
the interest rate causes a fall in the demand for goods and thus a (negative)
excess demand in the real market, which is confirmed by the fact that point
Al, which is reached from A following the increase in i (vertical arrow from
A towards Al), is above IS. Given, as we said, that at Al there is negative
excess demand on the real market, by hypothesis (b) income falls (horizontal
arrow from Al towards the left). At Al, on the other hand, we are still
below BB and therefore there is still a deficit in the balance of payments;
consequently the money supply falls still further and LM continues to shift
upwards and to the left, so that at Al a situation of positive excess demand
for money remains, with a further tendency for the interest rate to increase
(vertical arrow rising above Ad. We thus have a situation in which y and i
approach their respective equilibrium values and also a shift of LM toward
the position LEME.
We can now ask ourselves what the economic meaning of the conditions
of stability might be. As far as concerns the condition that the marginal
propensity to domestic expenditure is less than one, the meaning is the usual
one: an increase in income, due to a positive excess demand, causes a further
increase in domestic demand, but the process is certainly convergent, if the
increases in demand are below the increases in income, that is to say, if the
marginal propensity to domestic expenditure is less than one. In the oppo-
site case, the process could be divergent, unIess other conditions of stability
intervene.
With regard to the condition that concerns the marginal propensity to
import, the meaning is as folIows: if this propensity is too great, it may hap-
pen, in the course of the adjustment process, that the reduction in imports
(induced by the reduction in y and the increase in i) is such as to bring the
balance of payments into surplus (that is to say, point Eis passed). An 00-
justment in the opposite direction is then set into motion: the money supply
increases, the rate of interest drops, domestic demand, income and imports
all increase (both because y has increased and i decreased). And if the
marginal propensity to import is too high, then it may be that the increase
in imports is such as to produce a new deficit in the balance of payments. At
this point, a new process comes into being, working in the opposite direction
and so on, with continual fluctuations around the point of equilibrium which
each time may take the system further away from equilibrium itself.
6.4.2 Flexible Exchange Rates

The model (6.29)-(6.31) can easily be extended to flexible exchange rates
(prices are, however, still assumed to be rigid and normalized to unity). We
have
y = A(y, i) + x(r) - rm(y, i, r),
M* = L(y, i), (6.32)
B = x(r) - rm(y, i, r) + K(i) = O.
The money supply is indicated with an asterisk because, unIike under
fixed exchange rates, it must now be considered as given in a static context.
In fact, whilst under fixed exchange rates the basic three-equation system
would be overdetermined if M were considered given, as there would be only
two unknowns (y and i: this is case (a) of Sect. 6.4.1.2, represented in Fig.
6.6a), now-under flexible exchange rates-there are three basic unknowns
(y, i, r), so that the system would be underdetermined if M were considered
as an unknown. On the contrary, in adynamie context it is possible to
consider M as an endogenous variable as weIl (see below).
Unfortunately it is not possible to give a simple graphie representation

like that used in the case of fixed exchange rates. As a matter of fact, if
we take up the IS and BB schedules again, we see that a different position
of these schedules in the (y, i) plane corresponds to each different exchange
rate. This position will in turn depend on the critical elasticities condition.
Take in fact the BB schedule: if the critical elasticities condition is satisfied,
we find that higher (lower) values of r imply a balance-of-payments surplus
(deficit); hence at any given i, higher (lower) values of y are required, so that
the higher (lower) value of m exactly offsets the surplus (deficit). This means
that the position of the BB schedule will be found more to the right (left) as
the exchange rate is higher (lower). The opposite will be true if the critical
elasticities condition is not satisfied.
As regards the I S schedule, if the critical elasticities condition is satisfied,
greater (lower) values of the aggregate demand [A + (x - rm) 1correspond to
higher (lower) values of r, so that at any given y the interest rate i will have
to be higher (lower) to keep total demand at the same value as before. This
means that the position of the I S schedule will be found further to the right
(left) as the exchange rate is higher (lower).
Fortunately the LM schedule does not shift as it does not directly depend
on the exchange rate.
To examine the dynamics of the adjustment process let us assume that the
system is initially in equilibrium and that an accidental disturbance moves
it out of equilibrium. We must now introduce suitable dynamic behaviour
assumptions, which are:
(a) income varies in relation to the excess demand for goods and, to be
exact, it increases (decreases) according to whether this excess demand is
positive (negative);
(b) the rate of interest varies in relation to the excess demand for money
and, more precisely, it increases (decreases) if this excess demand is positive
(negative) ;
(c) the exchange rate varies in relation to the payments imbalance and,
to be precise, it increases (decreases) if there is a deficit (surplus);
(d) as regards the money supply, we must distinguish two cases. In the
first, the exchange-rate variations described in (c) cannot instantaneously
maintain the balance of payments in equilibrium. This means that there will
be balance-of-payments disequilibria, which will cause changes in the money
supply, with consequent shifts in the LM schedule. This is what we meant
when we said that in a dynamic context it is possible to consider M also as
a variable. In the second case, the exchange-rate variations do instead in-
stantaneously maintain the balance of payments in equilibrium. This means
that there is no effect of the balance of payments on the money supply, which
remains constant (insofar as there are no other causes of variation); hence,
the LM schedule does not shift.
Assumptions (a), (b), (d) (first case) are the same as those adopted under
fixed exchange rates. As regards assumption (c), it can be considered valid

not only in the context of freely flexible exchange rates (in which case the
cause of exchange-rate variations is to be seen in market forces set into mo-
tion by the excess demand for foreign exchange), but also in the context of
a managed float if we assume that the monetary authorities manage the ex-
change rate in relation to balance-of-payments disequilibria. The difference
will consist in the speed of adjustment of the exchange rate: very high in the
case of a free float, slower in the case of a managed float (as the monetary
authorities may deern it advisable to prevent drastic jumps in the exchange
rate and so intervene to moderate its movements).
Thus we have movements of the I S, B B, LM schedules, which may give
rise to changes in the signs of the excess demands, etc., so that it is not
possible to ascertain the final result of all these movements by way of a
graphic analysis. The situation is less complex if we adopt the second case
of assumption (d), so that the LM schedule does not shift. In any case point
A will converge on the equilibrium point E if the appropriate conditions for
dynamic stability are satisfied.
6.4.3 Capital Mobility and Economic Policy

If we introduce the traditional policy measures (fiscal and monetary policy)
in the MundeH-Fleming model we can obtain several important results, which
turn out to cruciaHy depend on the degree of capital mobility. More precisely,
with imperfect capital mobility and fixed exchange rates the possibility arises
of solving the so-called "dilemma" cases ineconomic policy.
The typical dilemma case arises when an economy operating under fixed
exchange rates suffers from a balance-of-payments deficit as weH as from un-
employment. To stimulate output and hence employment an expansionary
policy is called for, but the increase in output causes a further deterioration
in the balance of payments via increased imports. On the other hand, the re-
duction of the balance-of-payments deficit requires a restrictive policy, hence
a further decrease in output and employment.
This dilemma case can be solved, according to the Mundell-Fleming
model, by an appropriate use of monetary and fiscal policy. More precisely,
an expansionary fiscal policy can be used to increase output and hence em-
ployment. It is true that this will cause a further deterioration in the balance
of payments, but the simultaneous use of monetary policy in such a way as
to increase the domestic interest rate causes a capital inftow that offsets the
deterioration in the current account caused by the output increase.
The opposite dilemma case arises when an economy suffers from excess
demand with respect to full-employment output (hence an inflationary pres-
sure) coupled with a balance-of-payments surplus. To eliminate the former
a restrictive policy is called for, which however would increase the balance-
of-payments surplus via lower imports. In this case a restrictive fiscalpolicy
coupled with an increase in the interest rate that causes a capital outflow
will do the job.
Since nowadays capital mobility is practically perfect in developed coun-
tries, the model's results on the effectiveness of the various policies under
fixed and flexible exchange rates with perfeet capital mobility are particu-
larly relevant.
It should at this point be recalled from Sect. 4.6 that Munden implicitly
assumed perfect capital mobility to imply perfect asset substitutability, so
that VIP holds, ih = if + (f - r)/r. Prom this it is possible to obtain
the condition, used by Munden, that the domestic and foreign interest rate
coincide, i h = if> assuming that, if we are under fixed exchange rates, the
given exchange rate is supposed to be credible (so that agents expect no
change), while in the case of flexible exchange rates static expectations are
held by the representative agent. In the case of perfeet capital mobility it
was shown by Munden that fiscal policy becomes completely ineffective under
flexible exchange rates while monetary policy is fully effective. This result
is symmetrie to that of the complete ineffectiveness of monetary policy and
fuH effectiveness of fiscal policy under fixed exchange rates.
M
I ",M'
/
/
if
B B
YE y' y
Figure 6.8: Perfect capital mobility and fiscal and monetary policy under
fixed and flexible exchange rates
Let us examine Fig. 6.8, where we have drawn the 18, BB, LM sched-
ules corresponding to the equilibrium value (rE) of the exchange rate. This
diagram is similar to Figs. 6.6(b) and 6.7, except for the fact that the BB
schedule has been drawn parallel to the y axis with an ordinate equal to i f, to
denote that the domestic interest rate cannot deviate from the given foreign
interest rate (if) owing to the assumption of perfect capital mobility. In the
initial situation the system is in external equilibriuym.

We first consider an expansionary monetary policy: the LM schedule
shifts rightwards to L' M' and the excess supply of money puts a downward
pressure on the domestic interest rate, which in turn has an expansionary
effect on output. However, the real-monetary equilibrium point EH is hy-
pothetical: in fact, as soon as the interest rate tends to decrease below i J ,
a capital outflow takes place which brings ab out a deficit in the balance of
payments.
At this point we must distinguish between fixed and flexible exchange
rates. Under fixed exchange rates the balance-of-payments deficit causes a
decrease in the money stock which pushes the monetary-equilibrium schedule
back to the initial position, i.e. from L' M' to LM. Any attempt at an ex-
pansionary monetary policy gives rise to a loss of international reserves with
no effect on national income: monetary policy is completely ineffective. If
the policy maker insists on increasing the money supply the system becomes
unstable: when the stock of international reserves is down to zero, the fixed
exchange rate regime will have to be abandoned (a currency crisis: see Sect.
8.3).
On the contrary, under flexible exchange rates the exchange rate depre-
ciates as a consequence of the balance-of-payments deficit (we assume that
the appropriate elasticity conditions are satisfied). The exchange-rate depre-
ciation also causes a rightward shift in the 18 schedule, for example to the
position 1'8'. A new equilibrium is thus established at E' where income is
higher: monetary policy has achieved its aim.
The same kind of diagram can be used to examine the effects of fiscal
policy. An expansionary fiscal policy shifts the 18 schedule to 1'8' in Fig.
6.8. The pressure of excess demand stimulates output; the increase in in-
come causes an increase in the demand for money which, as the supply is
given, exerts an upward pressure on the domestic interest rate. However, the
real-monetary equilibrium point EH is hypothetical: in fact, as soon as the
interest rate tends to increase above iJ, a capital infiow takes place which-
if the exchange rate is fixed-brings about an increase in the money supply
(LM shifts to L' M'). The new equilibrium is established at E', where income
is higher: fiscal policy has achieved its aim.
On the contrary, under flexible exchange rates the money supply remains
constant (the implicit assumption is that we are in the second case of assump-
tion (d) in Sect. 6.4.2), and the upward pressure on the domestic interest
rate is greater: there is, in fact, no increase in the money supply since the
exchange rate moves instantaneously to maintain external equilibrium. The
increased capital infiow causes an exchange-rate appreciation which nullifies
the effects of the expansionary fiscal policy (the real-equilibrium schedule in
the upper panel shifts back from 1'8' to 18). Income falls back to YE: fiscal
policy is completely ineffective.
BOX 6.3 Applications of the Mundell-Fleming model

The Mundell Fleming has found many applications. In the words of M undell himself:
"One implication of the model was that a domestic boom would raise interest rates,
attract capital inflows, appreciate the real exchange rate, and worsen the balance
of trade, a conclusion that would hold under either fixed or flexible exchange rates.
This was very relevant to an understanding of the economy of Canada, which was
the only major country with a flexible exchange rate in the 1950s, and of course
later very relevant for understanding the Reagan boom in the early 1980s and the
German unification boom in the context of the exchange rate mechanism crisis in
the early 1990s" (Mundell, 2001, p. 221). Further,
"Fortunately for the United States (and me), President Kennedy reversed the policy
mix to that of tax cuts to spur growth in combination with tight money to protect
the balance of payments. The result was the longest expansion ever (up to that
time) in the history of the U.S. economy, unmatched until the Reagan expansion of
the 1990s" (Mundell, 2001, p. 222).
This model continues to offer a useful framework for policy making in practice. For
example, its conclusions on the effectiveness of fiscal and monetary policy under
fixed and flexible exchange rates with perfect capital mobility underlie the so-called
inconsistent triad (or incompatible trinity), which is so important in the field of in-
ternational monetary integration (see Sect. 11.3). More precisely, these results show
that it is impossible for a country to simultaneously peg its exchange rate and allow
unfettered movement of international capital, while retaining any autonomy over
its monetary policYj hence the set of fixed exchange rates, perfect capital mobility,
and monetary independence has been called the inconsistent triad or incompatible
trinity. Other examples of practical applications concern developing economies and
economies in transition: see, for example, Kannapiran (2003)j Savov (2002).
6.4.4 Some Observations on the Model

The Mundell-Fleming model enjoys an enduring popularity and still forms
the basis for many policy analyses of small open economies. However, several
weak points have been pointed out over the years, of which the main are:
1) capital movements induced by interest differentials are considered as
pure fiows. This means that as long as a given interest differential persists,
capital will continue to fiow in the same direction and amount, of course
ceteris paribus. However, it is to be presumed that capital fiows induced by
a given difference between domestic and foreign interest rates will be limited.
This is a consequence of the general principle of capital stock adjustment. In
fact, to each given difference between the rates of interest, there corresponds a
certain stock of financial capital which investors wish to place; if the existing
stock (that is, the stock they have already placed) is different, there will be
a capital fiow--spread out over a certain period of time-to bring the stock
already in existence up to the level desired. Onee the adjustment proeess is
completed, the fiows cease.
2) A situation in which balance-of-payments equilibrium is kept thanks
to continuing capital infiows that match a eurrent account deficit cannot be
maintained in the long run. In fact, foreign debt will steadily increase and
6.5. Suggested Further Reading 99
with it the burden of interest payments (a debit item in the current account)
will also increase.
If we also consider the previous point, it follows that the capital inflow can
be maintained only through an increasing interest differential, which makes
the burden of interest payments still more serious. This casts serious doubts
on the validity of the use of an expansionary fiscal policy coupled with a
restrictive monetary policy to solve the dilemma cases under fixed exchange
rates. Such a use can be at best considered as a short-run measure.
In the next chapter we will tackle the problems deriving from the fact that
capital movements are actually a stock adjustment (portfolio approach).

Bahmani-Oskooee, M. and T.J. Brooks, 1999, Bilateral J-Curve between
V.S. and Her Trading Partners, Weltwirtschaftliches Archiv/ Review of
World Economics 135, 156-65.
Bahmani-Oskooee, M. and G.G. Goswami, 2003, A Disaggregated Approach
to Test the J-Curve Phenomenon: Japan versus Her Major Trading
Partners, Journal of Economics and Finance 27, 102-13.
Bickerdicke, C.F., 1920, The Instability of Foreign Exchange, Economic
Journal 30, 118-22.
Deardoff, A.V. and R.M. Stern, 1979, What Have we Learned from Linked
Econometric Models? A Comparison ofFiscal-Policy Simulations, Ban-
ca Nazionale deI Lavoro Quarterly Review 32, 415-432.
Ferrara, L., 1984, Il moltiplicatore in mercato aperto nelle analisi dell'interdi-
pendenza internazionale: teoria e evidenza empirica, unpublished the-
sis, University of Rome La Sapienza, Faculty of Economics.
Frenkel, J.A. and A. Razin, 1987, The Mundell-Fleming Model a Quarter
Century Later, International Monetary Fund Staff Papers 34, 567-620.
Fleming, J.M., 1962, Domestic Financial Policy under Fixed and under
Floating Exchange Rate, IMF Staff Papers 9, 369-379.
Gagnon, J.E., 2003, Long-Run Supply Effects and the Elasticities Approach
to Trade, Board of Governors of the Federal Reserve System, Interna-
tional Finance Discussion Paper No. 754
(http://wwwJederalreserve.gov/pubs/ifdp).
Gandolfo, G., 2002, International Finance and Open-Economy Macroeco-
nomics, Berlin Heidelberg New York: Springer-Verlag, Part H.
Hacker, R.S. and A. Hatemi-J, 2003, Is the J-Curve Effect Observable for
Small North European Economies?, Open Economies Review 14, 119-
34.
Hooper, P., K. Johnson and J. Marquez, 2000, Trade Elasticities for the
G-7 Countries, Princeton University, International Economics Section:
Princeton Studies in International Economics No. 87.
Johnson, B.G., 1958, Towards a General Theory of the Balance of Pay-

ments, Chap. VI in H.G. Johnson, International Trade and Economic
Growth, London: Allen&Unwin. Reprinted in: R.E. Caves and B.G.
Johnson (eds.), 1968, Readings in International Economics, London:
Allen&Unwin, and in: R.N. Cooper, (ed.), 1969, International Finance
- Selected Readings, Harmondsworth: Penguin.
Kannapiran, C.A., 2003, A Macroeconometric Model of a Developing Econ-
omy, Journal 0/ the Asia Pacific Economy 8, 41-56.
LaI, A. K and T.C. Lowinger, 2002, The J-Curve: Evidence from East Asia,
Journal 0/ Economic Integration 17,397-415.
Lerner, A.P., 1944, The Economics 0/ Control, London: Macmillan, pp. 377-
79.
Laursen S. and L.A. Metzler, 1950, Flexible Exchange Rates and the Theory
of Employment, Review 0/ Economics and Statistics 32, 281-299.
Magee, S.P., 1973, Currency Contracts, Pass-Through, andDevaluation,
Brookings Papers on Economic Activity, No. 1,303-323.
Machlup, F., 1943, International Trade and the National Income Multiplier,
Philadelphia: Blakiston; reprinted 1965 by Kelley, New York.
Marquez, J., 2002, Estimating Trade Elasticities, Boston, Dordrecht and
London: Kluwer Academic.
Mundell, R.A., 1968, International Economics, New York: Macmillan, Parts
II and III (reprint of the seminal articles written in the early 1960s).
Mundell, R.A., 2001, On the Bistory of the Mundell-Fleming Model: Keynote
Speech, IMF StafJ Papers 47 (Special Issue), 215-27.
NIESR (National Institute of Economic and Social Research, UK), 1968, The
Economic Situation. The Horne Economy, National Institute Economic
Review, No. 44, 4-17.
Robinson, J., 1937, The Foreign Exchanges, in J. Robinson, Essays in the
Theory 0/ Employment, Oxford: Blackwell.
Rotondi, Z., 1989, La trasmissione internazionale delle perturbazioni in cambi
fissi e flessibili, unpublished thesis, University of Rome La Sapienza,
Faculty of Economics.
Savov, S., 2002, Equilibrium in an Open Economy, Economic Thought 0,
3-20.
Chapter 7
The Monetary and Portfolio

Approaches
7.1 The Monetary Approach

The supporters of the monetary approach to the balance of payments (MABP)
claimed their allegiance to David Hume (1752), considered the author of the
first complete formulation of the classical theory of the mechanism for the
adjustment of the balance of payments based on the flows of money (gold).
This theory can be summed up as folIows: under the gold standard (hence
with fixed exchange rates) a surplus in the balance of payments causes an
inflow of gold into a country, that is to say-as there is a strict connection
between gold reserves and the amount of money-it causes an increase in
prices (the quantity theory of money is assumed to be valid). This increase
tends on the one hand to reduce exports, as the goods of the country in ques-
tion become relatively more expensive on the international market, and on
the other, it stimulates imports, as foreign goods become relatively cheaper.
There is thus a gradual reduction in the balance-of-payments surplus. An
analogous piece of reasoning is used to explain the adjustment in the case of
a deficit: there is an outflow of gold which causes a reduction in the stock of
money and a reduction in domestic prices, with a consequent stimulation of
exports and a reduction of imports, which thus lead to a gradual elimination
of the deficit itself.
The claim of the supporters of MABP is only partly correct.
It is correct insofar as it states that the ultimate cause of the balance-
of-payments disequilibria is to be found in monetary disequilibria, namely in
a divergence between the quantity of money in existence and the optimum
or desired quantity. This was indeed Hume's idea. It is incorrect insofar
as it states that the adjustment mechanism is based on a direct effect of
monetary disequilibria on the expenditure functions. We have in fact seen
that according to Hume the adjustment mechanism worked through changes
101
102 Chapter 7. The Monetary and Portfolio Approaches
in relative prices.
Be it as it may, we now turn to summarize the MABP in a few basic
propositions, from which certain implications for economic policy can be
derived.
7.1.1 The Basic Propositions and Implications

Proposition I
The balance of payments is essentially a monetary phenomenon and must
therefore be analysed in terms of adjustment of money stocks. More precisely,
balance-of-payments disequilibria reflect stock disequilibria in the money
market (excess demand or supply) and must therefore be analysed in terms
of adjustment of these stocks toward their respective desired levels (it is in
fact the disequilibria in stocks which generate adjustment flows). It follows
that the demand for money and the supply of money represent the theo-
retical relations on which the analysis of the balance of payments must be
concentrated.
In order to fully understand the meaning of this proposition, we shall
begin by examining the initial statement.
That the balance of payments is essentially a monetary phenomenon is
obvious (if we take this statement in the trivial sense that the balance of
payments has, by its very nature, to do with monetary magnitudes) and a
necessary consequence of the accounting relationships examined in Sect. 5.3.
In particular,
B =6R=6M-6Q, (7.1)
which shows that the balance of payments is a monetary phenomenon. But
we could also say, still on the basis of the accounting identities, that the
balance of payments (or more precisely the current account) is areal phe-
nomenon, because, on the basis of Eq. (5.3), we have
CA=Y-A.
Thus, in order to derive operational consequences from the statement

that the balance of payments is a monetary phenomenon, it is necessary
to go beyond the identity (7.1) and introduce behaviour hypotheses, and
this in fact constitutes the aim of the second part of the proposition under
examination.
More precisely, the basic idea is that any monetary disequilibria produce
an effect on the aggregate expenditure for goods and services (absorption) in
the sense that an excess supply of money causes-ceteris paribus-absorption
to be greater than income and, conversely, an excess demand for money
causes absorption to be smaller than income itself.
On the other hand, the divergence between income and absorption which
is created in this way, is necessarily translated into an increase or decrease
7.1. The Monetary Approach 103
in the stock of assets owned by the public: in fact, this divergence is the
equivalent of one between saving and investment and therefore, given the
balance constraint of the private sector (see Sect. 5.3), it is translated into a
variation in the stock of assets held by this sector. If, for the sake of simplicity,
we introduce the hypothesis that the only asset is money, a variation in the
money stock comes ab out , which in turn, given (7.1), coincides with the
overall balance of payments.
Ultimately what has happened, through this sequence of effects (for which
we shall give a model below) is that an excess demand or supply of money, by
causing an excess or deficiency of absorption with respect to national income
(product), has been unloaded onto the balance of payments: an excess of
absorption means a balance-of-payments deficit (the only way of absorbing
more than one pro duces is to receive from foreign countries more than one
supplies to them) and a deficiency in absorption means a balance-of-payments
surplus. In other words, if the public has an excess supply of money it gets
rid of it by increasing absorption and, ultimately, by passing this excess on
to foreign countries in exchange for goods and services (balance-of-payments
deficit). If on the other hand the public desires more money than it has
in stock, it procures it by reducing absorption and, ultimately, it passes
goods and services on to foreign countries in exchange for money (balance-
of-payments surplus).
What is implicit in our reasoning is the hypothesis that the level of prices
and the level of income are a datum (otherwise the variations in absorption
with respect to income could generate variations in prices and/or income)
and in fact this is what, among other things, the next propositions refer to.
Proposition II
There exists an efiicient world market for goods, services and assets and
that implies, as far as goods are concerned (as usual, goods refers to both
goods and services), that the goods themselves must have the same price
everywhere (law of one price), naturally account being taken of the rate of
exchange (which is, by hypothesis, fixed) and therefore that the levels of
prices must be connected-if we ignore the cost of transport-by the rela-
tionship
(7.2)
where PI is the foreign price level expressed in foreign currency, pis the da-
mestic price level in domestic currency, and r is the exchange rate. Equation
(7.2), which is also called the equation of purchasing power parityl, has the
effect that, given r and PI, P will be fixed.
Proposition III
Production is given at the level of fuH employment. This proposition
implies that the MABP is a long-term theory, in which it is assumed that
lWe shall deal more fully with the purchasing power parity later, among other things
so as to examine the reasons for deviations from it. in Sect. 9.1.
production tends toward the level of fuH employment thanks to price and
wage adjustments.
Given these assumptions, important policy implications follow, and pre-

cisely:
Implication 1. In a regime of fixed exchange rates, monetary policy does
not control the country's money supply. This implication comes directly
from the propositions given above and particularly Proposition I. In fact, if
the monetary authorities try to create a different money supply from that
desired by the public, the sole result will be to generate a balance-of-payments
disequilibrium, onto which, as we have seen, the divergence between the
existing money stock and the demand for money will be unloaded.
Implication II. The process of adjustment of the balance of payments
is automatie, and the best thing that the monetary authorities can do is
to abstain from all intervention. This implication also immediately derives
from the propositions given above and particularly from Proposition I. The
balance-of-payments disequilibria are in fact monetary symptoms of money-
stock disequilibria which correct themselves in time, if the automatic mech-
anism of variation in the money stock is allowed to work. If, let us say, there
is a balance-of-payments deficit (which is a symptom of an excess supply
of money), this deficit will automatically cause a reduction in the stock of
money-see (7.1), where (as we assumed above) l::,.Q is zero-and therefore
a movement of this stock towards its desired value. When the desired stock
is reached, the deficit in the balance of payments will disappear. It may
happen, however, in a fixed exchange regime other than the gold standard,
that in the course of this adjustment the stock of international reserves of
the country will show signs of exhaustion before equilibrium is reached. In
this and only this case, a policy intervention is advisable, which in any case
should consist of a monetary restriction (so as to reduce the money supply
more rapidly towards its desired value) and not of a devaluation in the ex-
change rate or any other measure, which are inadvisable palliatives, with
purely transitory effects.
7.1.2 A Simple Model

It is possible to give a SImple model for the MABP in the basic version so
far illustrated.
The first behavioural equation expresses the fundamental assumption of
the MABP that any excess or deficiency of absorption with respect to income
varies in relation to the divergence between money supply (M) and demand
(L):
7.1. The Monetary Approach 105
or
(7.3)
The parameter a is a coefficient which denotes the intensity of the effect on
absorption of a divergence between M and L. It is assumed positive but
smaller than unity because the divergence is not entirely eliminated within
one period, due to lags, frictions and other elements.
Equation (7.3) is the crucial assumption of the MABP, and represents
expenditure as coming out of a stock adjustment rather than deriving from a
relation between ßows as in the functions in the Keynesian tradition encoun-
tered in the previous chapter. Here the representative agent does not directIy
decide the ßow of expenditure in relation to the current ßow of income, but
does instead decide the ßow of (positive or negative) saving out of current
income in order to bring the current stock of wealth (here represented by
money) to its desired stock (here represented by money demand).
We then have the accounting equation (see Sect. 5.3)
(7.4)
which expresses the fact that the excess of income over expenditure coincides
with an increase in the money stock held by the public, if we assume that
money is the sole asset in existence. This same assumption allows us to write
the accounting relation (7.1) as
D..R= 6M. (7.5)
By substituting (7.5) into (7.4) and then into (7.3), we have
6R=a(L- M), (7.6)
which says that the variation in reserves (coinciding with the balance of
payments) depends, through coefficient a, on the divergence between the
demand and supply of money.
The self-correcting nature of the disequilibria can be clearly seen from Bq.
(7.6): if, for example, the existing money stock is excessive, that is if M > L,
there is a balance-of-payments deficit (B = 6R is negative) and therefor~
via Eq. (7.5)-M decreases. This reduction restores the equilibrium between
monetary stocks (M ~ L) and hence brings the balance of payments back
to equilibrium.
7.1.3 Concluding Remarks

The demolishing effect of the MABP on the traditional theory of the adjust-
ment processes is obvious: not only are standard measures, like devaluation,
ineffective, but even the more sophisticated macroeconomic policies derived
from the Mundell-Fleming model have to be discarded. It is enough to leave
the system to its own devices (Implication II) for everything to be automat-
ically adjusted.
It is not surprising therefore that the MABP gave rise to a large num-
ber of criticisms and rejoinders. Most of this debate, however, did not get
the gist of the matter, which is the validity of the behavioural assumption
(7.3). If it is valid, the MABP is perfectly consistent, since other contro-
versial points (such as the neglect of financial assets other than money, the
constancy of price levels, etcetera) are really not essential for its conclusions.
If, on the contrary, the representative agent behaves according to a pure flow
expenditure function A = A(y, ... ), then the MABP conclusions are clearly
unwarranted.
Be it as it may, the MABP should be given due acknowledgement for
one fundamental merit: that of having directed attention to the fact that
in the case of balance-of-payments disequilibria and the related adjustment
processes, stock equilibria and disequilibria must be taken into account. Nat-
urally, this must not be taken in the sense-typical of the cruder versions
of the MABP-that only stock equilibria and disequilibria matter, but that
they also matter in addition to pure ftow equilibria and disequilibria.
7.2 The Portfolio Approach

We have seen in the previouschapter (Sect. 6.4.4) the criticism levied at the
assumption that capital movements are pure flows. They are, in fact, flows
deriving from a stock adjustment. This problem will be examined here in
the context of fixed exchange rates and in a partial equilibrium framework.
The formulation of these adjustments comes within the framework of
the Tobin-Markowitz theory of portfolio equilibrium, extended to an open
economy by McKinnon and Oates (1966), McKinnon (1969), Branson (1974,
1985) and numerous other scholars.
The central idea of the Tobin-Markowitz theory of portfolio equilibrium
is that holders of financial wealth (which is a magnitude with the nature
of a stock) divide their wealth among the various assets on the basis of the
yield and risk of the assets themselves, and of their utility function (i.e., the
holders' "tastes" as regards return and risk). Let us suppose therefore that
the holders of wealth have a choice between national money, and national
and foreign bonds; the exchange rate is assumed to be fixed. If we indicate
total wealth by W, considered exogenous, and the three components just
mentioned by L, N and F, we have first of all the balance constraint:
L N F
L +N +F = W, W +W +W = 1. (7.7)
The three fractions are determined, as we said, on the basis of the yield
and risk, account also being taken of income (among other things, this ac-
counts for the transactions demand for money). Supposing for the sake of
7.2. The Portfolio Approach 107
simplicity that the risk element and the utility function do not undergo any
variations, we have the functions
(7.8)
where ih and i f indicate as usual the horne and foreign interest rates respec-
tively. The three functions (7.8) are not independent of each other insofar as
once two of them are known the third is also determined given the balance
constraint (7.7).
It is then assumed that these functions have certain plausible properties.
The signs under the explanatory variables express the eifect of each such
variable on the dependent variable. First of all, the fraction of wealth held in
the form of money is a decreasing function of the yields of both national and
foreign bonds: an increase in the interest rates ih and i f has, other things
being equal, a depressive eifect on the demand for money and, obviously,
an expansionary eifect on the demand for bonds (see below). Also, f is an
increasing function of y and this means that, on the whole, the demand for
bonds is a decreasing function of y.
The fraction of wealth held in the form of domestic bonds, on account of
what has just been said, is an increasing function of i h ; it is, furthermore, a
decreasing function of i f insofar as an increase in the foreign interest rate will
induce the holders of wealth to prefer foreign bonds, ceteris paribus. Similarly
the fraction of wealth held in the form of foreign bonds is an increasing
function of if and a decreasing function of i h . Finally the fraction of wealth
held totally in the form of bonds, (N + F) /W, is-for the reasons given
above--a decreasing function of y.
We could at this point introduce similar equations for the rest of the
wor1d, but so as to simplify the analysis we shal1 make the assumption of
a smal1 country and thus use a one-country model. This implies that the
foreign interest rate is exogenous and that the variations in the demand for
foreign bonds on the part of residents do not influence the foreign market
for these bonds, so that the (foreign) supply of forE:lign bonds to residents is
perfect1y e1astic. Another implication of the small-co~try hypothesis is that
non-residents have no interest in holding bonds from this country, so that
capital flows are due to the fact that residents buy foreign bonds (capital
outflow) or sell them (capital inflow).
Having made this assumption, we now pass to the description of the asset
market equilibrium and introduce, alongside the demand functions for the
various aSsets, the respective supply functions, which we shall indicate by
M for money and NB for domestic bonds; for foreign bonds no symbol is
needed. as the hypothesis that their supply is perfectly elastic has the eifect
that the supply is a1ways equal to the demand on the part of residents. The
equilibrium under consideration is described as usual by the condition that
supply and demand are equal, that is
It is easy to demonstrate that only two of (7.9) are independent and

therefore that, when any two of these three equations are satisfied, the third
is necessarily also satisfied. This is a refiection of the general rule (also called
Walras' law) according to which, when n markets are connected by a balance
constraint, if any n - 1 of them are in equilibrium, then the nth is necessarily
in equilibrium. In the case under consideration, let us begin by observing
that the given stock of wealth W is the same seen from both the demand
and the supply sides, namely
M+NS+F=W. (7.10)
From Eqs. (7.7) and (7.8) we obtain
(7.11)
and so, if we subtract (7.11) from (7.10), we obtain
which is the formal statement of Walras' law. From Eq. (7.12) we see that,
if any two of the expressions in square brackets are zero (namely, if any two
of Eqs. (7.9) are satisfied), the third is also.
Equations (7.9) therefore provide us with two independent equations
which, together with (7.10) make it possible to determine the three un-
knowns, which were the horne interest rate (i h ), the stock of foreign bonds
held by residents (F), and the stock of domestic money (M): the equilib-
rium values of these three variables will thus result from the solution of the
problem of portfolio equilibrium, while the stock of domestic bonds (N S ) is
given as are i h , y and W.
7.2.1 AGraphie Representation

The system being examined can be represented graphically. In Fig. 7.1 we
have shown three schedules, LL, NN and FF, derived from Eqs. (7.9).
The LL schedule represents the combinations of i h and F which keep the
money market in equilibrium, given, of course, the exogenous variables. It
is upward sloping on account of the following considerations. An increase
in the stock of foreign securities held by residents implies-ceteris paribus
(and so given N)-a decrease in the money stock (because residents give up
domestic money to the central bank in exchange for foreign money to buy
the foreign securities). Thus, in order to maintain monetary equilibrium,
7.2. The Portfolio Approach 109
N------~~------N
L F
F. F
Figure 7.1: Determination of portfolio equilibrium in an open economy
domestic money demand must be correspondingly reduced, which requires

an increase in i h .
The N N schedule represents the combinations of ih and F which ensure

equilibrium in the domestic bond market. It is a horizontal line because,
whatever the amount of foreign bonds held by residents, variations in this
amount give rise to variations of equal absolute value in the stock of money,
but in the opposite direction, so that W does not change. The mechanism is
the same as that described above with regard to LL: an increase (decrease)
in F means that residents give up to (acquire from) the central bank national
money in exchange for foreign currency. Note that F is already expressed in
terms of national currency at the given and fixed rate of exchange. Hence
the demand for domestic bonds does not vary and consequently, as its supply
is given, i h cannot vary.
Finally, the F F schedule represents the combinations of ih and F which

keep the demand for foreign bonds on the part of residents equal to the supply
(which, remember, is perfectly elastic). It has a negative slope because an
increase in ih by generating, as we have said, a reduction in the residents'
demand for foreign bonds, generates an equal reduction in the stock of these
bonds held by residents themselves.
The three schedules necessarily intersect at the same point A, thanks

to Walras' law, mentioned above. In economic terms, given the stock of
domestic bonds NB and the other exogenous variables, the equilibrium in the
market for these bonds determines i h • Consequently the demand for money
is determined and thus the stock of foreign bonds to which it corresponds,
given the balance constraint, a stock of money exactly equal to the demand
for money itself.
110 Chapter 7. The Monetary and Portfolio Approa.ches
7.2.2 Monetary Policy, Port folio Equilibrium, and

Capital Flows
What interests us partieularly in all this analysis is to examine what happens
to eapital movements as a eonsequenee of monetary poliey, whieh, by acting
on the national interest rate, generates a portfolio realloeation. In this eon-
text, monetary poliey influenees the interest rate indirectly, by aeting on the
stock of money. This action ean eome about in various ways, for example
by way of open market operations, in which the central bank trades national
bonds for money. Let us suppose then that the monetary authorities inerease
the supply of domestie bonds, N S . We can now begin an examination of the
shifts in the various schedules (see Fig. 7.2). N N shifts parallely upwards
to position N' N' : in fact, a greater value of ih is needed in order to have a
greater value of the demand for bonds so as to absorb the greater supply. In
eoneomitanee, LL shifts upwards to the left, because, as a eonsequenee of the
acquisition of new bonds, the stock of money is reduced. The F F sehedule
remains where it was, because none of the exogenous variables 2 present in it
has changed.
i.
N--~~~~~--------N
~.
1', Fo p
Figure 7.2: Monetary poliey, portfolio equilibrium and eapital flows
The new point of equilibrium is obviously A' to which there corresponds

a stock of foreign bonds (Fd sm aller than that (Fo) which oceurred in eor-
respondence to the previous point of equilibrium A. The reduction in the
stock of foreign bonds from Fo to F1 obviously involves an infiow of capital,
but when this stock has reached the new position of equilibrium, these cap-
ital movements will cease, and can begin again only in the case of a further
inerease in ih. This provides a rigorous demonstration of what was already
said in Sect. 6.4.4.
2From (7.9) it can be seen that the exogenous variables in FF are W,iJ and y; in NN
theyare W, iJ, y, NS (the last of which has increased) ; in LL they are W, iJ, Y and M (the
last of which has decreased) .
We shall conclude with a mention of the dynamic process which takes

the system from A to A'. The supply of new domestic bonds on the part of
the monetary authorities creates an excess supply of bonds with respect to
the previous situation of equilibrium, so that the price falls: thus i h , which
is inversely related to the price of bonds, increases until the demand for
bonds increases to a sufficient extent to absorb the greater supply. As the
bonds are sold by the monetary authorities in exchange for money, the stock
of money is reduced; besides, as i h has increased, the demand for money
falls so that monetary equilibrium is maintained. Finally, as the demand
for foreign bonds is in inverse relationship to i h , the increase in the latter
leads to a reduction in F of which we have already spoken. As the quantities
being demanded and supplied have the nature of stocks and as the total in
existence (wealth W) is given 3 , once the new equilibrium stocks have been
reached, the adjustment flows (including capital movements) will cease, as
already stated.

Branson, W.H., 1974, Stocks and Flows in International Monetary Analysis,
in A. Ando, R Herring and R Marston (eds.), International Aspects
of Stabilization Policies, Federal Reserve Bank of Boston Conference
Series No. 12, 27-50.
Branson, W.H. and D.W. Henderson, 1985, The Specification and Influence
of Asset Markets, in RW. Jones and P.B. Kenen (eds.), Handbook of
International Economics, Vol. H, Amsterdam: North-Holland, Chap.
15.
De Grauwe, P., 1983, Macroeconomic Theory for the Open Economy, Hamp-
shire: Gower Publishing Co.
Frenkel, J.A. and H.G. Johnson (eds.), 1976, The Monetary Approach to the
Balance of Payments, London: Allen&Unwin.
nomics, Berlin Heidelberg New York: Springer-Verlag, Chaps. 12, 13.
Hume, D., 1752, Of the Balance of Trade, in D. Hume, Political Discourses,
Edinburgh. Reprinted in D. Hume, 1955, Writings on Economics,
edited by E. Rotwein, London: Nelson, 60ff, and (partially) in RN.
Cooper (ed.), 1969, International Finance: Selected Readings, Har-
mondsworth: Penguin, 25-37.
McKinnon, RI., 1969, Portfolio Balance and International Payments Adjust-
ment, in RA. Mundell and A.K. Swoboda (eds.), Monetary Problems
of the International Economy, Chicago: Chicago University Press, 199-
234.
3It is cJear that if W went on increasing in time, then there could be a continuous flow
of capital.
McKiIlllon, R.I. and W. Gates, 1966, The Implications of International Eco-

nomic Integration fOT Monetary, Fiscal and Exchange Rate Policy,
Princeton Studies in International Finance No. 16, International Fi-
nance Section, Princeton University.
Chapter 8
Capital Movements,
Speculation, and Currency
Crises
International capital movements have been mentioned several times in pre-

vious chapters. The purpose of the next sections is to bring these together
in a unified picture, and to examine the causes and effects of the main types
of capital movements in detail; for convenience the traditional distinction
between short-term and long-term movements will be maintained.
8.1 Long-Term Capital Movements

The main types of private long-term capital movements are portfolio invest-
ment and direct investment (other types of long-term capital movements
are internationalloans and commercial credits, naturally with a maturity of
more than one year). The difference between portfolio and direct investment
is that the direct investor holds (or seeks to have), on a lasting basis, an ef-
fective voice in the management of a nonresident enterprise, whilst portfolio
investment is of a purely financial nature.
In general, the typical direct investment is in ordinary shares (equities)
and the operator is usuaily a multinational corporation. Portfqlio investment
covers government bonds, private bonds, bonds issued by international orga-
nizations, preference shares, equities (but not so as to gain control over the
corporation), various kinds of other securities (certificates of deposit, mar-
ketable promissory notes, etc.). At this point the problem arises of determin-
ing the percentage of ownership of an enterprise above which one can talk of
control. It is true, of course, that fulliegal control is achieved by owning just
over 50% of the equities (or other form of ownership of the enterprise), but
in the case of big corporations with a widely distributed ownership among
numerous small shareholders a much lower percentage is often sufficient to
113
114 Chapter 8. Capital Movements, Speculation, and Currency Crises
achieve the actual control of the corporation. Thus a conventional account-

ing solution is inevitable. Most countries, therefore, rely on the percentage
of ownership of the voting stock in an enterprise (usually it is 10%).
Portfolio investment, once assumed to be a function of differential yields
and of risk diversification, but without a precise framework to fit in, has
received an adequate theoretical placing within the general theory of portfolio
selection. This theory starts from a given amount of funds (wealth) to be
placed in a certain set of admissible domestic and foreign assets, where the
rates of return and the direct and cross risk coefficients of the various assets
are known. The maximization procedure is then carried out in two stages:
first the set of efficient 1 portfolios is determined, then the optimum portfolio
in this set is determined by using the investor's utility function. To put
it another way, given the stock of wealth, the optimum stock of each of the
various assets included in the portfolio is a function of the rates of return and
risk coefficients of all assets as weH as of the "tastes" of the wealth holder (at
the same rates of return and risk coefficients, the portfolio of a risk-averse
investor will be different from that of a risk lover). Now, since portfolio
investment is an aggregate of flows, it is self-evident that these arise if, and
only if, the currently owned stocks of the various assets pertinent to the
balance of payments (that is, of foreign financial assets owned by residents,
and of domestic financial assets owned by nonresidents) are different from
the respective optimum stocks. As soon as these are reached by way of the
adjustment flows, the flows themselves cease. Therefore, according to this
theory, the existence of continuous flows of portfolio investment derives both
from the fact that the elements (yields, risk, tastes) underlying the optimum
composition are not constant but change through time (since the optimum
composition changes as they change, continuous adjustment flows will be
required) and from the fact that the stock of wealth is not itself a constant
but changes through time, so that even if the composition were constant,
the desired stocks of the various relevant assets change just the same and
so adjustment flows take place. This is a very plausible picture, as even a
casuallook at world financial markets will confirm that yields and risks are
in astate of continual change in all directions (we neglect tastes, not because
they are not important, but because they are not direct1y observable); the
stock of financial wealth is also a magnitude in continual evolution. Thus the
theory of portfolio selection is capable of giving a consistent and satisfactory
explanation of portfolio investment.
The problem of direct investment is much more complicated and does
not seem susceptible to a single simple explanation. The typical enterprise
which makes direct investment is usually a big corporation which operates in
1 A portfolio, that is a given allocation of funds among the various assets, is efficient if
a greater return can be achieved only by accepting a greater risk (or a lower risk can be
obtained only by accepting a lower return).
8.1. Long-Term Capital Movements 115
a market with a high product differentiation, and, for this corporation, direct
investment is often an alternative to exporting its products, as the ownership
of plants in foreign countries facilitates the penetration of foreign markets.
From this point of view it is clear that the theory of direct investment belongs
to the theory of multinational firms (which has had an enormous development
in recent times). Abrief account of this theory will now be given.
8.1.1 Multinational Enterprises and Foreign Direct

Investment
Multinational enterprises (MNE) are firms that engage in foreign direct in-
vestment (FDI) namely investments in which the firm acquires a substantial
controlling interest in a foreign firm or sets up a subsidiary in a foreign coun-
try (controlled foreign firms and subsidiaries are called foreign affiliates of
the parent firm). Foreign direct investment is defined as horizontal when
the foreign affiliate produces commodities and/or services roughly similar to
those the MNE pro duces for its home market. Vertical FDIs refer to those
that geographically fragment the production process by stages of production.
Vertical firms produce intermediate inputs in a country and export them to
another country where they are used to produce the final good. In this case,
since intermediate inputs remain within the same enterprise but cross the
border, we have intrafirm international trade. Mixed horizontal-vertical FDI
is of course possible. A significant percentage of world trade (about 30%) is
now intrafirm trade, and most FDI seems to be horizontal, at least insofar
as most of the output of foreign affiliates is sold in the foreign country.
The point of departure of the theory of MNE is the observation that
firms doing business abroad incur higher costs than domestic firms in those
countries. Hence there must be offsetting advantages for a firm to become
multinational. The OLl (Ownership-Location-Internationalization) classifi-
cation of advantages due to Dunning is still useful to understand the incentive
for a firm to become multinational.
a) Ownership advantage. MNE enterprises usually own a special kind of
capital known as knowledge capital. This consists of human capital (man-
agers, engineers, financial experts, etc.), patents, know how, reputation, trade
marks, etc. The main features of knowledge capital are:
1. it can be easily transferred to foreign affiliates without particular cost.
For example, managers, engineers and other skilled workers can visit foreign
affiliates and communicate with them via fax, telephone, e-mail.
2. it can be used repeatedly and in different pI aces without a decline in
its productivity: chemical formulae, blueprints, reputation are very costly to
produce, but once they are created they can serve foreign affiliates without
losing value or productivity. This means that knowledge capital possesses
some of the characteristics of public goods (essentially the non-rivalry in
consumption) and hence can be considered as a public input for the firm
that owns it.
b) Location advantages. With production plants located near the final
consumers, MNE save on transport costs and may hire cheap local factors of
production (for example, labour in developing countries). Besides, they can
circumvent possible barriers to trade such as tarifIs imposed by the foreign
country (tanff-jump argument). Vertical multinationals may find it optimal
to export intermediate inputs and the services of its knowledge capital to
a foreign affiliate for final assembly and shipment back to the MNE's home
country (jragmentation).
c) Internalization advantages. Ownership and location advantages could
in principle be reaped also through agreements with foreign licensees. How-
ever, the property of knowledge capital that makes it easily transferred also
makes it easily dissipated: licensees can absorb the knowledge capital and
then defect, or ruin the firm's reputation for greed. Thus MNE transfer
knowledge internally in order to maintain the value of their knowledge capi-
tal and avoid its dissipation.
Several other theoretical developments have taken place in recent years,
see Markusen (2002).
8.2 Short-Term Capital Movements and

Foreign Exchange Speculation
The economic role of speculation is a moot question also outside international
economics. On the one hand, in fact, it is claimed that speculators, by
buying when the price is low and reselling when the price is high, help to
smooth out and dampen down the fiuctuations of the price around its normal
value, so that their operations are beneficial (stabilizing speculation). On the
other hand, the possibility is stressed that speculators buy precisely when
the price is rising in order to force a further rise and then profit from the
difIerence (bullish speculation: the case of bearish speculation is perfectly
symmetrieal), so that their operations destabilise the market. It does not
therefore seem possible to reach an unambiguous theoretical conclusion, as
we shall see below.
This said in general, let us pass to the examination of foreign-exchange
speculation, in particular of speculation on the spot market. The asset con-
cerned is foreign exchange, whose price in terms of domestic currency is the
(spot) exchange rate. Therefore, if speculators anticipate a depreciation (i.e.
if the expected exchange rate is higher than the current one), they will de-
mand foreign exchange (simultaneously supplying domestic currency) in the
expectation of reselling it at a higher price and so earning the difIerence. It
goes without saying that the expected difIerence will have to be greater than
8.2. Short-Term Capital Movements and Foreign Exchange Speculation 117
the net costs of the speculative operation.

Conversely they will supply foreign exchange (simultaneously demanding
domestic currency) if the expected exchange rate is lower than the current
one.
In order better to examine the effects of speculation, we must distinguish
a fixed exchange-rate regime of the adjustable peg type (see Sect. 3.1) and
a freely flexible exchange-rate regime.
Under an adjustable peg regime (such as the Bretton Woods system),
speculation is normally destabilising, for a very simple reason. Since the
regime allows once-and-for-all parity changes in the case of fundamental dis-
equilibrium, in a situation of a persistent and serious balance-of-payments
disequilibrium it will be apparent to all in which direction the parity change,
if any, will take place, so that speculation is practically risk-free (the so-
called one-way option). The worst that can happen to speculators, in fact,
is that the parity is not changed, in which case they will only lose the cost of
transferring funds, the possible interest differential against them for a limited
period of time, and the possible difference between the buying and selling
prices (which is very small, given the restricted margins of oscillation around
parity). It goes without saying, that these speculative transfers of funds
make the disequilibrium worse and thus make the parity change more and
more necessary: they are intrinsically destabilising.
Among the cases of this type of speculation, those that occurred on the
occasion of the parity changes of the pound sterling (devaluation of Novem-
ber, 1967), of the French franc (devaluation of August, 1969), and of the
Deutschemark (revaluation of October, 1969) are usually pointed out. In
fact, in the case of a fundamental disequilibrium of the deficit type, the pres-
sure on the exchange rate is in the sense of a devaluation, and the authorities
are compelled, as we know, to sell foreign exchange to defend the given par-
ity. Now speculators demand foreign exchange: this demand has to be added
to the demand deriving from the fundamental deficit and, by increasing the
pressure on the exchange rate, may cause the monetary authorities defence
to collapse (this defence might otherwise have been successful in the absence
of speculation). A similar reasoning holds in the case of a fundamental dise-
quilibrium in the surplus direction.
It should be noted that in what we have said, there is an implicit judge-
ment that destabilising speculation is harmful. This judgement is generally
shared, whether implicitly or explicitly. Friedman has tried to oppose it, by
arguing, for example, that "destabilising" speculation (in an adjustable peg
regime) compels the monetary authorities to make the parity adjustment,
thus accelerating the attainment of the new equilibrium.
Under a freely flexible exchange-rate system, the situation is different.
First of all, the uncertainty about the future path of the exchange rate in-
creases the risk and so tends to put a brake on speculative activity. But
the fundamental issue consists in examining the destabilising or stabilizing
nature of speculation, to which we now turn.
8.2.1 Flexible Exchange Rates and Speculation

According to one school of thought, speculation under flexible exchange rates
is necessarily stabilizing. The basic argument of those supporting this claim
is that speculation is profitable insofar as it is stabilizing: consequently,
destabilising speculators lose money and must leave the market, where only
stabilizing speculators, who make profits, remain. Here is a well-known quo-
tation on the matter from Friedman (1953, p. 175): "People who argue
that speculation is generally destabilising seldom realize that this is largely
equivalent to saying that speculators lose money, since speculation can be
destabilising in general only if speculators sell when the currency is low in
price and buy it when it is high".
But the equation destabilization = losses (and so stabilization = prof-
its) does not seem generally valid, as can be easily argued. Assurne, for
example, that the non-speculative exchange-rate (i.e., the one determined by
fundament als in the absence of speculation) follows a cyclically oscillating
path (due for example to normal seasonal factors) around a constant average
value. If speculators concentrate their sales of foreign currency immediately
after the upper turning point and their purchases immediately after the lower
turning point, an acceleration of both the downwards and the upwards move-
ment (as shown by the broken lines) follows, with an explosive increase in the
amplitude and/or frequency of the oscillations. The effect is destabilising,
and it is self-evident that speculators, by selling the foreign currency at a
higher price than that at which they purchase it, make profits.
This case shows that profitable destabilising speculation may cause a
speculative bubble, a term used to describe an episode in which the price of
a commodity (for example the Dutch tulips in 1634-37, which gave rise to
the tulipmania bubble) or asset (in our case the foreign exchange) displays
an explosive divergence from its fundamental value.
One can also point out the case, already mentioned above, of buHish
or bearish speculation (much like that which takes place in the Stock Ex-
change). This leaves out of consideration any normal or average reference
value. Bullish speculators, weH aware of the effects that their action will
have on the price (in this case the exchange rate), buy foreign exchange with
the aim of forcing an increase in its price;,;their intervention will be followed
by other, less sagacious, operators hoping to make a killing by purchasing
an asset (in this case, the foreign exchange) which is appreciating. When
the exchange rate has depreciated sufficiently, the initial speculators sell the
foreign exchange they bought in the first place (which may well give rise to
a wave of sales and an abrupt fall in the price): they have certainly made
profits and just as certainly destabilised the market.
Naturally in this example someone has to bear the losses and willleave
8.3. Speculative Attacks and Currency Crises 119
the market, but will be replaced by someone else who wishes to have a go.
The idea that professional speculators might on the average make profits and
destabilise the exchange rate while achanging body of "amateurs" regularly
loses large sums is not far from reality.
It should be stressed that it would not be correct to argue, from what we
have said, that under flexible exchange rates speculation is always destabil-
ising. It is, in fact, quite possible for speculators to behave as described by
Friedman, in which case their stabilizing effect is self-evident.
Thus we have seen that, whilst under an adjustable peg regime specula-
tion is generally destabilising, under flexible exchange rates it may have either
effect, so that the question we started from has no unambiguous answer.
8.3 Speculative Attacks and Currency Crises

To improve our understanding of currency crises (collapse of a fixed exchange
rate regime) as determined by speculative attacks, several analytical mod-
els have been developed in the literature. It is now customary to classify
the abundant literature on this topic into three categories: first generation,
second generation, and third generation models.
The framework of first generation models (also called "exogenous policy"
models) is quite simple. The country engaged in maintaining a fixed exchange
rate is also engaged in domestic expansionary policies, that are financed by
expanding domestic credit. With fixed real and nominal money demand, do-
mestic credit expansion brings about international reserve losses. However,
money financing of the budget deficit has the higher priority and continues
notwithstanding its inconsistency with the fixed exchange rate. Thus inter-
national reserves are gradually depleted until they reach a certain minimum
level (this point in time is called the collapse time), after which they are ex-
hausted in a final speculative attack, that compels the authorities to abandon
the fixed exchange rate.
First generation models were applied to currency crises in developing
countries (e.g., Mexico 1973-82, Argentina 1978-81), where the cause of the
crisis could indeed be shown to be an overly expansionary domestic policy.
Second generation models (also called "endogenous policy" models or
escape-clause models) introduce the reaction of government policies to changes
in private behaviour. For eXaInple, rather than given targets (the fixed
exchange rate, the expansion of the domestic economy) the government
faces a trade-off between the various targets (the exchange rate, employ-
ment, etc.). More generally, the commitment to the fixed exchange rate
is state dependent (hence the name of endogenous policy models) rather
than state invariant as in first generation models, so that the government
can always exercise an escape clause, that is, devalue, revalue, or float.
BOX 8.1 The main recent currency crises

The round of major financial crisis began with Mexico at the end of 1994.
A broader phase then followed with the collapse of currency and banking sys-
tems in Thailand, Indonesia and Korea in 1997-98. Russia's default and
currency collapse in 1998, Brazil's currency collapse in 1999 followed. The
latest (as of now) two major crises are those of Thrkey and Argentina.
The Mexican crisis 1994-1999
The Mexican currency crisis (as the ERM crisis of 1992) contributed to a rethink-
ing of the causes and genesis of currency and financial crisis and led to a "second
generation" of crisis models. In addition to fundamental weaknesses such as an
unsustainable current account deficit, real exchange rate misalignments, implicar
tions of borrowing to defend a peg, etc., also elements of self-fulfilling panic are
particularly useful in explaining a currency crisis.
In Mexico, as a large arnount of short term foreign-currency linked debt was coming
to maturity and foreign reserves were insufficient to service the debt, a self-fulfilling
rollover crisis driven by investors' panic was at work.
The Russian crisis 1997-1998
After six years of economic reform in Russia, privatization and macroeconomic star
bilization had experienced some limited success. Yet in August 1998, Russia was
forced to default on its sovereign debt, devalue the ruble, and declare a suspension
of payments by commercial banks to foreign creditors. What caused the Russian
economy to face a financial crisis? Two features are indicated by researchers as the
major causes: exchange rate misalignment and debt crisis. The strong ruble was a
major obstacle to economic growth and led to deterioration of exports that decreased
in 1997 and the excessive burden of public debt in the form of short-term securities
put pressure on the exchange rate. In addition, a large amount of short-term foreign
debt marle Russia's deficit problem more serious. The Russian crisis was a "first
generation" currency crisis caused by a fundamental inconsistency between domestic
fiscal policy and a managed exchange rate that ultimately led to speculative attacks
on the currency. The Russian crisis had also an important international aspect: the
contagious selling on the part of non-resident investors contributed to the collapse
of the Russian financial market.
The Asian crisis 1997-1998
This crisis is described in the text.
The Argentinian crisis 2001-2002
The Argentinian crisis debate emphasized the origins of the crisis in multiple vulner-
abilities: exchange rate overvaluation, defiationary adjustment under the hard peg,
high public debt and fiscal fragility, hidden weaknesses in the financial sector. All
these explanations reinforced one another leading to pessimistic expectations about
growth prospects. A furt her factor has been emphasized as crucial to understand
the crisis: the link between the eurreney board and the financial system. The deei-
sion of the government to peg the peso to the US dollar through a eurreney board in
1991 pushed a rapid process of financial development. The Argentinian government
introdueed banking system reforms quickly and the result was an internationalized
banking system highly eonsidered worldwide. But the banking system had some
important hidden weaknesses that undermined its capacity to deal with shocks (the
Brazilian crisis, the appreciation of the US dollar vis-a...vis most eurrencies, high
fiscal spending that set the Argentinian economy into a currency-growth-debt trap
by 1999).
Second generation models can explain speculative attacks even when funda-
mentals are not involved, as they can take into account "bandwagon" effects
(if somebody starts selling a currency, others will follow the example, without
bothering to look at fundamentals ), etcetera.

Second generation models were applied to currency crises in industrial
countries (Europe in the early 1990s) and to the Mexican crisis of 1994,
where speculative attacks seemed unrelated to economic fundamentals.
However, neither generation of models seems able to give an explanation
of the Asian crisis that broke out in the late 1990s.
The Asian crisis became official on July 2, 1997, when the Bank of Thai-
land, after aseries of speculative attacks, realized that it could no longer
defend the baht and allowed it to float. What started as a local financial
crisis within weeks became a regional problem. Malaysia, Indonesia, South
Korea and Taiwan devalued their currencies. Stock markets across the region
fell as investors pulled out their capital. The speed and the severity of the
Asian currency and financial crisis took both investors and economists by sur-
prise. The consistently high growth performance of the East and Southeast
Asian countries was marked by growth rates in the range of 6-8 percent per
year. Why was this strong economic performance interrupted? The general
interpretations of the crisis as poor economic fundamentals and policy in-
consistencies, financial panic, were weak explanations. To explain the causes
of the Asia crisis it is necessary to take into account a number of additional
vulnerabilities such as the fragility of the banking and financial sector that
reduces the amount of credit available to firms and increases the likelihood
of a crisis. The Asian crisis also highllghted the role of the financialliberal-
ization that increases the probability of a banking crisis ("twin crises"). The
Asian crisis launched much new empirical and theoretical research that led
to a third generation of currency and financial crisis models. These mod-
els suggest that a currency crisis is brought about by a combination of high
debt, low foreign reserves, domestic borrowing constrains, falling government
revenue, increasing expectations of devaluation.
An element stressed by this literature is that currency crises cannot be
seen in disjunction from banking crises: on the contrary, banking and cur-
rency are "twin" crises that should be modelled as interrelated phenomena.
However, these links are not clear.
The chain of causation might, in fact, run either way. Problems of the fi-
nancial sector might give rise to the currency crisis and collapse, for example
when central banks print money to finance the bailout of domestic finan-
cial institutions in trouble (note that, if we abstract from the cause of the
excessive money creation, the setting is the same as that of first-generation
models). At the opposite side, balance-of-payments problems might be the
cause of banking crises, for example when an initial foreign shock (say, an
increase in foreign interest rates) in the context of a pegged exchange rate
gives rise to areserve loss. If this loss is not sterilized, the consequence will
be a credit squeeze, hence bankruptcies and financial crisis. Finally, there is
the possibility that currency and financial crises might have common causes,
for example financial liberalization coupled with implicit deposit insurance
followed by a boom financed by a surge in bank credit, as banks borrow

abroad.. When the capital inflows become outflows, both the currency and
the banking system collapse.
We suggest a classmcation based on the three main causes of the crisis
set forth in the existing literature:
A) Moral Hazard: the crisis is due to over-investment. Over-investment
takes place because domestic firms feel as implicitly insured by the govern-
ment any investment volume. In other words, domestic firms behave as if
their investments were insured by government. In case of need firms expect
the government to step in and save them from bankruptcy. Foreign lenders
are supposed to share that opinion and continue to lend at the same rate till
debt reaches a critical fraction of international reserves.
This moral hazard interpretation is not extravagant. Any authority an-
nouncement of a non-intervention policy is never fully credible ex-ante be-
cause agents know that policy intervention will be decided ex-post via a
cost-benefits analysis.
B) Financial Fragility: the crisis is due to a liquidity squeeze, caused
by panic of foreign or domestic lenders who run on domestic financial in-
termediaries. The liquidity· problem in turn causes apremature liquidation
of intermediaries' assets. Liquidation has real effects because assets prema-
turely liquidated loose part of their value. This model is inspired by the bank
crisis literature.
C) Balance Sheet: the crisis is due to the firms' foreign debt blowing
up following devaluation. The model is developed analyzing the movement
of Asian macroeconomic variables and the plan implemented by the Interna-
tional Monetary Fund (IMF). "If there is a statistic that captures the violence
of the shock to Asia most dramatically, it is the reversal in the current ac-
count" (Krugman, 1999, p. 9). For example, Thailand with a pre-crisis
(1996) deficit equal to 10% of GDP, had. to move its current account to an
8% surplus in 1998. This was necessary because of the unexpected and huge
capital outflow. An increase in net exports can be obtained reducing imports
and\or increasing exports. In the short run this means exchange rate devalu-
ation and\or economic activity reduction. This is exactly what happened in
Asia. The exchange rate, few weeks earlier stably anchored to the US dollar,
lost in few days almost 50% of its value. Economic activity fell into a deep
recession never experimented by those economies.
The other element highHghted is the IMF plan. During all crises the
IMF's main concern has been exchange rate stabilization. That policy was
due to the necessity of avoiding the explosion of high foreign debt. The
exchange rate defence was to be implemented by rising the interest rate
in the short run, and reorganizing (liberalizing) financial structure in the
medium term. Rad. the plan succeeded, the international creditors confidence
would have been restored, the interest rate would have been reset to normal
level and the Asian economies would have boomed again with a stronger
(more similar to the western standard) financial system. But something went
wrong. Stabilization policy failed and did not prevent the materialization of
a deep recession.
According to Krugman and others, in any case the plan could not have
ben successful, given the features of the crisis. To abandon the parity would
have undoubtedly caused the crisis, as seen above. On the other hand, when
the leverage is high, as in the countries under consideration, the economy
can stabilize the real exchange rate only at the cost of a deep depression.
Given this dilemma, the heated debate on the role of the IMF in managing
the crisis (according to some it has well performed, according to others it has
failed) might seem pointless, because both policies (to defend the parity or
to abandon it) would have been unsuccessful.
We conc1ude by mentioning two related problems, that of indicators and
that of contagion.
The former proposes to forecast a crisis by using several macroeconomic
indicators such that, when they exceed certain threshold values, this can
be taken as a signal that a crisis is approaching. The suggested indicators
inc1ude financial indicators (the M2 multiplier, the ratio of domestic credit
to nominal GDP, the real interest rate on deposits, the ratio of lending-
to-deposit interest rates, etc.), real indicators (industrial production, equity
prices, etc.), fiscal indicators (the overall budget deficit as apercent of GDP,
the public debt/GDP ratio, etc.). It is not yet certain whether the use of
indicators can indeed help to forecast a crisis.
The term contagion means that speculative attacks and the ensuing cur-
rency crises are like infectious diseases: they tend to spread contagiously.
The channels of contagion are both commercial (dose commercial relations)
and financial. However, diseases do not only spread to disease-prone persons
hut also to healthy people: can we carry the similitude as far as to state that
speculative attacks against a misaligned currency tend to spread not only to
other misaligned currencies hut also to apparently sound currencies? This
question has enormous policy implications, because an affirmative answer
would warrant the bailout (by international organisations, other governments
or groups of governments like the G-7) of any country under speculative at-
tack, so as to prevent contagion to other (sound) countries. On this point no
definite answer yet exists.
8.3.1 The Bipolar View

The observation that most currency crises have involved a pegged exchange
rate regime has given rise to the so called bipolar view (or corner solution),
according to which, in order to avoid currency crises, countries should either
adopt a hard peg or allow their currencies to fioat, but definitely not adopt
a soft peg (hard and soft pegs are defined in Sects. 3.1 and 3.3). On the
exc1usion of soft pegs everybody agreeSj after all, the collapse of the Bretton
Woods system (see Sect. 3.5.1) had already shown the unsustainability of an
adjustable peg regime. However, the corner solution has been criticized, and
a less extreme view is now gaining ground, according to which, excluding
soft pegs, a variety of exchange rate arrangements (in addition to hard pegs
and free floats) of the managed float type remains viable (Fischer, 2001).

Fischer, S., 2001, Exchange Rate Regimes: Is the Bipolar View Correct?
Journal of Economic Perspectives 15, No. 2, 3-24.
Flood, R. and N. Marion, 1999, Perspectives on the Recent Currency Crisis
Literature, International Journal of Finance and Economics 4, 1-26.
Friedman, M., 1953, The Case for Flexible Exchange Rates, in M. Friedman,
Essays in Positive Economics, Chicago: University of Chicago Press,
157-203.
Jeanne, 0., 2000, Currency Crises: A Perspective on Recent Theoretical De-
velopments, Special Papers in International Economics No. 20, Prince-
ton University, International Finance Section.
Krugman, P., 1999, Balance Sheets, the Transfer Problem, and Financial
Crises, in P. Isard, A. Razin and A.K. Rose (eds.), International Fi-
nance and Financial Crises: Essays in Honor of Robert. P. Flood, Jr.,
Norwell, Mass.: Kluwer.
Markusen, J.R., 2002, Multinational Firms and the Theory of International
Trade, Cambridge (Mass.): MIT Press. .
Roubini, N., Chronology of the Asian Currency Crisis and Its Global Conta-
gion, in Roubini's web page, http://www.stern.nyu.edu/globalmacro/
Various Authors, The Debate on the Role of the IMF in the Crisis: Did IMF
Plans Worsen the Crisis, collected in N. Roubini's web page
(http://www.stern.nyu.edu/globalmacro/).
Wong, Kar-Yiu, Web page on the Asian crisis,
http://faculty.washington.edu/Karyiu/ Asia/lndex.htm
Chapter 9
Exchange-Rate Determination
The problem of the forces that determine the exchange rate and, in particu-
lar, its equilibrium value, is self-evident under flexible exchange rates, but is
also important under limited flexibility and even under fixed exchange rates
(if the fixed rate is not an equilibrium one, the market will put continu-
ing pressure on it and compel the monetary authorities to intervene in the
exchange market, as we have seen in Sect. 3.2.1).
A related problem is the age-old debate on fixed versus flexible exchange
rates, that will also be examined in this chapter.
9.1 The Purchasing-Power-Parity Theory

The oldest theory of exchange-rate determination is probably the purchasing
power parity (henceforth PPP) theory, commonly attributed to eassel (1918)
even though-as usual-precursors in earlier times are not lacking. Two
versions of the PPP are distinguished, the absolute and the relative one.
According to the absolute version, the exchange rate between two cur-
rencies equals the ratio between the values, expressed in the two currencies
considered, of the same typical basket containing the same amounts of the
same commodities. If, for example, such a basket is worth US $10,000 in the
United States and euro9,500 in the European Union, the $/euro exchange
rate will be 10,000/9, 500 ~ 1.05263 (1.05263 dollars pe~ euro).
A tongue-in-cheek version of absolute PPP is the comparison of the prices
of the McDonald's Big Mac™ sandwich! in various countries around the
world published by the weekly The Economist. The appealing feature of the
Big Mac as an indicator of PPP is its uniform composition. In fact, with
few exceptions (for example India, where chicken patties replace the beef
patties), the ingredients of the Big Mac are the same everywhere around
the world. Thus the Big Mac serves as a uniform market basket of goods
lBig Mac™ is a registered trademark of the McDonald's corporation.
125
126 Chapter 9. Exchange-Rate Determination
through which the purchasing power of currencies can be compared (Pakko

and Pollard, 2003).
According to the relative version, the percentage variations in the ex-
change rate equal the percentage variations in the ratio of the price levels of
the two countries (the percentage variations in this ratio are approximately
equal to the difference between the percentage variations in the two price
levels, or inflation differential).
In both versions the PPP theory is put forward as a long-run theory
of the equilibrium exchange rate, in the sense that in the short-run there
may be marked deviations from PPP which, however, set into motion forces
capable of bringing the exchange rate back to its PPP value in the long
term. The problems arise when one wants better to specify this theory,
which implies both a precise singling out of the price indexes to be used and
the determination of the forces acting to restore PPP: the two questions are,
in fact, strictly related.
Those who suggest using a price-index based on internationally traded
commodities only, believe that PPP is restored by international commodity
arbitrage which arises as soon as the internal price of a traded good deviates
from that prevailing on international markets, when both prices are expressed
in a common unit (the law of one price).
On the contrary, those who maintain that a general price-index should be
used, think that people appraise the various currencies essentially for what
these can buy, so that-in free markets-people exchange them in proportion
to the respective purchasing power.
Others suggest using cost-of-production indexes, in the belief that inter-
national competition and the degree of internationalization of industries are
the main forces which produce PPP.
A fourth proposal suggests the use of the domestic inflation rates starting
from various assumptions:
(a) the real interest rates are equalized among countries;
(b) in any country the nominal interest rate equals the sum of the real
interest rate and the rate of inflation (the Fisher equation);
(c) the differential between the nominal interest rates of any two coun-
tries is equal (if one assumes risk-neutral agents) to the expected percentage
variation in the exchange rate (for this relation, see Sect. 4.2).
Prom these assumptions it follows that there is equality between the ex-
pected percentage variations (which, with the further assumption of perfect
foresight, will coincide with the actual ones) in the exchange rate and the
inflation differential.
None of these proposals is without its drawbacks and each has been sub-
jected to serious criticism which we cannot go into here, so that we shall
only mention a few points. For example, the commodity-arbitrage idea was
criticized on the grounds that it presupposes free mobility of goods (absence
of tariffs and other restrictions to trade) and a constant ratio, within each
9.2. The Traditional Flow Approach 127
country, between the prices of traded and non-traded goods: the inexistence,
even in the long run, of these conditions, is a well-known fact. Besides,
the law of one price presupposes that traded goods are highly homogeneous,
another assumption often contradicted by fact and by the new theories of
international trade (see below, Chap. 17), which stress the role of product
differentiation.
The same idea of free markets, of both goods and capital, lies at the basis
of the other proposals, which run into trouble because this freedom does not
actually exist. Cassel himself, it should be noted, had alreadY singled out
these problems and stated that they were responsible for the deviations of
the exchange-rate fram PPP.
These deviations, which make the PPP theory useless to explain the be-
haviour of exchange rates in the short-run, were one of the reasons which
induced most economists to abandon it in favour of other approaches. It
should however be pointed out that the PPP theory has been taken up again
by the monetary approach (which has been dealt with in Sect. 7.1; see also
below, Sect. 9.3.2), and used as an indicator of the long-run trend in the
exchange rate.
9.2 The Traditional Flow Approach

This approach, also called the balance-of-payments view or the exchange-
market approach, starts from the observation that the exchange rate is ac-
tually determined in the foreign exchange market by the demand for and
supply of foreign exchange, and that it moves (if free to do so) to bring these
demands and supplies into equality and hence (if no intervention is assumed)
to restore equilibrium in the balance of payments.
That the exchange rate is determined in the foreign exchange market by
the demand for and supply of foreign exchange is an irrefutable fact (we do,
of course, exclude economies with administrative exchange controls), but it
is precisely in determining these demands and supplies that most problems
arise. The traditional flow approach sees these M pure"'flows, deriving-in
the older version-fram imports and exports of goods, which in turn de-
pend on the exchange rate and-after the Keynesian-type models-also on
national income. The introduction of capital movements does not change
the substance, as these are seen as pure flows (the Mundell-Fleming model).
This approach has been widely described before, in particular in Chap. 6, to
which we refer the reader.
The flow approach can be criticized for several shortcomings, amongst
which the fact that it neglects stock adjustments, a point that we have already
extensively treated (see Sect. 7.2). It should however be stressed that, if
on the one hand the criticism must induce us to consider the traditional
approach inadequate in its specification of the determinants of the demands
for and supplies of foreign exchange, on the other, it does not affect the fact
that it is the interaction between these demands and supplies which actually
determines the exchange rate.
9.3 The Modern Approach: Money and

Assets in Exchange-Rate Determination
9.3.1 Introductory Remarks
The modern approach (also called the asset-market approach) takes the ex-
change rate as the relative price of monies (the monetary approach) or as
the relative price of bonds (the port folio approach). The two views differ
as regards the assumptions made on the substitutability between domestic
and foreign bonds, given however the common hypothesis of perfect capital
mobility.
The monetary approach assurnes perfect substitut ability between domes-
tic and foreign bonds, so that asset holders are indifferent as to which they
hold, and bond supplies become irrelevant. Conversely, in the portfolio ap-
proach domestic and foreign bonds are imperfect substitutes, and their sup-
plies become relevant.
To avoid confusion it is as well to recall the distinction between (perfect)
capital mobility and (perfect) substitutability (see Sect. 4.6). Perfect capital
mobility means that the actual portfolio composition instantaneously adjusts
to the desired one. This, in turn, implies that-if we assurne no risk of default
or future capital controls, etc.-covered interest parity must hold (see Sect.
4.1). Perfect substitut ability is a stronger assumption, as it means that asset
holders are indifferent as to the composition of their bond portfolios (provided
of course that both domestic and foreign bonds have the same expected rate
of return expressed in a common numeraire). This, in turn, implies that
uncovered interest parity must hold (see Sect. 4.2).
It is important to note that according to some writers, the condition of
covered interest parity itself becomes a theory of exchange-rate determination
(the interest parity model, where interest parity may be expressed either in
nominal or real terms), if one assurnes that the forward exchange rate is an
accurate and unbiased predictor of the future spot rate (see Sect. 4.5): it
would in fact suffice, in this case, to find the determinants of the expected
future spot exchange rate to be able to determine, given the interest rates,
the current spot rate.
Since classifications are largely a matter of convenience, we have chosen
to follow the dichotomy based on the perfect or imperfect substitutability be-
tween domestic and foreign bonds within the common assumption of perfect
capital mobility.
9.3. The Modern Approach: Money and Assets in Exchange-Rate Determination 129
9.3.2 The Monetary Approach

The monetary approach to the balance of payments has been treated in
Chap.7; we only recall that it assumes the validity of PPP as a long-run
theory. Now, if one considers fixed exchange rates, as in Chap. 7, then the
monetary approach determines the effects of (changes in) the stock of money
(which is an endogenous variable) on the balance of payments and vice versa;
if one assumes flexible exchange rates the same approach (with the money
stock exogenous) becomes a theory of exchange-rate determination. In fact,
if we consider a very simple monetary model in which in both countries there
is equilibrium between money supply and demand in real terms, and PPP
holds, we have
Considering flexible exchange rates (r is an unknown), after simple manipu-

lations we get
(9.2)
From this equation it can clearly be seen that-ceteris paribus-an increase

in the domestic money stock brings about a depreciation in the exchange rate,
whilst an increase in national income causes an appreciation, and an increase
in the domestic interest rate causes a depreciation. These conclusions, espe-
cially the last two, are in sharp contrast with the traditional approach, where
an increase in income, by raising imports, tends to make the exchange rate
depreciate, whilst an increase in the interest rate, by raising capital inflows
(or reducing capital outflows), brings about an appreciation in the exchange
rate.
These (surprisingly) different conclusions are however perfectly consistent
with the vision of the MABP, described in Sect. 7.1. For example, an
increase in income raises the demand for money; given the money stock and
the price level, the public will try to get the desired additional liquidity by
reducing absorption, which causes a balance-of-payments surplus, hence the
appreciation. This appreciation, by simultaneously reducing the domestic
price level Ph (given that PPP holds), raises the value of the real money stock
(Mh/Ph increases), and so restores monetary equilibrium. Similar reasoning
explains the depreciation in the case of an increase in i h (the demand for
money falls, etc.).
The monetary approach to the exchange rate can be made more sophisti-
cated by introducing additional elements, such as sticky prices which do not
immediately reflect PPP, arbitrage relations between ih and i" the possibility
that domestic agents hold foreign money, etcetera: see the next section.
9.3.2.1 Sticky Prices, Rational Expectations, and Overshooting of

the Exchange-Rate
Let us consider, following Dornbusch (1976), a small open economy under
flexible exchange rates with perfect capital mobility and flexible prices but
with given full-employment output. Agents hold rational expectations: in the
present context of a deterministic model, rational expectations are equivalent
to perfect foresight.
Let us now consider the phenomenon of exchange-rate overshooting in
response to 'news', i.e. to unanticipated events such as a monetary shock.
Suppose that the economic system is initially at its long-run equilibrium,
where no exchange rate variation is expected (and hence ih = iJ given VIP).
Suppose now that the nominal money stock permanently increases. Eco-
nomic agents immediately recognize that the long-run equilibrium price level
and exchange rate will increase in the same proportion, as in the long-run
money is neutral.
From the economic point of view, the current exchange rate will depreciate
because an increase in the money supply, given the stickiness of prices in the
short run, will cause an increase in the real money supply and hence a fall
in the domestic nominal interest rate. Since the VIP condition is assumed
to hold instantaneously, and the nominal foreign interest rate is given, the
exchange rate immediately depreciates by more than the increase in the long-
run equilibrium value to create the expectation of an appreciation. This is
required from the VIP condition that the interest-rate differential equals the
expected rate of appreciation: in fact, given i h = i J in the initial long-run
equilibrium, the sudden decrease in ih, given i J , requires (r - r)jr < 0 [recall
that VIP implies i h = iJ + (r - r)jr] namely an anticipated appreciation.
Thus the exchange rate initially overshoots its (new) long-run equilibrium
level, after which it will gradually appreciate alongside with the increase in
the price level following the path to the new equilibrium point.
More technically, we note that, in the terminology of rational expecta-
tions, the exchange rate is a typical jump variable, since it is free to make
discontinuous jumps in response to 'news'. On the contrary, commodity
prices are assumed to be predetermined variables, namely they are assumed
to adjust slowly to their long-run equilibrium value, hence the denomination
of sticky-price monetary model of exchange rate determination. The distinc-
tion between jump and predetermined variables lies at the heart of rational
expectations models.
As said above, economic agents immediately recognize that in the new
long-run equilibrium the exchange rate will increase. The economy, however,
cannot instantaneously jump from the old to the new equilibrium because of
the sticky-price assumption. On the other hand, a gradual adjustment of botk
variables is inadvisable, because it would bring the system on a path away
from equilibrium. In fact, there is only one path that will bring the system to
the new equilibrium point. This path implies an exchange rate temporarily
higher than its new long-run equilibrium value. Since the exchange rate is a
jump variable, the economy can jump from the initial equilibrium point on
the (unique) stable trajectory; after this overshooting, the exchange rate will
gradually appreciate towards its new long-run equilibrium.
9.3.3 The Portfolio Approach

This approach, in its simplest version, is based on a model of portfolio choice
between domestic and foreign assets. As we know from the theory of portfolio
selection (see Sect. 7.2), asset holders will determine the composition of their
bond portfolios, i.e. the shares of domestic and foreign bonds, on the basis
of considerations of (expected) return and risk. If perfect substitut ability
between domestic and foreign assets existed, then uncovered interest parity
should hold, that is
T-T
i h = if + --,
T
(9.3)
where r denotes the expected change in the exchange rate over a given time
interval; i and i f are to be taken as referring to the same interval. In the
case of imperfect substitutability this relation becomes
ih = if
r-T
+ -T- + 15, (9.4)
where 15 is a risk premium.

HenceJ... with imperfect substitutability a divergence may exist between i h
and (i f + r~r); the extent of this divergence will-ceteris paribus-determine
the allocation of wealth (W) between national (N) and foreign (F) bonds.
For simplicity's sake we make the small-country assumption, Le. we assume
that domestic bonds are held solely by residents, because the country is too
small for its assets to be of interest to foreign investors.
Given our simplifying assumption we can write
(9.5)
where the demands are expressed, in accordance with portfolio selection the-
ory,as
'
h( zh-zf r --T)W,
. - -
_T (9.6)
T-T
g(i h - if - --)W,
T
where h( ... ) + g( ... ) = 1 because of (9.5). If we impose the equilibrium

condition that the amounts demanded should be equal to the given quantities
existing (supplied), we get
(9.7)
and so, by substituting into (9.6) and dividing the second by the first equation
there, we obtain
rFS .. r-r
Ns = <p(Zh - zf - -r-)' (9.8)
where <p( ... ) denotes the ratio between the g( ... ) and h( ... ) functions. From
Eq. (9.8) we can express the exchange rate as a function of the other variables
(9.9)
Equation (9.9) shows that the exchange rate can be considered as the
relative price of two stocks of assets, since it is determined-given the interest
differential corrected for the expectations of exchange-rate variations-by the
relative quantities of NS and PS.
The basic idea behind all this is that the exchange rate is the variable
which instantaneously adjusts so as to keep the (international) asset markets
in equilibrium. Let us assurne, for example, that an increase occurs in the
supply of foreign bonds from abroad to domestic residents (in exchange for
domestic currency) and that (to simplify to the utmost) expectations are
static (r - r = 0). This increase, ceteris paribus, causes an instantaneous
appreciation in the exchange rate.
To understand this apparently counter-intuitive result, let us begin with
the observation that, given the foreign-currency price of foreign bonds, their
domestic-currency price will be determined by the exchange rate. Now, res-
idents will be willing to hold (demand) a higher amount of foreign bonds,
ceteris paribus, only if the domestic price that they have to pay for these
bonds (i.e., the exchange rate) is lower. In this way the value of rF d = rFs
remains unchanged, as it should remain, since all the magnitudes present on
the right-hand side of Eqs. (9.6) are unchanged, and the market for foreign
assets remains in equilibrium (F d = PS) at a higher level of Fand a lower
level of r.
9.3.3.1 Interaction Between Current and Capital Accounts
The simplified model that we have described is a partial equilibrium model,

as it does not consider the determinantsof the interest rate(s) and the pos-
sible interaction between the current account and the capital account in the
determination of the exchange rate. As regards this interaction, we consider
a model suggested by Kouri. As usual we simplify to the utmost by assuming
static expectations, absence of domestic bonds in foreign investors' portfo-
lio, an exogenously given interest differential. Thanks to these assumptions,
the stock of foreign bonds held in domestic investors portfolios becomes an
inverse function of the exchange rate. In fact, from the portfolio equilibrium
described in Sect. 9.3.3, we have (in what follows we use F to denote the
equilibrium stock of foreign bonds held by residents, F = F d = FS):

r-r
rF = g(i h - if - --)W, (9.10)
r
so that, given ih, ij, W, and letting r - r = 0 (static expectations), the right-
hand side of Eq. (9.10) becomes a constant, hence the relation of inverse
proportionality between r and F.
As regards the current account, Kouri assumes that its balance is an
increasing nmction of the exchange rate (i.e. the critical elasticities con-
dition occurs). The long-run equilibrium can prevail only when both the
current account and the capital account are in equilibrium. In the oppo-
site case, in fact, since any current-account disequilibrium is matched by a
capital-account disequilibrium in the opposite sense2 , the latter will cause a
variation in the stock of foreign assets held by residents and so a variation
in the exchange rate, which will feed back on the current account lmtil this
is brought back to equilibrium.
, ,
CA
'0 ,
-~,
B
I
1
--------'0 -- ,
I
I I
-+---------'E __ L_
I 1
I I
I I
I
t I
-
1 I
1 I
I 1-
0 C + 0 Fo FE F
Figure 9.1: Exchange-rate determination: interaction between the current

account and the capital account
To illustrate this mechanism we can use Fig. 9.1, where the left-hand
panel shows the current account (CA) as a nmction of the exchange rate (the
2 As we know from balance-of-payments accounting, the algebraic sum of the current
account and the capital account is necessarily zero (see Sect. 5.1). Here the implicit as-
sumption is that there are no compensatory capital movements, Le. that there is no official
intervention (the exchange rate is perfectly and freely flexible). Under this assumption all
capital movements are autonomous and originate from private agents.
positive slope means, as we have said, that the critical elasticities condition
occurs); the right-hand panel shows the relation between r and F, which is
a rectangular hyperbola as its equation is (9.10).
The long-run equilibrium corresponds to the exchange-rate rE, where the
current account (and so the capital account) is in equilibrium. Let us assume,
for example, that the exchange rate happens to be ro, hence a current account
surplus oe; the initial stock of foreign assets (which corresponds to ro) is
Fo. The current-account surplus is matched by a capital outfiow, i.e. byan
increase in foreign assets; thus the residents stock of foreign bonds increases
(from Fo towards FE, which is the equilibrium stock) and so the exchange
rate appreciates (point A moves towards point E). This appreciation reduces
the current-account surplus; the process goes on until equilibrium is reached.
The case of an initial exchange rate lower than rE is perfectly symmetrical
(current-account deficit, decrease in the stock of domestically held foreign
assets, exchange rate depreciation, etc.).
Although this is a highly simplified model, it serves weH to highlight
the features of the interaction between the current account and the capital
account. This interaction, it should be emphasized, does not alter the fact
that in the short-run the exchange rate is always determined in the asset
market(s), even if it tends towards a long-run value (rE) which corresponds
to current-account equilibrium. All the above reasoning, in fact, is based
on the assumption that Eq. (9.10) holds instantaneously as an equilibrium
relation, so that any change in F immediately gives rise to a change in r,
which feeds back on the current account, which ''foHows'' the exchange-rate
behaviour. The assumption of instantaneous equilibrium in asset markets, or
(at any rate) of a much higher adjustment speed 0/ asset markets compared to
that 0/ goods markets, is thus essential to the approach under consideration.
Thanks to this assumption, in fact, the introduction of goods markets and
so of the current account does not alter the nature of the relative price of
two assets attributed to the exchange rate in the short run.
9.4 The Exchange Rate in Macroeconometric

Models
Let us begin with some remarks on the modern approach. As Kouri-an
author who is certainly not against the modern approach-aptly put it, if it
is true by definition that the exchange rate is the relative price of two monies,
it is vacuous to state that it is determined by the relative supplies of (and
demands for) the two monies. To borrow a comparison of his, it is also true
that the (money) price of steel is a relative price between steel and money,
but nobody would analyse the determination of the price of steel in terms
of supply of and demand for money: what one should do is to understand
9.4. The Exchange Rate in Macroeconometric Models 135
the determinants of the supply of and demand for steel and the mechanism
which brings these into equilibrium in the steel market, and so determines
the price of steel as weIl as the quantity exchanged.
Exactly the same considerations apply, according to Kouri, to the ex-
change rate, which is a price actually determined in the foreign exchange
market through the demand for and supply of foreign exchange. This lack
of, or insufficient, consideration of the foreign exchange market is, in Kouri's
opinion, the main shortcoming of the modern theory. In fact, no theory of
exchange-rate determination can be deemed satisfactory if it does not explain
how the variables that it considers crucial (whether they are the stocks of
money or the stocks of assets or expectations or whatever) actually translate
into supply and demand in the foreign exchange market which, together with
supplies and demands coming from other sources, determine the exchange
rate.
We fully agree with these considerations of Kouri's which, of course, are
not to be taken to mean that the modern approach is useless. Indeed, we
believe that neither the traditional nor the modern theory is by itself a satis-
factory explanation. In fact, as we have already observed, the determinants
that we are looking for are both real and financial, derive from both pure flows
and stock adjustments, with a network of reciprocal interrelationships in a
disequilibrium setting. It follows that only an eclectic approach is capable
of tackling the problem satisfactorily, and from this point of view we believe
that more complex models seem called for, because-as soon as one consid-
ers the exchange rate as one among the various endogenous variables which
are present in the model of an economic system-simple models like those
which have been described in this book are no longer suflicient. One should
move toward economy-wide macroeconom(etr)ic models. When doing this,
however, one shOuld pay much attention to the way in which exchange-rate
determination is dealt with.
In order to put this important topic into proper perspective, we first intro-
duce the distinction between models where there is a specific equation for the
exchange rate and models where the exchange rate is implicitly determined
by the balance-of-payments equation (thus the exchange rate is obtained by
solving out this equation). From the mathematical point of view the two
approaches are equivalent, as can be seen from the following considerations.
Let us consider the typical aggregate foreign sector of any economy-wide
macroeconomic model, and let CA denote the current account, N F A the
stock of net foreign assets of the private sector (its variation, 6.N FA, rep-
resents net capital flows) , R the stock of international reserves. Then the
balance-of-payments equation simply states that
CA - 6.NFA - 6.R = 0, (9.11)
where the minus signs reflect the accounting convention explained in Sect.
5.1. Introduce now the following functional relations:
CA = f(r, ... ), (9.12)
6NFA = g(r, ... ), (9.13)

6R = h(r, ... ), (9.14)
r=cp( ... ), (9.15)
wherer is the exchange rate and the dots indicate all the other explana-
tory variables, that for the present purposes can be considered as exogenous.
These relations do not require particular explanation. We only observe that
the reserve-variation equation, Eq. (9.14), represents the (possible) mone-
tary authorities' intervention in the foreign exchange market, also called the
monetary authorities' reaction junction.
System (9.11)-(9.15) contains five equations in four unknowns, but one
among equations (9.12)-(9.15) can be eliminated given the constraint (9.11).
Which equation we drop is irrelevant from the mathematical point of view
but not from the point of view of economic theory. From the economic point
of view there are three possibilities:
a) we drop the capital-movement equation (9.13) and use the balance-
of-payments equation (9.11) to determine capital movements residually (i.e.,
onee the rest of the model has determined the exchange rate, the reserve
variation, and the eurrent aecount).
b) we drop the reserve-variation equation (9.14) and use the bal~ee
of-payments equation to residually determine the change in international
reserves.
e) we drop the exehange-rate equation (9.15) and use the balanee-of-
payments equation as an implicit equation that determines the exchange
rate. The exehange-rate, in other words, is determined by solving it out
of the implicit equation (9.11). More preeisely, if we substitute from Eqs.
(9.12)-(9.14) into Eq. (9.11), we get
f(r, ... ) - g(r, ... ) - h(r, ... ) = 0, (9.16)
which can be eonsidered as an implicit equation in r. This ean be in principle

solved to determine r, which will of course be a function of all the other
variables represented by the dots.
Sinee the functions f, 9 and h represent the excess demands for foreign
exchange coming from commercial operators (the current account), finan-
cial private operators (private eapital fiows), and monetary authorities (the
change in international reserves), what we are doing under approach (c) is
simply to determine the exchange rate through the equilibrium condition in
the foreign exchange market (the equality between demand and supply of for-
eign exchange).
9.4. The Exchange Rate in Macroeconometric Models 137
BOX 9.1 Geologists, alchemists, and the exchange rate

Everybody knows that "explanation" and "prediction" are not necessarily related.
Geologists, for example, have very good explanations for earthquakes, but are as yet
unable to predict them with any useful degree of accuracy. The effects of putting
certain substances together in certain proportions were accurately predicted by al-
chemists long before the birth of chemistry (prediction without explanation).
Exchange rate determination offers a good example of this dilemma. Surprisingly
enough, no rigorous test of the true predictive accuracy of the structural models of
exchange rate determination was carried out before the studies of Meese and Rogoff
(1983a, 1983bj see also 1988).
What Meese and Rogoff did was to examine the out-of-sample predictive perfor-
mance of these models. As a benchmark they took the simple random-walk model,
according to which the forecast, at time t, of the value of a variable in period t+ 1, is
the current (at time t) value of the variable. To avoid possible confusion, it is as weil
to stress that to compare the forecasts of a model with those of the random walk
does not mean that one is assuming that the exchange rate does folIowarandom
walk process (it might or might not, which is irrelevant for our present purposes).
It simply means taking as benchmark the simplest type of forecast, which is that of
the random walk. This benchmark amounts to assuming a naif agent who has no
idea of how the exchange rate will evolve, and feels that increases or decreases are
equally likely.
What Meese and Rogoff found was that the structural models failed to outperform
the random-walk model even when the actual realized values of the explanatory
variables were used (ex post forecasts ). The choice of ex post forecasts was made
by Meese and Rogoff to prevent a possible defence of the structural models, namely
that they do not perform weil only because of the forecast errors of the exogenous
variables that one has to use to forecast the exchange rate as endogenous variable
(Meese and Rogoff, 1983a, p. 10).
The results of Meese and Rogoff have been updated and confirmed in several later
studies (Cushman, 20oo)j even using more sophisticated techniques (such as error-
correction models, time-varying coefficients, cointegration techniques, threshold au-
toregressive models, etc.), there has been no appreciable improvement except in
sporadic cases.
One of the reasons of this failure might be that all the approaches tested rely on
single equations of the reduced form type. Two studies that use the general equi-
librium macroeconometric approach described in Sect. 9.4 have, in fact, been able
to outperform the random walk: see Gandolfo et al. (1990) and Howrey (1994).
It should be stressed that if one uses the balance-of-payments definition
to determine the exchange rate one is not necessarily adhering to the tra-
ditional or "fiow" approach to the exchange rate, as was once incorrectly
believed. A few words are in order to darify this point. Under approach
(c) one is simply using the fact that the exchange rate is determined in the
foreign exchange market, which is refiected in the balance-of-payments equa-
tion, under the assumption that this market dears instantaneously. This
assumption is actually true, if we indude the (possible) monetary authori-
ties' demand or supply of foreign exchange as an item in this market; this
item is given by Eq. (9.14), which defines the monetary authorities reac-
tion function. As we have already observed above, in fact, no theory of
exchange-rate determination can be deemed satisfactory if it does not ex-

plain how the variables that it considers crucial (whether they are the stocks
of assets or the flows of goods or expectations or whatever) actually trans-
late into supply and demand in the foreign exchange market which, together
with supplies and demands coming from other sources, determine the ex-
change rate. When all these sources-including the monetary authorities
through their reaction function in the foreign exchange market, Eq. (9.14)-
are present in the balance-of-payments equation, this equation is no longer
an identity, but becomes a market-clearing condition. Thus it is perfectly le-
gitimate (and consistent with any theory of exchange-rate determination) to
use the balance-of-payments equation to calculate the exchange rate once one
has specified behavioural equations for alt the items included in the balance
of payments.
As we have said above, the various cases are equivalent mathematically
but not from the economic point of view. In models of type a) and b),
in fact, it is in any case necessary to specify an equation for exchange-rate
determination, and hence adhere to one or the other theory explained in the
previous sections. Besides, these models leave the foreign exchange market
(of which the balance-of-payments equation is the mirror) out of the picture.
On the contrary, the foreign exchange market is put at the centre, of the
stage in models of type c). Hence, these models are not sensitive to possible
theoretical errors made in the specification of the exchange-rate equation
(9.16).
9.5 Fixed Vs Flexible Exchange Rates

The problem of the "best" exchange-rate regime-fixed or flexible- has al-
ways been a source of debate in international economics. Alongside with
traditional arguments we shall also review the modern approach.
9.5.1 The Traditional Arguments

It may seem that the old debate on fixed and flexible exchange rates has
been made obsolete by international monetary 'events, as the international
monetary system abandoned the Bretton Woods fixed exchange rate regime
(of the adjustable peg type) in the early 1970s, and is now operating under
a managed float regime mixed with others (see Sect. 3.4); nor does it seem
likely that freely flexible exchange rates will be generally adopted or fixed
ones will return. However, a general outline of the traditional arguments is
not without its uses, because many of these keep cropping up. The reference
to aspects already treated in previous chapters will allow us to streamline
the exposition. In examining the main pros and cons of the two systems it
should be borne in mind that the arguments for one system often consist of
9.5. Fixed Vs Flexible Exchange Rates 139
arguments against the other.

The birth of a Keynesian economic policy ab out 1950 explains one of the
main criticisms then directed at the existing system of fixed parities. This
system, it was argued, in many instances created dilemma cases between
external and internal equilibrium. In particular, a situation of underem-
ployment (which would require expansionary policies) could contrast with a
concomitant balance-of-payments deficit (which would be gave good reason
to the advocates of flexibility to point out the importance of exchange-rate
flexibility for the achievement of external equilibrium, so as to be able to
use fiscal and monetary policy to solve internal problems without burdening
these tools with external problems.
The critics of flexibility pointed out the serious consequences for interna-
tional trade and investment that would derive from a situation of uncertainty
on the foreign exchange markets (whence higher risks). But the advocates
replied that foreign exchange risks can be hedged by way of the forward mar-
ket (see Sect. 2.3), and pointed out that habitual use of this market would
stimulate its development and efficiency, so that forward cover could be ob-
tained at moderate cost. On the contrary, the lack of development of an
efficient and ''thick'' forward market under the adjustable peg regime, meant
that, when parity changes were expected, forward cover could be obtained
only at a prohibitive cost. FUrthermore, the possibility-which actually be-
came a reality on several occasions-of parity changes, did not generate that
certainty which the advocates of the adjustable peg claimed against the un-
certainty of flexible exchange rates.
Among the further criticisms against fixed exchange rates two more points
are worthy of note. One is the observation that this regime has a distortionary
efIect on markets when the relative competitiveness of two countries varies.
If the exchange rate does not reHect this variation because it is fixed, it then
means that an additional advantage is created for the country with the lower
rate of inflation against the country with the higher one. The former, in fact,
seIls its commodities to the latter at increasing prices (under the assumption
that the exporting country adjusts the price of its exports towards the price
of similar goods in the importing country) while maintaining the same rate
of conversion, notwithstanding the fact that the latter's currency has been
losing purchasing power. It should be added that the country with the lower
rate of inflation will probably see a decrease in its exports of capital (capital
outflows) and an increase in its imports of capital (capital inflows), which
may give rise to a disparity in the growth of the two countries.
The second point is that the maintenance of fixed parities ultimately
amounts to subsidizing firms engaged in international trade, as it implies
the use of public funds to absorb part of the risks inherent in private inter-
national transactions, and so involves a possible misallocation of resources
(unless there is a diversion of social costs and benefits from private ones,
which, however, has to be demonstrated). As Lanyi (1969) aptly put it, "if
one should ask an economist whether it is necessarily (italics added) desirable

to subsidize industry X while not subsidizing industry Y, he would immedi-
ately reply in the negative". Therefore the answer to the question "are we
necessarily (italies added) better off because international commerce is subsi-
dized through the government's bearing the exchange risk, while most types
of domestic commerce receive no government assistance in risk-bearing?"
must also be in the negative.
Among the advantages of flexible exchange rates the advocates included,
in addition to the greater freedom of economic policy to achieve internal
equilibrium, already mentioned above, the following:
(a) the possibility ofprotecting domestic price stability by an appreciating
exchange rate with respect to countries with a higher inflation rate. The
existence was also claimed of an insulating power against disturbances of a
real nature;
(b) the greater effectiveness of monetary policy: a restrictive monetary
policy, for example, by causing a capital inflow, brings ab out an appreciation
in the exchange rate, with depressive effects on aggregate demand which
reinforce those already due to the increase in the interest rate; the opposite
is true in the case of an expansionary monetary policy;
(c) the lower need for international reserves, as the elimination of possible
deficits is ensured by the exchange-rate flexibility.
Among the disadvantages of flexible exchange rates, in addition to the
increased risk in international transactions, already mentioned above, the
critics included the following:
(1) the possible non-verification of the critical elasticities condition (see
Sect. 6.1) would make the system unstable;
(2) the possible presence of destabilising speculation; the advocates of
flexible exchange rates, however, pointed out the undoubtedly destabilising
nature of speculation under the adjustable peg and argued for its stabilizing
nature under flexible exchange rates (this debate has been treated in Sect.
8.3);
(3) the resource reallocation costs of flexible rates, which induce resource
movements into and out of export and import-competing domestic industries;
(4) the loss of monetary discipline, as the need for restrictive monetary
policies in the presence of inflation is reduced if there is no external con-
straint; the advocates of flexible rates, however, pointed out that an exces-
sive exchange-rate depreciation is as good as an excessive reserve loss as an
indicator of the need for monetary restriction;
(5) the alleged inflationary bias due to a ratchet effect of exchange-rate
movements on prices: a depreciation, by raising the domestic prices of im-
ported final goods and of imported intermediate goods, raises the domestic
general price level, whilst an appreciation does not bring it down at all or not
as much. Hence the possibility of a ''vicious circle" of depreciation-inflation.
9.5. Fixed Vs Flexible Exchange Rates 141
9.5.2 The Modern View

It is impossible to strike a balance between all the traditional arguments for
and against the two regimes. The reason for the impossibility of declaring
one regime definitely superior from the theoretical point of view lies in the
fact that neither one has inferior costs and superior benefits on all counts.
The modern view has tried to overcome this impasse by concentrating on a
subset of criteria, namely has tried to assess which regime better stabilizes
the economy in the face of shocks of various type. The exchange rate regime
that provides the greater stability is considered superior.
To illustrate the effects of shocks let us modify an old acquaintance, the
Mundell-Fleming model with perfect capital mobility (see Sect. 6.4.3). This
model does not consider the price level nor the aggregate supply function.
Since we take it that the two main goals of society are output and price
stability, and we also want to consider the effects of supply shocks, we can
introduce a simple aggregate supply function according to which, given the
wage rate, supply of output is a positive function of the price at which pro-
ducers are able to seIl their output. We also assume that excess demand for
domestic output causes an increase in the supply of output (according to the
standard mechanism used in these models) as weIl as an increase in the price
level (according to a Walrasian mechanism). Finally, we assume that the
social preference function (or the objective function of the authorities) nega-
tively depends on the deviations of both output and the price level from their
respective target levels, where the weights given to the two deviations reflect
the relative importance or subjective trade-off between the two targets.
Thus we are equipped for considering various types of shocks. To avoid
problems related to expectations, we assume that all shocks are unanticipated.
9.5.2.1 Money Demand Shock
Starting from an equilibrium situation in which both prices and output are at
their respective target levels, suppose that there is an unanticipated exoge-
nous rise in money demand. Given the money supply, this tends to cause an
increase in the interest rate. Because of the assumed perfect capital mobility,
there is an incipient capital inflow.
Under fixed exchange rates the incipient capital inflow causes an increase
in money supply until it becomes equal to the increased money demand.
Output does not change neither does the price level. The fixed exchange
rate regime completely stabilizes the economy.
Under flexible exchange rates the incipient capital inflow causes an ap-
preciation of the exchange rate which depresses aggregate demand. The
(negative) excess de~and for output causes both a decrease in output and a
decrease in the price level.
It is clear that in these circumstances the flexible exchange rate regime is
inferior, independently of the weights attached to output and price stability.
9.5.2.2 Aggregate Demand Shock

We now consider an unanticipated exogenous decrease in aggregate demand.
This tends to cause a decrease in both output and the price level. Hence
we have a tendency for the interest rate to decrease, both because money
demand decreases and because the real money supply increases owing to the
price decrease. Due to perfect capital mobility there is an incipient capital
outflow.
Under fixed exchange rates the incipient capital outflow causes a decrease
in money supply until it is brought in line with the lower money demand. In
the final equilibrium both output and the price level will be lower.
Under flexible exchange rates the incipient capital outflow causes an
exchange-rate depreciation which sustains aggregate demand. Both output
and the price level will decline less than in the case of fixed exchange rates,
which are clearly inferior.
9.5.2.3 Aggregate Supply Shock

We finally consider an unanticipated exogenous decrease in aggregate supply.
The resulting fall in income causes a demand fall (though not by the same
extent, ifwe assume a marginal propensity to spend smaller than 1) causes a
decrease in money demand and hence an excess supply of money. The excess
demand for goods will tend to cause an increase in both output and the price
level, but of course output will remain below its previous level. The price
rise reduces the real supply of money and the demand rise increases money
demand. Depending on the structural parameters of the economy (which
determine the extent of the demand and price changes) the initial excess
supply of money may remain such or turn into an excess demand for money.
The two cases must be considered separately.
I) In the former case the excess supply for money causes a tendency for
the interest rate to decrease and hence an incipient capital outflow.
Under fixed exchange rates the incipient capital outflow causes a decrease
in money supply until it is brought in line with the lower money demand. In
the final equilibrium output remains lower and the price level remains higher
than in the initial equilibrium.
Under flexible exchange rates the incipient capital outflow causes an
exchange-rate depreciation which sustains aggregate demand and hence out-
put. Thus in the final equilibrium output will be higher than under fixed
exchange rates (though lower than before the shock) and the price level will
be higher.
Thus we see that flexible exchange rates are superior as regards output
stabilization, inferior as regards price stability. The decision on the better
exchange-rate regime will depend on the relative weights given to the two
targets.
11) In the latter case the initial excess supply for money turns into an
excess demand for money, which causes a tendency for the interest rate to
increase and hence an incipient capital inflow.
Under fixed exchange rates the incipient capital inflow causes an increase
in the money supply until it is brought in line with the increased demand. In
the final equilibrium output remains lower and the price level remains higher
than in the initial equilibrium, a result qualitatively similar to case I).
Under flexible exchange rates the incipient capital inflow causes an
exchange-rate appreciation which lowers aggregate demand and hence out-
put. In the final equilibrium output will be lower than under fixed exchange
rates, and the price increase will also be lower than in the fixed exchange
rate regime.
Thus we see that now fixed exchange rates are superior as regards output
stabilization, inferior as regards price stability. Also in this case the decision
on the better exchange-rate regime will depend on the relative weights given
to the two targets. However, given the weights, the decision will be crucially
dependent on the structural parameters of the economy. With the same
relative weights, in fact, the choice in case I will be exactly the opposite of
the choice in case 11, and vice versa.
9.5.2.4 Conclusion
The modern approach has succeeded in reducing the range of uncertainty
but has not been able to settle the debate. Notwithstanding its simplicity,
the model adopted has clearly shown the reasons for this failure. The choice
between the two regimes does, in fact depends on several factors:
a) the type of shock,
b) the structural parameters of the economy,
c) the objective function of the authorities.
More complicated models would not change this conclusion.
Costs and benefits will have to be weighted according to a social pref-
erence function, which may vary from country to country (and from period
to period in the same country). In addition, the structural parameters of
the economy are not given once-and-for-all, but are subject to change, the
more so the more dynamic is the economic system. In conclusion, "no single
currency regime is right for all countries or at all times" (Frankei, 1999).

Cassel, G., 1918, Abnormal Deviations in International Exchanges, Economic
Journal 28, 413-15.
Cushman, D.O., 2000, The Failure of the Monetary Exchange Rate Model
for the Canadian-U.S.
Dollar, Canadian Journal of Economics 33, 591-603.
De Grauwe, P., 1996, International Money: Postwar Trends and Theories,
2nd edition, Oxford: Oxford University Press.
Dornbusch, R, 1976, Expectations and Exchange Rate Dynamics, Journal
of Political Economy 84, 1161-76.
Frankei, J.A., 1983, Monetary and Portfolio Models of Exchange Rate De-
termination, in J.S. Bhandari and B.H. Putnam (eds.), Economic In-
terdependence and Flexible Exchange Rates, Cambridge (Mass.): MIT
Press, 84-115.
Frankei, J. A., 1999, No Single Currency Regime is Right for All Countries
or at All Times, Essays in International Finance No. 215, International
Finance Section, Princeton University.
Gandolfo, G., P.C. Padoan and G. Paladino, 1990, Exchange Rate Deter-
mination: Single-Equation or Economy-Wide Models? A Test Against
the Random Walk, Journal of Banking and Finance 14,965-92.
Howrey, P.E., 1994, Exchange Rate Forecasts with the Michigan Quarterly
Econometric Model of the U.S. Economy, Journal of Banking and Fi-
nance 18, 27-41.
Isard, P., 1995, Exchange Rate Economics, Cambridge (UK): Cambridge
University Press.
Kouri, P.J.K., 1983, Balance ofPayments and the Foreign Exchange Market:
ADynamie Partial Equilibrium Model, J .S. Bhandari and B.H. Put-
nam (eds.), Economic Interdependence and Flexible Exchange Rates,
Cambridge (Mass.): MIT Press.
Lanyi, A., 1969, The Case for Floating Exchange Rates Reconsidered, Es-
says in International Finance No. 72, International Finance Section,
Princeton University.
Meese, RA. and K. RogofI, 1983a, Empirical Exchange Rate Models of the
Seventies: Do They Fit Out of Sampie?, Journal of International Eco-
nomics 14, 3-24.
Meese, RA. and K. RogofI, 1983b, The Out-of-Sample Failure of Empir-
ical Exchange Rate Models: Sampling Error or Misspecification?, in
J.A. Frenkel (ed.), Exchange Rates and International Macroeconomics,
Chicago: Chicago University Press.
Meese, RA. and K. RogofI, 1988, Was It Real? The Exchange Rate-Interest
Differential Relation over the Modern Floating-Rate Period, Journalof
Finance 43, 933-48.
Pakko, M.R. and P.S. Pollard, 2003, Burgernomics: A Big Mac™ Guide to
Purchasing Power Parity, Federnl Reserve Bank of St Louis Review 85,
9-27.
Stockman, A.C., 1999, Choosing an Exchange-Rate System, Journal of Bank-
ing and Finance 23, 1483-98.
Chapter 10
The Intertemporal Approach to

the Balance of Payments
10.1 Introduction: The Absorption Approach

Forward-Iooking behaviour, namely current behaviour (for example current
saving and investment decisions) determined by calculations based on expec-
tations of future variables (for example future income, productivity growth,
real interest rates, etc.) is one of the hallmarks of modern macroeconomics,
and forms the basis of the new open-economy macroeconomics (for a survey
see Lane, 1999). Forward-Iooking calculations have already been illustrated
as regards financial variables in Chap. 4; in this chapter we apply them to
the balance of payments.
The starting point is the observation that the current account is also
national income less absorption, or national saving less investment. This
follows from the accounting identities illustrated in Chap. 5, and is by no
means a new idea, since it was set forth as far back as the 1950s by Alexan-
der's absorption approach. To put the question into proper perspective a
brief digression on the absorption approach is called for.
If we denote national income (product) by y, total aggregate demand
(for both consumption and investment) or absorption by A, the balance of
payments (current account) by B, we have
y=A+B, (10.1)
whence, considering the variations and rearranging terms,
(10.2)
Equation (10.2) shows that for a devaluation to improve the balance of pay-
ments it must either cause a decrease in absorption at unchanged income, or
an increase in income at unchanged absorption or (better still) both effects,
or suitable combinations of changes in the two variables (for instance, both
145
146 Chapter 10. The Intertemporal Approach to the Balance of Payments
Table 10.1: Effects of a devaluation according to the absorption approach

Effects upon and via income Direct effects on absorption
(1- c)Lly d
Idle-resources effect Cash-balance effect
Terms-of-trade effect Income-redistribution effect
Money-illusion effect
Three other rninor effects
income and absorption· may increase, provided that the latter increases by
less, etc.). No elasticities are actually involved.
Equation (10.2) is of course an accounting identity, and, to give it a causal
interpretation, we must answer three questions:
(i) how does the devaluation affect income;
(ii) how does a change in income affect absorption;
(iii) how does the devaluation directly (i.e., at any given level of income)
affect absorption.
For this purpose we first recall from Chap. 6 that consumption and in-
vestment are functions of income, so that we can write the functional relation
LlA = cLly - d, (10.3)
where c is the sum of the marginal propensity to consume and the marginal
propensity to invest, and d denotes the direct effect of the devaluation on
absorption. By obvious substitutions we get
LlB = (1 - c)Lly + d. (10.4)
Question (i) bears on Lly, question (ii) on the magnitude of c, question

(iii) on d.
Table 10.1 summarizes the various effects, a synthetic exposition of which
is:
Idle-resources effect: if there are unemployed resources, the increase in
exports following the devaluation brings about an increase in income via the
foreign multiplier.
Terms-oj trade effect: the devaluation causes a deterioration in the terms
of trade and hence a reduction in the country's real income.
Thus the two effects upon income are in opposite directions, so that Lly
may have either sign and the answer to question (i) is ambiguous.
As regards question (ii), Alexander was inclined to believe that cis greater
than one, hence (1 - c) is negative, so that as regards effects (i) and (ii) a
devaluation will improve the balance of payments if its net effect on income
is negative. This is, however, an empirical problem whose answer may be
different through space (different countries ) and time (changing habits).
10.1. Introduction: The Absorption Approach 147
Let us now turn to the direct effects on absorption.

Cash-balance effect: the devaluation causes an increase in the domestic
price of imports and hence in the general price level. This brings ab out a
decrease in the real value of wealth held in monetary form (cash balances):
the public will try to build up their cash balances (to restore the real value of
these) both by reducing absorption and by selling bonds. The sale of bonds
causes a decrease in their price, i.e. an increase in the interest rate, which
further reduces absorption.
Income-redistribution effect: the increase in prices caused by the deval-
uation may bring about a redistribution of income (for example from fixed-
income recipients to the rest of the economy), and this influences absorption
provided that the different groups of income recipients have different marginal
propensities to spend.
Money-illusion effect: assuming that prices and money income increase
in the same proportion, real income does not change, but if people do not
realize this because they are subject to money illusion, they will change their
absorption (the direction of change depends on the type of money illusion).
The three other minor direct effects concern the expectation of further
price increases (so that people may buy goods in advance to avoid paying
higher prices in the future); the discouragement to investment caused by
the increased price of imported investment goods; the discouragement to
expenditure on foreign goods in general, caused by their increased price.
The absorption vs elasticity approach gave rise to a heated debate in the
1950s, that culminated in an unsatisfactory synthesis which simply amounted
to considering the effect of the devaluation as an initial exogenous change in
the balance of payments to which the standard multiplier was applied to
obtain the final result (for details see Tsiang, 1961). At the time nobody,
not even its author, seemed to understand the truly innovative content of the
absorption approach: the pioneering idea that it is the set of macroeconomic
factors underlying absorption (i. e., saving and investment decisions) that
ultimately determine the current account and hence international borrowing
or lending patterns (see the last column of the matrix illustrated in Chap. 5,
table 5.1).
The modern intertemporal approach to the current account can be seen
as an extension of the absorption approach, since it starts from the same idea
but supplements it with the recognition that private saving and investment
decisions are forward looking. Foreign borrowing and lending can, in turn,
be viewed as intertemporal trade, namely as the exchange of goods available
on different dates. Insofar as the intertemporal approach to the current ac-
count also considers relative prices as determinants of saving and investment
decisions, it can be viewed as offering a modern synthesis of the absorption
and elasticity approaches.
10.2 Intertemporal Decisions, the Current

Account, and Capital Flows
To simplify at the utmost, we start with a pure consumption economy in
which no production or investment take place, and consider two time peri-
ods. The economy is endowed with a fixed amount of a consumption good
(say, corn) in each of the two periods (these endowments can be considered
as the economy's incomes in the two periods ), and the preferences between
current consumption and future consumption can be represented by social in-
difference curves (or by the indifference curves of a representative individual),
according to a well-known diagram introduced by Irving Fisher.
The slope of the indifference curve refiects the marginal rate of time pref-
erence, namely the rate at which the consumer is willing to give up a small
amount of current consumption to obtain more consumption in the future
or, alternatively, the rate at which the consumer is willing to forego future
consumption to obtain a marginal increase in current consumption. Note
that the marginal rate of time preference is not a constant, but depends on
the marginal utility of current and future consumption.
We have said ''refiects'', because the slope of the indifference curve is not
equal to the rate of time preference p, but equals 1 + P in absolute value. In
fact, an increment dC1 in future consumption is discounted to the current
period by the variable subjective discount factor (1 + p)-l, hence its value
in the current period is dCI/(l + p). The consumer is indifferent between a
decrement dCo in current consumption and the present value (subjectively
discounted) of dC1 when
1
dCo + -1-dC1 = 0,
+p
whence
dC1
dCo = -(1 + p), (10.5)
which is the slope of the indifference curve.
In market equilibrium the marginal rate of time preference must be equal
to the interest rate i, since the latter refiects the market relative price of Cl
in terms of Co: if someone forgoes a unit of consumption today and lends it
to someone else, the lender will get back 1 + i tomorrow.
Let us first consider a closed economy endowed with yo == COA , Y1 == ClA
respectively in period 0 and 1. Since there is no trade, the consumption of the
economy in each period must be equal to the endowment. The equilibrium
point E A shows the tangency between the indifference curve iA and the line
whose slope in absolute value is tana = 1 + iA, where iA is the autarky
interest rate.
Suppose now that the economy can trade at a world interest rate i* =1= iA,
where without loss of generality we can take i* < iA. Utility maximization
10.2. Intertemporal Decisions, the Current Account, and Capital Flows 149
L -______~__-L~~_______ Co
o
Figure 10.1: Intertemporal trade: pure consumption
takes place at point Eh-, where the (absolute value of) slope of the indifference
curve I T equals tanß = 1 + i*, hence i* = p.
The attainment of point Eh- implies the borrowing from abroad of an
amount COTCOA in the current period (which is like an import, hence a current
account deficit) and the repayment of ClACIT in the next period (this is like
an export, namely a curent account surplus). It is easy to see that EAQ =
ETQ·tanß, hence ClACIT = COTCOA · (1 +i*), or COTCOA = CIACIT /(1+i*).
In general, letting CA denote the current account,
CAI
CAo + -1-. =0, (10.6)
+ z*
where each current account has to be taken with its sign, and the second re-
lation follows from the accounting identity (I - S) +CA = 0 (see the first row
of the matrix illustrated in Sect. 5.3; here we have neglected the government
sector). Equation (10.6) is ealled the intertemporal budget constraint.
The souree of intertemporal trade is a difference between i A and i*, just as
in the statie model trade is determined by a differenee between the autarkie
and world eommodity priees.
Unlike the statie model, where commodities are exehanged for commodi-
ties (barter trade), in the intertemporal model trade involves the exchange
of commodities for assets, which are claims on future production. Thus in
period 0 the importing country will give some sort of bond to the exporting
country; this bond states the obligation to repay in period 1 the amount of
the commodity borrowed plus interest. Using the terminology of the bal-
ance of payments (see Chap. 5), in period 0 our economy runs a current
account deficit matched by a capital account surplus (the sale of the bond
to the foreign country). This confirms what we stated at the beginning,
that the current account is determined by the saving-investment decisions of
the economy. These decisions also determine capital fiows as the necessary
counterpart to commodity fiows. Hence the overall balance of payments is
necessarily in equilibrium, and its structure is completely determined.
We have seen that in moving from E A to ET the economy attains a higher
welfare level. This, however, implies that the agent who borrows is the same
as the one who repays, and may be misleading when this is not the case. If,
for example, the actual length of the period is very long, so that the agents
living in period 1 are different from those who lived in period 0, the outcome
is that agents living in period 0 are better off at the expense of those living
in period 1, who must repay the debt without having previously enjoyed the
benefits of higher consumption. This problem is even more serious when
one extends the model to a multi-period setting, and can be dealt with in
several ways. One is to assume infinitely-lived agents. Another is to assume
overlapping generations, namely a multi-period setting in which people live
for two periods, so that in any period there are both "old" (those in their
second period of life) and ''young'' (those in their first period of life) agents.
A simpler way out is described here.
In the model so far examined there is no place for investment. Borrow-
ing and lending take place only to smooth consumption between different
time periods. Let us now assume that our homogeneous good can be both
consumed and invested (used as capital good) , so that lower consumption to-
day means higher output and consumption next period (less corn consumed
today means more corn planted and hence more corn produced tomorrow).
The intertemporal transformation curve is drawn in Fig. 10.2; it is concave
to the origin due to diminishing marginal productivity of capital.
Let us first consider autarky. The economy is endowed with OQOA, OQlA
respectively in the current and next period. By consuming less than the
current endowment and investing the amount COA QOA of saved output, the
economy can obtain the additional output QlAClA in period 1, thus being
able to consume OClA rather than just OQlA. This is actually the solution
that maximizes the country's welfare, as shown by the tangency between the
intertemporal transformation curve and the highest indifference curve I A at
EA .
The opening up of trade (with the same endowments) at the international
interest rate i*, where tan ß = 1 + i*, enables the country to attain the
optimum point E T , clearly superior to E A . But what is striking is that now
consumption is high er in both periods (hence no intergenerational confiict can
arise). In the previous case (Fig. 10.1), higher current consumption could be
10.2. Intertemporal Decisions, the Current Account, and Capital Flows 151
I
I
I
I
I
I
I
CIT ---:..-----
C --I..-----~.
lA I E
: A:
I I I
I I I
QIA _+ ______ 4Q
I I A' :
: : I I
I I I I
I I I I
L-~____~~~--------__ Co
COA r COT
QOA
Figure 10.2: Intertemporal trade: produetion and investment
aehieved only by sacrificing future eonsumption and vice versa. This is no

longer the ease when foreign borrowing ean also be used to finanee produetive
investment, as illustrated in Fig. 10.2.
More precisely, the produetion point QT means that the economy, by in-
vesting QOAQOT today, will obtain the additional output QIAQIT next period.
Part of this additional output, and precisely QIAC1T , will be eonsumed to-
gether with next period's endowment so as to raise eonsumption in period 1
to OClT, higher than the autarky level OCIA' The remaining part (QITCIT )
will be used to repay the loan eontracted in period 0 (QOTCOT ) that enables
the economy to raise period 0's eonsumption to OCOT (higher than the au-
tarky level OCOA). We see that QITCIT = QOTCoTtanß = QOTCOT · (1 + i*),
that is the intertemporal budget eonstraint.
It might then seem that foreign borrowing has been entirely used to fi-
nanee eurrent eonsumption, but it is not so. The interpretation is the follow-
ing: the economy eonsumes an of its eurrent endowment OQOA, plus part 0/
the loan (QoA COT ), using the rest of the loan (QOTQoA) as investment. The
obvious poliey implieation is that borrowing from abroad is not by itself a
negative or harmful action: it will be so if it is squandered in eonsumption,
but if it is used for produetive investment it will raise the welfare of future
generations.
Let us observe, in conclusion, that the country will run, as in the pure
consumption case, a current account deficit matched by a capital account
surplus, hence the overall balance of payments will be in equilibrium.
10.2.1 The Feldstein-Horioka Puzzle

In a closed economy (aggregating the public and private sector ) national
saving equals national investment. This is no longer true in an open economy,
where a divergence between saving and investment can be accommodated by
a corresponding current account imbalance. The intertemporal approach
examined in the previous section shows that such a divergence is indeed the
normal outcome of the action of optimizing agents. It should however be
pointed out that, since the corresponding current account imbalance is only
possible through foreign borrowing and lending, free capital mobility is an
essential ingredient.
Thus, while in a closed economy saving and investment cannot but move
concomitantly, there is no reason why they should do so in an open econ-
omy provided that capital is internationally mobile. With capital immobility
changes in national saving rates ultimately change national investment rates
by the same amount. This is the point made in the Feldstein and Horioka
(1980) well-known paper. They reported empirical evidence, showing a high
and strong correlation between gross domestic I/Y and gross domestic S/Y
in a cross-sectional sampie of 16 OECD countries over the period 1960-84,
according to the least-squares regression
I/Y =0.04
(0.02)
+ 0.89
(0.07)
S/Y, R 2 = 0.91,
where the numbers below the coefficients are the standard errors. The au-
thors took this as evidence for the lack of capital mobility. Subsequent studies
by the same and other authors found similar econometric results.
This poses a puzzle, because these results contradict other evidence that
capital is quite mobile within developed countries. The main theoretical point
is then whether a high correlation between saving and investment indicates
low capital mobility.
Various explanations have been set forth to solve the puzzle, and the most
recent ones have focused on two points.
The first evaluates the appropriateness of the saving-investment correla-
tion as a measurement criterion, and argues that international parity con-
ditions are better criteria. It shows that international parity conditions,
properly viewed and estimated, provide strong evidence for capital mobility,
and hence the puzzle is resolved.
The second draws on the intertemporal approach, and starts by observ-
ing that saving and investment are related over time, as is implied by the
10.3. Intertemporal Approaches to the Real Exchange Rate 153
intertemporal budget constraint: see Eq. (10.6). The effect of this con-
straint seems strong enough to explain the high correlation between saving
and investment, without any implication on capital immobility.
10.3 Intertemporal Approaches to the Real

Exchange Rate
The real exchange rate has been defined in Chap. 2, Sect. 2.1.1. Now,
it might seem that no specific theory is necessary, since the real exchange
rate is a derived concept: knowing the nominal exchange rate and the other
magnitudes involved in the definition of real exchange rate, the real exchange
rate follows. However, nothing prevents us from building a specific theory of
the real exchange rate. One reason for doing so could be the poor empirical
performance of the nominal exchange rate models, while a specific theory of
the real exchange rate (henceforth RER) might do better. The intertemporal
approach seems to be particularly useful for this purpose.
Among the theories of the RER based on the intertemporal approach
we shall briefly mention the NATREX (NATural Real EXchange rate) ap-
proach.
This approach, though based on intertemporal optimization and micro-
unit behaviour, presents two important departures from the standard in-
tertemporal approach.
The first is that the hypotheses of perfect knowledge and perfect fore-
sight are rejected. Rather, rational agents that efficiently use all the avail-
able information will base their intertemporal decisions upon a sub-optimal
feedback control (SOFe) rule. Basically, SOFC starts from the observation
that the optimal solution derived from standard optimization techniques in
perfect-knowledge perfect-foresight models is such that the slightest error in
implementing it will put the system on a trajectory that will diverge from
the optimal steady state. Actual optimizing agents know that they do not
possess the perfect knowledge required to implement the optimal solution
without error, hence it is rational for them to adopt SOFC, which is a closed
loop control that only requires current measurements of the variable(s) in-
volved, not perfect foresight, and will put the economy on a trajectory which
is asymptotic to the unknown perfect-foresight stable arm of the saddle.
The second is that expenditure is separated between consumption and
investment, which are decided by different agents. The consumption and
investment functions are derived according to SOFC, through dynamic opti-
mization techniques with feedback control.
In other words, given the well-known identity (see Sect. 5.3)
where SN and IN are national saving and investment, economic agents de-
termine SN and IN according to SOFC, hence CA is determined.
The NATREX is the intercyclical equilibrium real exchange rate that
ensures balance-of-payments equilibrium in the absence of cyclical factors,
speculative capital movements and movements in international reserves. In
other words, the NATREX is the equilibrium real exchange rate that would
prevail if the above-mentioned factors could be removed and the GNP were
at capacity. Since it is an equilibrium concept, the NATREX guarantees
both the internal and the external equilibrium, the focus being on the long
run.
The study of the NATREX requires complex mathematical and econo-
metric analyses that we shall not go into; what we want to stress is that the
NATREX does not aim at tracking the actual real exchange rate, but is,
on the contrary, a measure of the long-run equilibrium real exchange rate,
the benchmark against which we can measure the misalignment of the actual
real exchange rate. Thus expressions like "the domestic currency is weak" ,
"the domestic currency is strong", "the domestic currency is undervalued" ,
"the domestic currency is overvalued", etcetera, which are often used in a
vague sense, can be given a precise meaning. Let us remember that the real
exchange rate (and hence the NATREX) is defined in such a way that an
increase means a (real) appreciation of the domestic currency. Hence when
the actual real exchange rate is lower (higher) than the NATREX, it follows
that the domestic currency is undervalued (overvalued).

Alexander, S.S., 1952, Effects of a Devaluation on a Trade Balance, Interna-
tional Monetary Fund StafJ Papers 2, 263-78.
Feldstein, M. and C. Horioka, 1980, Domestic Saving and International Cap-
ital Flows, Economic Journal 90, 314-29.
Fisher, 1., 1930, The Theory 0/ Interest, New:York: Macmillan.
Lane, P.R., 1999, The: New Open Economy Macroeconomics: A Survey,
CEPR Discussion Paper No. 2115.
Obstfeld, M. and K. Rogoff, 1995, The Intertemporal Approach to the Cur-
rent Account, Chap. 34 in G. Grossman and K. Rogoff (eds.), Handbook
0/ International Economics, Vol. III, Amsterdam: North-Holland.
Stein, J.L., 1999, The Evolution of the Real Value of the US Dollar Relative
to the G7 Currencies, in R. MacDonald and J.L. Stein (eds.), 1999,
Equilibrium Exchange Rates, Dordrecht: Kluwer Academic Publishers,
67-101.
Tsiang, S.C., 1961, The Role of Money in Trade-Balance Stability: Synthe-
sis of the Elasticity and Absorption Approaches, American Economic
Review 51, 912-36.
Chapter 11
International Monetary
Integration and European
Monetary Union
11.1 Introduction
There are various degrees of monetary integration, from the simple currency
area to the full monetary union (with a single currency). Thus a preliminary
conceptual and terminological clarification is called for. A good starting
point is the definition given in areport to the Council and Commission of
the European Economic Community commonly known as the Werner Report
(1970). It identifies a first set of conditions (called "necessary conditions" by
the subsequent Delors Report, 1989) to deflne a monetary union:
1) within the area of a monetary union, currencies must be fully and
irreversibly convertible into one another;
2) par values must be irrevocably fixed;
3) fluctuation margins around these parities must be eliminated;
4) capital movements must be completely free.
The second set of conditions identified in the Werner Report concerns the
centralization 0/ monetary policy. In particular, this centralization should
involve all decisions concerning liquidity, interest rates, intervention on the
exchange markets, management of reserves, and the fixing of currency parities
vis-a-vis the rest of the world.
Finally, in the Werner Report the adoption of a single currency, though
not indispensable for the creation of a monetary union, is considered prefer-
able to maintaining the various national currencies. This is so for psycholog-
ical and political factors, as the adoption of a single currency would demon-
strate the irreversible nature of the undertaking.
Some authors take the first set of elements listed in the Werner Report
and call it monetary integration. In practical usage this latter definition is
155
156 Chapter 11. International Monetary Integration and European Monetary Union
then simplified to fixed exchange rates and freedom of capital movements.

Other authors, on the contrary, take the view that monetary integration must
imply something more. For example, Corden (1972) states that monetary
integration consists of two elements:
1) "complete exchange-rate union", i. e. irrevocably fixed exchange rates
and centralization of exchange-rate policy towards the rest of the world and
of part of monetary policy, by a supranational body;
2) "convertibility", namely complete elimination of any control on inter-
national (within the area) transactions on both current and capital accounts.
Other authors, however, use "monetary integration" as the analogous, in
international monetary theory, of the term "commercial integration" used as
a generic term in trade theory. Monetary integration, in other words, is taken
as the generic term that contains various categories (including the process of
transition from a simple currency union to a full monetary union).
Be it as it may, from the point of view of economic theory the starting
point of any analysis of monetary integration (we shall take this term in the
generic meaning) is the theory of optimum currency areas. These will be
examine in the next section. We shall next analyse the common monetary
policy prerequisite and the problem of the single currency in a monetary
union. The European monetary union will be examined in the final section.
11.2 The Theory of Optimum Currency

Areas
The notion of optimum currency area (introduced by Mundell, 1961) is an
evolution of the concept of currency area.
A currency area is a group of countries which have a common currency (in
which case full monetary integration prevails) or which, though maintaining
different national currencies, have permanently and rigidly fixed exchange
rates among themselves and full convertibility of the respective currencies
into one another; instead, the exchange rates vis-a-vis non-partner countries
are flexible. Theoretically defined, currency areas do not necessarily corre-
spond to national frontiers, as they might include part of a nation only. But
as it would not be viable, we shall not consider this case.
The problem consists in determining the appropriate domain of a currency
area (hence the adjective optimum) and, specifically, whether the adhesion
of a country to a currency area (to be set up or already existing) or its
remaining in one is beneficial. Optimality can be judged in various manners,
for example on the basis of the capability of maintaining external equilibrium
without unemployment at horne and with price stability. It is clear that the
question of (optimum) currency areas exists insofar as the debate on fixed
versus flexible exchange rates has proven to be inconclusive (see Sect. 9.5).
11.2. The Theory of Optimum Currency Areas 157
In fact, if either the fixed exchange rate regime or the flexible one could be
shown to be definitely superior, then there would be no need for a theory of
(optimum) currency areas: the optimum currency area would coincide with
the world (if fixed exchange rates were superior) or would not exist (in the
case of superiority of flexible exchange rates).
Three approaches can be distinguished in the theory of optimum currency
areas. The first is the traditional approach, which tries to single out a crucial
criterion to delimit the appropriate domain. The second is the cost-benefit
approach, which believes that the participation in a currency area has both
benefits and costs, so that optimality has to be evaluated by a cost-benefit
analysis. The third is the "new" approach.
11.2.1 The Traditional Approach

Several single criteria to delimit the domain of an optimum currency area can
be found in the literature, since different authors have singled out different
criteria as crucial.
(a) One criterion is that of international lactor mobility: countries be-
tween which this mobility is high can profitably participate in a currency
area, whilst exchange rates should be flexible between countries with a low
factor mobility between them. With a high factor mobility, in fact, interna-
tional adjustment would resemble the adjustment between different regions
of the same country (interregional adjustment), between which; obviously, no
balance-of-payments problem exists. Let us assume, for example, that there
is a decline in the exports of a region to the rest of the country because of
a fall in the demand by the rest of the country for the output of an indus-
try located in that region. The region's income and consumption decrease
and, to ease the transition to a situation of lower real income, it is necessary
for the region to get outside financing to be able to consume more than the
value of output (high mobility of capital, possibly stimulated by policy inter-
ventions). Furthermore, the unemployed workers can move to other regions
and find a job there (high mobility of labour). A similar process would take
place at the international level. It is also dear that, in the absence of the
postulated factor mobility, the elimination of the imbalances described above
would require exchange-rate variations.
(b) A second criterion is that of the degree olopenness of the economy, as
measured by the relative importance of the sectors producing internationally
traded goods or tradables (both exportables and importables) and the sectors
producing non-traded goods. A country where traded goods ate a high PI(}-
portion of total domestic output can profitably participate in a currency area,
whilst it had better adopt flexible exchange rates in the opposite case. Let
us assume that a highly open economy incurs a balance-of-payments deficit:
if this is cured by an exchange-rate depreciation, the change in relative prices
will cause resources to move from the non-traded goods sector to the traded
goods one, so as to meet the increased (foreign) demand for exports and the
higher (domestic) demand for import substitutes. This implies huge distur-
bances (amongst which possible inflationary effects) in the non-traded goods
sector because of its relative smallness.
In this situation it would be more effective to adopt fixed exchange rates
and expenditure-reducing policies which reduce imports and free for expor-
tation a sufficient amount of exportables previously consumed domestically.
(c) A third criterion is that of product diversijication. A country with
a high productive diversification will also export a wide range of different
products. Now, if we exc1ude macroeconomic events which influence the
whole range of exports (for example a generalized inflation which causes
the prices of all domestically produced goods to increase), in the normal
course of events commodities with a fine or brilliant export performance
will exist beside commodities with a poor export performance. It is self-
evident that these offsetting effects will be very feeble or will not occur at
all when exports are concentrated in a very limited number of commodities.
On the average, therefore, the total exports of a country with a high product
diversification will be more stable than those of a country with a low one.
Since the variations in exports influence the balance of payments and so-
ceteris paribus-give rise to pressures on the exchange rate, it follows that
a country with high product diversification will have less need for exchange-
rate changes and so can tolerate fixed exchange rates, whilst the contrary
holds for a country having low product diversification.
(d) A fourth criterion is that of the degree of jinancial integration. It par-
tially overlaps with criterion (a), but it is especially concerned with capital
flows as an equilibrating element of external imbalances. If there is a high de-
gree of international financial integration, no need will exist for exchange-rate
changes in order to restore external equilibrium, because slight changes (in
the appropriate direction) in interest rates will give rise to sufficient equili-
brating capital flows; in this situation it is possible to maintain fixed exchange
rates within the area where financial integration exists. It goes without say-
ing that a condition for financial integration is the elimination of all kinds of
restrictions on international capital movements.
(e) A fifth criterion is that of the similarity in rates 0/ inflation. Very
different inflation rates do, in fact, cause appreciable variations in the terms of
trade and so, insofar as these influence the flows of goods, give rise to current-
account disequilibria, which may require offsetting exchange-rate variations.
When, on the contrary, the rates of inflation are identical or very similar,
there will be no effect on the terms of trade and so-ceteris paribus-an
equilibrated flow of current-account transactions will take place (with fixed
exchange rates) within the currency area.
(f) A sixth criterion is that of the degree 0/ policy integration. Policy
integration can go from the simple coordination of economic policies among
the various partner countries to a situation in which these surrender their
monetary and fiscal sovereignty to a single supranational monetary authority

(necessary for consistently managing the international reserves of the area
and the exchange-rates of the partner countries vis-a-vis the rest of the world,
for achieving an appropriate distribution of the money supply within the area,
etc.) and a single supranational fiscal authority (necessary to coordinate
taxation, transfer payments and other measures-for example in favour of
those workers who remain unemployed notwithstanding fulliabour mobility,
etc.). It is clear that this ideal situation presupposes complete economic
integration which, in turn, cannot be achieved without some form of political
integration.
(g) A seventh criterion is that of the degree of price and wage jlexibility.
If wages and prices are highly flexible throughout the area, the transition
toward adjustment following an external shock is less likely to be associated
with unemployment in one country and inflation in another, reducing the
need for exchange-rate adjustment.
All the above-listed criteria-with the exception of the sixth, which is
almost a truism, as it amounts to saying that when there is full economic and
political integration there also is monetary integration-have been criticized
as incomplete and partial. As a matter of fact, the reader who has followed
us through the previous chapters will readily see that all these criteria stress
only one or the other element present in the adjustment processes of the
balance of payments under the various exchange-rate regimes, and that these
elements can be subjected to the same criticism examined in the previous
chapters. Just as an example, the criterion of financial integration and so of
the equilibrating influence of capital flows is susceptible to the same criticisms
examined in Sect. 6.4.4 (burden of interest payments, stocks and flows, etc.).
11.2.2 The Cost-Benefit Approach

Participation in a currency area involves benefits but also costs, so that to
take the best course of action a careful determination of both is necessary
by weighting these costs and benefits through some kind of social preference
function. It is self-evident that the final decision will depend on the set of
weights chosen; as these may vary from country to country (and from period
to period in the same country), no general rule can be given. What we shall
do is to describe the benefits and costs.
The main benefits inc1ude the following:
(1) A permanently fixed exchange rate eliminates speculative capital flows
between the partner countries. This, of course, depends on the confidence in
the fixity of the exchange rates within the area, as in the opposite case, desta-
bilising speculation (of the type which affected the adjustable peg system:
see Sect. 8.3) would inevitably come about. This problem cannot obviously
arise in the case of a common currency.
(2) The saving on exchange reserves. The members no longer need inter-
national reserves for transactions within the area, exactly as in the case of
regions within a country. This, of course, will occur when the credibility of
the fixed exchange rates is complete, whilst in the initial stages it may be
necessary to hold the same amount of pre-union reserves to ensure the agreed
exchange-rate rigidity, i.e. to enforce the fixed parities established within the
area.
(3) Monetary integration can stimulate the integration of economic poli-
eies and even economic integration. The idea is that partieipation in a cur-
rency area, and so the obligation to maintain fixed exchange rates vis-a..vis
the other members, compels all members to make their economic policies uni-
form (in particular anti-inflationary polieies) with those of the most virtuous
member, at the same time making more credible domestically the statements
of a firm intention to pursue a strong policy against inflation. This is essen-
tially the same argument of monetary discipline already set forth in general
in the debate on fixed versus flexible rates (see Sect. 9.5), strengthened by
the fact that the commitment to maintain fixed exchange rates within the
area would be feIt more strongly than the commitment to defend a certain
parity vis-a..vis the rest of the world as under the Bretton Woods regime.
Another argument, however, suggests that monetary agreements might give
rise to more inflation. This might happen when the national policy author-
ity is involved in a policy game with other institutional agents (trade unions,
etc.).
The argument of uniform inflation rates has been the subject of much
debate. Firstly, it has been noted that it curiously turns the position of
the traditional approach upside down: we have in fact seen in Sect. 11.2.1,
criterion (e), that according to the traditional approach the similarity in the
rates of inflation is a precondition for taking part in an (optimal) currency
area, whilst it now becomes a (beneficial) effect of taking part. Secondly,
many nonmonetarist writers deny that the achievement of a common rate of
inflation is ontologically a benefit, and observe that different countries may
have different propensities to inflate: some are more or less inflation-shy,
others more or less inflation-prone, and this reflects a different structure of
their national preference function.
In effect, some confusion seems to exist in relation to this argument.
Benefits (1) and (2) are fairly objective ones, in the sense that they do not
presuppose the adhesion to a particular school of thought or to a particular
preference function (practically everybody agrees that elimination of desta-
bilising speculation, and saving on international reserves, are benefits). On
the contrary, the equalization of the inflation rates is not considered univer-
sally desirable. Prom this point of view the traditional approach seems more
neutral, because it only states that if there is similarity in inflation rates,
then ground exists for participating in a currency area.
Behind the idea that monetary integration is conducive to economic inte-
gration there is a psychological expedient. Assuming that a certain number

of countries wish to effect an economic union, and assuming also that some
of these are not able to implement domestically and as an expression of their
autonomy the policies which bring ab out the characteristics necessary to an
economic union (one of these characteristics is the uniformity in inflation
rates), then monetary integration may well be a useful instrument to enable
them to implement those policies. This reasoning is based on the belief (or
hope) that society is affected by a kind of "economic policy illusion", in the
sense that it is not willing to accept certain economic policies as an expression
of its own autonomy, but it is willing to accept them if these are presented
as deriving from external conditioning, i.e. required by the participation in a
currency area. How justified is this belief, is an empirical matter; in general
one can only observe that a common currency can certainly be brought into
being and manifest all its advantages when it is established as the final step
of a process of economic integration, whilst one can doubt its effectiveness as
a tool to compel the refractory countries to realize the conditions necessary
for economic integration.
(4) Besides the advantages listed above there may also be advantages of
a political type, in the sense that a currency area (and, more generally, an
economic union) carries more weight than the single countries in negotiating
as a whole with outside parties. This of course requires that, although the
exchange rates vis-a-vis non members are flexible, the currency area adopts
a common exchange policy towards outside currencies. This is in the nature
of things when the area adopts a common currency in the strict sense, whilst
it not so easily and automatically realizable when the individual members
maintain their respective national currencies. In fact, the currency of any
member may turn out to be stronger or weaker than those of other members
with respect to outside currencies which are key currencies in international
transactions (as for example the US dollar). This may give rise to tensions
within the currencies of the area (remember what was said inSect. 2.2 about
cross rates), unless there is a coordination of the interventions on the foreign
exchange rates.
Let us now come to the costs, amongst which we list the following:
(1) loss of autonomy in monetary and exchange policy of the individual
members. The financial integration and the related perfect capital mobil-
ity makes monetary policy impotent (see Sect. 6.4.3); in the case of full
integration the central banks of the members will merge into one suprana-
tional central bank. The disappearance of a possible policy tool such as the
managed variations in the exchange rate may give rise to serious problems if
wage rates, productivity, and prkes, have different trends in different mem-
ber countries. These problems may become particularly severe in the case of
shocks coming from outside the area.
(2) Constraints on national fiscal policy. It is true that fiscal policy-for
the same reasons for which monetary policy is ineffective-is fully effective
under fixed exchange rates (see Sect. 6.4.3), but this is true for an isolated
country. In the case of a country belonging to a currency area, its fiscal
policy may be constrained by the targets of the area as a whole (for example
to maintain a certain equilibrium in the area's balance of payment vis-a-
vis the rest of the world). And since the joint management of the single
members' fiscal policies is carried out in the interest of the majority, it may
happen that some member is harmed (unless a vetoing power is given to each
member, in which case, however, there is the risk of a complete paralysis).
(3) Possible increase in unemployment. Assuming that the area includes a
country with low inflation and an external surplus, this country will probably
become dominant and compel the other members (with greater inflation and
an external deficit) to adjust, because-as there are no means to compel the
former country to inflate-the deficit countries will have to take restrictive
measures which will lead to a decrease in employment. The writers of the
monetarist school claim that in the long-run every country will be better off
thanks to the lower rate of inflation, but, even allowing this to be true, the
problem remains of determining how long is the long-run, as it is clear that
in the short-run there are costs to be borne.
4) Possible deterioration of previous regional disequilibria. "Regional" is
here used in the strict sense, i.e. referring to single regions within a mem-
ber country. Since the international mobility of capital (in the absence of
controls) is higher than the international mobility of labour, the greater pos-
sibilities of finding better-rewarded uses of capital in other count ries of the
area, together with the relatively low internationallabour mobility, may ag-
gravate the development problems of the underdeveloped regions of a coun-
try. It should be noted that this negative effect occurs insofar as what was
listed as the first criterion in the traditional approach (the high international
mobility of all factors) does not occur, but it seems in any case likely that
international labour mobility is lower than that of capital.
Having thus listed the benefits and costs, we conc1ude by pointing out
that the already mentioned problem of weighing them cannot be given a
generally valid answer, as it depends on the social welfare functions of the
different countries, that may be quite different.
11.2.3 The new Theory

The new theory of currency areas is not really new in its approach, as recent
studies continue both to examine various criteria and to enumerate benefits
and costs. The novelty resides in the fact that new theoretical results are
being applied to old issues. For example, the cost associated with the loss
of monetary autonomy was based on the idea that flexible exchange rates
would allow a country to choose an optimum point along its Phillips curve.
But the idea of a permanent trade-off between inflation and unemployment
has been undermined by development in both theory (the displacement of
the Phillips curve first by the natural rate of unemployment and then by the
NAIRU) and reality (the stagflation problem in the 1970s and early 1980s).
Thus it seems that, under this respect, the main benefit of flexible exchange
rates is only the ability of choosing a different rate of inflation from other
countries.
Recent work on the theory of optimum currency areas and monetary
integration concentrates on two issues: the effects 0/ shocks and reputation al
considerations.
As regards the effects of shocks, we have already seen in the new debate on
fixed versus flexible exchange rates (Sect. 9.5.2) that the modern approach
has succeeded in reducing the range of uncertainty but hasn't been able
to settle the debate. There are various reasons for this failure: the shock-
absorption capability of fixed and flexible exchange rates depends on several
factors, such as the type of shock, the structural parameters of the economy,
and the objective function of the authorities.
Reputational considerations start from the observation that, since policy
makers can do little more than choose an optimal rate of inflation, they should
aim at a zero (or at least very low) inflation rate. This is so because inflation
distorts relative prices through which information is usually transmitted,
thus creating uncertainty and inefIicient allocation of resources. The more
credible the anti-inflation commitment, the lower the costs associated with
a given decrease in the inflation rate, and the easier the implementation of
an anti-inflation plan. Credibility requires time consistency, namely that the
government will pursue the policy in the future because it has no incentive to
change it, and the public is convinced that the government will not change
it.
Given this, the view has been set forth that a high-inflation country in-
creases its credibility by fixing its exchange rate with respect to the currency
of a low-inflation country. But why the exchange rate rather than monetary
policy? The answer is twofold. First, the exchange rate is an easily observ-
able and still more easily understood variable by the public, while the money
supply is not (or is less) and, to the extent that it is observable, is difIicult
to control. Second (and related to the first), is the discipline argument: by
pegging the exchange rate the monetary authorities tie their hands much
more strictly than by a money supply commitment, hence gain in credibility.
Thus we must conclude that recent theoretical and empirical work has
produced ambiguous results. But, after all , the move to international inte-
gration is more an expression of political will than the outcome of purely
economical calculations.
11.2.4 Optimum for whom?

Optimum currency areas are by definition optimum for the participating
countries. But what about the rest of the world? This is the third-country
problem, which means that the agreement to create a currency area may have
a negative efIect on non-participating countries. Consider,for example, the
formation of a currency area among countries with regionally difIerentiated
goods: a possible result is a reduction in the area's output (because of the
interaction between the common exchange rate and lower wage flexibility).
This will not only be a cost for the union's members, but also for the rest
of the world whose trade will be negatively afIected. On the contrary, the
benefits from the union are limited to the union's members.
Although these results need not be valid in general, the possibility of a
welfare-Iowering efIect (for the rest of the world) due to the creation of a
currency union should be taken into consideration.
11.3 The Common Monetary Policy

Prerequisite, and the Inconsistent Triad
We examine whether a common monetary policy is only desirable or also
necessary for monetary integration to be viable. To analyse this question
let us begin by recalling a few well-known interest-rate-parity conditions (see
Chap. 4). Given perfect capital mobility, we must distinguish the cases of
perfect and imperfect asset substitutability (see Sect. 4.6). With perfect
asset substitutability, uncovered interest parity must hold, i. e.
. . r-r
'th='tj+ - - . (11.1)
r
With imperfect asset substitutability, condition (11.1) has to be modified by

the introduction of a risk premium 8, namely
.
'th =
. r-r
'tj+ - - +u.
1"
(11.2)
r
Let us begin by considering Eq. (11.1). In a currency area (and in higher

degrees of monetary integration), exchange rates are irrevocably fixed, hence
(7'" - r) Ir = 0 and, consequently,
(11.3)
With perfect asset substitut ability only the money stock matters (see
Sect. 9.3), so that we can consider only money-market equilibrium (demand
for money = supply of money) at home and abroad. Thus we have
PhLm.(Yh, ih) = M h, (11.4)
PfLRf(Yf,if) = M f , (11.5)
where Lm., L Rf denote the real money deniand at home and abroad.
11.3. The Common Monetary Policy Prerequisite, and the Inconsistent Triad 165
Even if we take the price levels and the outputs as given, the three equa-
tions (11.3)-(11.5) form an undetermined system, which is unable to deter-
mine the four unknowns (the two money supplies and the two interest rates).
Thus, there is a fundamental indeterminacy of the money supply and the in-
terest rate in this two-country system. It follows that the two countries will
have to (implicitly or explicitly) agree on the conduct of monetary policy.
We must stress that the apparent absence of agreement can simply be due
to the presence of an implicit agreement. The typical implicit agreement is
asymmetrie, in the sense that it is based on the dominant role of one coun-
try. This means that one country sets its money supply according to its own
criteria and the other country adapts its money stock.
Suppose, for example, that the foreign country is the dominant country
and fixes M J . Then Eq. (11.5) determines i J , which sets ih by Eq. (11.3).
Finally, Eq. (11.4) determines M h . Thus the horne country must set its
money supply at this level.
If it does otherwise, the currency area will break down. In fact, suppose
for example that the horne country tries to fix a higher money supply. This
will depress i h below i J . As a consequence, immediate and disrupting capital
flows from horne to abroad will take place, unless controls on capital flows
are introduced (but such controls are hardly compatible with monetary in-
tegration). These flows will lead to expectations of a future exchange rate
adjustment and to the breakdown of the exchange rate commitment.
Explicit agreements on the conduct of the overall monetary policy are, on
the contrary, of the cooperative type. This requires that countries agree to
cooperate in setting their money stocks (or interest rates). This presents the
weIl known free-riding problem, the same kind of problem treated at length
in the theory of international price cartels (see Sect. 14.4.2). In general, this
means that once a cooperative agreement has been reached, there are usually
incentives for one partner to do something else than was agreed upon. This
follows from the fact that, by so doing, the partner will be better off, if the
other partners do not retaliate (for example by reneging on the agreement).
Thus some institutional mechanism has to be devised to avoid the free-riding
problem.
These considerations confirm the essential importance of viable agree-
ments on the conduct of monetary policy within the currency area. We have
illustrated this proposition by the simplest model possible, but the results do
not change substantially with more complicated models, such as those based
on Eq. (11.2) instead of Eq. (11.3). This would require the introduction of
the stocks of assets (money and other financial assets) and the determination
of the portfolio-balance equilibrium.
Since it is impossible for a country to simultaneously peg its exchange rate
and allow unfettered movement of international capital, while retaining any
autonomy over its monetary policy, the set of fixed exchange rates, perfect
capital mobility, and monetary independence has been called the inconsistent
triad or incompatible trinity (if we also inc1ude perfect commodity mobility,

namely free trade, this becomes an inconsistent quartet: Padoa Schioppa,
1988, p. 373).
11.4 The Single-Currency Problem

This problem is best examined in the context of cost-benefit analysis. In
fact, the demonstration that the adoption of a single currency is required
for the elimination of the inefficiencies linked to the coexistence of national
currencies, is not a proof of the necessity of a single currency. What it shows
is that a single currency is somehow better than the fixity of exchange rates,
not that it is essential for a monetary union. Thus the proper framework is
that of cost-benefit analysis.
In general, the fuH advantages of a monetary union can be obtained only
through the perfect substitutability of all the union members currencies in
the three basic functions of money: unit of account, means of payment, and
store of value. Once the credibility of the irrevocable fixity of exchange
rates is firmly established, perfect substitutability in the unit-of-account· and
store-of-value functions does not present particular problems. Problems are
present, on the contrary, in the means-of-payment function. Transaction
costs create a wedge between buying and selling rates, since foreign exchange
operators charge a cost for their service. These costs could be eliminated for
private agents if the authorities subsidize the conversion between the various
national currencies. This, however, would simply shift the costs onto the
unions budget. In practice bid-ask spreads are such that, by simply convert-
ing one currency into another, one after each other, and finally reverting to
the initial currency in, say, a fifteen-member union (such as the European
Monetary Union), without actually spending a penny one might weH end
up with less than 40% of the initial amount! In addition, these spreads are
likely to vary from country to country in the union, thus altering the degree
of substitut ability among currencies.
Let us now come to the examination of the main benefits and costs of a
single currency. The benefits are due to the fact that a single currency by
definition eliminates a number of problems and shortcomings inherent in the
use of several national currencies. These are:
(1) The elimination of imperfections in the substitutability of currencies,
as detailed above.
(2) The elimination of any possibility, even if remote, of changes in par
values. The expression irrevocably fixed exchange rate has no practical sig-
nificance. Although the international community tries to observe the rule
pacta sunt servanda (pacts must be observed), history is full of examples
of irrevocable commitments to fixed exchange rates that have broken down.
The reason is simple: assuming that national governments behave rationally,
11.4. The Single-Currency Problem 167
they will evaluate the costs and benefits of the fixed exchange rate union, as
shown in Sect. 11.2.2. If the costs become overwhelming with respect to the
benefits, the government concerned may be tempted to change the parity,
even if this means breaking an international agreement. This is by no means
an impossible occurrence. The evaluation of the costs and benefits, in fact,
may vary over time, for example in relation to economic conditions and/or
to preference functions of different governments. Thus a fixed exchange rate
system does not eliminate the risk that a temporary change in this evaluation
might lead a member country to alter the parity. Rational economic agents
know this, hence the possibility of speculative capital flows and of an un-
certain climate for businesses. Actually, models of currency crises have been
built based on the possibility of the government to renege the commitment
to fixed exchange rates (an escape clause: see Sect. 8.3).
(3) The elimination of destabilising speculative capital flows within the
union, due to expectations of parity changes as detailed under (2).
(4) The elimination of the need for intra-union international reserves,
required to make the commitment credible and to offset possible speculative
capital flows.
(5) We have shown in Sect. 11.3 that a common monetary policy is
necessary for a monetary union. A single currency would greatly facilitate
the conduct of this overall monetary policy, and would eliminate free-riding
problems.
(6) A single currency would carry more international weight and enable
the union to reap the benefits of seignorage. In addition, the interventions
in the foreign exchange market vis-a..vis other currencies would be greatly
facilitated and would require a smaller amount of international reserves vis-
a-vis the rest of the world.
The main costs that have been stressed are the following:
(1) Costs for the transformation of the system of payments. These include
the costs of changing existing monetary values into the new currency, the
costs of changing coin machines, etc.
(2) The psychological cost to the public of introducing the new currency
and their getting used to it. It is not sufficient to declare a currency legal
tender for this to be used willingly in a country in the place of the existing
national currency. A new currency cannot be merely imposed by legislative
act, but must gain social consensus and be accepted by the market. Thus the
authorities will have to ensure that the new currency performs the functions
of money at least as efficiently as the existing national currencies. This
process of convincing the public is not without costs.
(3) This point is usually presented as an advantage of the fixed exchange
rate system, rather than as a cost of the single-currency system. It is called
the currency competition argument. Several currencies in competition stim-
ulate each national monetary authority in the group to pursue a lower rate of
inflation and, more generally, a stable value of its respective currency. How-
ever, a system based on competition between monetary policies will result

either in the breakdown of the fixed exchange rate commitment or in the
dominance of one currency, as shown in Sect. 11.3.
To conclude, we observe that the benefits of a single currency seem much
greater than the costs. From this, of course, it does not follow that a sin-
gle currency is necessary for a monetary union. It is preferable, but not
indispensable. There is, however, a further consideration that points to the
necessity of a single currency. We have already mentioned above, under entry
(2) of the list of benefits, the problems related to maintaining fixed parities.
In the absence of capital controls (whose elimination necessarily accompa-
nies the formation of a monetary union), permanently fixed exchange rate
is an oxymoron. No matter what governments say, speculators know that
exchange rates between distinct national currencies exist only to be changed.
And-confronted with one-way bets thanks to fixed exchange rates, and hav-
ing practically unlimited resources thanks to free capital mobility-they can
indeed compel the authorities to change the parities, as the crises of the Eu-
ropean Monetary System (see below) have shown. Hence there is a strong
suspect that a monetary union maintaining distinct national currencies with
permanently fixed exchange rates would not be viable.
The single currency issue is not disjunct from the central bank issue.
Once a single currency has been decided upon, the necessity arises of the
centralization of monetary policy in a single supranational body. This is the
union's central bank, which could be of the federal type to take advantage of
the long experience that national central banks have built up over the years.
11.5 The European Monetary Union

The European Monetary Union (EMU, an acronym that also stands for Eco-
nomic and Monetary Union, which in turn means the EU or European Union,
which is the official denomination), besides its obvious interest for European
students, also has a general interest: it is, in fact, the first large-scale exper-
iment of setting up a monetary union among industrialized countries. The
precursor of the European Monetary Union was the European Monetary Sys-
tem (henceforth EMS), of which we shall give an overview in the next section,
before passing on to treat the European Monetary Union.
11.5.1 The European Monetary System

On 13th March 1979 the EEC countries (with the exception of Britain),
in application of the Bremen Agreement of 7th July 1978, gave birth to a
currency area called the European Monetary System (henceforth EMS) based
on a unit of account called the European Currency Unit (ECU; it should be
noted that this acronym considered as a word, is in French the name of an
11.5. The European Monetary Union 169
ancient French coin).

Since the EMS has been superseded by the European Monetary Union,
we shall just give abrief overview, especially to check whether it was an
optimum currency area.
The EMS was based on three elements: the exchange rate mechanism
(ERM), the European Currency Unit (ECU) , the credit mechanisms. As
regards the ERM, the member countries declared their bilateral·parities (giv-
ing rise to a so called "parity grid"), around which the actual exchange rates
could oscillate within predefined margins. These margins were originally
±2.25% (±6% in exceptional cases), and were widened to ±15% from 2 Au-
gust 1993. The first commitment of the ERM was that the participating
countries were obliged to intervene in the foreign exchange market when the
market exchange rate hit one of the fluctuation margins. The second com-
mitment of the ERM required central rates to be modified only by collective
agreement, with no unilateral action on the part of any partner.
As far as the ERM is concerned, the EMS (with reference to the classifi-
cation in Sect. 3.3) belonged to the category of limited-flexibility exchange
systems, and was a combination of the adjustable peg and the wider band,
Le. an adjustable band system.
The EMS was therefore a currency area sui generis, as it officially contem-
plated the possibility of parity changes. However, one of the distinguishlng
features, in the original intentions, was the ECU and its role in the EMS.
The ECU was a basket-currency, that was used (a) as the unit of reference
to define the central rates (parities) of the grid, and (b) as the basis for
defining an "indicator of divergence" , i.e. an indicator of a currency's diver-
gence from its central ECU price, with the proviso that when this indicator
exceeded a certain threshold (the "threshold of divergence"), this resulted in
a presumption that the authorities concerned would correct the situation by
adequate measures (in the form of exchange market interventions or of inter-
nal policy measures). To put it another way, the crossing of the ECU-defined
threshold of divergence was intended as a kind of alarm-bell to warn that a
currency was deviating too much (though not having yet reached the maxi-
mum bilateral margin againSt any other currency), and so it was presumed
that this currency would take corrective action (but it was not obliged to:
the obligation came into force only when a bilateral margin was reached).
The third element of the EMS was a set of measures of monetary coop-
eration and of monetary help to currencies under pressure.
The EMS was subject to several crises, the last of which (August 1993)
compelled the participating countries to widen the margins of oscillation to
±15%. It is obvious that in such a situation to talk of fixed exchange rates
is a sham, because a band of 30% is nearer to flexible exchange rates.
These crises were of the speculative type, as is the rule under any regime
of fixed but adjustable exchange rates (see Chap. 8), and showed the impos-
sibility of maintaining fixed exchange rates among countries with divergent
economic flllldamentals, different monetary policies, and perfect capital mo-

bility. An impossibility known since the Bretton Woods era.
11.5.2 The Maastricht 'freaty and the Gradual

Approach to EMU
The European COllllcil (composed of the Heads of State or Government of
the cOlllltries forming the European Commtmity), held in the Dutch town of
Maastricht on 9-10 December 1991, approved a Treaty containing important
modifications to the Treaty of Rome signed in 1957 (which came into force
in 1958 and gave rise to the European Economic Community). The final
version of the Maastricht Treaty was signed on 7th February 1992 in Maas-
tricht. We have already touched upon the Danish and French referendum
for the approval of this Treaty. Here we shall deal with the main innova-
tions introduced by the Treaty as regards the European Union. The Treaty,
adopting the strategy suggested by areport of the Committee for the Study
of Economic and Monetary Union (commonly known as the Delors Report,
1989), envisaged the movement to EMU in three stages the first of which,
already begun in 1990, was further strengthened in the Treaty, that then
went on to layout the second and third stages in detail.
It is evident that the Maastricht Treaty adopted the gradualist approach
to monetary tmion, as opposed to the so-called "shock therapy" approach,
which consists of the sudden (or at least very quick) introduction of a com-
plete monetary union, i.e., with a common currency.
Let us now consider the various stages in detail.
I) The first stage (1990-1993) consisted of the following main measures:
(I.1) abolition of any restrietion to capital movements, both within the EC
and with respect to third cOlllltries. The latter movements may be subjected
to restrictions but only if they threaten the functioning of the Union, and in
any case cannot be imposed for more than a six-month period.
(1.2) prohibition of financing the public deficit through the central bank.
(1.3) adoption of programmes of long-rllll convergence, in particular as
regards price stability and public finance issues.
(lA) adoption of the narrow band by all cOlllltries; avoidance of frequent
realignments; prohibition of any modification of the composition of the ECU
basket lllltil its transformation in the single European currency.
II) The second stage (1994-6/8) was aimed at securing the convergence of
the economies of the EEC countries and to pave the way for the third stage.
It contemplated the following main measures:
(II.1) control of the public deficit and debt, with the aim of reducing the
former to 3% of GDP and the latter to 60% of GDP.
(II.2) constitution of the European Monetary Institute (EMI), with the
task-amongst others-to coordinate the monetary policies and to pave the
way for the European System of Central Banks (to come into being in the
stage 111). The EMI will dissolve on the starting day of stage three.
(11.3) obligation on the part of the member countries to conform domestic
legislative provisions concerning their central banks to the principles of the
Union.
(11.4) elimination of any automatie solidarity commitment to aid member
countries faced with problems.
111) The third stage was to begin on 1st January 1997 or 1st January 1999
at the latest. More precisely, the proviso was that at the end of 1996 the
European Council would meet and decide whether the majority of member
countries satisfied certain convergence criteria: in the affirmative case, the
third stage would begin on 1st January 1997. In the negative case, the
third stage would be postponed but not later than 1st January 1999, when
it would in any case begin with the participation of those countries that
met the convergence criteria. The other countries would obtain a temporary
derogation and enter when they will satisfy the criteria.
The third stage actually began on 1st January 1999.
Let us now examine the convergence criteria, which are the following:
(a) an inflation rate (as measured by the rate of increase of the consumer
price index) that does not exceed by more than 1.5 percentage points the
rate of inflation of the three best performing countries (i.e., those having the
three lowest inflation rates);
(b) a long-term nominal interest rate (measured on the basis of long-term
government bonds) that does not exceed by more than 2 percentage points
the average of those same three countries;
(c) an exchange rate that has respected the normal fluctuation margins
in the last two years;
(d) a public deficit and debt that satisfy the criteria detailed under ILl
above.
The measures contemplated in the third stage, that gave rise to the Eu-
ropean Union proper, are the following:
(IlI.1) creation of the European System of Central Banks (ESCB), which
consists of the national central banks plus the European Central Bank (ECB).
The ESCB has the task of taking all decisions concerning monetary policy,
including the control of the money supply, with the primary objective of
maintaining price stability and the subordinate (i.e., without prejudice to
the objective of price stability) objective of supporting the general economic
policies in the Union.
(Il1.2) the bilateral exchange rates are irrevocably fixed, as well as those
vis-a-vis the ECU, that will become a currency by full right.
(111.3) the ECU will replace the single national currencies at the earliest
possible date.
(IIl.4) the Community will be entitled to apply appropriate sanctions
against the countries which infringe the EC financial regulations after joining
stage three.
(III.5) the position of those countries that were granted aderogation
(and were therefore temporarily left out of the Union: see above) will be
reconsidered every two years.
These measures were subsequently integrated by
a) the Madrid meeting of the European Council (December 1995), where
it was established that the common European currency should be called euro
rather than ECU, to emphasize that it was a brand new currency and not a
basket currency like the ECU (for further details see below, Sect. 11.5.6);
b) the Dublin summit in December 1996, where the so-called stability and
growth pact was adopted on a proposal of the Commission and the Council
of the economic and financial Ministers of the European Union (Ecofin), that
in turn acted at the behest of Germany. Under this pact the 3% deficitjGDP
ratio is taken as an upper limit, since in normal circumstances the ins (i.e.,
the countries that have been admitted to stage III) should pursue a medium-
term balanced budget or even a surplus. Several institutional mechanisms
are introduced to ensure the respect of the 3% upper limit, in particular the
possibility of Ecofin to issue fines (up to 0.5% of GDP in any one year) to
members that, after having been admitted to the third phase, do not respect
the 3% deficitjGDP ratio. However, in the meeting of 25 November 2003,
Ecofin decided not to issue fines to France and Germany which had exceeded
the 3% limit.
11.5.3 The Institutional Aspects

The ESCB consists of the newly established ECB and the existing national
central banks (NCBs) of the EU. However, the NCBs of the member countries
that do not participate in the euro area are members of the ESCB with a
special status, namely they do not take part in the decision-making regarding
the single monetary policy for the euro area and the implementation of such
decisions.
The ECB is managed by an Executive Board consisting of the President,
the Vice-President, and four more members, and by a Governing Council
consisting of the governors of the central banks of the countries that entered
the third phase plus the six components of the Executive Board. There also
exists a General Council, which comprises the President and Vice-President
of the ECB and the governors of all the NCBs. The components of the
Executive Board are appointed by common accord of the Heads of state
or government for aperiod of eight years and cannot be reappointed. This
relatively long term in office and the non-renewability of the appointment are
directed at insulating monetary policy makers from political pressure. In fact,
the principle of independence of the central bank has been fully accepted:
the ESCB decides in autonomy, namely without either seeking or taking
instructions from national governments or supranational EU authorities. The
Community authorities and the national governments agree to respect this

principle and not to seek to infiuence the members of the decision making
bodies of the ESCB.
The Governing Council's main responsibilities are:
a) to adopt the guidelines and make the decisions necessary to ensure the
performance of the tasks entrusted to the ESCBj
b) to formulate the monetary policy of the Community, including, as ap-
propriate, decisions relating to intermediate monetary objectives, key interest
rates and the supply of reserves in the ESCB, and to establish the necessary
guidelines for their implementation.
The Executive Board has the following main responsibilities:
i) to implement monetary policy in accordance with the guidelines and
decisions laid down by the Governing Council of the ECB and, in doing so,
to give the necessary instructions to the NCBsj
ii) to execute those powers which have been delegated to it by the Gov-
erning Council of the ECB.
The General Council has some minor responsibilities: it contributes to the
collection of statistical information, to the preparation of the ECB's quarterly
and annual reports, to the preparations for irrevocably fixing the exchange
rates of the currencies of the member countries that were granted aderogation
in phase III (see the previous section).
Aß we said, the ESCB is responsible for all monetary policy decisions,
with the primary objective of price stability and the subordinate objective
of giving support to the economic policy of the Union. It also has the task
of carrying out intervention in foreign exchange markets, holding and man-
aging the official international reserves of the member countries, promoting
the orderly functioning of the payment system. Besides, the ESCB shall con-
tribute to the smooth conduct of the prudential supervision activity of the
single national authorities over credit institutions.
Can we say that-once adopted the single European currency-the ESCB
will function like a true central bank of the Union?
The answer to this question requires the examination of the functions of a
central bank. If one believes that, in addition to conducting monetary policy,
a central bank should also have the power of surveillance over the banking
system, then the answer is clearly in the negative. The closest that one finds
in the Treaty is article 105(5): "The ESCB shall contribute to the smooth
conduct of policies pursued by the competent authorities relating to the pru-
dential supervision of credit institutions and the stability of the financial
system". But of course to "contribute" means that the supervisory power
remains with the single national authorities. Actually, under article 105(6) it
is possible to confer upon the ECB specific tasks concerning the prudential
supervision, but only through an unanimous deliberation of the European
Council acting "on a proposal from the Commission and after consulting the
ECB and after receiving the assent of the European Parliament" .
However, prudential supervision and monetary policy do not necessarily

go hand in hand. In fact, a moot question is whether prudential supervision
should be assigned to the same institution (the central bank) that is respon-
sible for monetary policy, or to aseparate agency. One reason for separation
is that price stability might confl.ict with prudential supervision. Price sta-
bility, in fact, might require high interest rates, which might confl.ict with
the wish of keeping interest rates low so as to help banks' debtors in avoid-
ing default (which could weaken the balance sheets of banks). On the other
hand, monetary policy measures would gain additional force if the central
bank can influence bank policy through regulatory pressure. In practice, in
a sampie of 167 countries, bank supervision is conducted by the central bank
in over 60%; however, in the Western hemisphere the percentage is only 50%
(Tuya and Zamalloa, 1994; Prati and Schinasi, 1999).
Whichever solution is adopted, centralized prudential supervision in a
monetary union with complete financial integration appears necessary, as it
will be impossible to contain possible banking and financial crises within na-
tional boundaries. The ECB does not possess this power, and an EC agency
endowed with the prudential supervision power has not been contemplated
in the Treaty, with the result that the Union has a single currency and a
centralized monetary policy, but no centralized prudential supervision. The
lack of a centralized agency possessing powers of surveillance and banking
regulation might be a problem.
11.5.3.1 The ECB's Monetary Policy

The Treaty establishing the European Community (Art. 105(1), Art. 2, 3a)
also states that the primary objective of the European System of Central
Banks (ESCB) is the maintenance of price stability over the medium run.
In order to comply with this mandate, the Treaty provides the ESCB with
a significant degree of institutional independence, though supplemented by
the commitment to transparency and accountability. The institutional inde-
pendence is crucial for maintaining price stabilityn, as it removes the sources
of political pressures, with a positive impact on the credibility of monetary
policy. It is indeed well documented that central banks lacking indepen-
dence are potentially subject to short-term pressures, that may inhibit the
maintenance of price stability.
The Eurosystem (like any other central bank), while pursuing its pri-
mary objective, cannot directly control the price level by the means of avail-
able monetary policy instruments. Central banks face a complex transmis-
sion mechanism from monetary policy decisions to price level changes. This
mechanism is characterized by the occurrence of various channels of trans-
mission that may show long, variable and not completely predictable lags.
The transmission mechanism may also vary according to changes in economic
behaviour and institutional structure. Hence, the role of the monetary pol-
icy strategy in preparing and discussing monetary policy decisions is crucial.

First, on the basis of the information and analysis provided by the strategy,
the Governing Council takes monetary policy decisions in an effective man-
ner. Second, the monetary policy strategy is also at the basis of the ECB's
communication strategy with the public. Monetary policy, in fact, is effective
when it is credible, i.e. when the public is confident on the commitment to
the objective of price stability.
In October and December 1998, the Governing Council announced the
Eurosystem's monetary policy strategy. The main characteristics of the strat-
egy have been presented on October 13th 1998, and subsequently clarified
in statements and speeches by the President and other member of the Gov-
erning Council. The Eurosystem's stability-oriented strategy is composed by
three main elements: a quantitative definition of the primary objective, Le.
price stability, and "two pillars", which are:
1. a primary role for money, as signalled by the announcement of a
quantitative reference value for the growth of a broad monetary aggregate,
and
2. a broad evaluation of future price development in the euro area and of
risks to price stability.
As to the primary objective, the ECB Governing Council has defined price
stability as a yearly change of the HICP (the euro area harmonized index
of consumer prices) below 2%. According to the ECB's strategy, therefore,
inflation is ultimately viewed as a monetary phenomenon. With the aim of
signalling the primary role of money, the Governing Council has announced
a quantitative reference value for money growth (under the first pillar of the
strategy) under the assumption that the given monetary aggregate, e.g. M3,
has a stable relationship with the price level in the euro area. The reference
value of M3 has been set to a yearly growth rate of 4.5%. In parallel with the
analysis of money growth, a broad evaluation of future price developments
and risks to price stability in the euro area also plays a crucial role, under
the second pillar of the strategy. The latter analysis is carried out through a
wide set of economic leading indicators and macroeconomic projections. Both
projections and the analysis of indicators provide the Governing Council with
the information on the economic outlook and potential risks on the basis of
which implementing monetary policy decisions.
11.5.4 The Maastricht Criteria

The aim of these criteria was clearly to prevent the destabilisation of the
Union by the premature admission of countries whose economic fundamen-
tals are not compatible with a permanently fixed exchange rate. Each of
these criteria can be (and has been) criticized on economic grounds; there
is particularly severe criticism on the criteria concerning public deficit and
debt, and it has even be said that "The two numerical fiscal criteria of the
Maastricht treaty make no sense and should be jettisoned" (Buiter, 1997,

page 24). However, they have been further emphasized by the EU institu-
tions through the stability and growth pact (see above).
Thus there seems to be a contrast between economists and politicians.
However, before conduding that politicians ignore (as they often do) the
suggestions of economic theory, a doser look at the Maastricht criteria has
to be taken, to determine whether they are at least qualitatively consistent
with economic theory.
Let us begin with the inflation criterion (inflation rate not higher than
the inflation rate of the three most virtuous countries plus 1.5 percentage
points). Now, from Chap. 6 we know that terms-of-trade modifications
due to inflation differentials are a cause of trade-balance disequilibria; fur-
thermore, taking PPP as valid in the long run, stability of exchange rates
requires identical inflation rates (see Chap. 9). Similarity in inflation rates is
a very reasonable criterion contemplated in the traditional theory of optimum
currencyareas (see Sect. 11.2.1).
The interest-rate criterion (long-run interest rate not exceeding that of the
three most virtuous countries plus 2 percentage points) is also obvious if one
recalls that under perfect capital mobility and permanently fixed exchange
rates (more so under a common currency) UIP must hold, hence i h = if +6,
where 6 is a possible risk premium (see Sect. 4.3). The two percentage points
should account for possible risk premia among government bonds issued in
different countries of the European Union.
The deficit and debt criteria are not to be seen independently, as they are
related by simple mathematical relations. Let g, Ng, Y respectively denote
the budget deficit, the stock of public debt, and GDP, all in nominal terms.
We now seek the conditions under which the debt to GDP ratio (Ng /Y)
is non-increasing (sometimes called the "sustainability" condition of public
finance). Since a fraction remains constant (decreases) when the numerator
changes in the same proportion as (proportionally less than) the denomina-
tor, it follows that b. (Ng /Y) ~ 0 is equivalent to
b.Ng b.Y
-Ng- < -
- Y'
hence multiplying through by Ng /Y,
b.Ng b.Y Ng
-Y- <
- Y- -
y·
If we remember that 9 = b.Ng due to the prohibition of financing the public

deficit by issuing money, we finally have
9 b.Y Ng
-
Y <
- Y- -
y· (11.6)
This inequality determines a zone of sustainability, whose boundary (constant

debtjGDP ratio) is defined by
!!...= ~Yb (11. 7)
Y Y'
where b is the constant value of N9 jy.
There are two ways of looking at these relations, one concerning positive
economics, the other one normative economics. The former takes actual
figures, and checks where the economy is situated. For example, in Italy
in 1997 the data were N9jY = 121.6%,~YjY = 4.1%,gjY = 2.7%, hence
this country was weil within the sustainability zone, since 2.7% is lower than
121.6% x 4.1% = 4.98%. This meant that the actual debt to GDP ratio was
decreasing.
The second way fixes some numbers as normative values, which is the
line foilowed in the Maastricht treaty, but of course these numbers should be
mutually consistent according to relations (11.6) and (11.7), as an increasing
debt-to-GDP ratio is ruled out. Using (11.7) it is easy to see that gjY = 3%,
N9 jY = 60%, and ~YjY = 5% constitute a triplet of mutually consistent
values on the boundary. But there is an infinite number of such triplets, hence
we may wonder whether the numbers chosen have an economic rationale or
come out of the blue sky (in this latter case we should agree that the two
fiscal criteria make no economic sense).
Let us begin with the rate of growth of nominal GDP, ~YjY, that can
be decomposed into
~Y ~p ~y
-
Y-- -p+ -
y , (11.8)
where ~pjp is the inflation rate and ~yjy is the rate of growth ofreal GDP.
In a target-instrument policy framework, it is perfectly reasonable that
policy makers assign "desired" values to real growth and inflation. For ex-
ample 3% and 2% respectively, are plausible desired values, whence ~YjY =
5%.
As regards b, oral tradition says that b = 60% simply came out of the fact
that 60% happened to be the EEC average when the Maastricht treaty was
drafted. Given these values of b and ~YjY, the value of gjY = 3% foilowed.
Another oral tradition says that a public deficit was to be allowed only for
public investment expenditures, whose value could be taken as 3% of GDP,
hence gjY = 3%. Given ~YjY = 5%, the value of b = 60% followed.
We can however argue in favour of a less casual explanation. We know
that equilibrium on the real market consistent with current-account equilib-
rium requires
g+ (1 - 8) = 0, (11.9)
which follows from Chap. 5, Sect. 5.3, letting CA = o. Thus we have
9 8-1
Y = y-, (11.10)
namely the deficit/GDP ratio consistent with current-account equilibrium

should equal the ratio of the excess of private saving over private investment
to GDP.
Now, in mature industrialized economies the (8 - I)/Y ratio is becoming
very low (in the United States, for example, it is around zero), and in several
European countries it has a similarly downward trend. In EU-15 this ratio
was around 3-4% on average in 1991-1992. Hence g/Y = 3% was a perfectly
reasonable value for European countries, from which b = 60% follows given
the inflation and real-growth targets.
Up to now we have dealt with gas a whole, but we know that the budget
deficit can be decomposed into interest payments on the public debt and the
rest, which is called the primary deficit. Thus we have
9 = iN9 + gp, (11.11)
where i is the nominal interest rate and gp the primary deficit (let us re-
member that according to our convention, a negative value of gp means a
primary surplus). Substitution of (11.11) into (11.6) yields
gp <
Y-
(ßY
Y
_.)• N9y· (11.12)
Using (11.8) and the definition ofreal interest rate iR = i-b.p/p, Eq. (11.12)
can be rewritten as
(11.13)
Equation (11.12) shows that sustainability requires a primary surplus as long

as the rate of growth of nominal GDP is smaller than the nominal interest
rate, while Eq. (11.13) states the same result in terms of real rates. Only
when the nominal (real) rate of growth is higher than the nominal (real)
interest rate would sustainability allow a primary deficit.
We have seen above, Sect. 11.3, that a eommon monetary poliey is es-
sential for the viability of a monetary union. This has been achieved by
transferring the conduct of monetary policy in the hand of the ESCB and by
forbidding monetary financing of the public deficit. The two fiseal criteria
are an attempt to impart a minimum common amount of fiseal discipline.
11.5.5 The new Theory of Optimum Currency Areas

and EMU
There is an ongoing debate on whether the European Monetary Union is an
optimum eurreney area. Many authors share the opinion of M. Feldstein that
"a European monetary union would be an economic liability", "the eeonomie
eonsequences of EMU, if it does come to pass, are likely to be negative"
(Feldstein, 1997, p. 32 and 41). This opinion is based on the observation
that the basic criteria for an optimum currency area, in particular high factor
mobility and high flexibility of wages and prices (see Sect. 11.2.1) are not
satisfied.
This is undoubtedly true, but these criteria should be seen in the context
of the degree of similarity in economic structure. In general, given that
each member of a single-currency area cannot use the exchange-rate tool
to cope with asymmetrie shocks, the main possibilities are migration from
low to high growth countries, wage flexibility, unilateral transfers from high
to low income countries. None of these seems to exist in EMU. However,
it should be pointed out that predominantly asymmetrie shocks do require
high factor mobility and high pricejwage flexibility for being absorbed in
areas with pronouneed regional disparities (such as the United States). These
requirements are however much less important when similarity in eeonomie
strueture reduees the likelihood of asymmetrie shoeks.
In effect, the analysis of the consequences of exogenous disturbances on
the participating countries is one of the main areas of research in the so-called
"new" theory of optimum currency areas (see Sect. 11.2.3, and Tavlas, 1993).
Unfortunately in the context of cost-benefit analysis it becomes diflicult to
make definitive statements, and we fully agree with Wyplosz when he writes
"Assessing the costs and benefits of a monetary union quantitatively is both
frustrating and useless. It is frustrating because, frankly, as economists we
are unable to compute them with any precision, and we owe it to the pro-
fession to admit so in public. Our understanding of monetary and exchange
rate policy is regrettably limited, and the lack of a precedent leaves us with
more conjectures than certainties. Moreover, quantitative estimates are use-
less unless they are sized up against the costs and benefits of the relevant
alternatives, which is equally beyond our current ability. The best that can
be done in this situation is to gain an understanding of where the costs and
benefits are likely to reside" (Wyplosz, 1997, pp. 18-19).
In this respect, it is interesting to point out a usually neglected cost-
benefit, due to the distribution of seignorage in EMU. As noted by Sinn and
Feist (1997, p. 666), some countries joining the EMU "will win more than
others, because they will receive a better currency than the one they lose. A
good currency is highly demanded as a medium of transactions and a store
of value and its wide usage creates a substantial seignorage wealth for the
issuing country. With the introduction of the euro, national currencies will
disappear and seignorage wealth will be socialized". Some countries stand to
gain, others to lose, depending on different scenarios as regards membership
in the euro.
The European Commission's study (1990) diseusses at some length the
advantages of EMU: macroeconomic stability, price stability (both low in-
flation and low variability), reduction in transactions costs, elimination of
currency risk. According to the Commission the direct costs of foreign trans-
actions in the EU were estimated at between one half and one percent of its
gross domestie produet.

Another effect of EMU is that, by reducing the eosts of international
transaetions, it inereases trade and openness. Rose (2000) has used a large
eross-eountry panel data set to show that countries with the same eurreney,
trade over three times more with one another than countries with their own
eurreneies. An inerease in trade eould not only inerease the benefits of a
eurreney union, but also reduee its eosts. Rose argued that, historieally,
eloser international trade among countries has been assoeiated with more
synehronized business eyeles, which reduee the effect of asymmetrie shoeks.
The inerease in trade stemming from a eommon eurreney is one gain from
EMU. Moreover, Frankel and Rose (2002) show that the trade indueed by
a eurreney union has a benefieial effect on ineome. In their empirie al paper
they investigate two relationships: the effeets that a eurreney union has on
trade among its eonstituent units and the effeet that in turn trade has on
output. Then they eombine these results and estimate the eonsequenees
that a eurreney union has on the long-run level and rate of growth of real
ineome. By using a large data set they find evidenee that a eurreney union
boosts a eountry's total trade and that every one percent inerease in total
trade (relative to GDP) raises ineome per eapita by at least one third over a
twenty-year period. While a number of subsequent papers have questioned
the results, in partieular the magnitude of the effect, there is little doubt that
trade flows tend to be higher for countries in a eurreney union (for a review
of the literature see Rose, 2002).
There are recent studies that show the effect of the eommon eurreney on
priee eonvergenee in the EU. Rogers et al. (2001), Parsley and Wei (2001),
for example, report a reduetion in priee dispersion due to the introduetion
of the euro for the EMU countries.
Finally, we would like to point out the important distinetion between
ex ante and ex post evaluations, a distinction widely used in the field of
eommereial integration but usually overlooked in the evaluation of monetary
integration (an exeeption is llieci, 1995). The degree of trade integration and
the symmetry in business eycles eannot be eonsidered separately, sinee both
eriteria are inter-related and endogenous to the proeess of monetary integra-
tion. This means that entry in EMU, possibly motivated by non-economie
reasons, may give ex post results quite different from ex ante evaluations.
That is, a eountry may be more likely to satisfy the eriteria for entry in a
eurreney union ex post than ex ante! (llieci, 1995; Frankel and Rose, 1997).
11.5.6 The Euro and the Dollar

Aeeording to the Maastricht treaty the ECU was to become the (future)
single European eurreney. In the Madrid meeting of the European Couneil
(Deeember 1995) it was decided that the future European single eurrency
should be ealled euro instead ofthe generie term ECU, that from 1st January
1999 the official ECU basket would cease to exist, and the euro would become
a non-circulating currency in its own right, that it would begin to circulate
together with national currencies as legal tender from 1st January 2002,
totally replacing national currencies from 1st July 2002 at the latest. In the
case of contracts denominated in ECUs substitution by the euro has been at
the rate one to one.
At the Dublin Summit (December 1996) the Heads of State or Govern-
ment ascertained that the Maastricht criteria were not satisfied by a majority
of the fifteen Member States, hence the third step (see Sect. 11.5.2) could
not begin on 1st January 1997.
On 1st May 1998 the Council of the economic and financial Ministers of
the European Union (Ecofin) reviewed the situation of the member states as
regards the Maastricht criteria and identified the member states that satis-
fied the conditions for the introduction of the euro; these countries (called
the "participating countries" ) were, so to speak, the "founding members" of
the euro. On 2nd May the recommendation of Ecofin was ratified by the
Council of the Heads of State and Government of the EU and by the Euro-
pean Parliament. The eleven founding members turned out to be Belgium,
Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Aus-
tria, Portugal and Finland (on 1st January 2001 Greece has been admitted).
It is important to note that, as regards the two fiscal criteria, the one con-
cerning the deficitjGDP ratio was applied strictly, while the criterion of the
debtjGDP ratio was interpreted "dynamically", in the sense that a country
to qualify should have shown a consistently decreasing trend towards the
60% reference value, even if the current debtjGDP ratio was actually higher
(this was the case, for example, of Italy, where in the last few years this ratio
had been on the decrease, but in 1997 was still 121.6%).
On 3rd May 1998 Ecofin also established the fixed bilateral exchange
rates among the participating countries, valid in the transitional period May-
December 1998, when the euro did not yet exist. This gave rise to some fears
concerning possible destabilising speculation before the conversion rates of
the various currencies into the euro after this transitional period were estab-
lished, or possible withdrawals by prospective EMU members, but nothing
happened.
At the moment the main international currency remains the dollar, but
the importance of the euro is on the increase. According to some writers
it is possible that in about ten years the dollar and the euro will be con-
sidered equally important. If so, the countries in the rest of the world will
presumably wish to include in their international reserves an equal amount
of dollars and euros. Since the current composition of international reserves
sees the predominance of the dollar, there will probably be an increase in the
demand for euros on the part of the rest-of-the-world countries. To satisfy
this increased demand deficits in the EU balance of payments will be called
for.
BOX 11.1 The international role of the euro

The study of the European Central Bank (ECB, 2003) has shown that as an in-
ternational currency the euro ranks second behind the US dollar and ahead of the
J apanese yen. Moreover, the international role of the euro continues to grow both in
global financial markets and in international trade but its use, at least so far, remains
broadly unchanged in third countries' exchange rate policies. In addition, central
banks have not moved into euros in their holdings of foreign exchange reserves. Two
features of the development of the euro's international role are highlighted by the
ECB's report: a) the international role of the euro has a strong regional focus as
its use is most prominent in countries neighbouring the euro area, and b) the euro's
international role is to an important extent driven by the euro area itself.
What explains the persistence of the dollar as international money?
A currency such as the dollar has a long history as an international currency and
so benefits from a strong inertia: the well-established transactional networks exter-
nalities which generate a stickiness in use preferences. Theory tell us that the use
of a currency as a vehicle will lead to "thick" externalities, Le., the more widely
the currency is used for trade and invoicing, the longer will it continue to be used.
In addition, there are economies of scale: unit transaction costs are lower for huge
volumes.
A number of studies point to a significant potential global role for the euro (MeKin-
non, 2002; Kenen, 2002). Within a time span that it is difficult to specify, European
economic and monetary unification is expected to produce a euro capable to chal-
lenge the role of the dollar as the dominant international means of payment, unit
of account and store of value. However, the historical experience of international
currencies suggests that this possible outcome is rather a long term issue.
The euro has the potential to share the international role with the dollar because the
euro area: a) is about as large an economic and trading unit as the United States;
b) has a large, well-developed and growing financial market, which is free of con-
trols and as euro financial markets become further integrated they will also become
more liquid and deep, transactions costs will fall and euro assets will therefore be
more attractive to external investors; and c) is expected to deliver a good inflation
performance that will keep the value of the currency stable.
It is important to note that the ECB has adopted a neutral stance concerning the
international role of the euro, implying that the ECB neither fosters nor hinders the
process: the decisions of market agents will determine the international role of the
euro.
In addition to the future role of the euro as an international currency,
a problem that has attracted attention is the behaviour of the euro vis-a-
vis the dollar and, in particular, the euro/dollar exchange-rate variability.
The question is: will the euro/dollar exchange rate be more or less vari-
able than a pre-euro comparator basket of the eurrencies of the participating
eountries? Aecording to some authors, the ereation of the euro will lead the
participating eountries to attach a lower weight toexehange-rate stability in
their poliey reaction funetions, a kind of "benign negleet" such as the one
attributed to the US authorities as regards the dollar during the Bretton
Woods era, and hence to eliminate or reduce one of the EU's main interests
in international cooperation in managing exchange rates (on international
poliey eooperation see Sect. 12.2). In an optimizing framework it ean in
fact be shown that a lower weight attached to exchange-rate variability will
result in less intervention to manage the exchange rate and henee in higher
exchange-rate variability.
The final problem remains of how to determine the dollar/euro (real)
equilibrium exchange rate. In fact, expressions like "the dollar is weak",
"the euro is strong", or "the euro is over/under-valued" are meaningless
without a benchmark. A reliable theoretical framework for the calculation of
a fundamental equilibrium exchange rate is of invaluable importance for the
EU, not only as regards monetary matters (which are delegated to the ECB),
but also as regards real matters such as trade and growth, which are the main
responsibility of the Council, which may formulate general orientations for
exchange rate policy (article 109(2) of the Maastricht Treaty on European
Union). Trade and growth are clearly related to the EU's welfare.
There is no reason to believe that the exchange rate theories examined
in Chap. 9 would perform better with the dollar/euro exchange rate than
with the dollar/Single currencies. A better research program might be to
concentrate on the real exchange rate in the context of the intertemporal
approach according to the NATREX model (see Chap. 10, Sect. 10.3).

Buiter, W.B., 1997, The Economic Case for Monetary Union in the European
Union, in C. Deissenberg, R.F. Owen and D. Ulph (eds.), European
Economic Integration, special supplement to Review 0/ International
Economics 5, issue 4, 10-35.
Corden, W.M., 1972, Monetary Integration, Essays in International Finance
No. 93, International Finance Section, Princeton University.
De Grauwe, P., 2003, Economics 0/ Monetary Union, 5th edition, Oxford:
Oxford University Press.
Delors Report, 1989, Report on Economic and Monetary Union in the Euro-
pean Community, Brussels: Commission of the European Communities,
12 April.
European Commission, 1990, One Market, One Money: An Evaluation ofthe
Potential Benefits and Costs of Forming an Economic and Monetary
Union, European Economy No. 44, October.
European Central Bank, 2003, Review 0/ the International Role 0/ the Euro,
December.
Feldstein, M., 1997, The Political Economy of the European Economic and
Monetary Union: Political Sources of an Economic Liability, Journal
0/ Economic Perspectives 11,23-42.
Frankei, J.A. and A.K. Rose, 1997, Is EMU More Justifiable Ex Post than
Ex Ante?, European Economic Review 41, 753-60.
Frankei, J. and A. Rose, 2002, An Estimate of the EfIect of Common Cur-
rencies on Trade and Income, Quarterly Journal 0/ Economics 117,
437-66.
Kenen, P. B., 2002, The Euro Versus the Dollar: Will There Be a Struggle
for Dominanee?, Journal of Policy Modeling 24,347-354.
MeKinnon, R, 2002, The Euro Versus the Dollar: Resolving a Historical
Puzzle, Journal of Policy Modeling 24, 355-359.
Mundell, RA., 1961, A Theory of Optimum Currency Areas, American Eco-
nomic Review 51, 509-17.
Mundell, RA., 1973, Uneommon Arguments for Common Currendes, in H.J.
Johnson and A.K. Swoboda (eds.), The Economics of Common Cur-
rencies: Proceedings of the Madrid Conference on Optimum Currency
Areas, London: Allen&Unwin.
Mundell, RA., 1998, What the Euro Means for the Dollar and the Interna-
tional Monetary System, Atlantic Economic Journal 26, 227-37.
Parsley, D. and S. Wei, 2001, Limiting Currency Volatility to Stimulate Goods
Market Integration: A Price Based Approach, NBER WP No. 8468.
Prati, A. and G.J. Schinasi, 1999, Financial Stability in European Economic
and Monetary Union, Princeton Studies in International Finance No.
86, International Finance Section, Princeton University.
Ried, L., 1995, Exchange Rate Regimes and Location, International Eco-
nomics Working Papers No. 291, University of Konstanz (SFB178),
December; revised version circulated as International Monetary FUnd
Working Paper No. 97/69, June 1997.
Rogers, J. et al., 2001, Price Level Convergence and Inflation in Europe,
W.P. 01-1, Institute for International Economics (Washington DC).
Rose, A., 2000, One Money, One Market: The Effect of Common Currendes
on TI:ade, Economic Policy 30, 7-45.
Rose, A., 2002, The Effect of Common Currencies on International Trade:
A Meta-Analysis, mimeo.
Sinn, H.-W. and H. Feist, 1997, Eurowinners and Eurolosers: The Distri-
bution of Seignorage Wealth in EMU, European Journal of Political
Economy 13, 665-89.
Tavlas, G.S., 1993, The 'New' Theory of Optimum Currency Areas, World
Economy 16, 663-85.
Thya, J. and L. Zamalloa, 1994, Issues on Placing Bank Supervision in the
Central Bank, in T. Balino and C. Cottarelli (eds.), Frameworks for
Monetary Stability, Washington (DC): IMF.
Werner Report, 1970, Report to the Council and the Commission regard-
ing the Step-by-Step Establishment of the Community's Economic and
Monetary Union, Brussels: Commission of the European Communities,
80ctober.
Wyplosz, C., 1997, EMU: Why and How it Might Happen, Journal of Eco-
nomic Perspectives 11, 3-22.
Chapter 12
Problems of the International

Monetary System
12.1 Introduction
In this final chapter of Part II we examine some current problems of the
international monetary system. Any choice is inevitably arbitrary, and what
is a problem today might cease to be such tomorrow. However, the problems
that we are going to consider are likely to present a theoretical interest to
students of international finance and open-economy macroeconomics also in
the future. In any case we owe an explanation for the omission of the standard
topic called "plans for reform of the international monetary system". We
have already mentioned the current international monetary ''non system"
(see Chap. 3, Sect. 3.4). Proposals for the creation of a new international
monetary system have been made from time to time, but the amount of
international agreement that this creation would require (see the section on
international policy cooperation, below) makes it unlikely. Hence we prefer to
concentrate on a much more modest but viable alternative, the international
management of exchange rates.
Thus the topics we are going to deal with are:
1) international policy coordination;
2) the debt problem;
3) the Asian and other currency crises;
4) the management of exchange rates.
The third problem has already been examined elsewhere (see Sect. 8.3).
When dealing with the second problem we shall integrate our treatment with
the exposition of the basic model that the IMF and the World Bank had in
mind when dealing with crises: the so-called growth-oriented adjustment
programs.
185
186 Chapter 12. Problems of the International Monetary System
Table 12.1: Payoff matrix of the international policy game

Europe USA
Contraction Expansion
Contraction Recession in both countries; No employment change;

B=O B favourable to Europe
Expansion No employment change; Boom in both countries;

B favourable to US B=O
12.2 International Policy Coordination

12.2.1 Policy Optimization, Game Theory, and
International Coordination
The international policy coordination problem arises from the observation
that-as a consequence of the ever increasing economic interdependence of
the various countries-the economic policies of a country influence (and are
influenced by) the economic situation and the economic policy stance in
other countries. Hence if all countries pursue totally independent policies,
undesirable outcomes may result for the world as a whole.
From the terminological point of view, "coordination" and "cooperation"
are usually considered as synonyms. Some authors, however, take coordina-
tion as implying a significant modification of domestic policies in recognition
of international interdependence, namely as something more than coopera-
tion (which in turn is something more than simple "consultation"). We shall
use cooperation and co ordination interchangeably.
As any case of strategic interdependence, international cooperation can
be interpreted in terms of game theory. The players are the governments
of the various countries, that adopt various 'strategies' (the policy actions)
to pursue their objectives (employment, balance of payments, etc.). Each
combination of strategies will give rise to a precise result in terms of each
country's objectives. Table 12.1 illustrates the simple case of two countries
(United States and Europe), two targets (employment and current account
balance) and two strategies (expansionary and restrictive economic policy)
under fixed exchange rates.
If both countries expand, both will be better off in terms of employment
and there will also be current account balance. If both adopt a contractionary
policy, both will suffer a recession though reaching current account balance.
If one expands and the other contracts, there will be no employment change
in either country, but the expanding country will suffer a deterioration in
12.2. International Policy Coordination 187
the current account (the current account of the contracting country will of
course improve). In terms of game theory we are in the so-called 'prisoner's
dilemma' situation!. If one country expands and the other does not, the
latter will gain (in terms of current account balance) at the expense of the
former. Without coordination, it is impossible to reach the optimal situation
in which both countries expand.
In reality no economic policy consists of two alternatives only (expan-
sion/ contraction in our example), but can vary in more or less continuous
manner from restriction to expansion. Furthermore, even a partial fulfilment
of a target (maybe at the expense of another target) has a value. This means
that the government of a country does not carry out its economic policy in
a fixed-target context (in our example this would be a given level of employ-
ment and equilibrium in the current account balance), but in a flexible-target
context. The flexible-target approach means that there is a trade-off among
the various targets, in the sense that a higher fulfilment of a target can com-
pensate for a lower fulfilment of another, given a social welfare function. The
policy maker aims at maximizing the social welfare function, which depends
on the degree of fulfilment of the objectives, given the constraints (repre-
sented by the economic system and the other countries' actions). This more
general framework can be represented by a diagram due to Hamada.
If we assurne that the policy configuration of each country can be rep-
resented by a synthetic and continuous variable, we can show the policy
configurations of the two countries on the axes of a diagram like Fig. 12.1.
The policy configuration of country 1 is shown on the horizontal axis, while
the policy configuration of country 2 is shown on the vertical axis. A point
in the diagram thus represents a combination of the two countries policy
IThe prisoner's dilemma was originally formulated by mathematician Albert W. Thcker

and is by now a classic in game theory. The standard illustration of this game is the
following. Two persons are caught with stolen goods, that the police suspects coming
from burglary. However, there is not sufficient evidence to convict them of that crime,
unless one or both confess. They could in any case be convicted of possession of stolen
goods, a minor crime.
The two prisoners are not allowed to communicate, and the following deal is illustrated to
each of them separately. If both confess, they will be convicted of burglary and sentenced
to two years of jai!. If neither confesses, they will be convicted of possession of stolen
goods and sentenced to sixth months. If only one confesses, he will be set free without any
punishment, while the other will be convicted of burglary and get a five-years sentence.
The best strategy for each prisoner, according to the minimax principle (minimization of
the maximum loss), is to confess: the worst that dm happen to hirn, in fact, is a two-year
sentence, while not confessing the worst that can happen is a five-year sentence. Hence
both confess and get a two-year sentence.
If the two prisoners could have cooperated, agreeing on not confessing, they would have
got only a sixth-month sentence, a much better outcome: the cooperative solution is clearly
better. However, in this case cooperation is prevented by the separate imprisonmentj we
shall see in the text (Sect. 12.2.2) which are the obstacles to coordination in the field of
economics.
Country2
p,t:
2
p'
2
P' p,E Country 1

1 1
Figure 12.1: The Hamada diagram
configurations, which will give rise to a well-defined result in terms of the

two countries targets. This result will of course depend on the underly-
ing model representing international interdependence, on which more below
(Sect. 12.2.2). The welfare level corresponding to the result will depend
on each country's social welfare function. Such a function has a maximum
corresponding to the best possible result for the country concerned (the bliss
point). Let us assume that El, E 2 , are the points which give rise to the max-
imum welfare for country 1 and country 2 respectively. We can then draw
around these points the welfare indifference curves of the two countries. A
welfare indifference curve of a country is the locus of all points (combinations
of the two countries' policy configurations) that give rise to results (in terms
of the country's targets) which are considered equivalent by the country un-
der consideration. Let us consider country 1: since we have assumed that
the bliss point corresponds to Ei, any other point in the diagram represents
a lower welfare. The closer the indifference curve is to point Ei, the better
off country 1 is: any policy combination that puts it on indifference curve
U~' is preferred to any policy combination that puts it on U~. The welfare
indifference curves are closed curves around the bliss point, but for graphical
simplicity we have drawn them only partly. In a similar way we can draw
country 2's welfare indifference curves around point E 2 • Let us note in pass-
ing that in the special case of no interdependence (total independence) the
indifference curves of country 1 would be vertical straight lines and those of
country 2 horizontal straight lines. In this case each country could achieve
12.2. International Poliey Coordination 189
its optimal welfare independently of the policy pursued by the other coun-
try. Hence the case for coordination is based on the presence of international
interdependence.
In the case of interdependence, the first step of the constrained-optimum
problem that each country has to solve is to determine its welfare-maximizing
policy configuration for any given policy configuration of the other country.
Let us consider, for example, country 1, and let us assume that country 2
adopts the policy configuration represented by point p~. If we draw from
this point a straight line parallel to country l's axis, we see that the highest
indifference curve that country 1 can reach is U~, tangent to the aforesaid
straight line. U~, in fact, is the indifference curve nearest to Ei compatibly
with the given policy choice of country 2 (the constraint). Hence, given p~,
the optimal choice for country 1 is policy p{E. Going on in like manner,
we obtain a set of points that give rise to the RiRi curve, called the policy
reaction junction of country 1 (for graphical simplicity we have drawn it
linear).
In a similar way we obtain country 2's policy reaction curve. Given for
example country 1's policy configuration P{, the indifference curve of country
2 which is nearest to the bliss point E 2 is the curve tangent to the straight
line originating from P{ and parallel to country 2's axis.
In the diagram we also have drawn a segment joining the two ideal points
Ei, E 2 , which is the locus of all points where the two countries' indifference
curves are tangential to one another. This locus is a Pareto-optimal or con-
tract curve, since in each of these points the property holds that it is not
possible to increase the welfare of one country without decreasing the other
country's welfare.
We can now use the Hamada diagram to illustrate what happens without
coordination, and the advantages of coordination. In Fig. 12.2 we have
drawn the two policy reaction curves obtained as explained above, and we
now want to know what will be the behaviour of the two countries.
Let us begin by considering a non-co operative behaviour, that can take
on various forms. The most commonly used are the Cournot-Nash and Stack-
elberg scenarios.
In the former, each country maximizes its welfare by choosing its own
optimal policy taking as given the policy configuration of the other country,
on the assumption that this configuration is beyond its influence. Given for
example country l's policy p?, country 2 will choose P~ on its own reaction
function. In its turn country 1, taking as given country 2's P~, will change
its policy to P{ on its own reaction curve; country 2 will then react to P{ by
changing its policy to P~ and so forth, until point N is reached. This is the
Ur
ur
Cournot-Nash equilibrium, where the welfare achieved is for country 1
and for country 2.
The Stackelberg or leader-follower solution is obtained when one country
(for example, country 2) is dominant (the leader) and takes account of the
Country 2
P'2
pO
2
pO P'I Country 1
I
Figure 12.2: The international policy game: Cournot-Nash, Stackelberg, and

cooperative solution
fact that its actions infiuence the other country's decisions, while the follower
country behaves like in the previous case. The leader knows the reaction
curve of the follower and hence country 2 knows that country 1 will react to
the leader's policy choices by choosing a policy along the R1R1 curve. Thus
country 2 maximizes its welfare function taking account of this curve as a
constraint. This means that country 2 will choose the highest indifference
curve compatible with the constraint. This curve is ul which is tangential to
R1R1 at point S. In fact, ul is country 2's indifference curve that is nearest
to E 2 compatibly with R1R1.
It can be seen that in the Stackelberg equilibrium point S, country 2 (the
leader) obtains a welfare level clearly higher than in the Cournot-Nash equi-
librium, while the follower may or may not be better off. Both equilibria are
however inefficient, since they do not lie on the contract curve E 1E 2 • Both
countries could be better off if they agreed to cooperate: if they coordinate
their policies they can reach a point on the segment at of the contract curve.
Any such point is clearly superior to both the Cournot-Nash and the Stack-
elberg equilibrium. The precise point where the two countries will end up
will of course depend on the relative bargaining power.
12.2. International Policy Coordination 191
12.2.2 The Problem of the Reference Model and the

Obstacles to Coordination
If coordination is favourable to all , why is it not universally adopted, and
why many talk of obstacles to co ordination? Let us first note that forms of
''weak'' international co operation (or "consultation", according to the ter-
minology introduced in Sect. 12.2.1) are very frequent. All countries hold
routine consultations in the context of various international economic or-
ganizations such as the IMF. The industrialised countries routinely consult
with one another in the context of the OECDj the seven and the five most
industrialised countries hold the G7 and G5 summits respectively, and there
are several other subsets of countries holding routine consultations. But here
we are dealing with policy coordination proper, and we focus on economic
rather than political obstacles.
The first and foremost impediment can be illustrated by an illuminating
analogy due to Cooper (1989). It took over seventy years (from 1834 to
1907)-he observes-for the various countries to reach an agreement on the
best way to prevent the spread of virulent diseases such as cholera. The rea-
son is that in the 19th century there were two completely different theories or
models on the transmission of such diseases: the "miasmatic" and the "con-
tagionist". Miasmatists held that infectious diseases were not transmitted
by diseased persons but originated in environment al "miasms". Contagion-
ists supported the view that such diseases were transmitted by contact with
diseased persons. Now, "epidemiology in the nineteenth century was much
like economics in the twentieth century: a subject of intense public interest
and concern, in which theories abounded but where the scope for controlled
experiment was limited" (Cooper). Hence both views had the support of the
scientific community. It is clear that the age-old technique of quarantining
ships infected (or suspected of being infected) was a decisive measure accord-
ing to the contagionist theory, but a pointless measure for the miasmatists.
Quarantine represented a severe burden on trade and shipping, the cost of
which would have been unequally shared, as the greater part of merchandise
and passenger trade was carried out by Britain (a country that, not surpris-
ingly, vigorously supported the miasmatist theory). Hence an agreement on
the means to prevent the spread of virulent diseases could not be reached un-
til the validity of the contagionist model was demonstrated. Thus, as Cooper
observes, the world was in a situation in which all agreed on the objectives
(the prevention of the spread of virulent diseases), but sharp dis agreement
existed on the instruments and on the related cost sharing, because of the
conflicting views on the theory that could explain the facts.
In economics all agree on the objectives: high employment, and growth
without inflation are universally considered as desirable. The attached weights
may be different in different cbuntries, but this is normal given the differ-
ent welfare functions of the various countries, and does not cause particular
problems. It is the lack 0/ agreement on the model that explains the trans-
mission of the effects of economic policies (both domestically and from one
country to another) that determines the impossibility of international policy
coordination to fight unemployment, low (or negative) growth, inflation as
the case may be. In Fig. 12.1 we have taken for granted the existence of
a model-no matter which-accepted by all countries. In the contrary case
there is no ground at all for carrying out the analysis.
A further problem is model uncerlainty. Assuming that all countries
agree on a model, it might happen that this model turns out to be wrong.
Cooperation based on an incorrect model might be negative rather than
positive.
In addition to these theoretical problems, there are practical problems,
the most important of which are the free-rider problem and the third-country
problem.
The Jree-rider problem is a typical problem of all cooperative equilibria
(inc1uding all kinds of agreements) in games of the prisoner's dilemma type.
Even if the various countries happen to be in a situation in which cooperation
is beneficial to all, the problem remains of how to ensure that all countries
participating in the cooperative equilibrium respect the agreement. In terms
of Table 12.1, each country-taking the other country's expansionary policy
for granted-has the incentive not to respect the agreement and adopt a re-
strictive policy, leaving the burden of expansion on the other country. Each
country tries to move from the last cell in the payoff matrix to a cell out-
side the main diagonal. Such a behaviour causes retaliation from the other
country, and we are back in the non-cooperative inferior situation. Hence
institutional mechanisms have to be devised and introduced to enforce the
co operative agreement.
The third-country problem is related to the fact that the agreement to
co ordinate usually inc1udes only a subset of the countries of the world. It
may then happen that the coordinated policies undertaken by the partici-
pating countries have a negative effect on non-participating countries. These
third countries could react by carrying out policies that negatively affect the
cooperating countries, which might then ultimately be worse off. For ex-
ample, suppose that country 1 and 2 cooperate and decide to deflate their
economies. The adverse effects on country 3's exports may lead this country
to deflate as weH. This aggravates the recession in country 1 and 2 above
what they had anticipated in deciding their coordinated policy, making them
worse off than if they had not jointly deflated.
These problems have given rise to a copious literature, that has amongst
others tackled the question of the consequences of uncertainty on the ''true''
model. The conc1usion has been that internationally coordinated policies
based on an invalid model can give rise to a lower welfare than the case
of no coordination. However, if we introduce the assumption that policy
makers have a learning ability (namely the ability of adjusting the actual
12.3. The International Debt Crisis 193
model towards the true model by modifying it through the observation of

the policy results), then international policy coordination is better than no
coordination.
Attempts at empirically estimating the benefits of coordination have been
carried out using linked macroeconometric models and have shown that the
potential gains from co ordination are not very high (generally around 0.5%
of GDP) even under favourable circumstances. These potential gains will
have to be weighed against the potential losses deriving for example from
the use of a wrong model.
These results may help to explain why, while during the 1970s and 1980s
the coordination of macroeconomic policies among major industrialized eco-
nomies was an important issue (especially during periods of crisis), from the
1990s there has been a dramatic fall in both the perception of anY need
for macroeconomic policy coordination, and (apart from some brief periods )
there has apparently been a decline in the practice of coordination at the
global level. In contrast, at the regional level there is increased interest
in the coordination of macroeconomic policies, as the debate on European
Monetary Union (see Chap. 11) highlights.
12.3 The International Debt Crisis

An international debt crisis arises when the government of a country declares
its incapability to service its foreign debt, namely to pay the interest and/or
repay the principal as scheduled. Cross-border debt also typically involves
exchange risk. If the debt is denominated in the lender's currency, then the
borrower takes on the exchange risk and viceversa. Most cross-border debt
contracts are denominated in the lender's currencies, so international debt
and currency crises often coincide.
The beginning of this crisis is usually placed in August 1982, when the
Mexican government informed the US Treasury, the IMF, and the creditor
foreign banks that it could no longer service its foreign debt. Similar cases
had already occurred previously, but the fact that the country concerned
was Mexico, an oil producing country and with a debt of more than US
$ 80 billion of the time, shook the international financial markets. The
example of Mexico was soon followed by several other countries. By the
end of 1982 approximately 40 nations were defaulting on their repayments,
and a year later 27 countries rescheduled their debts to banks. Sixteen of
them were from Latin America induding the four largest, Mexico, Brazil,
Venezuela and Argentina, that approximately owed 74 percent of total LDC
debt outstanding.
The reasons why these countries had indebted themselves are dear (mainly
the financing of overambitious development programs). The reasons for their
difficulties are also dear: the hoped-for huge export increases with which to
get the foreign exchange to service the debt did not materialize, partly be-
cause of the unfavourable international economic situation.
BOX 12.1 The causes of Mexico's debt default
Mexico was an oi! producing nation and therefore benefited from oi! shocks in the
1970s. Non-oi! exports, however, deteriorated rapidly during this period while im-
ports increased, contributing to a current account deficit. Other factors that led to
the current account deficit include the liberalization of trade and the revaluation of
the real exchange rate between 1978-8l.
To finance the widening current account deficit, Mexico's public and private sectors
relied on foreign debt, increasing interest payment abroad. When the second oi!
shock occurred in 1979, the US and the OECD countries responded by dramatically
increasing interest rates and imposing tight monetary controls. But the Mexican
government continued increased its public spending even as debt service became
more expensive. The Mexican private sector , however, began to shift its assets
abroad in the wake of the changes in the international economy. By August, Central
Bank reserves were almost exhausted, international banks refused to lend further
and the government announced its impossibility to service its debt. In the wake of
Mexico's default, most commercial banks reduced or stopped new lending to Latin
America. Because of the staggering accumulation of debt over the previous 10 years,
and the recent increase in the real and nominal interest rates, the interest payment
on debt were enormous. In 1984, interest due on debt as a ratio of gross national
product of the region reached 5%. To pay off their debts, Latin American countries
went through a long and painful process of adjustment. The IMF coordinated the
international credit aid and the debt renegotiations, which lasted unti! the late
1980s.
Among the causes of the debt crisis was the combination of high interest rates,
which exacerbated debt-service costs for Mexico and the other debtor nations, and
the sharp decline of oi! prices in 1982 that triggered the overall crisis. This was
coupled with the slowdown in world growth and the drop in commodity prices that
left exports stagnant and debt-service commitments hard to meet. Finally also the
private sector played an important role in causing the debt crisis. The majority of
the debt was held in non-guaranteed private sector loans which were nationalized
to meet obligations.
But to create a debt situation there must be two parties, the debtor and
the lender who supplies the funds. Hence we must examine the reasons why
the main international banks had so easily granted huge amounts of credit
to the countries under consideration. A widely shared thesis starts from the
oil shocks (see above). These had generated huge financial surpluses in the
OPEC countries, that had deposited them with the main international banks
in London and in the United States. The enormous funds received by these
banks raised the issue of how they could profitably utilise the money. A
good outlet was found to be the lending to less developed countries in the
course ofindustrializing their economies (the Newly Industrializing Countries
or NICs). The fact that the debt was incurred by governments or guaran-
teed by governments made the risk of default look fairly low. Paradoxically,
it were the increasing prices of the export goods of these countries (hence
increasing proceeds in foreign currency) rather than the industrialization to
give confidence to the lending banks, so much so that ab out one half of the
stock of debt outstanding in 1992 had been contracted in the previous two
12.3. The International Debt Crisis 195
years.
BOX 12.2 The Paris Club
The Paris Club is an informal group of official creditors with the role of finding coor-
dinated and sustainable solutions to the payment difficulties experienced by debtor
nations. Paris Club creditors agree to rescheduling debts due to them. Rescheduling
is a means of providing a country with debt relief through a postponement and, in
the case of concessional rescheduling, a reduction in debt service obligations. Since
the first meeting with a debtor country in 1956, the Paris Club or ad hoc groups
of Paris Club creditors have reached more than 360 agreements concerning over 70
debtor countries with a total amount of debt covered over $400 billion since 1983.
Although the Paris Club has no legal basis nor status, agreements are reached fol-
lowing a number of rules and principles settled by creditor countries, which help a
coordinated agreement to be reached efficiently. The basic principles layout that:
(1) decisions within the Paris Club have to be made on a case by case basis in
order to take into account the individuality of each debtor country and (2) with
the consensus of participating creditor countriesj (3) conditionality applies to debt
treatments, i.e. only for countries that need a rescheduling and that implement re-
forms to resolve their payment difficultiesj (4) solidarity ensures that creditors agree
to implement the terms agreed in the context of the Paris Club. Finally, (5) the
comparability of treatment between different creditors is preserved (in other words,
the debtor country cannot grant to another creditor a treatment less favorable for
the debtor than the consensus reached in the Paris Club). Among the different
types of debt, Paris Club agreements generally only apply to debts of the public
sector, medium and long term debts and credits granted before the "cutoff date",
i.e. when a debtor country first meets with Paris Club creditors, and not changed
thereafter. Prom the creditor side, the debts treated are credits and loans granted,
or commercial credits guaranteed by the Governments or appropriate institutions of
Paris Club creditors. Debt that was already treated in a previous Paris Club agree-
ment is normally not treated again, except for those countries where the financing
gap is large or where all pre-cutoff-date debt was already rescheduled. But with
the aim of producing agreements leading to sustainable levels of payments, longer
repayment periods have been considered over time, especially for poorer countries
(ranging from 23 to 40 years) and debt cancellation has been increasingly used.
The international debt crisis has given rise to serious problems, not only
for the creditor banks but also for the governments of the countries to which
these banks belong, and for the international monetary system. The pos-
sible bankruptcy of these banks, in fact, would create serious dangers for
both the national monetary system and the international monetary system.
Most cross-border debt contracts are denominated in the lender's currency,
so international debt and currency crises often coincide.
Although several general proposals and plans have been put forward (the
Baker plan, the Brady plan, and so on), in practice the international debt
problem has been tackled on a case by case approach, through a combination
of measures that can be summarized into three categories:
(a) modifications in the structure and nature of the debt, for example
by rescheduling, i.e. lengthening the time horizon of the debt (so that the
repayment instalments become smaller) or postponing the payment of inter-
est andj or principal to some date in the future. Another measure in this
category consists of debt-equity swaps, namely part of the debt is exchanged,
through third parties, for equities of corporate firms of debtor countries.

(b) economic reforms in debtor countries, which are usually summed up
in the d-triad: devaluation, deflation, deregulation. These are the macroe-
conomic measures usually suggested by the IMF to debtor countries. Their
aim is to improve the economic situation of debtor countries and hence these
countries capability of servicing the debt. In the short run these measures
may however have strong negative effects on employment and so turn out to
be politically destabilising for debtor countries.
(c) debt forgiveness. This can take place in various ways (in addition to
simply writing off part of the debt): for example, by allowing the debtor to
buy back its debt at a huge discount, or by drastically reducing the interest
rate.
Given the very different nature of the situation and prospects of debtor coun-
tries, it is difficult if not impossible to make generalizations. Hence the case-
by-case approach seems indeed the most suitable. The boxes on the Paris
Club and on the Heavily Indebted Poor Countries initiative give details.
BOX 12.3 The HIPC initiative

The Initiative for the "Heavily Indebted Poor Countries" (HIPC Initiative) was de-
signed, in 1996 - and enhanced in September 1999, upon the recognition by the
international financial community that the external debt situation for a number of
low-income countries, mostly in Africa, had become extremely difficult and influ-
enced the prospects for economic development. For these countries, even full use
of traditional mechanisms of rescheduling and debt reduction may not be sufficient
to attain sustainable external debt levels within a reasonable period of time and
without additional external support. A group of 41 countries in such a situation
and potentially considered for the HIPC initiative was defined by the international
financial institutions. The HIPC Initiative entails a reduction in the net present
value of the future claims on the indebted country, providing, at the same time, the
incentive for investment and enhancing domestic support for policy reforms. The
initiative requires the participation of all multilateral creditors, beyond the tradi-
tional debt relief mechanisms provided by official bilateral and private creditors. On
the debtor side, a country must satisfy a set of criteria to be eligible for special assis-
tance, such as (i) being eligible only for concessional assistance from IMF and WB,
(ii) facing an unsustainable debt burden, and (iii) showing a track record of reform
and sound policies through IMF- and World Bank-supported programs. Many Paris
Club creditors have announced that they will also provide debt forgiveness over and
above the HIPC Initiative assistance.
12.4 Growth-Oriented Adjustment Programs

The models underlying the prescription given by the IMF and the World
Bank to countries in difficulty asking for help to solve their balance-of-
payments and growth problems are very simple: they are based on a com-
bination of the monetary approach to the balance of payments and the neo-
classical growth model.
12.4. Growth-Oriented Adjustment Programs 197
Let us start by observing that the basic equation of the monetary ap-
proach to the balance of payments (see Sect. 7.1) can be written as
TollR = ßM - llQ, (12.1)
where TO is the given initial exchange rate. This equation lies at the basis
of the International Monetary FUnd 's (IMF) adjustment programs, whose
adoption is the condition for obtaining the FUnd's credit by countries in
balance-of-payments trouble that have applied for the Fund's support.
There are several reason why the FUnd adopts the monetary approach,
but the most compelling one is that data on monetary variables, in addition
to containing important macroeconomic information, are relatively more ac-
curate, easily available, and timely than other data, especially in developing
countries. The framework und~r consideration is a small open economy under
fixed (but adjustable) exchange rates.
FUnd-supported adjustment programs are aimed at the short run. Growth
problems are dealt with by the World Bank, whose growth model is of the
neoclassical type. Its basic equation is
(12.2)
where ßy is the change in real GDP, determined by the marginal productivity

of capital al multiplied by the increase in real capital llk. The parameter
ao captures all the rest, namely the increase in the labour force and in total
factor productivity. An even simpler form of this equation is sometimes
used, where ao is set to zero: the result is the so-called incremental capital
output relationship (ICOR), that lies at the basis ofthe World Bank's RMSM
(Revised Minimum Standard 'Model), used to calculate external financing
needs for developing countries.
In the short-run monetary model product growth is taken as exogenous,
while in the growth model it is the price change that is taken as exogenous.
The obvious question then arises, why aren't the two approaches integrated.
Growth-oriented adjustment pTograms are the answer to this question.
The theoretical underpinnings of growth-oriented adjustment programs
are examined in a paper by two members of the FUnd's Research Department
(Khan and Montiel, 1989). Their model can be summarized in a simple
diagram (Fig. 12.3), where llPD is the change in the domestic price level
and lly the change in real gross domestic product. Since the variables are
measured v:.ith reference to the initial state normalized to unity (yo = PDO =
1), these changes can also be interpreted as growth rates.
The M M schedule shows the monetary model equilibrium. It is down-
ward sloping because increases llPD and ßy both tend to increase the (fiow)
demand for money. Hence an increase in either variable must be offset by
a decrease in the other so as to maintain monetary equilibrium. The GG
schedule shows the equilibrium in the growth model. It is upward sloping
Figure 12.3: The integrated monetary / growth model
because higher domestic prices, given the nominal exchange rate, imply a
competitiveness loss and hence an increase in the trade deficit (on the as-
sumption that the relevant critical elasticity conditions are satisfied: see
Chap. 6); the associated increase in foreign saving results in an increase in
investment (given the standard neoclassical assumption that all saving gets
automatically invested) and hence in real growth.
The intersection between the two schedules determines the simultaneous
monetary-real growth equilibrium, since from the equilibrium values tl PjJ ,
tly·, the equilibrium values of the other variables follow.
Given the targets of real growth, balance of payments improvement, re-
duction of inflation, this model suggests a number of policies. These include
demand management policies, exchange rate policies, structural policies, ex-
ternal financial support.
For example, demand management policies include a reduction in gov-
ernment current spending. This reduction, at the same level of fiscal revenue
and domestic credit expansion, implies an increase in saving and hence in
investment (remember that in the neoclassical context all saving gets auto-
matically invested). Since domestic credit expansion does not change, the
market for money is not influenced. The increase in output brought about by
the increase in investment has a depressive effect on domestic prices, hence
the new equilibrium will be characterized by higher growth and lower infla-
tion. Finally, if the substitution efIect prevails on the income efIect, and the
price efIects are sufficiently strong, the balance of payments improves. The
efIects on growth and inflation can easily be determined by Fig. 12.3, where
12.5. Proposals for the International Management of Exchange Rates 199
the decrease in government spending gives rise to a rightward shift of the GG

schedule (not shown in the diagram) while the M M schedule is unaffected,
so that the new equilibrium point implies a lower flPDand a higher fly*.
12.5 Proposals for the International

Management of Exchange Rates
12.5.1 Introduction
A much more modest but viable alternative to a plan for creating a new
international monetary system starts from the observation that it would be
desirable to prevent excessive (and often disrupting) oscillations in the ex-
change rates ofthe major currencies (see Sect. 8.3 on currency crises). There
is however no agreement on the best way to reach this goal. Among the var-
ious proposals the best known are McKinnon's global monetary objective,
John Williamson's target zones, and the Tobin tax.
12.5.2 McKinnon's Global Monetary Objective

This proposal was set forth in the 1970s by Ronald McKinnon, who has
later perfectioned it (see McKinnon, 1988, 1997). It is based on fixed ex-
change rates (that he considers superior to flexible rates), with a ±5% band,
integrated by a precise intervention rule to be followed by the monetary au-
thorities.
According to McKinnon, the main cause for exchange-rate volatility is
currency substitution. In a world practically free from controls on inter-
national capital flows, private international economic agents (multinational
enterprises, portfolio investors, etc.) wish to hold a basket of various national
currencies. McKinnon holds that the overall demand for this currency basket
is, like the traditional domestic demand for domestic money, a stable func-
tion (the Friedman thesis extended to international economies), but that the
desired composition of the global basket may be very volatile. This implies
that the control of the single national domestic supplies is unsuitable, and
that Friedman's monetary rule (according to which the money supply must
grow at a constant predefined rate) should be shifted from the national to
the international level.
In practice this means that, once the nominal exchange rates (McKinnon
suggests a PPP rule) and the rate of growth of the world money supply have
been fixed, the national monetary authorities interventions in the foreign ex-
change markets to maintain the fixed parities should consists of non sterilized
purchases and sales of foreign currencies. Such interventions cause changes
(an increase in the case of a purchase of foreign exchange, a decrease in the
200 Chapter 12. Problems of the International Morietary System
case of a sale) in the national money supplies. Thus the currency substi-
tution desires of the international agents, which are the cause of the excess
demands and supplies of the various currencies, give rise to changes in the
national money supplies while leaving the world money supply unchanged
and the exchange rates fixed. Hence currency substitution will have no effect
on the national economies.
This proposal has been criticized for various reasons. The first and fore-
most concerns the foundation itself of the proposal: currency substitution
seems to be neither the main cause of exchange-rate volatility nor the main
determinant of exchanges rates. Rather , it is asset substitution concerning
assets denominated in the various currencies that appears to have a much
greater role. Besides-the critics continue-by fixing nominal exchange rates
no room is left for real exchange-rate adjustments. These adjustments might
be required not so much because of differences in inflation rates (these could
not occur according to the proposal), but to offset different productivity
changes in the various countries.
12.5.3 John Williamson's Target Zones

The idea of trying to combine the advantages of both fixed and flexible
exchange rates while eliminating the disadvantages of both is at the basis
of this proposal. John Williamson (1985) and his coworkers have elaborated
this idea in much detail, giving rise to the target zone proposal, which is
based on two main elements.
The first is the calculation of a fundamental equilibrium exChange rate
(FEER), defined as that exchange rate 'which is expected to generate a cur-
rent account surplus or deficit equal to the underlying capital flow over the
cycle, given that the country is pursuing internal balance as best it can and
not restricting trade for balance of payments reasons' (Williamson, 1985, p.
14). SuCh a rate should be periodically recalculated to take account of the
change in its fundamental determinants (for example the relative inflation
rates); thus it must not be confused with a fixed central parity.
The second element is the possibility for the current exchange rate to
float within wide margins around the FEER (at least ±1O%). These margins
should be soft margins, namely there would be no obligation for the monetary
authorities to intervene when the current exchange rate hits a margin; this
is aimed at preventing destabilising speculation of the kind that was present
in the Bretton Woods system.
The target zone proposal has been criticized for various reasons. We
shall just point out two of them. The first is the difficulty of calculating the
FEER. Even by using the most sophisticated econometric techniques and
models, there remains a rather wide error margin. The second concerns the
"credibility" of the target zone. A target zone is viable only if economic
agents find it credible. The experience of the European Monetary System
12.5. Proposals for the International Management of Exchange Rates 201
(see Sect. 11.5.1), which before August 1993 could be considered as a target
zone with narrower margins, shows that the monetary authorities, even when
there are monetary cooperation agreements like in the ERM, are helpless
when credibility lacks.
The credibility problem has been theoretically studied in several mod-
els that can be divided into first-generation and second-generation mod-
els. First-generation models are based on simplified assumptions: economic
agents are convinced that the exchange rate will not go beyond the margins
and that the central parity will not be changed. Second-generation mod-
els are based on more general assumptions: economic agents assign non-zero
probabilities to both events (the exchange rate going beyond the margins and
the central parity being changed). For a survey of these models see Kempa
and Nelles (1999).
12.5.4 The Tobin Tax

Tobin (1974, 1978, 1996) has suggested a tax (with a modest rate) on all
foreign-exchange transactions as a means of "throwing sand in the wheels"
of international speculation, namely of contrasting speculative capital fiows
without disturbing medium-Iong term "normal fiows". Such a tax should be
applied on all foreign-exchange transactions (both infiows and outfiows) in-
dependently of the nature of the trans action. This is necessary to avoid the
practically insurmountable enforcement problem of distinguishing between
foreign exchange transactions for "speculative" purposes and for other pur-
poses. Such a tax, in fact, given its modest rate would not be much ofa
deterrent to anyone engaged in commodity trade or contemplating the pur-
chase of a foreign security for longer-term investing, but might discourage
the spot trader who is now accustomed to buying foreign exchange with the
intention of selling it a few hours later, and who would have to pay the tax
every time he buys or sells foreign exchange. A tax of, say, 0.1% (Tobin,
1974, p. 89 originally suggested 1% but later-1996, p. xvii-recommended
a lower rate, between 0.25 and 0.1%), namely 0.2% on a round trip to an-
other currency, would cost 48% a year if transacted every business day, 10%
if every week, etc., but would be a trivial charge on commodity trade and
long-term foreign investment.
The Tobin tax has raised much less discussion than it would deserve:
in the words of the author himself, "it did not make much of a ripple. In
fact, one may say that it sunk like a rock. The community of professional
economists simply ignored it" (Tobin, 1996, p. x). Raffer (1998) gives a
historical survey of the debate on the Tobin tax as well as reasons (mainly
political, in his opinion) why this debate has been so scanty. A special issue
of the Economic Journal (Various Authors, 1995) and a book edited by ul
Haq et al. (1996) contain several papers both pro and against.
In the discussion on the Tobin tax two aspects are c10sely tied: enforce-
ability and effects. Let us for a moment suppose that it is enforceable and
examine its effects from the theoretical point of view.
The Tobin tax, when seen from the point of view of the agent engaged
in international capital movements, is a tax on the relevant foreign exchange
transactions, but can be translated into an equivalent tax on interest income.
It is, in fact, equivalent either to a tax on foreign interest income at a rate
which is an increasing function of the Tobin tax rate e, or to a negative tax
(i.e., a positive subsidy) on domestic interest income at a rate which is an
increasing function of e (see Gandolfo, 2002, Sect. R.3). Hence it acts by
suitably modifying the interest-rate differential which enters into the CIP
and UIP calculations. Here the opinions become divergent: on the one hand
there are those who maintain that its effects would be negligible, on the
other those who hold the opposite view. Both views are, however, based on
purely theoretical models without any empirical testing. Two exceptions are
Gandolfo and Padoan (1992) and Jeanne (1996).
Gandolfo and Padoan (1992) simulate the introduction of a Tobin tax
in their estimated continuous-time macrodynamic econometric model of the
Italian economy by suitably modifying the interest-rate differential on which
capital flows depend. In such a way the effects of this introduction on the
macroeconomic system can be examined taking account of all the dynamic
interrelations between the relevant variables. The results of the simulations
show that the introduction of a Tobin tax provides a crucial contribution to
the stabilization of the system with fuH capitalliberalization and speculative
capital flows. However there is more to it than that. A Tobin tax allows the
system to operate with a lower level of the domestic interest rate as it makes
the constraint represented by the foreign interest rate less stringent. This
obviously gives more room for domestic financial policy (in terms of e.g. the
financing of the domestic public debt).
Jeanne (1996) builds a target zone model in which an optimizing gov-
ernment is faced with a trade-off between its foreign exchange and domestic
objectives. The introduction of a Tobin tax would improve the credibility
of the peg by relaxing the foreign exchange constraint and reducing the cost
for the government of pegging the exchange rate. The author also applies
the model to the French franc and shows that the stabilizing effect of a 0.1 %
Tobin tax would have been quite sizeable.
Let us now come to the enforceability problem. The main practical ar-
gument against such a tax is wen known: if not an countries adopt it, then
the business would simply go to the financial centres where the tax is not
present (tax havens). Minor arguments concern the possibility of loopholes,
which could however by counteracted as soon as they are discovered.
Thus the real problem is generality of application. However, it has been
argued that it would be sufIicient that major dealing sites (the European
Union, the United States, Japan, Singapore, Switzerland, Hong Kong, Aus-
tralia, Canada and perhaps some other countries ) implemented the tax,
charging punitive tax rates for transactions crossing the border between "To-
bin countries" and ''tax havens". But the amount of international agreement
that this implementation would require makes it unlikely in the light of the
obstacles to international policy cooperation treated above, Sect. 12.2.2. In
fact, the formation of a "Tobin area" would ultimately be a manifestation
of political will, just as the formation of the European Monetary Union has
been (in spite of all its critics). And in any case a Tobin tax would be a much
less traumatic measure than the introduction of capital controls, which are
from time to time considered as a means of reducing international financial
instability.

Bryant, RC., 1995, International Coordination of National Stabilization
Policies, Washington (DC): Brookings Institution.
Cooper, RN., 1989, International Cooperation in Public Health as a Pro-
logue to Macroeconomic Cooperation, in RN. Cooper et al. (eds.),
Can Nations Agree? Issues in International Economic Cooperation,
Washington (DC), Brookings Institution, 178-254.
Dooley, M.P., 1995, A Retrospective on the Debt Crisis, in P. Kenen (ed.),
Understanding Interdependence: The Macroeconomics ofthe Open Econ-
omy, Princeton: Princeton University Press, 262-88.
nomics, Berlin Heidelberg: Springer-Verlag.
Gandolfo, G. and P.C. Padoan, 1992, Perfect Capital Mobility and the Italian
Economy, in E. Baltensperger and H.-W. Sinn (eds.), Exchange Rate
Regimes and Currency Unions, London: Macmillan, 26-6l.
Jeanne, 0., 1996, Would a Tobin Tax Have Saved the EMS?, Scandinavian
Journal of Economics 98, 503-20.
Hamada, K., 1974, Alternative Exchange Rate Systems and the Interde-
pendence of Monetary Policies, in RZ. Aliber (ed.), National Mone-
tary Policies and the International Financial System, Chicago: Chicago
University Press.
Hamada, K., 1985, The Political Economy of International Monetary Inter-
dependence, Cambridge (Mass.), MIT Press.
Kempa, B. and M. Nelles, 1999, The Theory of Exchange Rate Target Zones,
Journal of Economic Surveys 13, 173-210.
McKinnon, RI., 1988, Monetary and Exchange Rate Policies for Interna-
tional Financial Stability, Journal of Economic Perspectives 2(1), 83-
103.
McKinnon, RI., 1997, The Rules of the Game, Cambridge (Mass.): MIT
Press.
Raffer, K., 1998, The Tobin Tax: Reviving a Discussion, World Development
26,529-38.
Sneddon Little J. and G.P. Olivei (eds.), 1999, Rethinking the International
Monetary System, Boston: FOOeral Reserve Bank of Boston, Conference
Series No. 43.
Tobin, J., 1974, The New Economics One Decade Older, Princeton: Prince-
ton University Press.
Tobin, J., 1978, A Proposal for International Monetary Reform, Eastern
Economic Journal 4, 153-9.
Tobin, J., 1996, Prologue, in ul Haq et al. (OOs.), ix-xviii.
ul Haq, M., 1. Kaul and 1. Grunberg (OOs.), 1996, The Tobin Tax: Coping
with Financial Instability, Oxford: Oxford University Press.
Various Authors, 1995, Policy Forum: Sand in the Wheels of International
Finance, Economic Journal 105, 161-92.
Williamson, J., 1985, The Exchange Rate System, revisOO edition, Washing-
ton (DC): Institute for International Economies.
Williamson, J., 1993, Equilibrium Exchange Rates: An Update, Washington
(DC): Institute for International Economies.
Part 111
International Trade Theory and

Policy
Chapter 13
The Orthodox Theory:

Comparative Cost, Factor
Endowments, Demand
13.1 Comparative Costs and International

Trade: The Ricardian Theory
According to the classical theory of international trade (attributed to David
Ricardo and Robert Torrens), the crucial variable explaining the existence
and pattern of international trade is technology. A difference in comparative
costs of production-the necessary condition for international exchange to
occur-does, in fact, reflect a difference in the techniques of production.
The theory also aims at showing that trade is beneficial to all participating
countries.
If we simplify to the utmost, we can assume that there are two countries
(England and Portugal in the famous example of Ricardo's), two commodities
(cloth and wine) , that all factors of production can be reduced to a single
one, labour 1 , and that in both countries the production of the commodities
is carried out according to fixed technical coefficients: as a consequence, the
unit cost of production of each commodity (expressed in terms of labour) is
constant.
It is clear that if one country is superior to the other in one line of pro-
duction (where the superiority is measured by a lower unit cost) and inferior
in the other !ine, the basis exists for a fruitful international exchange, as
earlier writers, for example Adam Smith, had already shown. The simple
example in Table 13.1 is sufficient to make the point; the reader should bear
IThis is based on the classical labour theory of value. However, the validity of the
classical theory of international trade is not based on the validity of the labour theory of
value, as it is sufficient for unit costs of production to be measurable by a common unit
across countries and to be constant.
207
208 Chapter 13. Orthodox Theory: Comparative Cost, Factor Endowments, Demand
in mind that here as in the subsequent examples, the cost of transport is as-
sumed to be absent, as its presence would complicate the treatment without
altering the substance of the theory. As we see, the unit cost of manufac-
turing cloth is lower in England than in Portugal while the opposite is true
for wine production. It is therefore advantageous for England to special-
ize in the production of cloth and to exchange it for Portuguese wine, and
for Portugal to specialize in the production of wine and to exchange it for
British cloth. Suppose, for example, that the (international) terms 0/ trade
Table 13.1: Example of absolute advantage

Commodities Unit costs of production in terms of labour
in England in Portugal
~~ 4 6
Wine 8 3
(i.e., the ratio according to which the two commodities are exchanged for
each other between the two countries, or international relative price) equals
one, that is, international exchange takes place on the basis of one unit of
wine for one unit of cloth. Then England with 4 units of labour (the cost
of one unit of cloth) obtains one unit of wine, which otherwise-if produced
internally-would have required 8 units of labour. Similarly Portugal with 3
units oflabour (the cost of one unit of wine) obtains one unit of cloth, which
otherwise-if produced internally-would have required 6 units of labour.
In this example we have reasoned in terms of absolute costs, as one coun-
try has an absolute advantage in the production of one commodity and
the other country has an absolute advantage in the production of the other.
That in such a situation international trade will take place and benefit all
participating countries is obvious. Less so is the fact that international trade
may equally weIl take place even if one country is superior to the other in
the production of both commodities. The great contribution of the Ricardian
theory was to show the conditions under which even in this case international
trade is possible (and beneficial to both countries).
Now, this theory affirms that the necessary condition for international
trade is, in any case, that a difference in comparative costs exists. Compara-
tive cost can be defined in two ways: as the ratio between the (absolute) unit
costs of the two commodities in the same country, or as the ratio between the
(absolute) unit costs of the same commodity in the two countries. Following
common practice, we shall adopt the former, but they are totally equivalent.
In fact, if we denote the unit costs of production of a good in the two
countries by ab a2 (where the letter refers to the good and the numerical
subscript to the country: this notation will be constantly followed throughout
the book) and the unit costs of the other good by bl, b2 , then
(aI/bl = a2/~) -<==? (bI/al = ~/a2) -<==? (aI/a2 = bI/b2) -<==? (a2/al = b2/b l ),
13.1. Comparative Costs and International Trade: The Ricardian Theory 209
and similarly
(aI/bI ~ a2/b2) {::::=:? (aI/ a2 ~ bI/b2) {::::=:? (b2/a2 ~ bI/al) {::::=:? (b2/bl ~ a2/al)·
It therefore makes no difference whether the comparison is made between
aI/bI and a2/b2 or between aI/a2 and bt/b2, and so on.
The basic proposition of the theory under examination is that the con-
dition for international trade to take place is the existence of a difference
between the comparative costs. This is, however, a necessary condition only;
the sufficient condition is that the international terms of trade He between
the comparative costs without being equal to either. When both conditions
are met, it will be beneficial to each country to speciaHze in the production
of the commodity in which it has the relatively greater advantage (or the
relatively smaller disadvantage). Let us consider the following example.
Table 13.2: Example of comparative advantage

Commodities Unit costs of production in terms of labour
in England in Portugal
~~ 4 6
Wine 8 10
AB England is superior to Portugal in the production of both commodities, it

might seem that there is no scope for international trade, but this is not so.
Comparative costs are 4/8 = 0.5 and 6/10 = 0.6 in England and Portugal
respectively. England also has a relatively greater advantage (a comparative
advantage) in the production of cloth: its unit cost, in fact, is lower in
England than in Portugal by 33.3% (2/6), while the unit cost of wine is lower
in the former than in the latter country by 20% (2/10). It can similarly be
seen that Portugal has a relatively smaller disadvantage in the production
of wine: its unit cost, in fact, is higher in Portugal than in England by 25%
(2/8), while the unit cost of cloth is higher in Portugal than in England by
50% (2/4).
Therefore-provided that the terms of trade are greater than 0.5 and
smaller than O.6-British cloth will be exchanged for Portuguese wine to the
benefit of both countries. Let us take an arbitrary admissible value of the
terms of trade, say 0.55 (that is, international exchange takes place at the
terms of 0.55 units of wine per one unit of cloth). In England, on the basis of
the existing technology, one unit of cloth exchanges for 0.5 units of wine: 0.5
is, in fact, the comparative cost, and, according to the classical theory, the
relative prices of goods, that is their exchange ratios, are determined by costs.
For one unit of cloth, England can obtain, by way of international trade,
0.55 units of wine, more than the amount obtainable internally. Similarly
in Portugal, to obtain one unit of cloth, 0.6 units of wine (0.6 is Portugal's
comparative cost) are necessary, while by way of international trade only 0.55
units of wine are required. It is obvious that international trade is beneficial

to both countries.
It is possible to arrive at the same conclusion by reasoning in terms of
production costs. England with 4 units of labour (the cost of one unit of
cloth) obtains, on the international market, 0.55 units of wine which, if pro-
duced internally, would have required 0.55 x 8 = 4.4 units of labour. Similarly
Portugal with 5.5 units of labour (the cost of 0.55 units of wine, given by
0.55 x 10) obtains one unit of cloth, which would have required 6 units of
labour if produced internally.
It can easily be shown that the terms of trade must be strictly located
between the two comparative costs. If, in fact, the terms of trade were equal
to either comparative cost, the concerned country would have no interest in
trading, since the internal price ratio (given by the comparative cost) would
be equal to the international one (the terms of trade). This would mean that
the country in question would obtain the other commodity by way of trade
at the same cost as it could be got internally. Assurne, for example, that the
terms of trade are 0.5, equal to the British comparative cost. Then England
would obtain, on the international market, with 4 units of labour (the cost
of one unit of cloth) 0.5 units of wine, which would have required 0.5 x 8 = 4
units of labour if produced internally. In other words, by exchanging cloth
for wine on the international market England would obtain exactly the same
amount of wine obtainable internally (0.5 units of wine per one unit of cloth):
there is, then, no reason for engaging in international trade. It can similarly
be seen that, if the terms of trade were 0.6, there would be no reason for
Portugal to engage in international trade at all. We leave it to the reader
to check, as an exercise, that if the terms of trade were to fall outside the
interval between the comparative costs (that is, in our example, if they were
smaller than 0.5 or greater than 0.6) then, by engaging in international trade,
one of the two countries would suffer a loss.
13.1.1 AGraphie Representation

This diagram is based on the concept of transformation curve (or production-
possibility frontier) studied in microeconomic theory. In our simplified model,
in which there is only one factor of production and the technical coefficients
are fixed, the transformation curve is linear. It is in fact given, for country
1, by the equation
(13.1)
where L 1 is the total amount oflabour existing in country 1. Equation (13.1)
is the equation of a monotonically decreasing straight line in the (x, y) plane,
since we can write it as
(13.2)
13.1. Comparative Costs and International Trade: The Ricardian Theory 211
Figure 13.1: Thansformation curve and comparative costs
In absolute value, the slope of this line equals the comparative cost in
country 1. Comparative cost and marginal rate oftransformation (or oppor-
tunity cost) are therefore one and the same thing.
In a similar way, we obtain the transformation curve of country 2. Con-
sider then Fig. 13.1, where we have brought together the transformation
curves of the two countries.
The line A'B' is the transformation curve of country 1, i.e. the diagram
of (13.2); in absolute value, tan a equals the comparative cost of country 1.
The line A" B" is the transformation curve of country 2, rotated anticlockwise
by 1800 and placed so that point B" coincides with point A"; it goes without
saying that 0" B" and 0' B' are parallel. The absolute value of tan ß equals
the comparative cost in country 2.
Let us take an arbitrary admissible value of the terms of trade, say tan {!,
and assume that international trade occurs at point E, whose coordinates are
the quantities exchanged. Country 1 specializes completely in the production
of commodity x, of which it produces the amount O'A'; of this, apart is
consumed domestically (0' D'), whilst the remaining part (D' A') is exported
in exchange for the quantity O'G' = ED' = G" B" of commodity y. Note
that, since the terms of trade are measured by tan p, and since (by considering
the right-angled triangle ED'A') we have ED' = D'A'· tan{!, it follows that
by giving D' A' of X, ED' of y can be obtained, and vice versa. This means
that the trade balance is necessarily in equilibrium. In fact, balance-of-trade
equilibrium, or value of exports=value of imports, requires
PxD' A' = pyED' or Px D'A' = ED' , (13.3)

Py
which is indeed true, since commodities are exchanged at a relative price
(Px/Py) given by the terms of trade, namely Px/Py = tan [>.
Similarly, country 2 completely specializes in y and produces the amount
0" B" of this commodity, consuming 0" C" domestically and exporting C" B"
in exchange for 0" D" = D' A' of commodity x. This shows that in the
Ricardian model trade gives rise to complete specialization in both countries.
However, this may not be the outcome when one country (say country 1) is
small with respect to the other, so that this country's production of x is not
sufficient to fully satisfy, in addition to its own domestic demand, also the
demand for this commodity by country 2. In such a case country 2 will not
specialize completely in commodity y and will continue to produce both y
and x.
As can be seen, point E lies beyond both transformation curves, and so
it represents a basket of goods that neither country could have obtained in
autarky. Consider, for example, country 1. In autarky, together with 0' D'
of x this country could have obtained 0' F of y (less than the amount 0' C'
that it obtains through international trade). The gains from trade accruing
to this country can be measured, in terms of y, by C' F (in terms of x they
are measured by GD'). The gains from trade accruing to country 2 can be
found in a similar way.
It is also obvious from the diagram that the doser the terms-of-trade line
is to a country's transformation curve, the smaller that country's share of
the gains; this share drops to zero when the terms-of-trade line coincides
with that country's transformation curve (and all the gains go to the other
country).
13.2 The Heckscher-Ohlin Model

13.2.1 Basic Assumptions and their Meaning
We shall examine the Heckscher-Ohlin theory in its simplest version, that is
a model in which there are two countries, two final goods and two primary
factors of production.
This model, as we said in Sect. 1.2.2, stresses the differences in factor
endowrnents as the cause of trade; more precisely, its basic proposition is that
each country exports the commodity which uses the country's more abundant
factor more intensively (the Heckscher-Ohlin theorem).
In addition to the usual basic assumptions (no transport costs, free trade,
perfect competition, international immobility of factors) there are the follow-
ing:
13.2. The Heckscher-Ohlin Model 213
1) the production functions exhibit positive but decreasing returns

to each factor (i.e., positive but decreasing marginal productiv-
ities) and constant returns to scale (i.e., first degree homogene-
ity). They are internationally identical, but, of course, different
between the two goods, that is the production function of good
A is the same in country 1 and country 2, and is different from
that of good B (which is identical in the two countries ).
2) The structure of demand, that is the proportions in which the
two goods are consumed at any given relative price, is identical
in both countries and independent of the level of income.
3) Factor-intensity revers als are exduded (see below).
The first assumption, which embodies the usual properties of well-behaved

production functions, and exdudes the presence of international technological
differences, is self-evident. The difference between the production functions
of the two goods is of course necessary, otherwise it would not be possible to
speak of two different goods.
The second assumption implies that tastes are internationally identical
and represented by utility functions such that the income elasticity of demand
is constant and equal to one for each good. This assumption serves to exdude
the possibility that, although tastes are internationally identical, the two
goods are consumed in different proportions in the two countries because of
possible differences in income levels.
It is then dear that the first two assumptions serve to exclude any differ-
ence between the countries as regards technology and demand, so that one
can concentrate on the differences in factor endowments.
The third assumption is necessary to determine univocally the relative
factor intensities of the two goods. In general, given two factors (capital K
and labour L) and two commodities A and B, we say that a commodity (for
example A) uses a factor more intensively or is more intensive in a factor (for
example capital) relative to the other commodity if the (K/ L) input ratio in
the former commodity is greater than the (K/ L) input ratio in the latter.
Now, if production of each good took place according to only one tech-
nique with fixed and constant technical coefficients (L-shaped isoquants), it
would be an easy matter to determine the relative factor intensities once and
for all. But since we are dealing with production functions with a continuum
of techniques 2 (smoothly continuous isoquants), different techniques will be
chosen-in accordance with the standard cost minimization procedure-for
each good at different factor-price ratios. As already clarified in the previ-
ous chapter, we follow common practice in talking of the price of a factor in
the sense of price of the services or rental for the services of the factor, or
2The same problem would arise in the presence of many techniques, but limited in
number, of the fixed-coefficients type, such as are dealt with by activity analysis.
unit factor reward. This warning is to be considered as implicitly recalled

throughout the rest of the book.
It follows that the classification of goods according to their factor intensi-
ties becomes ambiguous. To remove this ambiguity we add the requirement
that the classification must remain the same for any (admissible) factor-price
ratio, namely-in our example- that commodity A is more capital-intensive
relative to commodity B if the (K/ L) input ratio in the former commodity
is greater than the (K/ L) input ratio in the latter for all factor-price ratios.
Conversely, when factor-intensity reversal(s) occur, it is not possible to
rank the commodities unambiguously for all factor-price ratios, that is, the
classification changes according to the value of the factor-price ratio. For
example, it may happen that A is more capital-intensive relative to B for a
certain range of factor-price ratios, whilst B becomes more capital-intensive
relative to A for another range of factor-price ratios: a factor-intensity rever-
sal has occurred.
We shall assume that no factor-intensity reversal occurs. It should be
noted the absence of factor-intensity reversals implies that a unique factor-
price ratio corresponds to each commodity-price ratio, and vice versa, i.e.
there is a one-to-one correspondence between the relative price of goods and
the relative price of factors.
13.2.2 Proof of the Fundamental Theorem

As stated at the beginning of Sect. 13.2.1, the basic proposition of the
Heckscher-Ohlin model is that each country exports the commodity which
uses the country's more abundant factor more intensively. The concept of
(relative) factor intensity has been clarified in Sect. 13.2.1; it is now the turn
of the concept of (relative) factor abundance.
The definition that immediately comes to mind is in physical terms: we
say that a country (say country 1) is abundant in one factor (say capital)
relative to the other, or that country 1 is relatively more endowed with capital
than country 2, if the former country is endowed with more units of capital
per unit of labour relative to the latter: Kd LI > K2/L 2 , where K I is the
total amount of capital available in country 1, etcetera.
An alternative definition is however possible, which makes use of the
relative price of factors and is therefore called the price definition: country
1 is said to be capital abundant, relative to country 2, if capital is relatively
cheaper (with respect to labour) in the former than in the latter country, at
the (pre-trade) autarkie equilibrium, namely PIK/PIL < P2K/P2L, where PIK
is the price of capital in country 1, etcetera.
It is obvious that the physical definition reflects relative physical abun-
dance, whilst the price definition reflects relative economic abundance. Since,
thanks to the simplifying assumptions made at the beginning of Sect. 13.2.1,
the Heckscher Ohlin theorem can be demonstrated with both the physical
and the economic definition, we shall not claim the superiority of either one.
Here we shall use the physical definition.
In the following treatment, we assume that commodity A is capital inten-
sive relative to commodity Band that country 1 is capital abundant relative
to country 2; it goes without saying that B is labour intensive relative to A
and country 2 labour abundant relative to 1. Thus we must prove that coun-
try 1 will export commodity A whilst country 2 will export commodity B.
For this purpose we must use the transformation curves of the two countries.
Let us recall from microeconomics that the transformation curve (also
called the production possibilities curve) of a country shows the maximum
quantity of a commodity that can be produced for any given quantity pro-
duced of the other commodity, of course optimally employing all the available
factors of production. The (absolute value of) the slope of the transforma-
tion curve, called marginal rate of transformation, measures the (marginal)
opportunity cost of B in terms of A, namely the amount of A that the eco-
nomic system must forgo to obtain an additional unit of B3. It goes without
saying that the opportunity cost of A in terms of B is measured by the slope
of the transformation curve with reference to the A axis, and is the reciprocal
of the opportunity cost of B in terms of A.
It should be noted that, since the transformation curve is obtained through
an optimization procedure, the amount of A (or of B) that must be forgone
to obtain an additional unit of B (or of A) is the minimum possible given the
technology. The assumed concavity of the transformation curve implies that
its slope increases moving on the curve from left to right, namely the oppor-
tunity cost of B increases as the quantity of this commodity being produced
increases.
In Fig. 13.2 we have drawn the transformation curves of the two coun-
tries; their relative position refiects the assumption that country 1 is capital
abundant relative to country 2 and that commodity A is capital intensive
relative to commodity B.
It should be noted that it is not necessary for the two curves to intersect:
what matters is that they have a different slope along any ray through the
origin. If relative factor endowrnents were the same in both countries, then
their transformation curves would have the same slope (that is, an identical
opportunity cost) along any ray through the origin (in other words, they
would be radial blow-ups of each other); similarly, the ratio of the outputs
in the two sectors would be the same in both countries at any given common
commodity-price ratio. In such a situation, given the assumption of identical
structures of demand, there would be no scope for international trade.
The first step in our proof is to show that-at the same commodity-price
3Let us observe that this definition has a general validity, independently of the con-
text. For example, in the context of the Ricardian theory, it is possible to identify the
opportunity cost with the comparative cost.
216 Chapter 13. Orthodox Theory: Cornparative Cost, Factor Endowrnents, Dernand
o B
Figure 13.2: Transformation eurve and the Heekseher-Ohlin theorem
ratio-a eountry abundant in one factor has a produetion bias in favour of

the eommodity whieh uses that factor more intensively namely, in our ease,
that eountry 1 has a produetion bias in favour of A whilst eountry 2 has a
produetion bias in favour of B.
Let us then eonsider a pre-trade (i.e. autarkie) situation and take a given
commodity-price ratio which is identieal in both countries (PIPI and P2P2
are parallel, thus denoting the same price ratio PB/PA). Country 1 is at
point H I on its own transformation eurve and country 2 at point H 2 • It can
immediately be seen that, at the same relative price of goods, the ratio of
the output of A to the output of B is greater in eountry 1 than in eountry
2 because the slope of OR I is greater than the slope of OR2 • This property
holds for any common relative price of goods.
It is now easy to show that each country exports the commodity which
uses the eountry's more abundant factor more intensively. This follow from
the lemma and from the assumption that the strueture of demand is iden-
tical in both eountries (and independent of the level of income). In fact,
with free trade and no transport eosts, the commodity-price ratio (terms of
trade) is the same in both countries. Now, according to the lemma, at the
same relative price of goods eountry 1 (the eapital-abundant eountry) will
produce relatively more A (the capital-intensive commodity) and country 2
(the labour-abundant country) will produce relatively more B (the labour-
intensive commodity): the ratio A/ Bis greater in country 1 than in country
2. But, given the assumption as to the structure of demand, at the same
relative price of goods both countries wish to eonsume A and B in the same
proportion: it follow that country 1 will export A (and import B, whieh will
be exported by eountry 2) so that after trade the structure of the quantities
of the goods available (the quantity available is given by domestie output

plus imports or less exports) turns out be identieal in both eountries and
equal to the strueture of demand. This eompletes the proof.
BOX 13.1 The Leontief paradox
The empirical relevance of the Heckscher-Ohlin theorem has been the subject of very
many studies, beginning with the pioneering one of Leontief (1953). By applying his
input-output analysis to the 1947 input-output table of the US economy, Leontief
computed the total (direct and indirect) input requirements of capital and labour
per unit of the composite commodity "US exports" and per unit of the composite
commodity "us competitive import replacements"; in both cases the unit was one
million dollars' worth of commodities at 1947 prices and composition. By "compet-
itive imports" Leontief refers to "imports of commodities which can be and are, at
least in part, actually produced by domestic industries", so that by replacing a unit
of imports with a unit of domestic production, it is possible to find out "whether
it is true that the United States exports commodities the domestic production of
which absorbs relatively large amounts of capital and little labour and imports for-
eign goods and services which-if we had produced them at home--would employ a
great quantity of indigenous labour but a small amount of domestic capital" (1953,
p. 75).
The findings of this analysis were striking: in fact, it turned out that the United
States exported labour-intensive commodities and imported capital-intensive ones!.
Now, since the United States was generally considered to be a capital abundant
country relative to all its trading partners (remember that the data refer to 1947),
Leontief's results were in sharp disagreement with the Heckscher-Ohlin theorem
(according to which the US ought to have exported capital-intensive commodities),
whence the "paradox", as it came to be known in the literature.
Leontief's analysis gave rise to wide debate, concerning both its statistical and the-
oretical aspects, and to a host of successive empirical studies, which still continue,
with confiicting results. Leontief hirnself 1953, pp. 87ff.) observed that Ameri-
can labour was-at that time--more efficient than rest-of-the-world labour, so that,
when the former was converted into equivalent units of the latter, the United States
became a labour abundant country relative to the rest of the world. According
to Leontief, it was plausible to assurne a coefficient of conversion of three: "Then,
in comparing the relative amounts of capital and labour possessed by the Uni ted
States and the rest of the world ( ... ) the total number of American workers must be
multiplied by three ( ... ). Spread thrice as thinly as the unadjusted figures suggest,
the American capital supply per 'equivalent worker' turns out to be comparatively
smaller, rather than larger, than that of many other countries" (1953, pp. 87-88). It
should however be noted that subsequent studies did not confirm the coefficient of
conversion of three that Leontief assumed, but gave much lower values, insufficient
to make the USA a relatively labour abundant country.
For a survey of the enormous empirical literature on the Heckscher-Ohlin theorem
see Leamer and Levinsohn (1995). The conclusion to be drawn from recent stud-
ies (see Davis and Weinstein, 2001) is that different factor endowments, though
important, are by themselves not sujJicient to explain international trade patterns:
differences in both technology and demand patterns should also be taken into ac-
count. But isn't this what the neoclassical theory (see Sect. 13.3) has been saying
for at least 125 years?
As a spin-off the terms of trade will be determined (and will He between
the autarkie eommodity-priee ratios of the two eountries)-we eall it a "spin-
off" beeause the main point of the Heekseher-Ohlin theory is to prove the
basic proposition on the pattern of trade rather than to determine the terms
of trade.
13.3 The N eoclassical Theory

Before discussing the neoclassical model of international trade, it is advis-
able to show how the general equilibrium of production and consumption is
determined in a simple closed economy, where two final goods (A and B) are
produced by fully employing of two primary factors of production (K and
L).
The given data are:
(a) the total amounts of the two factors existing in the economy;
(b) the distribution of these among the members of the economy,
namely the amounts of K and L owned by each member;
(c) the tastes of consumers;
(d) the state of technology, represented by well-behaved aggre-
gate production functions (a "well-behaved" production function
shows constant returns to scale and has positive but decreasing
marginal productivities).
Perfect competition obtains in all markets (commodities and factors).

Starting from the data it is possible to determine the demand and supply
curves of each commodity as functions of the relative price (PB/PA or PA/PB,
obviously one is the reciprocal of the other so that we can consider only one
price ratio, for example PB/PA). We shall assurne that each supply curve is
an increasing function of the own relative price (namely the supply of Bis an
increasing function of PB/PA, while the supply of Ais an increasing function
of PA/PB), and that each demand curve is a decreasing function of the own
relative price.
It should be noted that these supply and demand curves are different
from the standard supply and demand curves in a market. The latter are, in
fact, partial equilibrium curves (the prices of other commodities and income
are kept constant), while the former are general equilibrium curves, in which
everything is allowed to vary.
To show this let us begin by deriving the supply curves of the two com-
modities as a function of the price ratio or relative price, PB/PA. With
reference to Fig. 13.3, suppose that PB/PA is equal to tann: the optimum
point on the transformation curve is then H, where the marginal rate of
transformation and the relative price are equal. Therefore, quantities OA'
of commodity A and OB' of commodity B will be supplied when the rela-
tive price is tann. Similarly, quantities OA E of commodity A and OBE of
commodity B will be supplied when PB/PA is tanß. In short, a unique pro-
ductive combination will correspond to every admissible price ratio. From
13.3. The Neoclassical Theory 219
I
I
I
I
A' ---L----
I
I
I
I
I
I
I
o B
Figure 13.3: 'Ifansformation curve and supply of commodities
the diagram we see that tano: > tanß, namely PB/PA is higher at H than at
E. Furthermore, OB' > OBE and OA' < OA E . This shows that the quan-
tity produced (and supplied) of B increases as its own relative price PB/PA
increases, while the quantity of A decreases. Conversely, the quantity of A
increases (and that of B decreases) as PA/PB increases.
Let us now come to the demand curves of the two commodities. In
general equilibrium the demand for each commodity depends on the price
of all commodities (in our simplified model with only two goods, on their
relative price) and on the individual's real income. This last is determined
by the marginal productivities of the factors (labour and/or capital) owned
by the individual: under perfect competition, in fact, the real unit reward
of each factor equals the factor's marginal productivity. These marginal
productivities, given the technology, ultimately depend on the relative price
of the commodities which has given rise to the outputs shown in Fig. 13.3.
It should be emphasized that these demand curves are different from the
usual Marshallian or partial equilibrium demand curves, which express the
quantity demanded of a good as a function of its (relative) price, and are
obtained on the ceteris paribus assumption, namely that everything else--
including (individual) income--is equal. On the contrary, in our derivation
income changes as PB/PA changes: in fact, when PB/PA is different, we are at
a different point on the transformation curve; therefore the marginal produc-
tivities of the factors will be different and, consequently, each individual's real
income will be different. In other words, the demand curves we are dealing
with are general equilibrium demand curves, which depend on real income
as wellas on relative prices; but, since real income depends on relative prices
alone as shown above, we can express these demand curves as functions of

relative prices alone.
Equating supply and demand for each commodity we determine the equi-
librium relative price and hence the general equilibrium of the system. How-
ever, what ensures that the equilibrium relative price (PB/PA)E determined
in the market for commodity B is consistent with the equilibrium relative
price (PA/PB)E determined in the market for commodity A, namely that
these two relative prices are one the reciprocal of the other? This equality is
fundamental, since if the two markets were to be in equilibrium at different
relative prices, the model would be inconsistent.
13.3.1 A Digression on Walras' Law

Actually it is possible to show that if one market is in equilibrium the other
must also be in equilibrium, so that the equilibrium price ratio cannot be
different in the two markets. The proof is based on an important property
of all general equilibrium systems in which a budget constraint is present,
called Walras' law.
Let PK and PL indicate factor rewards, SA and SB the quantities of the
two commodities supplied, K and L with a subscript A or B the quantities
of the two factors allocated in the two sectors .. Let us now recall that under
perfect competition, in each sector total factor rewards equal the value of
output. Thus we have
PKKA +PLLA
PKKB+PLLB
from which
(13.4)
The left-hand side of (13.4) is the total income of all the individuals in the
ecoI,lomy (that they obtain by selling the services of the productive factors
they own). Since in this model income is entirely spent in buying commodities
A and B, we can write
(13.5)
where DA and DB are the quantities demanded of the two commodities.
Equation (13.5) is the aggregate budget constraint. From Eqs. (13.4) and
(13.5) it follows that the right-hand sides must be equal, as the left-hand
sides are equal. Therefore
(13.6)
whence
(13.7)
13.3. The Neoclassical Theory 221
which is true for any admissible value of PA and PB. The difference between
demand and supply is called excess demand and is to be taken with its sign, in
the sense that a positive excess demand means that demand is greater than
supply, while a negative excess demand (also called excess supply) means
that demand is smaller than supply.
Equation (13.7) states that the sum of the values of the excess demands
must be equal to zero, and is known as Walras' law. It is then immediately
obvious that, if a market is in equilibrium (zero excess demand), the other
must also be in equilibrium.
Walras' law teIls us something more, namely that if in a market there is an
excess demand with a certain sign, in the other market there must necessarily
be an excess demand with the opposite sign. For example, if DA - S A > 0
(positive excess demand in the market for commodity A, then D B - SB < 0
(negative excess demand, that is excess supply, in the market for commodity
B).
In general, given n markets linked by a (budget) constraint, Walras' law
implies that if n - 1 markets are in equilibrium, the nth must also be in
equilibrium. In our case there are only two markets, so that if one is in
equilibrium the other must also be: for example, if DA = SA then Eq. (13.7)
implies D B = SB, and vice versa.
13.3.2 International Trade

While in a closed economy the only possible equilibrium is where all excess
demands are zero, in an open economy the possibility arises of equilibria with
non-zero excess demands. Consider, for example, a positive excess demand
for a commodity (say, commodity A) matched (according to Walras' law)
by an excess supply of the other. Now, the positive excess demand can be
met by importing A, while the excess supply of B can be exported. Of
course there must be another country where exactly the opposite situation
(excess supply of A and excess demand for B) holds; furthermore, for an
international equilibrium to exist, the terms of trade must be such that the
excess demand for A is exactly equal in absolute value to the excess supply
of A by the other country, and vice versa for commodity B.
Let us then consider a two-country world exist, country 1 (the horne
country) and country 2 (the rest of the world). Perfect competition prevails
in international markets. Both countries use the same factors, which are
internationally immobile, and produce the same goods (which are perfectly
mobile); for simplicity's sake transport costs are neglected
In the absence of international trade, both countries will be in a situation
of equilibrium with zero excess demands for all commodities. But, as factor
endowrnents, technology, and tastes are different in each country, it is very
unlikely that the equilibrium price ratio will be the same in both. If this were
so, there would be no scope for international trade. Let us then assume that
the closed-economy equilibrium price ratios are different in the two countries;
without loss of generality we can assurne that this ratio is greater in country
2 than in country 1, as shown in the back-to-back diagram drawn in Fig.
13.4.
In this figure we have drawn the general-equilibrium demand and supply
curves for commodity A as functions of the relative price PA/PB in the two
countries: in the right-hand part there are the demand and supply curves for
commodity A in country 1, and in the left-hand part there are the demand
and supply curves for the same commodity in country 2. As assumed above,
the closed-economy equilibrium price-ratio in country 2 (0 RE) is greater
than in country 1 (0 PE).
It can be easily shown that when trade is opened up, commercial relations
are possible only if the international price ratio or terms of trade lies some-
where between the two internal equilibrium price ratios. We first observe
that with free trade, perfect competition and no transport costs, the same
commodity must have the same price everywhere (the law of one price), so
that the international and the national price ratios are the same. Now, for
terms of trade higher than ORE , both countries would supply commodity
PA/PB
S2A D2A
country 2 country 1
SIA
M 1A
D2A
PE
A 0 A
Figure 13.4: Determination of international equilibrium
A internationally, because in both of them there would be an excess sup-

ply of this commodity, and no equilibrium would be possible. Similarly, for
terms of trade lower than OPE , both countries would demand commodity A
internationally, because in both of them there would be an excess demand
for this commodity. Therefore, only intermediate terms of trade are to be
considered, since between 0 PE and 0 RE country 1 will supply, and country
2 will demand, commodity A.
13.4. Offer Curves and International Equilibrium 223
International equilibrium will be established at a point where the excess

demand for good A by country 1 (country 1's demand for imports) is exactly
matched by the excess supply of the same commodity by country 2 (country
2's supply of exports). This point is shown in Fig. 13.4 at the terms of trade
OQE, where M1AM1A = X 2A X 2A .
In Fig. 13.4, the position of the supply and demand curves for A in
each country depends, as we know from Sect. 13.3, on factor endowments,
technology, and tastes existing in the country. These are the elements that
determine, ceteris pari bus, the relative position of the two sides of the dia-
gram under consideration and, therefore, which commodity will be imported
and which exported. In fact, if the above elements were such that 0 RE were
lower than OPE , then it would be country 1 which would export, and country
2 which would import, commodity A. This proves the following important
conclusion: in the neoclassical model of international trade, the existence of
commercial relations, the pattern and the volume of trade, and the terms
of trade, are jointly determined in a general equilibrium setting by factor
endowments, technology, and tastes, none of which can be in general said
to be an exclusive or predominant causal agent.
Obviously, thanks to Walras' law extended to the international market,
the terms of trade which equate demand and supply in the international
market for commodity A must necessarily equate it in the other market. This
property enables us to examine international equilibrium by considering just
one of the two markets, that of commodity A (alternatively we could have
considered the market for B). In our case, in the market for B there will be
an excess supply for that commodity from country 1, and a corresponding
excess demand from country 2.
It is also worth pointing out that this conclusion implies that no coun-
try can be a net importer or exporter of both commodities: if it imports
commodity A it must export commodity B, and vice versa. This is an obvi-
ous consequence if we think that in the barter model under consideration a
country can obtain imports only by paying for them with exports.
13.4 Offer Curves and International

Equilibrium
An alternative way of determining international equilibrium is to use the
Marshallian reciprocal demand curves (also called offer curves and demand-
and-supply curves). The offer curve of a country can be defined as the locus
of all points which represent the quantity of the exported good that the
country is willing to give in exchange for a given amount of the imported
good (or, if we prefer, the quantity of the imported good that the country
is willing to accept in exchange for a given amount of the exported good).
B B
Gi
Gz
Figure 13.5: Offer curves and international equilibrium
Equivalently, this curve indicates the various terms of trade at which the
country is willing to trade.
In Fig. 13.5 we have drawn the offer curves of country 1 and country
2, DG l and DG 2 respectively, on the assumption that country 1 demands
commodity A in the international market, offering commodity B in exchange,
while the opposite is true for country 2. Each curve is normally increasing
and concave to its import axis.
Considering for example country 1, it will demand, say, OHA of commod-
ity A (a demand for imports) and offer OHB of commodity B in exchange
(a supply of exports). This gives rise to point Q of the OG l curve. At point
Q the relative price of goods (terms of trade) is measured by the slope of
the straight line connecting Q with the origin, namely by tan 0:: this relative
price, in fact, is given by the ratio of the quantities demanded and supplied,
namely by OHAjOHB = HBQjOHB = tano:.
International equilibrium is determined where the offer curves intersect,
namely at point E: country 1 demands OEA of commodity A, exactly equal
to the amount of A supplied by country 2, and supplies OEB of commodity
B, exactly equal to the amount of B demanded by country 2. International
trade will take place on the basis of OEB of B (exported by country 1 and
imported by country 2) for OEA of A (imported by country 1 and exported
by country 2); the equilibrium terms of trade are measured by tanß (slope
of the ray OE).
13.5. The Gains from Trade 225
13.5 The Gains from Trade

We saw in the context of the classical theory that international trade is
beneficial in so far as it enables a country to obtain a commodity at a lower
cost than the domestic production cost or, alternatively, to obtain commodity
bundles which were out of reach under autarky. A similar conclusion holds
in the neoclassical theory (and so in the Heckscher-Ohlin model, which is a
particular case).
Consider for example Fig. 13.6 and suppose that the pre-trade closed-
economy price ratio is represented by the slope of the straight line PP,
whereas the terms of trade (post-trade open-economy price ratio) are rep-
resented by the slope of the straight line RR. Before trading started the
country produced and consumed a commodity bundle given by the coordi-
nates of point E. When trade is opened up, the country pro duces the com-
modity bundle given by the coordinates of point E' (production point). But
it can now trade along the RR line, thus attaining previously unattainable
points, outside its transformation curve. For example, it can move to point
E,
,
EA _______ IL __
, E'
I I
I I R P
o B
Figure 13.6: The gains from trade
Eil (consumption point) by trading HBEBof commodity B (exportables) for

HAE~ of commodity A (importables); point Eil is clearly better (excluding
inferior commodities) than the pre-trade point E because the amounts of
both commodities are greater at Eil than at E.
But what if the post-trade situation is E"'? This point is undoubtedly
outside the transformation curve, and thus it could not be reached before
trade, but since with respect to E it contains a greater amount of com-
modity A and a smaller amount of commodity B, it cannot be considered
unambiguously better than E. It is however easy to observe that the value of
national income at E'" is in any case greater that at E. This is true whether
national income is calculated at the closed-economy (pre-trade) prices or at

the new (post-trade) prices.
Let us first consider the closed-economy prices. The value of national
income at E is given by the position of the equal income line (which we call
isoincome) PP, while at E III it is given by the position of the isoincome line
(not shown in the diagram) parallel to PP and passing through E III , which
is clearly more distant from the origin than PP. It foHows that national
income evaluated at the closed-economy prices is higher at E III than at E.
At the post-trade prices, the value of national income at E III is given by
the position of the isoincome line RR, while at E it is given by the isoincome
line (not shown in the diagram) parallel to RR and passing through E, which
is clearly nearer to the origin than RR (and hence represents a lower income).
A A R
p
o b)
a)
Figure 13.7: Sodal indifference curves and the gains from trade: consumption
and production gains
The gains from trade can be given a more predse treatment if one is will-
ing to accept the concept of community or sodal indifference curves. The
problems raised by this concept are among the moot questions in welfare eco-
nomics. This notwithstanding, these curves are widely used in international
economics and we do not depart from general practice by using them as a
helpful expository device, though fully aware of their shortcomings.
In Fig. 13.7a the pre-trade (autarkic equilibrium) situation is depicted;
sodal welfare is maximized at point E, where a sodal indifference curve
is tangent to the transformation curve. In Fig. 13.7b, the terms-of-trade
line RR is drawn: the highest indifference curve attainable is that which is
tangent to this line, thus determining the consumption point Ec predsely,
as weH as the imported and the exported commodities and the amounts
traded (HBE~ of exports for HAEAof imports). The gains from trade are
13.6. The Four Core Theorems 227
immediately visible, as the sodal indifference curve tangent at E c is higher

than the curve tangent at E, and so represents a better situation.
13.6 The Four Core Theorems

As clarified in Chap. 1, Sect. 1.2, Ricardian comparative-cost theory, neo-
classical theory, and Heckscher-Ohlin theory together form the body of the
orthodox theory of international trade. However, the factor-proportion the-
ory is often identified with ''the'' orthodox theory, and the Heckscher-Ohlin
theorem, together with the factor-price-equalization (FPE) theorem and two
additional theorems (the Stolper-Samuelson theorem and the Rybczynski
theorem), are said to constitute the four core theorems of the orthodox the-
ory of international trade.
Be it as it may, the purpose of the present section is to complete the
treatment of the previous sections by examining the factor-price-equalization
theorem, the Stolper-Samuelson and Rybczynski theorems. Both of them
are comparative statics theorems, as they examine the effects of a change
in some data on the general equilibrium of the economy. It is important to
note that they are general theorems, in the sense that they also hold for a
closed economy; but we shall be concerned with their ultimate impact on
open economies.
13.6.1 The Factor-Price-Equalization Theorem

This theorem states that international trade in commodities, notwithstanding
the international immobility of factors, equalizes factor prices across coun-
tries. It should be stressed that the equalization concerns not only rela-
tive factor prices (PL/PK) , but also absolute factor prices, that is, PIL =
P2L, PIK = P2K·
To prove FPE we shall assume that international trade does not bring
about complete specialization, so that each country continues to produce
both goods; it is important to stress that this assumption is necessary to
demonstrate the theorem under consideration. We shall also assurne that
technology is internationally identical and that there is a one-to-one corre-
spondence between the relative price of goods and the relative price of factors,
which is the same in both countries given that the technology is identical (this
correspondence always exists in the case of no factor:intensity reversal, see
the end of Sect. 13.2.1).
Since with free trade, no transport costs, etc., the same good must have
the same price in both countries (the law of one price), the relative price of
goods is the same in both countries. It follows from the common one-to-one
correspondence between the relative price of goods and the relative price of
factors that the relative price of factors is identical in both countries.
To arrive at absolute factor price equalization (which is what interests

us) some more groundwork is necessary.
As a consequence of the identity between the relative price of factors and
of the assumptions on technology, the optimum input combination in each
sector is the same in both countries (but for a factor of scale): in other words,
(K/LhA = (K/LhA and (K/LhB = (K/LhB. With constant returns to
scale, marginal productivities depend solelyon the factor input ratio and are
independent of scale. It follows that the marginal productivities of the two
factors in the two sectors are identical in both countries, namely
MPK IA = MPK2A,
MPL IA = MPL 2A ,
(13.8)
MPK IB = MPK2B ,
MPL IB = MPL 2B ,
where M P K and M P L denote the marginal productivities of capital and
labour respectively, and the subscripts refer to the countries and commodities
as usual.
The importance of the assumption of incomplete specialization should
be noted here. In fact, if specialization were complete (for example, coun-
try 1 produces exclusively commodity A and country 2 commodity B), the
quantities MPK IB and MPL IB could not be defined in practice (because
commodity Bis not produced in country 1), neither could be MPK2A and
M P L2A (because commodity A is not produced in country 2); therefore Eqs.
(13.8) could not be written and the rest of the proof would fall.
Now, under perfect competition the equilibrium condition value of the
marginal product of a factor = price of the factor must hold. In symbols (re-
member that PA and PB are internationally identical) we have, with reference,
for example, to capital,
PAMPKIA = PIK,
PA MPK2A =P2K, (13.9)
PBMPKIB = PIK,
PBMPK2B =P2K,
from which---since the marginal productivities obey (13.8)-it follows that
PIK = P2K· In a similar way it can be shown that PIL = P2L. This completes
the proof of FPE.
Better to appreciate the importance of this theorem, it is sufficient to
realize that it shows that free trade in commodities is a perfect substitute for
perfect international mobility of factors. Note that, if perfect international
factor mobility existed as well, then perfect competition would necessarily
lead to international equalization of factor prices. But in our models we have
assumed absolute international immobility of factors, hence there might seem
to be no reason the factor prices to be equalized across countries.
Contrary to this impression, the theorem under consideration shows that

FPE, far from being an improbable event, is a necessary consequence of
international trade in the assumed conditions. This came as a surprise to
the very writers who first gave a rigorous proof of this theorem: see Samuelson
(1948, p. 169).
This explains the great deal of attention paid by international trade the-
orists to this theorem.
13.6.2 The Stolper-Samuelson Theorem

The Stolper-Samuelson theorem states that the increase in the relative price
of a commodity favours (in the sense that it raises the unit real reward of)
the factor used intensively in the production of the commodity.
In the proof of the Stolper-Samuelson theorem it is customary to start
from the Heckscher-Ohlin theorem, but it is important to note that the former
theorem does not depend on the latter in any essential way. It is in fact
possible to prove the Stolper-Samuelson theorem in its general formulation
independently of the Heckscher-Ohlin theorem.
Let us then assume that the domestic relative price of commodity B in-
creases. We also assume that, in the interval under consideration, commod-
ity B is unambiguously labour-intensive (which does not exc1ude the presence
of factor-intensity reversals elsewhere). The increase in PB/PA causes a move-
ment on the transformation curve towards a point where more Band less
A is produced (see, for example, Fig. 13.3), so that resources will have to
be reallocated from the latter to the former industry. But, since B is more
labour intensive than A, it follows that-at given relative factor prices-the
proportion in which capital and labour become available as a result of the
decrease in the production of A does not coincide with the proportion in
which the expanding sector B is prepared to absorb them.
In fact, at the given factor price ratio, labour and capital are made avail-
able by sector A in a lower proportion than that required by sector B. There
follows, at the global level, an excess demand for labour and/or an excess
supply of capital, with the consequence that PL/PK increases. AB this ra-
tio increases, cost-minimizing firms will substitute capital for labour in both
sectors, that is, they will choose techniques with a higher K / L ratio. Since
the marginal productivity of labour is an increasing function of this ratio,
the theorem is proved.
The relevance of the Stolper-Samuelson theorem for international eco-
nomics lies in its use for the examination of the redistributive effects of
tariffs. A tariff, in fact, normally causes an increase (with respect to the
international price ratio) in the domestic relative price of the good on which
the tariff is levied, and hence income redistribution effects due to the change
in real factor rewards.
13.6.3 The Rybczynski Theorem

The point of departure for examining the effects of an increase in factor
endowments is Rybczynski's theorem, according to which the increase in the
quantity of a factor (given the other) will cause an increase in the output of
the commodity which is intensive in that factor and a decrease in the output
of the other commodity, at unchanged commodity and factor prices.
A graphical representation of this theorem can be given by a diagram
which uses the transformation curve. At the same time we shall also explain
an important corollary of Rybczynski's analysis, namely that the increase
in the quantity of a factor (at unchanged quantity of the other factor) will
cause a decrease in the relative price of the commodity that is intensive in
that factor. In Fig. 13.8, TT is the initial transformation curve which shifts
R'
Figure 13.8: Rybczynski's theorem and relative price of goods
to T'T' as a consequence of the increase in the quantity of labour, Q and

Q' are the two equilibrium points (production points in the case of an open
economy) at the same commodity price ratio (R' R' and RR are parallel).
Since A is the labour-intensive commodity, its output will increase and the
output of B will decrease, that is, Q' must be situated to the left of Q" (which
is the point at which the output of Bis the same as that at Q).
However, point Q' is only hypothetical. Since the R' R' line is higher than
the RR line, and since each of these can be interpreted as an isoincome line,
R' R' represents a higher national income at constant prices (that is, at the
same prices existing at the initial equilibrium point Q) than that represented
by RR. Now-if we exclude inferior goods-this increase in income will cause
an increase in the demand for both commodities; since, as we have seen, the
output of B is lower, there will be an excess demand for this commodity
which will cause an increase in its relative price (PB/PA) and, consequently,
in its output. Therefore the new equilibrium point will be found in the
stretch Q" QIII of the curve T'T': only there, in fact, is the output of both A
and B higher than at Q. It can also be seen from the figure that at any point
included in this stretch, for example QE, the relative price of Ais lower, as
this price is measured by the (absolute value of the) slope of the RERE line
with respect to the A axis, which is smaller than the analogous slope of the
RR line.
All this concerns a closed economy. We now consider a trading open
economy, where we must distinguish the small country case from the case in
which the country is sufficiently large for its demands and supplies on the
world market to infiuence the terms of trade.
Let us assume, for example, that commodity A is the importable. We
further assume, for simplicity, that no commodity is inferior, so that, when
income increases, the demand for both A and B increases (each, of course,
increases by less than income). In the passage from Q to Q', the output
of commodity A has increased more than income whilst the output of B
has decreased. It follows that, within the country: (a) the excess demand
for A (demand for imports) decreases, as output has increased more than
demand; (b) the excess supply of B (supply of exports) decreases, as output
has decreased whilst demand has increased. Therefore, on the world market,
at the given world relative price, there will be a decrease in both the demand
for A and the supply of B.
It is at this point that the distinction between the small and the large
country case becomes relevant. In the former case the terms of trade do not
change, and the country will go on producing at Q'.
In the large country case, the excess supply of A on the world market (due
to the decrease in the country's demand for imports), and the correlative
excess demand for B (due to the decrease in the country's supply of exports)
will cause changes in world prices, since the excess supply of A will put a
downward pressure on PA and the excess demand for B an upward pressure
on PB; therefore the terms of trade PB/PA increase. This confirms the closed-
economy result. Note that, since we have assumed A to be the importable,
the terms of trade have improved.
Let us now consider the case in which the importable is commodity B,
maintaining the assumption that there are no inferior goods. When the pro-
duction point shifts from Q to Q', the consequences for the country will
be: (a) the excess supply of A (supply of exports) increases, since its out-
put (which increases by more than income) increases by more than demand
(which increases by less than income); (b) the excess demand for B (demand
for imports) increases, because output decreases whilst demand increases.
Therefore-Ieaving aside the small country case-on the world market at
unchanged prices there will be an increase in both the supply of A and the
demand for B and so-since the initial situation was of equilibrium-an ex-
cess supply of A and an excess demand for B. This will cause a decrease
in PA and an increase in PB, so that PB/PA will increase, again confirming
the closed-economy results. As B is the importable, the terms of trade have
moved against the country.
The relevance of Rybczynski's theorem in international trade theory lies
in its use to examine the effects of growth, when the cause of growth is an
increase in factor endowments.
13.7 International Factor Mobility and Trade

in Factors
The international irrunobility of productive factors is, as we know, one of the
concepts around which the traditional theory of international trade revolves.
In effect, it would be possible to argue that, in a situation of free and perfect
international mobility, of both goods and factors, the need for a theory of
international trade disappears, as the whole world would become a single
integrated system.
In reality there is never perfect international mobility either of goods or
factors, but the assumption of absolute irrunobility of factors is undoubtedly
inexact, so that it is important to analyse the consequences of introducing
international mobility of factors into orthodox theory.
Before going on, however, a few terminological caveats are in order.
Firstly, although 'international factor mobility' and 'trade in factors of
production' are often used synonymously, we prefer to keep them distinct for
the following reasons.
International factor mobility remains rooted in the traditional model, in
the sense that we are always in the context in which final goods are produced
by means of primary factors. The only difference from the traditional model
is that the assumption of international factor irrunobility is dropped: factors
can freely move at both the national and international level. If, say, capital
moves from country 1 to country 2, and labour from country 2 to country
1, we may say for short that country 1 has 'exported' capital and 'imported'
labour, but we must keep in mind that these primary factors are not 'traded'
in the sense in which corrunodities are traded.
In fact, as we know from previous chapters, corrunodity trade depends
on the conditions of demand and supply, where supply implies production
in an essential way. The 2 x 2 x 2 simple general equilibrium model that
forms the basis of the orthodox theory of international trade is not a pure
exchange model, but a model with production and exchange. Primary factors
of production, by definition, are not produced. This is why we prefer not to
13.8. The Specific Factors Model 233
speak of factor trade when we are in the presence of the mere international
mobility of primary factors. Both capital and labour can be considered under
this heading, land being immobile by its very nature.
Trade in factors, on the other hand, implies that we are dealing with
factors which are themselves produced means of production and, in addition
to being internationally mobile, can be traded as any other good. This
practically restricts the picture to (physical) capital in its various forms,
both fixed and intermediate.
Our distinction is neither semantic nor whimsical, as it has important
consequences. Suffice it to point out that, in the case of mere factor mobil-
ity, when factor prices are equalized through factor movements, factors stop
moving. On the contrary, in the case of trade in factors, when the prices of
traded factors are equalized through free trade, these factors (in their quality
of traded goods) continue to move as any other traded commodity.
The second caveat is that by factor movements we mean the physical
movement of factors from one country to another, not the mere change of
ownership of an otherwise immobile factor. Suppose that a resident of coun-
try 1 buys real estate in country 2, or that a firm residing in country 1 buys
aplant located in country 2 and operates it there with local labour and
management: these are not factor movements from our point of view. They
may imply a movement of other commodities (in the case of barter) or more
realistically a financial capital flow from country 1 to country 2 (named a
direct investment when the purchase refers to a plant), but financial capital
is not considered by the pure theory of international trade. This is why we
feel that the study of direct investment and multinational corporations is
best carried out in the context of international monetary economics.
13.8 The Specific Factors Model

Factors of production have been so far assumed to be ubiquitous in an sectors.
It is however possible that, alongside with these all-purpose factors, other
factors exist which are specific to each sector. This means that they can
only be used in the sector of pertinence and not elsewhere. For example,
the (physical) capital required to produce computer microprocessors is quite
different from that used to produce textiles, and they are not interchangeable
in the short run. Long-run interchangeability is of course possible, as the
(Marshallian) long run is, in fact, defined as aperiod of time sufficient to allow
an factors to be in free intersectoral mobility. In the long run, capital can
move from the textile to the microprocessor sector via depreciation without
replacement in the former and new investment in the latter.
Thus the models so far examined can be considered as long-run models,
while the specific factors model is more appropriate for the short run.
Although it maintains the basic two-sector setting, the specific factors
model is actually a three-factor model. In fact, besides the ubiquitous homo-

geneous factor (say, labour), two additional and different factors are needed
to represent specificity. These may be, for example, capital and land, if we
wish to consider manufacturing and agriculture as our two sectors. We re-
main in the traditional framework and assurne that the specific factors are
two different capital goods (say, KA and K B ). Thus commodity A is pro-
duced using labour and K A, while commodity B is produced using labour
and K B .
Apart from this, the model's setting is identical with the orthodox one:
perfeet competition, homogeneous production functions of the first degree,
etcetera.
As we have already seen, perfect competition implies the equilibrium
condition value of the marginal product of a factor = price of the factor.
Labour mobility implies that the wage rate is equalized between sectors.
Hence we can write
PAMPLA = PL,
(13.10)
PBMPLB = PL,
where M P LA, M P L B are the (physical) marginal products of labour in the
two sectors, and PL is the wage rate. Letting w = PL/PA denote the real
wage rate in terms of commodity A, and P = PB/PA the commodity price
ratio, we have
MPL A =W,
(13.11)
pMPL B =W,
hence
MPLA = pMPL B, (13.12)
which determines the optimal allocation of labour between the two sectors
and hence-since the two stocks of specific capital are also fully employed-
the outputs of the two commodities for any given p.
Equation (13.12) can be given a simple graphie representation. In Fig.
13.9, the total amount of labour is measured by the segment OAOB. The
quantity of labour used in sector A is measured from the origin 0 A, while
that used in sector B is measured from OB. In the ordinate we show the
real wage rate w. Curves L~, L~ represent the demand-for-labour schedules
in the two sectors, derived from Eqs. (13.11) for a given p. The equilibrium
condition (13.12) obtains at point E. This determines the equilibrium real
wage rate WE and the optimal allocation of labour, which consists of 0 ALE
employed in sector A and OBL E employed in sector B.
Let us assume that the general-equilibrium commodity price ratio is that
corresponding to curve L~, say Pb and consider the introduction of inter-
national trade in a two-country framework. The condition for international
trade to take place is that P2, the closed-economy commodity price ratio in
country 2, is different from PI. Without loss of generality we can assume that
W w
:B :::::::::::::::~:::::::::)......... .. ...................................... WB
B LD . LD
B ~ A
L'E
Figure 13.9: The specific factors model
P2 > PI, hence the post-trade price ratio p* will be somewhere in between.
Thus we can take E' as the post-trade equilibrium in country 1. In country
2 there will be a downward shift of the demand for labour in sector B, since
p* < P2. This shows that there will be an increase in sector B's output in
country 1 and in sector A's output in country 2.
We now consider factor rewards. From Fig. 13.9 we see that an increase
in P (the relative price of commodity B) causes more labour to be used in
sector B and less in sector A. The (specific) capital to labour ratio decreases
in sector Band increases in sector A. Since the marginal productivity of
capital (which is the real unit reward of capital) depends negativelyon the
capital to labour ratio, it follows that the marginal productivity of capital
increases in sector B and decreases in sector A.
The effect on the ubiquitous factor is however ambiguous. The wage rate
does, in fact, increase in terms of commodity A (from WE to WB)' but declines
in terms of commodity B (since the marginal productivity of capital is higher
there, the marginal productivity of labour is lower). Whether wage earners
are better or worse off depends on the composition of their expenditure, a
result that has been dubbed the neoc1assical ambiguity in trade theory.

Allen, W.R. (ed.), 1965, International Trade Theory: Hume to Ohlin, New
York: Random House.
Bhagwati, J.N., A. Panagariya and T.N. Srinivasan, 1998, Lectures on In-
ternational Trade, 2nd edn., Cambridge (Mass): MIT Press, Part I.
Davis, D.R. and D.E. Weinstein, 2001, An Account of Global Factor Trade,
American Economic Review 91, 1423-53.
Heckscher, E.F., 1949, The Effect of Foreign Trade on the Distribution of
Income, in H.S. EHis and L.A. Metzler (eds.), Readings in the Theory
oi International Trade, Philadelphia: Blakiston (English translation of
the original 1919 article)
Leamer, E.E. and J. Levinsohn, 1995, International Trade Theory: The Evi-
dence, in G. M. Grossman and K. Rogoff (eds.), Handbook oi Interna-
tional Economics, Vol. III, Amsterdam: North-Holland.
Leontief, W.W., 1953, Domestic Production and Foreign Trade: The Amer-
ican Position Reexamined, Proceedings oi the American Philosophical
Society 97, 332- 349. Reprinted in: W. Leontief, 1966, Input-Output
Economics, New York: Oxford University Press, Chap. 5 (pages refer
to this reprint).
Leontief, W.W., 1956, Factor Proportions and the Structure of American
Trade: Further Theoretical and Empirical Analysis, Review oi Eco-
nomics and Statistics 38, 386-407; reprinted in: W. Leontief, 1966,
Input-Output Economics, op. cit., Chap. 6.
Negishi, T., 1982, The Labour Theory of Value in the Ricardian Theory of
International Trade, History oi Political Economy 14, 199-210 ..
Ohlin, B., 1933, Interregional and International Trade, Harvard University
Press (revised edition, 1967).
Ricardo, D., 1817, On the Principles oi Political Economy and Taxation,
London: J. Murray, Chap. VII.
Rybczynski, T.M., 1955, Factor Endowments and Relative Commodity Prices,
Economica 22, 336-41.
Samuelson, P.A., 1948, International Trade and the Equalization of Factor
Prices, Economic Journal 58, 163-84; reprinted in P.A. Samuelson,
1966, Collected Scientific Papers, Cambridge (Mass), MIT Press, Vol.
11.
Stolper, W.F. and P.A. Samuelson, 1941, Protection and Real Wages, Re-
view oi Economic Studies 9,50-73; reprinted in P.A. Samuelson, 1972,
Collected Scientific Papers, Cambridge (Mass), MIT Press, Vol. 111.
Torrens, R., 1815, An Essay on External Corn Trade, London: J. Hatchard.
Wong, K.-Y., 1995, International Trade in Goods and Factor Mobility, Cam-
bridge (Mass): MIT Press.
Chapter 14
Tariffs, and Non-Tariff Barriers
14.1 Introduction
This chapter is concerned with what is called the theory 0/ commercial policy
in the broad sense. The traditional theory focused on tariffs, starting from
two principles generally accepted until the first world war. These were: (a)
that impediments to international trade for protectionist purposes should be
limited to tariffs, and (b) that no commercial discrimination between supplier
countries should be instituted, in the sense that, if a tariff is levied on some
imported commodity, it should be applied at the same rate and to all imports
of that commodity independently of the supplying country.
Notwithstanding the fact that in the inter-war period, and especially dur-
ing the Great Depression, these principles were systematically violated, they
were taken up again and made the foundation of the international agreement
that, it was hoped, was to rule international trade after the second world
war: GATT (the General Agreement on Tariffs and Trade). Several interna-
tional meetings for the purpose of negotiating multilateral tariff reductions
took place under the aegis of GATT (now replaced by WTO, the World
Trade Organization, on which see Sect. 3.6.3) which, however, had to take a
permissive attitude towards the violations of the above principles. The last
few decades have seen an expansion of both non-tariff barriers to trade and
discriminatory commercial policies (preferential trading agreements etc.), so
that the traditional theory has had to be broadened to make the rigorous
analysis of these phenomena possible.
The emergence of a ''new'' protectionism, including administered protec-

tion, lobbying for protection, and so on, will be dealt with in Chap. 16.
237
238 Chapter 14. Tariffs, and Non-Tariff Barriers
BOX 14.1 Multilateral trade rounds

Since GATT's creation in 1947-48, there have been eight rounds of trade
negotiations, whilst a ninth round, under the Doha Development Agenda, is
now underway and expected to end by 1 January 2005 (see table below). The
first GATT trade rounds concentrated on further reducing tariffs. With the
Kennedy Round, over the sixties, an Anti-Dumping Agreement and a section
on development were brought into the GATT, while the Tokyo Round was the
first major attempt to tackle also non-tariff trade barriers. The eighth Round,
the Uruguay Round lasted for eight years and led to the creation of the WTO
and to a new set of agreements, such as the General Agreement on Trade in
Services (GATS) and on Trade-Related aspects of Intellectual Property (TRIPS).
Year PlacefName Subjects covered No. of
parties
1947 Geneva Tariffs 23
1949 Annecy Tariffs 13
1951 Torquay Tariffs 38
1956 Geneva Tariffs 26
1960-61 Geneva (Dillon Round) Tariffs 26
1964-67 Geneva (Kennedy Round) Tariffs and anti-dumping 62
1973-79 Geneva (Tokyo Round) Tariffs, non tariff measures, 102
framework agreements"
1986-94 Geneva (Uruguay Round) Tariffs, non-tariff measures, 123
rules, services, intellectual
property, dispute settlement,
textiles, agriculture,
creation of WTO
While the Singapore ministerial conference (1996) defined the WTO work plan,
the Geneva ministerial meeting, held in 1998, provided the mandate to launch a
new round of negotiations at its next summit, in Seattle (1999). As the Seattle
ministerial meeting turned out to be a complete failure, with critical issues
separating industrialised and developing countries, the next negotiating round was
launched in Doha, in 2001. The Doha Round delivered the Doha Development
Agenda, which, recognising the major role that international trade plays in
promoting economic development and poverty alleviation, comprises further market
opening and additional rule making, strengthened by commitments to increase
assistance to build capacity in developing countries. It also added negotiations
and other work on, among others, non-agricultural tariffs, trade and environment
and WTO rules such as anti-dumping and subsidies. With the end of the Cancun
ministerial conference (September 2003) without consensus, decisions related to the
implementation of the Doha agreement have been further postponed.
14.2 Effects of a Tariff

We begin with the traditional study of the effects of a tariff; henceforth the
tariff is assumed to have the form of an ad valorem tax on imports (so that,
if p is the pre-tariff price, the cum-tariff price will be (1 + d)p, where d1 is
IThe symbol generally used for the tariff rate is t. However, since the symbol t is also
used to denote time, another symbol (d, from duty) has been used to indicate the tariff
rate.
14.2. Effects of a Tariff 239
the tariff rate) and not of a specific tariff (so many dollars per unit of the
commodity).
price
Figure 14.1: Effects of a tariff
The effects of a tariff can be examined either in a partial or a general

equilibrium context. In the former case one considers solely the market for
the commodity on which the tariff is imposed and neglects-by a ceteris
paribus clause-the repercussions on and from the rest of the system; these,
on the contrary, are explicitly brought into the analysis in the latter case.
For simplicity's sake we shall concentrate on the partial equilibrium context,
which is however sufficient to bring out the main points.
In Fig. 14.1 we have drawn the domestic demand and supply curves-for
simplicity's sake they are assumed linear and normal-for the commodity
being examined. If we assume that its world price is p, this will also be its
domestic price given the usual assumptions (perfeet competition, no trans-
port costs, no tariffs). At this price the imports of the commodity are FH,
equal to the domestic excess demand. If a tariff is now levied, say d1 , the
domestic price will increase to p(1 + dd at the same world price p. This im-
plies the assumption that the country levying the tariff is small, so that the
variation in its import demand due to the tariff has negligible effects on the
world market of the commodity, and the world price remains constant (for
the consequences of dropping this assumption see Sect. 15.1).
The consequence is that demand decreases, domestic output (supply)
increases and imports decrease from FH to F1H1. As an extreme case, it is
possible to conceive a tariff-d2 in Fig. 14.1-80 high that the increase in the
domestic price brings this to the level at which domestic demand and supply
are equal and imports cease: such a tariff is called a prohibitive tariff.
In these brief considerations all the effects of the tariff are included, and can
be made explicit as follows:

1) consumption effect. Domestic consumption of the commodity decreases by
q3q4 = Hm·
2) Production (or protective) effect. Domestic output increases by ql q2 = F F{.
3) Import effect. Imports decrease by an amount equal to the sum of the two
previous effects, as q2q3 = qlq4 - (q3q4 + qlq2).
4) Fiscal revenue effect. The tariff represents a fiscal revenue for the govern-
ment of the levying country. To calculate total tariff revenue, note that it is given
by the absolute value of the tariff per unit of the commodity multiplied by the
quantity imported. The former is p (1 + d1 ) - p = dIP = MN + FIF{, the latter is
q2q3 = HHl· Therefore total tariff revenue is F1 F{ x HHl, that is, the area of
the rectangle Fl F{ H{ H 1.
5) Redistribution effect. Since the price has increased, there is aredistribution
of income from consumers to producers. This point needs to be went into a little
further.
Actually, it can be said that consumers subsidize the domestic production of the
commodity by an amount MN per unit, so that the total subsidy is MN F{ F1 . This
is also called the subsidy-equivalent of the tariff; in other words, if the government
directly subsidized the domestic production, instead of imposing a tariff, the total
cost of the subsidy to obtain the same amount of protection would be exactly
equal to the subsidy-equivalent. In fact, to induce domestic firms to produce the
quantity Oq2 and sell it at unit price ON instead of OM (in the absence of the
tariff the price would remain at ON), it is necessary to give them a subsidy equal
to the revenue loss, which is exactly MN F{ Fl.
But consumers do not only pay out the subsidy-equivalent: they are also taxed
byan amount equal to the tariff revenue which accrues to the government, because
this amount ultimately comes out of their own pockets. We can therefore define a
consumer tax equivalent to the tariff as the sum of the subsidy-equivalent and the
tariff revenue. In other words, if-instead of the tariff-a consumption tax were
imposed, with the aim of reducing consumption by the same amount as would
be reduced in consequence of the tariff, then the unit rate of this tax would have
to be MN, which would give rise to a fiscal revenue equal to MNH{Hl, in turn
equal to MN F{FI (subsidy-equivalent) +F1 F{ H{H1 (tariff revenue). As a matter
of fact, the tariff has the same effect as a consumption tax (with the same rate
as the tariff), the revenue of which is used by the government partly to subsidize
domestic producers and partly to increase its fiscal revenue.
14.3 The Social Costs of a Tariff

We must now investigate whether, account being taken of the various effects,
the imposition of a tariff is beneficial or not. The traditional theory proposed
to show that a tariff involves a cast for society (economic cost of the tariff or
cost of protection, as it is also called).
The basis for this demonstration is the concept of consumers' surplus2 ,
2Let us recall that consumers' surplus was defined by Alfred Marshall as the excess
14.3. The Sodal Costs of a Tariff 241
which can be measured as the area under the demand curve included between
the line of the price, the price axis and the demand curve itself. For example,
in Fig. 14.1, consumers' surplus is measured-when the price is p and the
quantity q4-by the area of triangle N H R.
Now, with the increase in price from p to p(l + dd, consumers' surplus
decreases by N H H1M. This is a cost; to compute the net cost, if any, we
must calculate the benefits. These are the tarifI revenue accruing to the
government, F1F{HfHl, and the increase in producers' surplus3 MNFF1.
It is important to stress that, in order to be able to net out benefits from
costs (both are expressed in money, and so are dimensionally comparable)
we must assume that each dollar 0/ gain or loss has the same importance
independently 0/ who is gaining or losing. Without this assumption, in fact,
it would not be possible to compare the consumers' loss with the producers'
and the government's gain.
Given this assumption, it can readily be seen from the diagram that the
reduction in consumers' surplus is only partly ofIset by the tarifI revenue
and the increase in producers' surplus: we are left with the areas of the two
triangles F F{ F1 and Hf H H1 , which represent the social costs of the tarif!.
The first one, F F{ F1, measures the production cost of protection. If the
country had imported an additional amount ql q2 at the price p, its cost would
have been ql q2F{ F. Instead the country produces this amount domestically,
with an additional cost measured by the increase in the area below the supply
curve, ql q2Fl F. The difIerence F F{ F1 represents the cost of the misallocation
of resources caused by the tarifI: in fact, if the country had used an amount
of resources equal in value to qlq2F{F to increase the output of its export
industry (not shown in the diagram), with the consequent increase in exports
it could have obtained ql q2 more of the imported commodity. When instead
it increases the domestic production of this commodity, the country roust
use a greater amount of resources (equal in value to qlq2FlF) to obtain the
same additional amount (qlq2) of the commodity.
The second one, Hf H H1 , measures the consumption cost of protection,
due to the fact that the tarifI brings about an increase in the domestic price
of the total priee that consumers would be wiIling to pay rather than go without the
commodity, over that which they actually pay. The graphie measure used in the text is
only one of the measures possible and hinges on several simplifying assumptions, &mongst
which the constancy of the marginal utility of money. It should also be stressed that
consumption and consumer should be interpreted in the broad sense to mean purchase
and purchaser respectively, for whatever purpose the product is bought.
3Unlike consumers' surplus, this is a well-defined concept, as it is a synonym for the
firms' profit (difference betwen total revenue and total cost). If we neglect the fixed cost
(which has no consequence on the variations), the total cost of any given quantity, say qI,
is the area under the marginal cost (i.e. the supply) curve from the origin to the ordinate
drawn from that quantity (OVFql). As total revenue is ONFqI, producers' surplus is
V N F. If we consider an increase in output from ql to q2, the increase in producers' surplus
is VMFI - VNF = MNFF1 •
of the imported eommodity relative to the priee of the other eommodities

and so eauses a distortion in consumption.
The results obtained above enable us to understand the reason behind
the traditional statement that free trade is better than tariff-ridden trade:
if, in fact, the imposition of a tarif! involves a social cost, the statement is
immediately proved.
According to some writers, the cost of protection is actually greater than
that found above. Among the arguments for this opinion we can mention the
administrative cost and the resource displacement cost of tarif!s. To impose
tarif!s, a eountry must maintain a special administrative strueture (customs,
border patrols, ete.) and so bear the relative eost. This cost will have to be
deducted from the tarif! revenue, so that the net benefit for the government
is less than the area FIF{H~Hl. Besides, as we have seen, a tarif! causes an
increase in the domestie output of the protected eommodity and so a greater
use of resourees which-assuming full employment-will have to be shifted
from other sectors; this shift involves a cost (displacement of the resourees).
It goes without saying that the latter eost will not be present if there
is underemployment of resourees (a ease, however, not contemplated by the
traditional theory, where full employment is assumed): in such a ease, on
the eontrary, a tarif! will have beneficial ef!ects. These are the employment
effects of the tarif!: with less than fuH employment, the imposition of a tarif!,
by causing an inerease in the domestic output of the imported commodity,
will ultimately increase the employment of domestic factors. This ef!ect,
however, is certainly present only under the hypothesis that exports remain
the same. If, on the contrary, these decrease because foreign countries impose
a tarif! in retaliation, employment will decrease in the sector of exportables.
It is then impossible to determine apriori the net employment ef!ect of the
tarif!.
We conclude our treatment by mentioning the fact that the imposition of
a tarif! has precise ef!ects on factor rewards and hence on ineome distribution.
A tarif!, in fact, causes an inerease in the priee of the commodity on which
the tarif! is levied; hence we ean apply the Stolper-Samuelson theorem (see
Sect. 13.6.2).
14.4 Quotas and Other N on-Tariff Barriers

Prom the theoretical point of view there are numerous impediments to free
trade other than tariffs. These impediments are taking on an ever increasing
practical importance, so that they deserve something more than a cursory
mention. Further analysis of them in the eontext of the "new" protectionism
will be carried out in Chap. 16.
14.4. Quotas and Other Non-Tariff Barriers 243
14.4.1 Quotas
An (import) quota is a quantitative restrietion (so many cars of a certain
type per unit of time) imposed by the government on the imports of a cer-
tain commodity and, therefore, belongs to the category of direct controls on
international trade. For this purpose the government usually issues import
licences (which it can distribute to importers according to various criteria)
but other forms are possible.
The effects of a quota can be analysed by means of a diagram similar
to that used in Sect. 14.2 (see Fig. 14.1) to analyse the effects of a tariff.
In Fig. 14.2, p is the world price of the commodity, of which a quantity
ql q4 is imported under free trade. The government now decides that imports
have to be reduced, for example from ql q4 to q2q3 and, accordingly, decrees
a quota. The domestic price of the commodity will rise to p', since the
(unsatisfied) excess demand by domestic consumers will drive it up from
p to the level at which the actual excess demand is exactly equal to the
given quota, F1H1 = q2q3. The effects of a quota on domestic price, output,
price
Figure 14.2: Effects of a quota
consumption, and on imports, are the same as those which would occur if a
tariff were imposed such as to cause an increase in the domestic price from
p to p': this can be readily seen by comparing Fig. 14.2 with Fig. 14.1. The
equivalent tarifj rate can be computed from the equation p' = (1 + dt}p.
There is, however, a difference between a quota and an equivalent tar-
iff: whilst in the case of a tariff the government collects a fiscal revenue
(FIF{H~Hl in Fig. 14.1), it now collects nothing and the quota gives rise to
a gain of equal size (FIF{H~Hl in Fig. 14.2) accruing to the quota holders
(this is true under assumption that the country is small and that there is
perfect competition among the foreign exporters. In the opposite case, these
could avail themselves of the occasion of the quota to raise the price charged
to domestic importers, thus depriving them of part of the gain under consid-
eration). Now, why should the government deprive itself of a fiscal revenue
if the same quantitative restriction and the same effects of a quota can be
obtained by a tariff?
Let us first observe that, in principle, the government could sell the import
licences by auction: with a perfect auction in a perfectly competitive market,
the revenue of the auction would be exactly the same as that of the equivalent
tariff. This is so because competition between importers to get hold of the
licences will induce them to make higher and higher bids until extra profits
(which are equal to FIF{H~Hl) disappear in favour ofthe government. But
this is a theoretical possibility difficult to realize in practice.
The answer to the above quest ion can be found in the fact that only a
quota gives the certainty of the desired quantitative restriction on imports,
which is lacking in the case of a tariff for various theoretical and practical
reasons, among which:
1) the equivalence of the effects on imports depends on the existence of
perfectly competitive conditions at horne and abroad: in the opposite Case, in
fact, the effects of a tariff and of a quota can be very different. For example, if
foreign exporters do not operate under perfect competition, they may reduce
the price in order not to lose market shares when the horne country imposes
a tariff, so that the increase in the domestic price will be smaller than that
required to achieve the desired reduction in imports.
2) A quota, unlike a tariff, can have important effects on the market
structure of the country which imposes it, far it can convert a potential into
an actual monopoly, that is, enable the domestic industry, fully protected
from foreign competition by the quota, to establish a monopoly. In fact, let
us assume that in the country there is a potentially monopolistic industry. In
the presence of a tariff, this industry cannot raise the price above the world
price plus tariff, for its sales would drop to zero (domestic consumers will buy
solely imported goods if the domestic importable has a price higher than the
world price plus tariff). If instead of the tariff the country decrees a quota,
the potential monopoly can become an actual one, because the domestic
industry can now raise the price without danger of its sales dropping to zero,
as imports cannot exceed the quota.
3) The computation of the tariff (d 1 in our example) which brings about
exact1y the desired reduction in imports can be made only if the curves D
and S are known exactly and do not shift unpredictably. Notwithstanding
the advances in econometrics, these curves can be determined only within
a (usually large) confidence interval. Furthermore, the possibility of (large
though predictable) shifts in these curves (because the underlying exogenous
factors change in a known way) compels the government to compute, levy
and enforce changing tariff rates.
14.4.2 International Cartels

An international cartel consists of a group of producers of a certain com-
modity located in various countries who agree to restrict competition among
themselves (in matters of markets, price, terms of sale etc.).
We shall be mainly concerned with cartels aimed at the control of the
world price of the commodity by fixing a common price. The agreement is
often at the level of governments (the typical example is OPEC, for which see
below), but agreements among private producers are also possible (examples
are the agreement among the main international firms trading in tobacco in
the 1880s and, in the same period, the cartel concerning the level of railway
fares).
If the cartel includes the total number of producers, a full monopoly comes
into being, to which the well-known principles of monopoly theory can be
applied. In such a situation, given the world demand curve for the cartelized
commodity, the price which maximizes the cartel's profits is obtained by
reading off the demand curve the price corresponding to the quantity deter-
mined by the intersection of the marginal cost curve MG and the marginal
revenue curve M R. In Fig. 14.3, the price is PE and the quantity sold qE (in
a competitive market, on the contrary, in the short run, price and quantity
would be determined in correspondence to point L); given the average total
cost curve ATG, the profit will be H~HIHpE. We also recall from microeco-
nomic theory that the monopolist's markup, namely the proportional excess
of price over marginal cost, is given by the reciprocal of the price elasticity
of demand (1Jw):
PE-MG 1
=-, (14.1)
PE 1Jw
so that the more rigid the world demand, the higher the cartel's markup.
So far we have implicitly assumed that the cartel behaves as a single entity,
but even in this case the problem arises of apportioning the production of
the commodity among the members. In an ideal cartel the various members
can be considered as the various plants of a single monopolist, so that we
can apply the theory of the multiple-plant monopolist. This tells us that the
optimum al1ocation is that in which the marginal cost in each plant is the
same and equal to the marginal revenue of output as a whole. To see this,
assume that MG of member i is greater than that of member j. It is then
possible to decrease the cartel's total cost of producing the same total output
by marginal1y decreasing member i's output and marginally increasing (by
the same amount) member j's output: in fact, the decrease in total cost
(MGi ) is greater than the increase (MGj ). This process continues up to
the point where MGi = MGj . Once the marginal cost has been equalized
everywhere for any given output, thus determining the minimum total cast
of the cartel, the maximum profit will be as usual determined by equating
marginal revenue of output as a whole to the (common) marginal cast of the
Figure 14.3: The monopolistic cartel
various producers.
This ideal allocation is not, however, easily realized in practice. In the
real world the production is apportioned on the basis of negotiations among
the members of the cartel, each of whom has its own interests and different
contraetual force. The more influential and skilful negotiators will probably
get a greater quota than the optimum corresponding to the application of the
principle of equalization of marginal costs, even if this will raise the cartel's
total cost of produetion.
We must now consider the more realistic case in which the cartel does
not include all but only part of the producers, so that besides the cartel,
also independent (i.e., not belonging to the cartel) competitive producers are
present in the world market for the commodity. These latter will have to
accept the price fixed by the cartel, but the cartel will have to take their
supply into account when fixing the price. The market form obtaining here
is quasi-monopoly. In Fig. 14.4, in addition to the world demand curve D,
we have drawn the aggregate supply curve S of the independent producers.
If we subtract, for any given price, S from D laterally, we obtain D', which
is the demand curve for the cartel's output. For example, at price ON, the
supply of the independent producers is N N': if we subtraet M M' (equal, by
construction, to NN') from world demand NM', we obtain segment NM,
that is the quantity that the cartel can sell at price ON.
Once the D' curve has been derived, the cartel can behave along it as a
monopolist and will maximize profits by the usual rule, that is, by equating
marginal cost to marginal revenue (the latter will, of course, be that con-
cerning curve D'). The cartel, therefore, will fix the price at 0PE and sell a
quantity PEH = OqE, whilst the independent producers will sell a quantity
HH' = qEq'.
One can easily check, by drawing the marginal revenue curve concerning
Figure 14.4: A quasi-monopolistic cartel
curve D (which we leave as an exercise for the reader), that the price is lower
and the quantity sold greater than in the case of a monopolistic cartel. It
is also possible to check graphically that the greater the elasticity of the
supply curve of independent producers S, the smaller the cartel's markup.
More precisely, the (price) elasticity of the D' curve (denoted by 'f/c) depends
on the elasticity ofthe D curve ('f/w), the elasticity of the S curve ('f/s), and on
the cartel's share in the total consumption of the commodity (k), according
to the formula
'f/w + (1- k) 'f/s
'f/c = k . (14.2)
Consequently, the cartel's markup is
(14.3)
Equation (14.3) is a generalization of Bq. (14.1): in fact, for k - 1, we are

back to the monopolistic cartel.
From Eq. (14.3) we can readily derive the conditions for the success of a
cartel, as measured by the capability of imposing a substantial markup and
so reaping high monopolistic profits. These are:
(a) a low elasticity of total world demand (a small 'f/w);
(b) a low elasticity of independent producers' supply (a small 'f/s);
(c) a high cartel share in the world market for the commodity [a high k:
for k = 1, Bq. (14.3) reduces to (14.1)].
These are the purely economic conditions, to which a further condition
must be added, namely
d) the members of the cartel must accept and adhere to the official deci-
sions taken by the cartel (by means of majority voting or some other way)
as regards price and output.
Condition (d) is essential for the life itself of the cartel. If, in fact, the
members begin to decartelize by selling greater amounts (than those allot-
ted to each) at lower prices, the cartel will soon break up. But why should
there be any incentive to behave in this manner? The answer is that, though
the profits of the cartel as a whole are maximized by respecting the official
decisions, the single member can obtain vastly greater profits by slightly
lowering the price below the official one, provided that the other members
adhere to the official price. In fact, buyers will be willing to buy all the
quantity demanded-previously bought from the cartel-from the single pro-
ducer who charges a slightly lower price, so that the demand curve facing
this single producer is in practice almost perfectly elastic. This producer will
therefore reallze increasing profits by increasing output, because his selling
price is greater than his marginal cost 4 , and he can seIl increasing amounts
without further reducing the price. He will therefore profit from increasing
output up to the point where his marginal cost has increased to the level of
the selling price charged by him.
Naturally, greater profits for the single producer who does not adhere to
the official price mean lower profits for the other cartel-abiding members, but
the single producer, especially if relatively small, can always hope that the
other members will not become aware of his infringement or will not react.
If, for example, his share in the cartel's output is 1%, he may think that
a 50% increase in his output (this means that his share goes up to 1.5%)
will cause so small a loss (spread out through all the other members) as to
be negligible. This is undoubtedly true, but if the same idea occurs to a
sufficient number of members and is put into practice by them, the cartel
dissolves. Therefore the cartel, to persist, must be able to put pressure (of an
economic or political or some other nature) on the single members to make
them adhere to the official decisions.
But unfaithful members are not the only cause of the dissolution of a
cartel. There are at least three other motives leading to a progressive erosion
of the markup (and so of the profits) of the cartel. They can be analysed
with reference to formula (14.3) and are:
1) The increase in "lw. Even ifworld demand is sufficientlyrigid when the
cartel is set up, the very success of the cartel, paradoxically, helps to make
this demand more elastic. As a consequence of the (usually very large) price
4We must remember that in the initial situation the official price fixed by the cartel is
higher than the marginal cost (this is true in both the monopolistic and quasi-monopolistic
cartel). From the point of view of the cartel as a whole, it is not profitable to reduce the
price (this, in fact, would lead to lower profits), whilst the single member can-for the
motives explained in the text~btain higher profits by slightly lowering his selling price
below the official one; this lower price is nevertheless higher than his marginal cost.
increase, buyers will put their every effort into the search for substitutes
for the cartelized commodity (it suffices to mention the search for energy
sources alternative to oil and the research into energy-saving production pro-
cesses and commodities that were set into motion as a consequence of the
Organization of Petroleum Exporting Countries-OPEC--cartel) and so "'W
increases.
2) The increase in "'S' Even if independent producers' supply is rigid
when the cartel is set up, the success itself of the cartel, again, helps to make
this supply more elastic, since these producers will multiply their efforts to
increase output. If the cartel concerns an agricultural commodity, such as
sugar or coffee, the price increase yvill induce independent producers to shift
increasing amounts of resources (land, labour, capital) to the production of
the cartelized commodity. If an exhaustible natural resource is concerned,
such as oil or copper , independent producers will multiply their efforts to
find new fields. Similar efforts will also come from countries previously not
exploiting the resource. These efforts, if successful, will increase not only the
output but also the number of independent producers (think of the oil fields
found by England under the North-Sea). All this causes an increase in "'S'
3) The decrease in k. In order to increase the price without building up
excessive inventories of the commodity, the cartel must restrict output and
sales relative to the pre-cartel situation. This, coupled with the efforts of
independent producers (point 2), leads to a decrease in k.
These three forces jointly operate to erode the cartel's monopolistic power.
Also, note that as the markup is wearing away, the incentive for the single
members to decartelize (see above) becomes greater and greater.
Economic theory, therefore, predicts that, in the long run, any cartel is
bound to dissolve, even if new cartels are always being set up, so that at any
moment a certain number of cartels is in existence. Historical experience
seems to confirm this conclusion, even in the most dramatic cases. Among
these one must undoubtedly count the cartel which gathers the main oil pro-
ducing countries into OPEC. Conditions (a), (b) and (c) above certainly held
in 1973: very rigid world demand for oil, low elasticity of the supply of inde-
pendent producers, high share (above 50%) in world production controlled by
the cartel. Furthermore, for various political motives, the degree of cohesion
of the cartel was high.
The great initial success of OPEC is, therefore, not surprising. However,
forces 1), 2) and 3), slowly but steadily got down to work.
The high price of oil set into motion o'r intensified the search for alterna-
tive energy sources, for productive processes less intensive in energy, for less
energy-consuming commodities and ways of life (energy-saving cars, limits
to domestic heating, better insulation of new buildings, etc.) began or was
intensified. As a consequence, the share of oil in world energy consumption
decreased, and energy consumption per unit of real GDP fell in industrial
countries as a whole.
Another element that reinforced the drop in demand for oil was the world
depression which, by slowing down (and sometimes by causing a decrease in)
the level of activity in the various industrialized countries, reduced their
energy needs. The supply of independent producers steadily increased (the
case of England, which became a net exporter of oil, is sensational). The
cartel's share in the world market decreased weil below 50%.
As a consequence of all this, cases of members not adhering to the cartel's
official decisions were not lacking, often not because of greed, but out of sheer
necessity (many OPEC countries had set up development programs based on
estimates of an increasing-or at least not decreasing-fiow of oil revenues
in real terms, and found themselves in trouble when this fiow started to
decrease).
14.4.3 Other Impediments to Free Trade

We give here a (by no means exhaustive) list of other impediments to free trade
with abrief description of each. A more in-depth treatment of some of them will
be given in Chap. 16.
(a) Export Subsidies. In general, they may take various covert forms besides
the overt one of a direct payment by the government to the export er (usually in
proportion to the volume of exports). Examples of covert subsidies are: more
favourable credit conditions (the difference between these and the normal con-
ditions applied to producers for the home market is paid by the government)j
insurance of certain risks (for example, that the foreign importer defaults) paid
by the governmentj promotional activities (such as trade fairs, advertising, etc.)
organized by public agencies. Export subsidies are usually considered legitimate
when they are a rebate of the tariff paid by the exporting industry on imported
inputs.
(b) "Voluntary" Export Restraints (VER) and Import Expansion (VIE). In
the case of a VER, the exporting country "voluntarily" curtails exports to the
importing country. In the case of a VIE, the importing country "voluntarily"
increases its imports from the exporting country. It is, of course, a relative "vol-
untarity" , for it is negotiated between the importing and the exporting country as
an alternative to traditional measures such as tariffs or quotas.
(c) Production Subsidies. If the government subsidizes the domestic production
of a commodity, this subsidy automatically becomes an export subsidy as regards
the exported part of the output, or a subsidy to the importables sector if the
commodity is an importable.
(d) Tied Aid. Developed count ries often grant financial assistance to developing
countries with the constraint that the recipient spends the sum received to purchase
commodities from the donor. This causes distortions, which are all the greater
when the price (and/or other conditions) in the donor country is not the cheapest.
(e) Advance-Deposit Requirements. Importers are required to deposit funds
(in the central bank, in a commercial bank, etc.) in an amount proportional to the
value of the imported commodities, with no interest and for a given period of time
(usually prior to the receipt of the commodities). Thus importers are burdened
BOX 14.2 Regulatory protectionism

As conventional trade barriers decline, there is growing concern that countries are
resorting to technical regulations to protect domestic producers (Technical Barriers
to Trade-TBTs). These barriers, resulting from national regulations and standards
on product safety, testing, labelling, paclmging, certification, labour and environ-
mental standards, have proliferated in recent years. Since these regulations can be
wielded for protectionist ends, their proliferation has led to widespread complaints
of regulatory protectionism. TBTs result from norms that control the sale of goods
in a particular market. There are two distinct aspects of this control: contents of
the norm and testing procedures necessary to demonstrate that a product complies
with the norm. Content-of-norm or, generally speaking, regulatory differences be-
tween countries, can be broadly classified as horizontalor vertical. Horizontal norm
involve, for example, imposing different technologies as certain plug forms for appli-
ances. With vertical standards a regulator insists that goods achieve at least certain
minimum standard of safety or performance (for example, that cars do not exceed
certain maximum levels of emissions). Product norms and testing procedures can
distort trade when they increase foreign firm's costs relative to those of domestic
firms. Of course, the major problem with the economic assessment of TBTs is that
they are potentially much more complicated to analyse than tariffs or quotas: the
main problem with TBTs is that it is difficult to ascertain whether a certain norm
serves the citizens' interests or protectionist interests. The problem that different
setting of regulations by EU governments might be hampering trade and compe-
tition has been a major reason for the institution of the Single Market program,
and mutual recognition agreements have been agreed between the EU and several
other countries. A similar rationale underlies the articles on Technical Barriers to
Trade and Sanitary and Phytosanitary Standards in the WTO Agreement from the
Uruguay Round.
For example, the Technical Barriers to Trade Agreement tries to ensure that regula-
tions standards and testing and certification procedures do not create unnecessary
obstacles. The agreement recognizes the countries' right to adopt the standards
they consider appropriate (for human, animal or plant life or health, for the protec-
tion of the environment) but discourages any methods that would give domestically
produced goods an unfair advantage.
A separate agreement on food safety and animal and plant health standard (the
Sanitary and Phitosanitary Measures Agreement) sets out the basic rules. It allows
countries to set their own standards. But it also says that regulations must be based
on science and should be applied only to the extent necessary to protect human,
animal or plant life or health, but should not arbitrarily or unjustifiably discriminate
between countries where identical or similar conditions prevail.
Notwithstanding these agreements there is of course considerable resistance by many
countries to conform their policies to trade treaties and to recognize each other's
rules and procedures. Liberalization of TBTs often entail preferential arrangements
between rich countries, creating a two-tier system of market access with developing
countries in the second tier.
with an additional cost, which depends on the percentage of the value of imports,
on the length of the period and on the rate of interest (which measures a direct
cost, if the importer has to borrow the funds, or an opportunity cost, if he owns
them). The advance deposit is equivalent to a tariff with a rate that can be easily
computed: if, for example, the rate of interest is 10% per annum, the period of time
is 3 months and the percentage of the value of imports is 80%, then the equivalent
tariff rate is 2%. In fact, the rate of interest per quarter is 2.5% (10% : 4), and
since the importer must deposit 0.8 dollars per dollar of imports, the additional
cost is 0.8 x 2.5% = 0.02 dollars per dollar of imports, which is equivalent to an
ad valorem tariff with a 2% rate.
(f) Government Procurement. Governments buy a large amount of goods
and services, and usually prefer to buy domestic rather than equivalent foreign
goods of the same price (in some cases they are allowed by domestic legislation
to buy domestic goods even if equivalent foreign goods have a lower price, not
below a certain percentage)j besides, governments may have recourse to aseries of
techniques aimed at limiting the opportunity for foreign producers to tender for
the supply of goods to the public sector . All this amounts to a discrimination in
favour of domestic producers, which restricts imports.
(g) Formalities of Customs Cleamnce. These are connected with the im-
position of tariffs, such as the classification and evaluation of the commodities in
transit at the customs and other bureaucratic formalities. A more rigid application
of these formalities hinders trade and involves a cost for importers.
(h) Technical, Safety, Health and Other Regulations. Countries often have
different regulations, and this is in itself an impediment to international trade, for
producers have to bear additional costs to make the commodities conform to the
different regulations, according to the country of destination. Besides, a country
may use these regulations to reduce or even stop the imports of certain commodities
from certain countries, for example, by checking with particular meticulousness
and slowness their conformity to the regulations, or even by issuing regulations
which actually prevent the acceptance of certain foreign commodities. This is
called regulatory protectionism.
(i) Border Tax Adjustments. Governments usually levy an "import equalization
tax" on imported goods equal to the indirect tax levied at home on similar goods
domestically produced and, vice versa, they give back to exporters the national
indirect tax. This may cause distortions if the import equalization tax is higher
than the national indirect tax (the difference is a covert import duty) or if the sum
returned to exporters is greater than the amount of the national indirect tax (the
difference is a covert export subsidy).

Baldwin, Robert E., 1971, Non-TanJJ Distortions of International Trade, Wash-
ington (DC): The Brookings Institution.
Bhagwati, J.N., A. Panagariya and T.N. Srinivasan, 1998, Lectures on Interna-
tional Trade, 2nd edition, Cambridge (Mass): MIT Press, Part II.
Caves, R.E., 1979, International Cartels and Monopolies in International Trade,
in R. Dornbusch and J.A. Frenkel (eds.), International Economic Policy,
Baltimore: Johns Hopkins, 39-73.
Razawi, H., 1984, An Economic Model of OPEC Coalition.
Takayama, A., 1972, International Trade: An Approach to the Theory, New York:
Holt, Rinehart & Winston, Part V.
Vousden, N., 1990, The Economics of Trade Protection, Cambridge (UK): Cam-
bridge University Press.
Chapter 15
Free Trade vs Protection, and

Preferential Trade Cooperation
In the previous chapter we have implicitly talked of proteetionism by talking

of tariffs, quotas, etc. This chapter explicitly examines the main arguments
in favour of protectionism and the rebuttal of them by the advocates of free
trade.
By protectionism in the broad sense we mean any intervention of the
government (which may consist of tariffs andjor any other non-tariff barrier)
giving rise to a divergence between domestic relative prices and world relative
prices of the same commodities. More preeisely, this divergence must be
greater than that accounted for by costs of transport (including insurance).
We shall then go on to examine preferential trade cooperation among
countries. This cooperation has the purpose of reducing or eliminating pro-
tection among the participating countries, and may take various forms, but
in any case the main question is whether these countries are better off.
Finally, we must point out that our treatment will be confined in the
context of the orthodox theory: strategie trade policy in the context of the
new trade theories will be examined in Seet. 17.7.
15.1 The Optimum Tariff

Proteetionism is better than free trade beeause-so the argument runs-it
is always possible to find a tariff such that the imposing country's welfare is
greater than under free trade.
The analysis carried out in the previous chapter assumed that the do-
mestie price increases by the same amount as the absolute value of the tariff
applied to the pre-trade world price of the commodity, owing to the hypothe-
sis that the latter price does not vary. It is however conceivable that the world
price decreases as a consequence of the tariff: this may be due to the usual
demand-supply mechanisms set into motion by the decrease in the demand
253
254 Chapter 15. Free Trade vs Protection, and Preferential Trade Cooperation
for the commodity on the world market (this implies that the tariff-imposing
country is a large country).
This reduces the cost of protectiori, and it is even possible that an im-
provement, instead of a social cost, takes place in the tariff-imposing country.
This possibility is illustrated in Fig. 15.1, which is based on Fig. 14.l.
As a consequence of the tariff, the world price decreases, far example to
p', so that the cum-tariff domestic price is p'(1 + d1 ), lower than p(1 + d1 ).
The decrease in consumers' surplus is measured by N H H1M. On the side of
benefits we count as usual the increase in producers' surplus (MNFF1) and
the increase in the government's fiscal revenue, F1F{' Hr H1. For convenience
of analysis let us break this rectangle in two parts: F1Fr Hr H1 = F1F{ H~ H 1+
F{ F{' H~' H~. The first of these, added to producers' surplus, leaves the two
triangles F F{ F 1 and H~ H H 1 (which in the previous case measured the cost
of protection) unaccounted for. But now on the side of benefits there is also
the area of the rectangle F{ F{' H~' H~, which is far greater than the sum of
price
o quantity
Figure 15.1: Variations in the world price, and benefits of a tariff
the areas of the two aforementioned triangles: the balance between benefits
and costs is now positive. It follows that the tarijJ has brought about a net
benefit to the country that imposes it!
It can be readily seen that the reason for this benefit lies in the decrease
in the world price, which means that foreign exporters have eventually taken
part of the burden of the tariff upon themselves. In fact, with respect to
the pre-tariff situation, domestic consumers are subjected to an increase in
15.2. The Infant Industry 255
the price of the commodity equal to MN only: the remaining part of the
absolute amount of the tariff (N NI) is indirectly paid for by foreign exporters
in the form of aprice decrease, so that it is as if the amount F{ F{' Hr Hf had
been paid out by these exporters.
By exactly knowing the situation of international demand and supply it
is then possible to calculate an optimum tariff, such that the tariff-imposing
country obtains the maximum welfare increase.
Where is the catch in this apparently impeccable reasoning? It lies in the
fact that the reaction of the rest of the world is neglected. When we bring
this reaction into the picture, results change dramatically. The exporting
country, in fact, is obviously harmed by the tariff, and will retaliate, with
the result that at the end of the trade war every country will be worse off.
On the settlement of trade disputes see Chap. 16.
15.2 The Infant Industry

This is probably the oldest and best known argument for protectionism: a
domestic industry in its infancy cannot compete with well-established foreign
firms and therefore it must be protected by a tariff, to give it time to grow
up and become competitive with foreign firms; at that point the protection
can, and must, cease. It is dear that for the validity of this argument it is
necessary for the protected industry to have within it the germs for growing
up to the level at which it can compete with foreign firms at world prices
and, in addition, that the benefits accruing to society from the operation of
this industry when protection is discontinued, will more than compensate for
the losses deriving from the protection itself.
But, even if these conditions are satisfied, it can be seen that the ad-
vantages of the infant industry becoming adult can be obtained with lower
costs by way of non-tariff protection, for example by giving the infant indus-
try a subsidy which enables it to charge domestic consumers a price for the
commodity equal to the world price.
It is in any case dear that the protection of an infant industry, even if it
may give benefits in the long run, will cause welfare losses in the short and
medium run. Isn't it possible, then, to balance benefits and costs and check
whether there is a net benefit or a net cost of protecting the infant industry?
In theory the answer is yes, provided that one has a sufiicient amount of very
precise information. One must, in fact, not only know the precise dynamic
path followed by the economic system but also assume that social welfare
can be measured (or proxied) by a cardinal function and, finally, determine a
social discount rate to bring to the same point in time the various quantities
of future welfare and thus be able to compare the various alternatives. Now,
even if it were granted that the required information can be obtained, it
would nevertheless remain true that the aforementioned elements would be
256 Chapter 15. Free Trade VB Protection, and Preferential Trade Cooperation
different from case to case, so that it is not possible to state in a general

way that protection of the infant industry is definitely beneficial or definitely
harmful. It is however possible to state that, with the same benefits, costs
are lower if a subsidy is used instead of a tariff.
15.3 Distortions
We are considering distortions in the commodity markets and distortions in
the factor markets.
By distortions in domestic goods markets we mean all those situations in
which the domestic relative price of commodities does not reflect, as it should,
the marginal rate of transformation. These distortions may be due to mo-
nopolistic elements (which make the selling price higher than the marginal
cost) or to external economies or diseconomies (which make the producer's
marginal cost different from the social marginal cost, that is, cause a diver-
gence between the private and the social marginal cost).
When the domestic relative price and the marginal rateof transformation
are unequal, free international trade may even cause a decrease in welfare
with respect to the autarkic situation, for example because the distortion has
induced the country to specialize in the wrong direction due to the wrong
signals coming from the distorted prices. Now-so the protectionist argument
runs-the introduction of a tariff would stimulate the production of the
commodity in which the true comparative advantage lies, thus increasing the
country's welfare. But the imposition of a tariff, which in this case involves
a production gain (deriving from a better allocation of resources), causes a
consumption loss, so that the net result can be, in general, either a loss or a
gain.
Let us now come to distortions in domestic factor markets. These distor-
tions imply that the equality between the price of a factor and the value of
its marginal productivity andj or the equalization of the price of a factor in
all sectors do not hold. This will lead to an inefficient allocation of resources
and, consequentIy, the country will not be on its true transformation curve,
but on a lower curve.
In other words, the distortions under consideration prevent the country
from reaching the conditions of efficiency, which require that the marginal
rate of technical substitution (given by the ratio between the marginal pro-
ductivities of the two factors) should be equal in both sectors and equal to
the (common) factor-price ratio.
The prescription is the same as that given in the previous case, namely
the introduction of a new distortion (the tariff) could offset the existing
distortion. But also in this case both an increase and a decrease in welfare
are possible.
15.4. The Theory of Second Best 257
15.4 The Theory of Second Best

It is time to inquire whether it is possible to reach general results on the
outcome of the free-trade-versus-protection debate. Many authors share the
opinion that free trade is better than restricted trade (excluding the case
of the optimum tariff without retaliation) and that, if the country wants
to help infant industries or correct the effects of distortions, it had better
use subsidies andj or taxes rather than tariffs. This opinion, however, must
be qualified, as its validity has been demonstrated in a situation of free
competition in all national and international markets (of both commodities
and factors).
When this situation does not occur (and as a rule it doesn't), the problem
is quite different and we have to turn to the theory of second best. This theory
purports to find the (second) best situation when (because of distortions or
whatever) it is not possible to fulfil all the conditions for a Pareto optimum
(first best). The fundamental principle of this theory is that once one or
more 0/ the Pareto-optimum conditions is violated, it is not necessarily true
that the (second) best situation is that in which all the remaining conditions
are fulfilled.
A corollary of this principle is that it is not possible to ascertain on
purely apriori grounds whether the replacement of a violation of the Paretian
conditions with another violation improves or worsens the situation. Another
corollary is that the elimination of a violation (except when it is the only
one) does not necessarily improve the situation, and that the introduction of
a further violation does notnecessarily worsen it. In other words, this means
that, in a world in which are present non competitive situations, distortions,
and various restrietions to free trade, the elimination %ne or more 0/ these
restrietions does not necessarily mean the achievement 0/ a better situation,
and the introduction 0/ one or more funher restrietions does not necessarily
mean a deterioration 0/ the situation but, paradoxically, might even lead to
a better situation, though still suboptimal.
A rigorous proof of the fundamental principle of the theory of second
best is a highly mathematical job; here we just give an intuitive idea of it,
by elaborating on an analogy due to Meade (1955, p. 7). Imagine a person
who wishes to reach the highest point on a range of hills. In walking towards
this point, the person will have to climb lower hills and then go downhill: it
is therefore not true that to reach the goal this person will always have to
walk uphill. Furthermore, as the highest hill is surrounded by lower ones of
different heights, after having climbed one hill the person will probably have
to climb yet another one but of lower height: it is therefore not true that any
movement towards the target brings the climber to an ever higher point.
Elaborating further on this effective analogy, if for example a gorge or
another insuperable obstacle prevents the climber from reaching the summit
and if this person's objective is despite everything to climb to the highest
altitude
v
Figure 15.2: Intuitive graphie representation of the theory of second best
possible point, our climber may have to go back quite a long way if the
second highest hill is a great distance from the very highest. In terms of Fig.
15.2, the climber arrives at B and sees that the way to V is blocked by an
insuperable gorge at D. Then, instead of staying at B or, worse, walking
towards V as far as D, the climber will have to backtrack to A to reach the
second highest point.
Now, if we apply the theory of second best to the free-trade-versus-
protection debate, it immediately follows that, in the real world, it is not
possible to ascertain apriori whether a protectionist poliey improves or wors-
ens the situation nor is it possible to state that any movement towards freer
trade automatically gives rise to an improvement.
Similarly, it is not possible to state, as the traditional theory goes, that
there exist other policies decidedly better than the imposition of a tariff. This
statement, in fact, is certainly true only if all the violations of the Pareto-
optimum conditions are eliminated.j a particular ease occurs when there is
only one violation (for example a distortion in the factor market or in the
goods market), in which case the elimination of the violation without the
introduction of others restores the optimum situation for certain (in terms
of Fig. 15.2, if our climber is at C, the last step uphill will certainly bring
this person to V). This has implicitly been the line of reasoning followed.-in
accordance with traditional theory-in the previous sections.
But if, as is true in the real world, there are numerous violations of
the Paretian conditions, it follows from the theory of second best that it is
not possible to state for certain that a policy which eliminates one of these
without introducing another violation is better than a policy which eliminates
the same violation by introducing another.
It is clear that, things being so, it becomes impossible to make statements
valid in general and deduce apriori policy prescriptions from a limited num-
15.5. Preferential Trading Cooperation 259
ber of guiding principles. In reality any outcome is possible and one must
ascertain which is the best policy (free trade or protection in its various forms)
in each actual case without being blinded by theoretical preconceptions.
15.5 Preferential Trading Cooperation

15.5.1 The Various Degrees of Cooperation
After dealing with tariffs and protectionism it is natural to proceed to the
theory of preferential trading cooperation, whose main forms (in order of
increasing degree of integration) are:
1) A prejerential trading club (or agreement), which is an agreement
between two or more count ries to reduce tariffs and other restrictions on
imports from one another; each member, however, retains complete freedom
to impose different tariffs and other rest riet ions on imports from non-member
countries.
2) A free-trade area (or association), in which the partner countries abol-
ish tariffs and other restrictions on imports from one another, while retaining
complete freedom over their commercial policies towards the rest of the world.
3) A customs union, which, in addition to the provisions of the free-trade
area, establishes a common external tariff schedule on all imports from non-
member countries.
4) A common market, in which the countries, in addition to the provisions
of the customs union, allow free movement of all factors of production among
themselves.
It should be pointed out that co operation can exceed agreements on free
movement of goods and factors. The partner countries may decide to unify
their economic policies. This unification can have various degrees, going
from the harmonization of a limited range of policies up to the complete
unification of all economic policies (induding monetary policy, possibly with
a common currency). In these cases we are in the field of international eco-
nomic integration, possibly leading to an economic and monetary union. In
the older literature preferential trading cooperation was often called (a form
of) international economic integration, but to avoid terminological confusion
we do not use this definition.
According to these dassifications the EEC (European Economic Commu-
nity), even before its transformation into the European Union, although ar-
tide 9 of the founding treaty (Treaty of Rome, 1957) stated that the Com-
munity was founded upon a customs union, more properly belonged, at least
in theory, to the category of economic unions, since it involved unification
of some economic policies (agricultural policy, for example).
We finally note that, as in the world there are several preferential trade
cooperation arrangements, the issue of their interrelations arises. This gives
rise to complex problems, for example of the "hub-and-spoke" type. This

term refers to arrangements that give one region (the hub) better access to
other regions (the spokes) than these have to one another. For example,
as a consequence of association agreements between the European Union
and several CEECs (Central and East European Countries ), bilateral trade
liberalisation between the EU and each of these CEECs has taken place, but
trade barriers between the CEECs have remained. These barriers are bound
to disappear when most CEECs join the European Union in 2004.
15.5.2 The Effects of a Customs Union

In this section we shall deal mainly with the theory of customs unions but
most of the analysis can be applied to other forms of trade cooperation. In
general, it might seem that, since a customs union represents a step towards
the ideal situation of free trade, it will improve social welfare. But this
is not the case: as we know from the theory of second best (Sect. 15.4),
when the Pareto-optimum conditions are violated, the elimination of part of
these violations does not necessarily bring about an improvement. We must
therefore examine the effects of the formation of a customs union more closely.
Viner (1950), in examining these effects on the production side, introduced
the distinction between trade creation, which represents an improvement in
resource allocation, and trade diversion, which, on the contrary, represents a
worsening in this allocation.
Trade creation refers to the fact that, as a consequence of the elimination
of tariffs (in this section, for brevity, "tarifIs" indicates "tarifIs and other
barriers to trade") within the union, a commodity-which before the union
was produced domestically by each partner country and not traded because
of tariffs-is now traded and so is produced by that partner country which
is most efficient in its production. This brings ab out a better allocation of
resources.
Trade diversion occurs when the elimination of tariffs within the union in-
duces a partner country to import a commodity from another partner country
instead of from a country outside the union as it did before, because, though
the latter is the most efficient in producing the commodity, it is no longer
competitive on account of the tariff, which has been maintained against it.
This leads to a worse allocation of resources.
Better to explain these effects, we must consider at least three countries:
two which form a union and a third representing the rest of the world. The
following numerical example may be helpful. Consider two countries, 1 and
2, forming a customs union, whilst country 3 remains outside, and three
commodities A, B, C. The arrows in Table 15.1 represent the direction of
trade ftows; no arrow means no trade. The productive efficiency is measured
in terms of the unit cost of production( a common unit is used) in the absence
of tariffs; for simplicity this cost is assumed constant. Before the customs
15.5. Preferential Trading Cooperation 261
Table 15.1: Effects of a customs union

Com- Cost Country 2 Country 1 Country 3 Effects
modity (exp to 1) (exp to 1)
A Cost 12 14 10
Cost + tariff before 15.6 14 +- 13
the union
Cost + tariff after 12 --> 14 13 Trade
the union diversion
B Cost 14 11 15
Cost + tariff before 18.2 11 19.5 Neither
the union diversion
Cost + tariff after 14 11 19.5 nor
the union creation
C Cost 12 15 13
Cost + tariff before 15.6 15 16.9
the union
Cost + tariff after 12 --> 15 16.9 Trade
the union creation
union, country 1 applied a 30% tariff on all imports, whilst after the union
it keeps the tariff on imports coming from country 3 and eliminates it on
imports from country 2. Let us now consider the effects of the union with
reference to country 1.
As regards commodity A, the most efficient country is country 3, where
the unit cost is lowest. Before the union, country 1 imports commodity A
from country 3, as its price, even with the tariff, is lower than the domestic
cost of production (13 instead of 14). After the union, country 1 imports
the same commodity from country 2, because its cost is 12, lower than 13:
the lower efficiency of country 2, with respect to country 3, in producing A
is more than offset by the tariff schedule. Therefore, the union causes a less
efficient allocation of resources (trade diversion). As regards commodity B,
the most efficient country is country 1: the formation of the customs union,
therefore, does not change the fact that, for this country, it is better to
produce B domestically rather than to import it. The situation for country
1 is the same both before and after the union and the union has no effect on
its trade.
Finally, the presence of a prohibitive tariff prevented country 1 from
importing commodity C; the formation of a union with country 2, which
is the most efficient in producing C, brings about a better allocation of
resources, as country 1 now imports this commodity from country 2 (trade
creation).
This analysis considers oniy the production effects of the union, but it
should be observed that, to evaluate the consequences of the formation of
a customs union, one must also consider the consumption effects and, more
precisely, the efIects on consurners' surplus. Thus we also have trade creation
and diversion from the point of view of consumption. The former derives
from the fact that consurners substitute cheaper foreign goods (imported
from a member country) for more expensive domestic goods, and so benefit
from an increase in consurners' surplus. The latter derives from the fact
that consurners' surplus decreases as a consequence of consurners having to
substitute more expensive foreign goods (imported from a member country)
for formerly cheaper goods (previously imported from a country remaining
outside the union) which are now non-competitive because the union has
decided to raise tarifI rates with respect to non-member countries.
If we add the efIects on production and consurnption together, we have
trade creation and diversion in the broad sense. The surn of the two efIects
constitutes the overall efIect of the union. Unfortunately not even this more
refined analysis enables us to reach general conclusions. The fact that it is
not possible to demonstrate general propositions (except the purely negative
one that it is impossible to state any precise result, as anything can happen)
is by now obvious if one refers to the theory of second best.
It is however possible to give some indications of a probabilistic type (thus
likely to be sometimes wrang, sometimes correct). These indications are that
a customs union will be more likely to produce beneficial efIects:
(i) the greater is the degree of competitiveness among member countries,
Le. the greater the nurnber of similar goods they produce. In such a case, in
fact, due to the difIerences in productive efficiency, each country will expand
its comparatively more efficient industries and contract the comparatively
less efficient ones; thus there will be more·scope for trade creation without
much trade diversion from other countries;
(ii) the higher are the initial tarifIs between the countries forming the
customs union: in fact, the gain deriving from the elimination of these tarifIs
will be larger;
(iii) the lower are the tarifIs with the outside world: trade diversion, in
fact, will be less likely;
(iv) the wider is the union, as this increases the probability that trade
creation efIects will override trade diversion efIects (in the extreme case, if
the union includes all the world, we have free trade and no trade diversion
can occur).
So far the analysis has been of a (comparative) static type. In addition to
this, the theory of customs unions also examines the dynamic benefits of a
union; the main benefits are:
1) the increase in the size of the market made possible by the union
allows the industries producing traded goods to enjoy the fruits of economies
of scale;
2) the elimination of protection with respect to member countries brings
about an increase in competition;
3) the fact that the member countries tagether negotiate the tariffs with
15.5. Preferential 'Thading Cooperation 263
the rest of the world, gives them greater bargaining power.
15.5.3 How can we Measure the Elfects of

Integration?
In concluding this treatment it is as weIl briefly to mention the methods used
for the empirical estimation of the effects of economic integration.
A first distinction is between ex ante and ex post estimates. Ex ante
estimates aim to evaluate the future effects of a prospective economic union
(in what follows we use the term economic union to indicate any one of the five
categories of economic integration listed at the beginning) or of the entry of
new members into an already existing economic union. In this case the data
concerning the existing pre-union situation is known and one has to estimate
the hypothetical result of the prospective integration, on which, naturally, no
data is available. Ex post estimates aim to evaluate the effects of an already
existing economic union. Although in this case the problem might seem
simpler, as the post-integration data is known, it should be pointed out that
the problem is to ascertain to what extent the events observed are due to the
union and to what extent they would have come about (even) in its absence.
One must, in other words, compare a known situation (the events observed)
with an unknown and hypothetical one (what would have happened if the
union had not been formed). This is the usual problem that derives from
the impossibility, in economics, of carrying out experiments under controlled
conditions.
A second distinction is based on the methods used for estimating the
hypothetical alternative, which are principally three. The direct method
consists in using a precise analytical model, the parameters of which are
estimated econometrically; simulation procedures are then used to produce
the alternatives. The survey (or Delphic) method consists in assessing the
views of the experts, for example by asking the managements of the firms
how they expect the sales in the domestic market and in the markets of
the partner countries to change as a consequence of the modification in the
trade barriers. The indirect method consists in projecting the pre-integration
trade flows into the post-integration period, then calculating the effects of
the economic union as the difference between actual and projected flows (so-
called residual imputation).
Many empirical studies were carried out as regards the EEC (European
Economic Community, now transformed into the European Union); the re-
sults of different studies are often different. The reader interested in these
can consult, for example, Robson (1998).
For estimates concerning the United States and NAFTA (North American
Free Trade Agreement) see Krueger (2000).
15.6 The Main Cases of Preferential Trading

Cooperation
15.6.1 The European Common Market (now European

Union)
The European Economic Community (EEC) was founded with the 'Ireaty of
Rome signed in 1957. The founding countries were West Germany, France,
Italy, Holland, Belgium, Luxembourg. At the beginning it contemplated
a common external tarif!; the complete liberalization of trade in industrial
goods among the members took place only in 1968. The still existing non-
tarif! barriers were eliminated in 1986, thus realizing a true customs union.
Free factor mobility among the members was realized subsequently, first that
of capital and then (1993) that of labour, thus giving rise to a true common
market.
Over the years other countries joined the initial six, reaching the num-
ber of 15 (Austria, Belgium, Denmark, Finland, France, Germany, Greece,
Holland, Ireland, Italy, Luxembourg, Portugal, Spain, Sweden, United King-
dom); other 10 countries (Czech Republic, Estonia, Cyprus, Latvia, Lithua-
nia, Hungary, Malta, Poland, Slovenia, Slovakia) are going to join in 2004,
and negotiations are under way with other countries (Bulgaria, Romania,
Thrkey) for their admission. In the meantime the name was changed, from
EEC to EU (European Union).
The European Union is something more than a common market, because
it contemplates various measures of coordination of the members' policies
(the best known is the common agricultural policy) and other interventions
to homogenize the economies of the member countries. Details can be found
in the EU's site, http://europa.eu.int
15.6.2 NAFTA
The North Atlantic Free 'Irade Association is a free trade area formed in 1993
among the United States, Mexico, and C~ada, aimed at the elimination not
only of tariffs, but also of non-tarif! barriers to the circulation of commodities
and services. The possibility is also contemplated for each member country
to invest capital in any other member, hence NAFTA is something more
than a mere free trade association. The official site is http://www.nafta-sec-
alena.org
15.6. The Main Cases of Preferential Trading Cooperation 265
BOX 15.1 European economic integration

The European Internal Market became a reality in 1993. Since then the EU coun-
tries have experienced convergence in terms of consumer prices though significant
differentials remain in some areas. There was aperiod of widening prices in the
mid-1990s, but overall the tendency is dear, and with the price transparency, and
with the elimination (thanks to the euro) of currency conversion costs and exchange
rate risk, the trend can be expected to continue. However, other costs of trading
(such as transport) remain, so significant variations in prices can be expected to
remain within the euro area, especially in sectors which are less exposed to trade.
The wide wage discrepancies prevailing among EU countries at the start of the in-
tegration have considerably decreased. As regards the prices of capital (interest
rates), convergence has been observed thanks to the creation of EMU.
To evaluate the economic effect of a regional trade agreement such as the EU on the
partners and third countries, theory-as we know-focuses on the concepts of trade
creation (switching of imports from a high-cost origin to a low-cost origin) and trade
diversion (switching of imports from a low-cost source to a high-cost source) that
can be measured by the share of intra-union versus extra-union trade. As a general
rule, the greater the absolute growth of extra-union trade, the less the danger of
trade diversion. In the EU's case, the share of intra-EU trade in total trade has
risen from 42% in 1961 to 61 % in 2001. The increase in the intra-EU trade share
was accompanied by a rapid absolute growth of extra-EU trade. This indicated
that trade creation dominated trade diversion. Tsoukalis (1997) argued that overall
trade creation dominated in manufactured goods and overall trade diversion in agri-
cultural goods. The latter is the result of the Common Agricultural Policy, which
has protected EU agriculture from foreign competition.
15.6.3 MERCOSUR
MERCOSUR (acronym from the Spanish Mercado Comu.n deI Sur, Common
Market of the South; or MERCOSUL, acronym from the portuguese Mercado
Comum do Sul) is an agreement signed in 1991 by some Latin-American
countries, originally Argentina, Brazil, Paraguay, Uruguay, which in 1996
were joined by Bolivia and Chile. This agreement aims at the formation of
a common market among these countries, that should be fully realized by
2005. The official site is http://www.mercosur.org.uy
15.6.4 ASEAN
The Association of Southeast Asian Nations was formed in 1967 for polit-
ical reasons, to defend the member countries against the then communist
1ndochina; the original members were Thailand, Malaysia, Singapore, 1n-
donesia, the Philippines. ASEAN was subsequently transformed into a pref-
erential trading association with the intention of moving on to a customs
union and then to a common market. The founding countries have been
joined over the years by Brunei Darussalam, Cambodia, Laos, Myanmar,
Vietnam. The official site is http://www.aseansec.org
15.6.5 FTAA
The Free Trade Association of the Americas (or ALCA, from the Spanish
Area de Libre Comercio de las Americas) was proposed in the Miami con-
ference held in 1994 among 34 countries of the Americas. It aims at giving
rise by 2005 to a free trade area that will eliminate all barriers to trade and
investment flows. This area will not be in competition with other existing
agreements (such as NAFTA). The official site is http://www.ftaa-alca.org

Bhagwati, J.N., A. Panagariya and T.N. Srinivasan, 1998, Lectures on In-
ternational Trade, 2nd edition, Cambridge (Mass): MIT Press, Part
III.
Bhagwati, J. and A. Panagariya (eds.), 1996, The Economics oi Preierential
Trading Agreements, Washington (DC): American Enterprise Institute.
Johnson, H.G., 1953, Optimum Tariffs and Retaliation, Review oi Economic
Studies XXI, 142-53.
Krueger, A.O., 2000, NAFTA's Effects: A Preliminary Assessment, World-
Economy, 23, 761-75.
Meade, J .E., 1955, The Theory oi International Economic Policy, Vol. 2:
Trade and Weliare, Oxford: Oxford University Press.
Molle, W., 2001, The Economics oi European Integration. Theory, Prac-
tice, Policy, Aldershot (UK): Ashgate Publishing Company (Fourth
Edition).
Robson, P., 1998, The Economics oi International Integration, 4th edition,
London: Allen & Unwin
Swann, D., 2000, The Economics oi Europe: From Common Market to Eu-
ropean Union, Harmondsworth: Penguin.
Takayama, A., 1972, International Trade: An Approach to the Theory, New
York: Holt, Rinehart & Winston, Part V.
Tsoukalis, L., 1997, The New European Economy Revisited, Oxford: Oxford
University Press (Third Edition).
Viner, J., 1950, The Customs Union Issue, New York: Carnegie Endowment
for International Peace.
Vousden, N., 1990, The Economics oi Trade Protection, Cambridge (UK):
Cambridge University Press.
WTO, 2002, Trade Policy Review: European Union 2001, Geneva.
Chapter 16
The new Protectionism
16.1 Why the new Protectionism?

The typical instruments of the "old" protectionism are tariffs and (non-
discriminatory) import quotas. The last decades have seen a progressive
reduction of these traditional trade barriers: GATT (now WTO) has pro-
vided a negotiating framework for such a reduction and outlawed the use in
general of import quotas, as weIl as established the extension to all mem-
bers of the MFN (Most Favoured Nation) treatment. Among the group of
major traders (European Union, United States, Japan, Canada), the current
average MFN rate for all products ranges from 5.4% in the Uni ted States to
6.9% in Japan. Applied MFN tariffs are much higher in developing countries
(for example, 32% in India, 22% in Bangladesh, etc.). The reason is that
tariffs represent a major source of revenue to the government.
However, notwithstanding the dramatic decrease in average world tariffs,
protectionism is still around under new forms. In fact, in parallel with the
decline of the old protectionism, the last decades have witnessed the emer-
gence of a "new" protectionism or neoprotectionism, based on the type of
non-tariff barriers (NTB) exemplified in items (a) through (i) listed in sec-
tion 14.4.3. A widely used NTB is subsidization. While the use of subsidies
in the manufacturing and services sectors has decreased, support to the agri-
cultural sector remains high, especially in the major industrialized countries.
Total support to agriculture by OECD count ries is estimated around 1.3% of
GDP of the OECD area. The largest share in this support, as measured by
the producer support estimate, is represented by the European Union (40%),
followed by the United States ( 21%) and Japan (20%). Data on NTBs can
be found on http://www.unctad.org/trains, the website of UNCTAD (United
Nations Conference on Trade and Development).
The common feature of these barriers is that they are less overt and more
subject to discretion than the instruments of the old protectionism. Several
reasons have been set forth in the literature to explain this trend:
267
268 Chapter 16. The New Protectionism
1) The countries members of GATT did agree not to use discriminatory

tariffs and quantitative import restrictions, except in special circumstances
contemplated by the GATT Articles (e.g. to relieve temporary balance-of-
payments pressures, and for the emergency protection of domestic industry).
By using the instruments of the new protectionism, GATT members avoided
a dash with the letter of the GATT rules (although, of course, these instru-
ments dashed with the spirit of GATT).
2) The barriers under consideration are politically much easier to imple-
ment. In fact, the traditional measures (tariffs and quotas) must be imple-
mented through either legislative acts or highly transparent administrative
channels. The measures of the new protectionism, on the contrary, can of-
ten be negotiated in secret: a typical example is that of voluntary export
restraints.
3) For the reason given under 2), pressure groups lobbying the government
for protection find it more convenient to ask for measures belonging to the
''new'' rather than to the "old" protectionism.
This brings us to the question of how protectionist measures are actually
introduced, a question that, largely neglected in the old theory, is given a lot
of attention in the new theory. Now, in reality, protection is usually sought
for by interested domestic industries through the lobbying of politicians or
the use of administered protection procedures. The difference is that in the
former case the possible introduction of a protective measure is a matter of
political discretion, while in the latter it is the result of a codified admin-
istrative procedure aimed at remedying an alleged injury. These topics will
also be dealt with in the present chapter.
16.2 Voluntary Export Restraintsand Import

Expansion
A voluntary export restraint (VER) is anagreement negotiated between the
exporting and the importing country, whereby ,the exporting country "vol-
untarily" curtails exports to the importing country. Another name under
which such agreements are also presented in order to avoid conflict with the
letter of the GATT articles is "orderly market agreements". A VER is really
an alternative, for the exporting country, to the imposition of a tariff or a
quota by the importing country.
Since the outcome of a VER is a quantitative reduction in the amount
of goods that the importing country receives from the exporting country,
the effects on the former country can be analysed-in the small-country,
partial-equilibrium context-by the same diagram developed for the analysis
of quotas (see Fig. 14.2, that we reproduce here for the reader's convenience).
Suppose that as a consequence of a VER the imports of the home country
16.2. Voluntary Export Restraints and Import Expansion 269
price
Figure 16.1: Effects of a VER
fall from qlq4 to Q2q3' The effects on the horne country's price and output
would then be the same as under a quota.
What is completely different is the destination of the sum represented
by the area F1F{HfH1. Under a quota this is a gain accruing to importers
(unless the government auctions off the licenses). But since a VER is by
definition administered by the foreign country, the sum under consideration
accrues to this country. Thus this part of the reduction in domestic con-
sumers' surplus is not offset by aredistribution to domestic importers or
authorities, but is redistributed abroad. The fact that this "rent" from VER
protection accrues to the exporting country is clearly an important motive
for this country to prefer a VER to the imposition of a tariff or quota by the
importing country. This is an economic reason (other non-economic reasons
have been given in Sect. 16.1) for the widespread acceptance of VERs in the
place of the measures of the "old" protectionism.
A trade policy tool that can be used as an alternative to a VER is a vol-
untary import expansion(VIE) . Rather than voluntarily restricting exports
from country 2 to country 1, trade agreements between the two countries can
take the form of country 2 voluntarily increasing imports from country 1. A
VIE sets a minimum market share for imports, hence symmetrically sets a
maximum share for the domestic producer. To reduce its market share to
the level required by the VIE, the domestic firm increases its price, which
induces an increase in the foreign firm's equilibrium price.
According to some authors, VIEs are to be preferred to VERs because,
while the latter are intended to restrict trade, the former are, on the con-
trary, designed to increase trade by increasing foreign sales in countries where
structural impediments and policies restrict access to foreign suppliers. Ac-
tually, the US-Japan trade negotiations seem to have shifted from trying to
limit the access of Japanese firms to the US market to trying to increase the
access of American firms to the Japanese market, namely from agreements

based on VERs to agreements based on VIEs.
16.3 Subsidies
Subsidies can be present in both the export and the import sector. As regards
the export sector, the subsidy can be either an export subsidy (Le., given to
domestic producers only on the exported part of their output) or a production
subsidy (i.e., given to domestic producers on their whole output). Let us
begin by considering an export subsidy. In Fig. 16.2, D and S represent as
S'
Figure 16.2: Effects of production and export subsidies
usual the domestic partial equilibrium demand and supply curves. With free
trade, given the ruling international price OM, domestic price is the same,
and exports are FH = (j2q3. Suppose now that an export subsidy, say MN
per unit of output exported, is given to domestic firms. The domestic price
increases from OM to ON: domestic producers, in fact, receive ON per unit
of the commodity exported, and will not be willing to serve the domestic
market unless they receive the same price. If we exclude the possibility of re-
importing the commodity to the domestic market at the world price 0 M, the
domestic price will be driven to ON. Thus domestic producers will seIl N F1
in the domestic market at the price ON and export F1H1 at the prevailing
world price OM, but actually getting ON given the subsidy MN. The total
amount of the subsidy that they receive is thus the area FIF{H~Hl'
Benefits and costs can be calculated using the concepts explained in Sect.
14.2 as regards an import duty. Producers' surplus increases by the area
MNHIH. Consumers' surplus decreases by the area MNHF. The govern-
ment has to pay an amount HFfmHl(note that the area HFfF appears
16.3. Subsidies 271
twice among the costs). Hence the net welfare cost of the export subsidy
is the sum of the two triangles H FI F (the consumption cost) and Hl Hf H
(the production cost). These have the same interpretation as in the case of
a tariff (Sect. 14.3).
The case of a production subsidy can also be examined using Fig. 16.2.
Since this subsidy is given to domestic producers on their whole output, the
result is an equiproportional shift downwards of the supply curve (from 8 to
8') by a percentage equal to the (ad valorern) subsidy. In Fig. 16.2 we have
assumed a production subsidy of the same percentage as the export subsidy.
This is shown by the fact that at output level Oq4 the vertical distance be-
tween 8 and 8' is Hl Hf = MN, denoting that the subsidy to producers is the
same per unit as in the case of the export subsidy. The cost to the government
is now higher: since the subsidy is given on all domestic output, the total
amount is MN Hl Hf. But now there is no decrease in consumers' surplus,
since the price remains at OM. Producers' surplus increases by MNHIH, as
before; hence the net cost is now only the tri angle Hl Hf H (the production
cost). Thus it appears that a production subsidy (which creates no wedge
between the domestic and the international price) is preferable to a direct
trade intervention like an export subsidy (which creates such a wedge).
Let us finally consider a subsidy to the domestic sector producing import-
competing goods (Fig. 16.3). This is actually a production subsidy, hence the
supply curve of domestic producers (8) shifts downwards equiproportionally
by a percentage equal to the (ad valorern) subsidy (8').
The effect of the subsidy is that, for any output, the price received by
producers is greater than the price paid by consumers by the amount of
the subsidy. Let us assurne a world price ON and a subsidy such that the
price received by domestic producers on every unit of output is MN. Hence
domestic producers will be able to supply N F[ = Oq2 instead of N F = Oql.
Consumers continue to pay ON per unit, but producers receive OM. The
outcome of this protective measure is that imports fall from qlq3 to q2q3.
If we now make the usual cost-benefit analysis, we see that there is no
decrease in consumers' surplus, since they continue to pay the same price as
before. The only cost is the government's outlay for the subsidy, namely area
MN F{ F1 • On the side of benefits we have the increase in producers' surplus,
which is MN F F 1 . The balance is a net cost of the subsidy equal to the
tri angle F F{ F 1 (the production cost). It follows that, if we compare a subsidy
to the import-competing sector with a tariff (which entails both a production
and a consumption loss) , we conclude that the subsidy is preferable to the
tariff. Ceteris paribus, a tariff creates two distortions (on both the production
and the consumption side) while a subsidy only creates one distortion (on
the production side).
Let us now put this result together with the previous result, that a pro-
duction subsidy on the side of exports is preferable to an export subsidy
(which can be taken as a negative tariff). The conclusion is that produc-
Figure 16.3: Effects of subsidies to the import-competing sector
tion subsidies are to be ranked above tariffs. This conclusion lies behind the
suggestion that a subsidy to domestic production is a better policy than a
tariff.
16.4 The Political Economy of Protectionism

The previous treatment explains why countries may prefer the instruments
of the new protectionism rather than the traditional ones. But it does not
explain why protectionism in general is still around. We know quite weIl from
the theory of second best (Sect. 15.4) that, when we are in the presence of
many violations to the Pareto-optimum conditions, it is not possible to say
in general whether the introduction or elimination of a violation (such as
a protectionist measure) decreases or increases sodal welfare. Hence the
continuing presence of protectionism would soom to imply that the above
uncertainty has been solved in the sense that sodal welfare increases in the
presence of protectionism. This is certainly not the case: no theoretical study
exists in this sense.
Thus we must look elsewhere, and the polltical economy of protectionism
offers an interesting answer . This school of thought starts from the obser-
vation that protectionist measures are not introduced (or eliminated) by a
benign, omnisdent government aiming at the maximization of sodal wel-
fare. Rather , they are the result of pressure groups lobbying the government
for particular policy changes. Hence, protectionism can be interpreted as a
rational policy for dedsion makers in a democracy.
16.4. The Political Economy of Protectionism 273
16.4.1 The Demand for and Supply of Protection

The observation of actual decision making in a democracy suggests that
there exists a political market for protection, where there is a demand for,
and a supply of protection. The demand for protection comes from particular
groups of voters, firms, and associated interest groups. The supply comes
from politicians and government oflicials.
Let us begin with the demand side. The economic agents who will gain
from protectionist measures invest resources in order to influence political
decisions in their favour. Hence the situation can be examined in the context
of cost-benefit analysis, as shown in Fig. 16.4. The amount of protection
is measured by the variable d, that for simplicity we take as the tariff rate
but can be any other protectionist measure. Benefits (B) and costs (C) of
lobbying are measured in money terms. The cost-of-lobbying curve OC is
Figure 16.4: The optimal amount of lobbying
drawn on the assumption of increasing marginal costs, since it is reasonable

to expect that it becomes more and more diflicult to obtain higher and higher
tariff rates from the government. The benefits-from-lobbying curve OB in-
creases up to a maximum, which corresponds to the prohibitive tariff. It is
not inconceivable that increasing tariff rates might yield increasing marginal
benefits over a certainrange, but for simplicity's sake OB has been drawn
assuming decreasing marginal benefits everywhere . .Aß in any case of cost-
benefit analysis with well-behaved curves, the net benefit is maximised where
the marginal benefit equals the marginal cost. This gives the associated tar-
iff rate d* (endogenously determined), where the slopes of the OB and OC
curves are equal, and the vertical distance between these two curves (Le., the
net benefit ) is highest.
The figure also shows that a lobbying activity is not always worthwhile.
The OC'C" cost curve shows that the initial costs of lobbying may be so high
that the curve lies above the benefits curve everywhere. This cost situation
may occur when the interest groups benefiting from protection are diHicult to
organise, and no organisation for other purposes (e.g., for socia! gatherings)
already exists that could be used for setting up the lobby, thus avoiding
the initial cost OG'. This explains why protection is not "demanded" by
everybody and why the interest groups that are already organised tend to
get additional advantages, while newcomers are in a difficult position in the
political market for protection.
Before turning to the supply side, it should be observed that, in addition
to the interest groups gaining from protection, there are groups losing from
protection. Pro-tariff groups mainly consist of firms (including the workers)
producing import-competing goods. On the contrary, anti-tariff groups are
typically the consumers and the exporters.
We now consider the supply of protection. The protectionist measures of
a country are determined by politicians (typically the government) and by
government officials (even if they are not entitled to decide the introduction
of a protectionist measure, bureauerats prepare, formulate and implement
trade bills). A government has certain ideological goals (amongst which
there may be a specific position with regard to free trade or protection), but
also has a number of other goals, amongst which the need or desire of being
re-elected. Since the interest groups demanding protection are usually better
organised than the anti-protection ones and have greater lobbying power
(which includes financial help for the election campaign), a government will
pay more attention to them. FUrthermore, a government also has constraints,
such as the budget and the balance of payments. A high balance-of-payments
deficit may induce protectionist measures, and a budget deficit may be an
additional element for a tariff (which gives a revenue to the government).
Actual tariff rates are the outcome of the interaction between the demand
and the supply in the political market for protection. Various models exist
for the analysis of this interaction.
Brock and Magee (1978), for example, consider the case of two lobbies,
one pro-tariff and the other anti-tariff, and two political parties. The pro-
tariff lobby is better organised and has more money but less votes than the
anti-tariff lobby. Hence there is a trade-off between the number of votes that
the lobby can offer to politicians and the amount of money that the lobby can
give the politicians to finance the electoral campaign. The parties want to
maximise the probability of re-election by choosing an appropriate position
on the free trade-protectionism issue. Each party knows that it can obtain
less votes but more financial resources (which in turn can be used to obtain
more votes through the electoral campaign) by taking a position in favour of
protectionism, and vice versa. The evaluation of the effects of this trade-off
on the probability of re-election is specific to each party.
It is intuitive that each party reaches the optimal position when the
marginal benefit (on the probability of re-election) of more financial re-
sources equals the negative marginal benefit of the votes lost. It can be
16.5. Administered and Contingent Protection, and Fair Trade 275
shown (Brock and Magee, 1978) that the equilibrium solution of the model
(a game-theoretic Cournot-Nash equilibrium) endogenously determines the
tariff level, the amount and distribution of the financial resources employed
in the financing of the parties, and the distribution of votes between the
two parties. In this context, tariffs can be seen as a "price" that clears the
political market for protection.
16.5 Administered and Contingent

Protection, and Fair Trade
In Sect. 16.4 we have seen how domestic industries can seek protection by
lobbying politicians. Another avenue for seeking protection is to petition
for import relief through so-called administered protection (AP) procedures.
These procedures are rules-oriented and are codified in both national leg-
islation and international agreements. Their characteristic is that they are
based on objective criteria rather than on political discretion, and offer pro-
tection when an alleged injury occurs. Antidumping, countervailing duty,
and safeguard actions are the foremost examples of such procedures.
However, AP is a somewhat broader concept than protection granted to
offset the domestic injury deriving from allegedly 'unfair' foreign trade prac-
tices (antidumping, countervailing duty: see below) or from an occasional
import surge (safeguard actions: see below). It also includes all kinds of pro-
tection deriving from domestic regulations whose primary aim is not that of
(directly or indirectly) influencing international trade as such: for example,
regulations aimed at environmental protection. A country worried that a
domestic industry is generating an excessive amount of pollution might sub-
sidize imports of the commodity produced by that industry, so as to reduce
its domestic production and hence pollution. Or export restrictions might
be imposed to curb exports of a commodity (say, timber) so as to prevent
excessive exploitation of natural resources (deforestation).
The broader concept of administered protection brings us to the problem
of 'fair' trade and harmonization. Trade between countries with different
environment al and labour standards, as weH as with different competition
rules, raises a number of new issues. Demands for harmonization to reduce
the diversities of domestic policies and institutions, so as to foster free (or at
least "fair") trade are now at the centre of the new debate on protectionism
versus free trade.
This problem involves not only economic, but also legal aspects, both of
which are fully addressed in the two-volume set of essays edited by Bhagwati
and Hudec (1996). While referring the reader to that work, we shall briefly
show how these two aspects (the economic and the legal ones) are intimately
intertwined even in the subset consisting of contingent protection.
Under the broader eoneept of administered proteetion, in fact, the subset

eonsisting of protection against unfair foreign praetiees or to offset an import
surge is ealled eontingent protection, to which we shalilimit our analysis.
BOX 16.1 Free or fair trade?
The pursuit of free trade involves activities as the harmonization of trading rules and
the reduction of barriers to trooe. In its simplest sense the issue of free trade should
be conducted on a level-playing field: more free trade would result from the applica-
tion of the same policies, rules, mechanisrns and institutions to each participant in
the trade regime, regardless of origin and capacity. This last point brings us to the
conceptual notion of fair trade. The term fair trade is used to indicate a position
that calls for protectionist measures by developed countries against products that
have been produced in developing countries at prices developed countries cannot
compete with because of their different economic circurnstances. As an example we
can consider demands by the rich countries for imposing higher environmental and
labour standards on the poor countries as preconditions for trade liberalization to
prevent social dumping and a so called ''race to the bottom" in wages and benefits.
Trade sanctions or eco-dumping duties (sometimes referred to as a "social dause")
are often imposed in response to violations of labour and environmental standards.
Developing countries consider such sanctions as disguised protectionism. Let us
shortly analyse the issue of labour standards.
The core labour standards--freedom of association and the right to organize and
bargain collectively, freedom from forced labour, the abolition of child labour and
freedom from discrimination-are recognized as fundamental rights to which all
workers are entitled regardless of the level of development of the country or sector
they work. Such list of labour standards is the OECD set of the core standards which
corresponds with the International Labour Organization's (ILO) core standards.
The literat ure on international labour standards can be broadly divided in two cat-
egories. The first focuses on the evaluation of the appropriateness of linking labour
standards with trade. For surveys see indude Brown, Deardoff and Stern (1996),
Stern (2003). The second indudes recent writings by development economists such
as Basu (2001), that link the issue of international labour standards to broader
perspectives on development.
The central question is whether implementation and enforcement of global labour
standards should be explicitly linked to trade agreement.
The reason why the issue of trade and labour standards is so much debated in
trade negotiations is that labour interests in high-standards countries argue that low
labour standards are an unfair source of comparative advantage and that increasing
imports from low-standards countries will have an adverse impact on wages and
working conditions: low wages and labour standards in developing countries threaten
the living standards of workers in developed countries. For low-standards countries
there is the fear that the irnposition of high labour standards upon then is just a
form of protectionism and is equally unfair as regards their competitiveness.
Before going on, however, it is interesting to point out that lobbying
and eontingent proteetion ean be viewed as alternative means for seeking
protection in the presenee of an alleged injury, so that the interested industry
can ehoose between them through an optimization proeess that maximizes
the expected net benefit. In addition, also antidumping law (see below) ean
be eonsidered as a strategie business tool (alternative to lobbying), sinee it
ean be used by domestic firms as an offensive tool, even though the law is
meant to be a defensive tool.
16.5.1 Dumping and Antidumping

Dumping is an international price discrimination which takes place when
a producer seIls a commodity abroad at a price lower than that charged in
the domestic market. The export price considered is f.o.b. (free on board),
and so transport cost and insurance are excluded. Also excluded are export
duties (if any) and the (possible) markup of the foreign wholesale importer.
Dumping is not necessarily a synonym of a bargain-sale below cost, as is
often thought, for, on the contrary, it may be a way of maximizing profits.
In general three types of dumping can be distinguished: sporadic, predatory,
and persistent.
Sporadic dumping, as the name suggests, occasionally occurs when a pro-
ducer, who happens to have unsold stocks (e.g., because of bad production
planning or unforeseen changes in demand ) and wants to get rid of them
without spoiling the domestic market, sells them abroad at reduced prices.
This is the type nearest to the concept of a sale below cost.
Predatory dumping takes place when a producer undersells competitors in
international markets in an effort to eliminate them. Of course this producer
also suffers losses but can subsequently (in case of success) raise the price to
the monopoly level, once competitors leave the market. This type of dumping
is, therefore, only temporary.
Persistent dumping is that started off by a producer who enjoys a certain
amount of monopolistic power and exploits the possibility of price discrim-
ination between domestic and foreign markets in order to maximize prof-
its. Now, in order to maximize profits, the monopolist must equalize the
marginal revenues (M R) in the various markets with one another and with
the marginal cast (MG) of output as a whole (for simplicity, we assurne that
the monopolist produees the eommodity at one plant, situated at horne). If,
in fact, the marginal revenue in market i were greater than that in market
j, the monopolist could-with the same output and so with the same total
cost-increase total revenue (and so profits) by selling one unit less in rnar-
ket j (total revenue decreases by M R j ) and one unit more in market i (total
revenue inereases by M R;. > M Rj ). The process would eontinue up to the
point where M R;. = M Rj . Onee the marginal revenues are equalized (this
equalization gives the maximum total revenue corresponding to any given
output), profits will be maximized by equating the (common level of the)
marginal revenue to marginal cost.
At the end of this process it may weIl turn out that the commodity is
sold in the foreign market at a lower priee (0PI) than at horne (0 Ph ), but
this is not due to a sale below cost: on the contrary, it is the condition
required by profit maximization (this explains why persistent dumping is
also called equilibrium dumping). The fact that it is profitable to seIl in the
foreign market at a lower price than on the horne market depends on the fact
that the elasticity of demand is higher in the foreign market, so that the
p,MR p,MR MC,MR
MC
q 0 Qf q 0 q
a) b) c)
Figure 16.5: Persistent dumping
monopolist's optimum markup--which equals the reciprocal of the elasticity

of demand-is smaller in the foreign than in the domestic market. And since
the markup is applied to marginal cost, which is one and the same, it follows
that the (optimal) price charged to foreign buyers is higher than that charged
domestically.
Whilst sporadic andpredatory dumping are undoubtedly harmful to the
foreign importing country, it might seem that persistent dumping is bene-
ficial, as the consumers of the importing country will pay a systematically
lower price for the commodity. But this opinion ignores the 10ss of the foreign
producers of the commodity (or of elose substitutes), who will ask for an-
tidumping protection. This (subject to a legal procedure) is granted through
an antidumping tariff, namely a duty on imports equal to the dumping mar-
gin.
The dumping margin may be calculated as the difference between 0 PI
and OPh (so as to equalize the price to that in the domestic market of
the exporting country); alternatively it may be calculated as the difference
between 0 PI and the so called ''fair value" of the commodity, which is usually
taken to be average cost of production by the exporting firm.
Subject to country-specific institutional differences, the process leading
to antidumping action may be broadly described as follows:
a) a domestic firm (or group of firms representing an industry) files a
petition against a foreign firm or industry. This petition is filed with the
domestic institution legally entitled to examine it. In the United States, this
petition has to be filed with both the International Trade Commission and
the Department of Commerce; in the European Union (where trade policy
vis-a-vis the rest of the world is centralized) with the European Commission.
This action is costly, for it entails data collection costs and legal expenses.
Let us call Co this initial (sunk) cost.
b) within a time to the institution issues a preliminary determination,
which may be interlocutory or negative. In the latter case, the procedure
ends, in the former case it continues with the next stage.
c) on the basis of the preliminary findings of the institution, the domestic
industry may decide to withdraw the petition or to pursue it. In the latter
case further ongoing legal expenses are incurred, say Cl, and the institution
continues its investigation, issuing the final decision within a time t 1 .
d) the decision may be positive or negative. In the former case, an an-
tidumping duty is levied (in the United States, the basis is usually the fair
value, see above).
Let us now examine the domestic welfare effects of a successful antidump-
ing petition. The traditional view is that the antidumping duty, as any duty,
increases producers' surplus at the expense of consumers' surplus. This view
has however been challenged on the basis of possible collusive behaviour of
the domestic and foreign industry. Let us start from the observation (Prusa,
1992) that in the United States each of the three possible outcomes of an-
tidumping cases initiated in the period 1980-85 (petition accepted, rejected,
withdrawn) accounted for approximately a third of the total. Now, since
most of the costs of a petition are sunk (Co is much greater than Cl), one
would expect few cases to be withdrawn. However, frequently a petition is
withdrawn only after the domestic industry has achieved some type of out-
of-court settlement with its foreign riYal. The settlement may involve either
a price undertaking or a quantity restriction.
Similar results hold for the European Union, where in the period 1980-
1990 the outcome was (Schucknecht, 1992, pp. 123-125) 24% rejection, 35%
acceptance (hence an antidumping duty), 41% settlement via a price under-
taking (i.e., a voluntary price increase by the foreign firm; the Commission
can negotiate undertakings with the involved parties).
Hence most if not all of the withdrawals are really out-of-court settle-
ments. This is interpreted by Prusa in terms of a game-theoretic bargaining
model which gives rise to a unique Nash solution. The result is that within
this bargaining process the domestic and foreign firms cooperate on pricing
decisions so as to achieve a collusive level of profits.
Thus antidumping cases may actually be used as a stratagem that paves
the way for collusion among (domestic and foreign) oligopolistic firms. In
these cases, as Prusa observes, the welfare conclusion is exactly the opposite
of conventional wisdom: the imposition of an antidumping duty, instead
of decreasing consumers' surplus, might actually increase it, because the
alternative is not free trade, but a collusive oligopolistic situation.
16.5.2 Countervailing Duty

A countervailing duty (CVD) is a duty levied in retaliation to an export or
production subsidy by a foreign country. It is interesting to observe that
export subsidies constitute a sort of official dumping, since they are paid out
by the government to domestic producers-exporters, enabling them to seIl
abroad at a lower price than at horne. This explains why export subsidies
are prohibited, except when they are rebates of indirect taxes [see above,
point (i) in Sect. 14.4.3].
Since an export subsidy increases consumers' welfare in the importing
country, why should there be a retaliation? The answer is the same as in the
case of dumping: the producers of the importing country are harmed, hence
they will ask for protection by filing a petition (the procedure is similar to
that described above in the case of an antidumping petition) to obtain a
CVD that offsets the subsidy.
One might then ask why can't countervailing duties deter export subsi-
dization. The answer is that there are three reasons that explain the coexis-
tence of export subsidies and CVDs.
The first reason is a delay in retaliation. A petition against an alleged
foreign export subsidy requires time to be examined by the domestic insti-
tution, and hence, even assuming a 100% probability of success, during this
time the export subsidy exerts all its effects. International agreements, in
fact, allow retaliation but not vengeance, which means that no CVD can be
levied if the foreign country withdraws the export subsidy at the end of the
procedure.
The second reason is the upper limit to a CVD. According to international
agreements, in fact, the CVD rate cannot exceed the subsidy rate. Now, it
turns out that the fully offsetting CVD rate is greater than the export subsidy
rate. The application of a CVD with the same rate as the subsidy would not
completely offset the subsidy.
The third reason is the phenomenon of out-of-court settlements that give
rise to VERs. This is the same phenomenon already examined above in
the case of AD petitions. The data are also similar: between 1980 and
1988, about 30% of CVD petitions were withdrawn in the US, most of them
resulting in VERs (Morkre and Kelly, 1994).
16.5.3 Safeguard Actions

International agreements also allow a country to protect domestic producers
against fair imports (that is, imports that are not dumped or subsidized by
the foreign country) under certain circumstances. The characteristic of this
form of administered protection (called a safeguard action) is that it must
be temporary and nondiscriminatory. For example, a country experiencing a
sudden surge of imports that threatens severe injury to domestic producers,
may impose a temporary nondiscriminatory tariff.
BOX 16.2 The US-EU dispute on steel

Among the various active WTO disputes between the European Union, as a com-
plaining party, and the United States - mostly associated with misuse of trade
defence instruments, 4 relate to the steel sector. Under case number WT/DS248, in
particular, the EU is complaining on the US definitive safeguard measures on im-
ports of certain steel products adopted on 5 March 2002, with the belief that such
measures are in breach of both the US obligations under the provisions of GATT
1994 and of the Agreement on Safeguards (SA).
Following the recommendations of the International Trade Commission (ITC) ,
which, on 22 June 2001, initiated a safeguard investigation on imports of 4 broad
groups of steel products, the US President announced, on 5 March 2002, definitive
safeguard measures in the form of an increase in duties ranging from 8 to 30 percent
on imports of certain steel products, effective as of 20 March 2002.
Although three rounds of consultations took place over March-April 2002, the last
jointly with Korea, Japan, China, Switzerland and Norway, they did not succeed in
solving the dispute, and a panel was established, under request by the EC, at the
special meeting of the Dispute Settlement Body (DSB) of 3 June 2002. More pre-
cisely, a single Panel was established against the US steel safeguards under Article
9.1 of the Dispute Settlement Understanding (DSU), following requests presented
by Japan, Korea, China, Switzerland, Norway, New Zealand and Brazil.
The claims put forward relate to violations of both the Article XIX of the GATT
agreement on "unforeseen developments" and a number of SA provisions, including,
among others, the lack of increased imports, the incorrect definition of the domestic
industries that produce like products, the lack of serious injury or threat thereof
serious injury and the absence of causallink between imports and serious injury.
The Panel report, which was circulated to all WTO Members on 11 July 2003, found
that all safeguard measures lacked a legal basis. However, on 11 August 2003 the
United States decided to appeal the panel report. The Appellate Body rejected the
appeal on 10 November 2003, and authorized an appropriate relaliation by the EU
against the United States in case the United States maintained the tariffs on steel
imports. On 4 December 2003 the United States withdrew these tariffs.
Safeguard actions are however a small minority with respect to AD and

CVD actions: for example, in the period 1980 to 1988 in the United States,
411 AD and 332 CVD actions were undertaken, but the cases based on safe-
guard procedures were only 71. Similar results hold for the European Union,
where however not only safeguard cases but also CVD actions are a small
minority. For example, in the period 1980-1990, only 10 safeguard cases and
12 CVD actions were undertaken as compared with ab out 400 AD cases. The
reason for this strikingly small number of CVD actions is to be seen in differ-
ent government practices: "While the US subsidizes its domestic producers
relatively little, the EU fears retaliation against its own highly subsidized
industries if it applies countervailing duties too frequently. The EU there-
fore uses its political discretion to discourage applications for countervailing
duties. Consequently, incurring lobbying costs for this trade barrier are not
profitable for special interests" (Schucknecht, 1992, p. 60).

Baldwin, Robert E., 1988, The Political Economy of Protectionism, in RE.
Baldwin, Trade Policy in aChanging World Economy, London: Harvester-
Wheatsheaf.
Basu, K., 2001, On the Goals of Development, in G. Meier and J. Stiglitz
(eds.), Frontiers of Development Economics: The Future in Perspec-
tive, Washington DC: World Bank and Oxford University Press.
Bhagwati, J. and RE. Hudec (eds.), 1996, Fair Trade and Harmonization:
Prerequisites for Free Trade?, Cambridge (MASS): MIT Press.
Brown, D., A. DeardofI and R Stern, 1996, International Labor Standards
and Trade: A Theoretical Analysis, in Bhagwati J. and R Hudec (eds.).
Brock, W.A. and S.P. Magee, 1978, The Economics of Special Interest Pol-
itics: The Case of the TarifI, American Economic Review 68, Papers
and Proceedings, 246-50.
Frey, B.S., 1984, International Political Economics, Oxford: Basil Blackwell.
Greaney, T.M., 1996, Import Now! An Analysis of Market-share Voluntary
Import Expansions (VIEs), Journal of International Economics 40,
149-63.
Jones, K., 1984, The Political Economy ofVoluntary Export Restraint Agree-
ments, Kyklos 37, 82-10l.
Jones, RW. and A.O. Krueger (eds.), 1990, The Political Economy of Inter-
national Trade, Oxford: Basil Blackwell.
Laird, S. and A. Yeats, 1990, Trends in Non-TarifI Barriers of Developed
Countries, 1966-86, WeltwiTtschaftliches Archiv 126,299-325.
Messerlin, P.A., 2001, Measuring the Cost of Protection in Europe: Euro-
pean Commercial Policy in the 2000s, Washington (DC): Institute for
International Economics.
Morkre, M.E. and K.H. Kelly, 1994, EfIects of Unfair Imports on Domestic
Industries: US Antidumping and Countervailing Duties Cases, 1980 to
1988, US Federal Trade Commission, Bureau of Economies.
Prusa, T.J., 1992, Why Are so Many Antidumping Petitions Withdrawn?,
Journal of International Economics 33, 1-20.
Schucknecht, L., 1992, Trade Protection in'theEuropean Community, Read-
ing (UK): Harwood Academic Publishers.
Stern, R, 2003, Labor Standards and Trade Agreements, Discussion Paper
No. 496, University of Michigan.
Vousden, N., 1990, The Economics of Trade Protection, Cambridge (UK):
Cambridge University Press.
Chapter 17
The new Theories of

International Trade
17.1 Introd uction

The paradigms treated in the previous chapters malm up a consistent doc-
trine in which from certain basic premises various theorems are deduced,
concerning both positive and normative economics. This is the doctrinal
body with which the conventional or orthodox theory of international trade
is nowadays identified.
Leaving aside the assumptions specific to each model, the fundamental
assumptions of the orthodox theory are:
(i) perfect competition obtains;
(ii) the commodities which are internationally traded are homogeneous,
and identical in the various countries. This means that the homogeneous
commodity A produced in country 1 is identical to the homogeneous com-
modity A produced in any other country, and so on for all commodities.
However, even a casual observation of reality shows that:

1) market forms different from perfect competition (such as monopolistic
competition and oligopoly) are the norm rather than the exception;
2) product differentiation is much more frequent than product homogene-
ity.
Although these aspects had already been examined in isolated pioneer-
ing contributions, it was only in the 1980s that they received due attention
and were tackled with an analytical apparatus (partly drawn from indus-
trial economics) comparable to that used in the orthodox theory. Thus, the
models of the new theories of international trade (also called the industrial
organisation approach to international trade) were born. We use the plu-
ral, because-unlike the orthodox theory-there is not one new theory but
several, with different assumptions and results.
283
284 Chapter 17. The new Theories of International Trade
BOX 17.1 Measuring international specialization and IIT

The concept of revealed comparative advantage (RCA) is widely used in practiee to
determine a country's weak and strong sectors. The most frequently used index in
this respect is called the Balassa index (Balassa, 1965). This measure captures to
what extent a country exports more of a product than the average country. Given
a group of reference countries the Balassa index basically compares the share of the
product category in that country's exports to the share of that product category
in the reference group (for example the overall world exports). In partieular, if
Xj is country i's export value of industry j, X,/f is industry j's export value for
the reference countries, Xi are the total exports of country j, and xref the total
exports of the group of reference countries, then country i's Balassa index of RCA
for industry j, BIj can be written as folIows:
. Xi/Xi
BP = --,'>----
, X,/f / Xref .
A value of BIj > 1 « 1) suggests that country i has a comparative advantage
(disadvantage) in industry j. The larger the BI value, the higher the degree of
comparative advantage.
However, BI turns out to produce values which are asymmetrie around
1, because the index ranges from zero to one (if a country is said not
to be specialized in a given sector), while it ranges from one to in-
finity (if a country is said to be specialized in that sector). To ob-
tain symmetric values an adjusted (or normalized) index is calculated as
(BI - 1)/ (BI + 1) ,
that ranges from -1 to +1. Similar to the export pattern, the structure of a coun-
try's imports may likewise contain useful information about a country's comparative-
disadvantage situation. Therefore it can be calculated a similar index for a country's
import side, the revealed comparative disadvantage (RCDA).
The degree 01 intra-industry trade (IIT) is commonly measured by Grubel and
Lloyd's index. Grubel and Lloyd (1975) defined IIT as the value of exports in
an industry whieh is exactly matched by imports in the same industry. Its value is
measured by:
Gi = (Xi + Mi) -lXi - Mil,
where Gi is the value of intra-industry trade and Xi and Mi are the values of exports
and imports of industry i, or a given country for a given period. To perform easy
comparisons across countries and industries, the values of the index can be expressed
as a percentage of each industry's (or country's) combined exports and imports:
Gi = (Xi + Mi) lXi - Mil x 100.
Xi+Mi
This measure ranges from 0 to IOD, with higher values representing higher levels of
IIT.
The common feature of these theories is that they drop the assumption of
perfeet competition and/or of product homogeneity.
Two additional features are often stressed as peculiar to the new trade
theories: the explanation of intra-industry trade and the use of increasing
returns to scale.
The first amounts to saying that the new theories can explain intra-
industry trade while the orthodox theory cannot. Intra-industry trade (also
called horizontal trade, two-way trade, cross-hauling) is defined as the simul-
taneous import and export of commodities belonging to the same industry.
17.1. Introduction 285
For example, country 1 simultaneously exports and imports commodity A

or, more precisely, similar goods belonging to the same category defined as
A (see Sect. 17.3.5). Now, so the conventional opinion continues, the kind
of international trade considered by the orthodox theory can only be of the
inter-industry type, i.e., exchange of products of different industries. In our
2 x 2 setting, this means that country 1 imports one commodity, say com-
modity A, and exports the other (commodity B), while country 2 imports B
and exports A.
In fact, according to the orthodox theory, a country cannot export and
import the same good at the same time (see Sect. 13.3). Therefore, this
theory cannot explain international trade of the intra-industry type, which
is a huge limitation because intra-industry trade is a an important part of
international trade (the greater part at the European level).
This opinion, however, does not seem to be acceptable. The orthodox the-
ory is perfectly able to explain intra-industry trade in identical commodities
in several cases:
1) transport costs. Let us consider two countries with a long common
border (the wavy line in Fig. 17.1) and assurne that both produce steel (in
mills situated respectively at a1 and a2) which they subsequently transform
into steel plate (in the mills situated at h and l2). Technology, tastes and
country 2 country 1
Figure 17.1: The cost of transport as adeterminant of intra-industry trade
factor endowments are absolutely identical in the two countries. However,

if we assurne that, other things being equal, the cost of transport increases
with distance, country 1 may find it cheaper to get its supply of steel from
a2, rat her than ab because a2 is nearer to II (country 1 thus imports steel
from country 2) and, in the same way, country 2 might find it cheaper to
import steel from country 1 because a1 is nearer to l2 than is a2. Hence both
countries will simultaneously import and export the same commodity (steei).
2) periodic trade, which can be due to seasonal factors. For example,

country 1 and country 2 both produce the same summer fruit, but they lie
at the antipodes, so that when it is summer in country 1 this country will
export summer fruit to country 2 where it is winter, and vice versa. Thus we
shall observe intra-industry trade on a yearly basis. This can be easily fitted
in the orthodox theory, by assuming transformation curves that periodically
change their position.
3) varying conditions oi demand. For example, it is normal that neigh-
bouring countries exchange electrical power with one another to meet demand
peaks in one or another country. This can also be fitted into the orthodox
theory, by assuming demand curves that periodically change their position.
4) import and export oi goods after mere storage and wholesaling (entrepöt
trade) or after simple manipulations (such as packaging, bottling, cleaning,
sorting, etc.) which leave the goods essentially unchanged (re-export trade).
Even in the case of re-export trade the manipulations are usually not suffi-
cient to warrant the reclassification of the goods in a different SITC class, so
that intra-industry trade is observed.
5) government intervention. Let us assurne, for example, that in a three-
country world countries 1 and 2 join a free trade area and country 2 levies
higher duties against country 3 than country 1 does. It may then be advan-
tageous for country 3, in order to export a good to country 2, first to export
the good to country 1 and so pay a lower tariff, and then re-export it to
country 2 as coming from country 1, thus paying no further duties. Country
1 will then appear as an import er and exporter of the same commodity.
As regards the second feature, it is claimed that the new theories can
accommodate increasing returns to scale while the orthodox theory cannot.
This is certainly not true if we consider increasing returns to scale due to
external economies, which are perfect1y compatible with the orthodox theory.
Only increasing returns to scale due to internal economies are incompatible
with perfect competition and hence with the orthodox theory. Besides, the
identification between increasing returns to scale and the new theories is
wrong for an additional reason: as we shall see, there are new trade theories
that take production as occurring under constant returns to scale.
Thus the essence of the new theories is to be seen in the fact, already
stated ab ove , that they drop the assumption of perfect competition andjor
the assumption of product homogeneity.
17.2 Classification of the new Theories

We have stressed that there is not one new theory but several, with different
assumptions and results. Table 17.1 gives an overview of the field.
In this table-taking the orthodox theory as the reference point-we have
classified all the new theories according to two main elements: the type of
17.2. Classification of the new Theories 287
Table 17.1: Orthodox theory and the new theories of international trade
PRODUCTS MARKETS
PerEect Monopolistic Oligopoly
competition competition
Homogeneous Orthodox - Brander
theory (1981)
Vertically Neo Heckscher- - Shaked and
differentiated Ohlin theories Sutton (1984)
(Falvey, 1981)
Horizontally - Demand for va- Eaton and
diJIerentiated riety (Krugman, Kierzkowsky
1979); Demand (1984)
for characteristics
(Lancaster, 1980)
good and the market form. The names of the authors are merely exempli-
ficative, given the host of contributions now existing.
About the market form it is sufficient to remark that in the "oligopoly"
heading we incIude not only duopoly but also, as a limiting case, monopoly.
About the differentiation of the product, it is instead as weIl to cIarify the
terminology.
Vertical differentiation refers to products that differ only in the quality.
For example, woollen suits that are identical except for the quality of the
wool.
Horizontal differentiation refers to products of the same quality that differ
in their (real or presumed) characteristics. For example, woollen suits made
of the same quality of wool but of different cut and colour.
In the case of vertical differentiation, it is incontrovertible that all con-
sumers prefer higher-quality to lower-quality goods. This, of course, presup-
poses the existence of universally accepted criteria for evaluating the quality.
Hence, in the absence of budget constraints, all consumers would demand
the highest-quality good (the assumption is that the price of a commodity
increases as its quality increases). It follows that the demand for different
commodities, Le. commodities of different quality, is related to different
income levels of consumers.
In the case of horizontal differentiation, the various characteristics are
valued differently by different consumers (there are those who prefer a colour
and those who prefer anotherj those who prefer a cut and those who prefer
another, etc.). In any case, consumers generally love variety (even the person
who prefers a certain colour will usually own suits of different colours rather
than all of the same colour). It follows that the demand for different com-
modities, Le. commodities having different characteristics, is related to love
for variety andjor to different subjective evaluations of the characteristics,
as we shall show in Sect. 17.5. Actually, most commodities can differ in both
quality and characteristics, but for analytical convenience we keep the two
cases distinct.
Given the greater realism of the assumptions underlying the new theories,
shouldn't we drop the orthodox theory as irrelevant? The answer is given by
Paul Krugman, one of the founders of the new theories. If one were asked to
give an actual example of the new theory of international trade with respect
to the orthodox theory, one could say that "conventional theory views world
trade as taking place entirely in goods like wheatj new trade theory sees it
as being largely in goods like aircraft. Since a good part of world trade is in
goods like wheat, and since even trade in aircraft is subject to some of the
same influences that bear on trade in wheat, traditional theory has by no
means been disposed of completely. Yet the new theory introduces a whole
range of possibilities and concerns" (Krugman, 1990, pp. 1-2).
Before examining the new theories it is as weH to mention the precursors,
namely those authors who, though not giving a rigorous analytical treatment
of the problems, set forth the basic ideas. Ideas that were later taken up,
explicitly or implicitly, by most models classified in Table 17.1. We shall
first examine these pioneering contributions, and then treat the models of
the table.
17.3 Precursors
17.3.1 Availability
According this approach, due to Kravis (1956), international trade is ex-
plained by the fact that each country imports the goods that are not avail-
able at horne. This unavailability may be due to lack of natural resources
(oil, gold, etc.: this is absolute unavailability) or to the fact that the goods
cannot be produced domestically, or could only be produced at prohibitive
costs (for technological or other reasons): this is relative unavailability. On
the other hand, each country exports the goods that are available at horne.
Now, as regards the presence or absence of natural resources, this aspect
could easily be fitted into the Heckscher-Ohlin model that, as we know,
stresses the differences in relative factor endowrnents. We only have to add
a factor natural resources and use the generalized version of the model.
The originality of this approach lies in its second aspect, that is, in the
reasons put forward to explain international differences in relative availabil-
ity. Essentially there are two reasons: technical progress and product
differentiation.
As regards the first reason, Kravis observes that the stimulus to exports
provided by technological change is not confined to the reduction in costs (in
which case we remain in the context ofthe orthodox theory) but also includes
17.3. Precursors 289
the advantages deriving from the possession of completely new products and
of the most recent improvements of existing types of goods. In such cases
the operation of the demonstration effect of Duesenberry creates an almost
instantaneous demand abroad for the products of the innovating country and
thus generates international trade.
As regards product differentiation, the idea of Kravis is to extend to in-
ternational trade the results of the theory of monopolistic competition. Dif-
ferent countries produce similar commodities or, more exactly, commodities
that are not substantially different from the point of view of their intended
purpose (clothes, automobiles, watches, cameras, cigarettes, liqueurs, etc.).
These commodities, however, due to different industrial designs, past ex-
cellence, advertising, real or imaginary secondary characteristics and so on
and so forth, are considered different by consumers. This creates, on the one
hand, a more or less limited monopolistic power of the single producing coun-
tries, and on the other a consumers' demand for foreign commodities that
they believe different from similar domestic commodities, the result being to
create international trade.
17.3.2 Technology Gaps

The advantage enjoyed by the country that introduces new goods, already
considered by Kravis as one of the elements of his availability approach, is
focused on by Posner (1961) and other authors. As a consequence ofresearch
activity (especially of the Research & Development type) and entrepreneur-
ship, new goods are produced and the innovating country enjoys a monopoly
until the other countries learn to produce these goods: in the meantime they
have to import them. Thus, international trade is created for the time nec-
essary to imitate the new goods (imitation lag).
Once the imitation has been successfully performed, imports by the im-
itating country tend to cease, but as there is a flow of innovations through
time, this aspect of international trade perpetuates itself. Besides, the imita-
tion lag has not the same length in all countries, so that even if one or more
countries successfully imitate the new good, the innovating country will have
an advantage in other countries, where the imitation lag is longer , thanks to
its greater experience in producing the good.
With reference to this, Posner defines the dynamism of a country as a
function of its flow of innovations (that is, the number of new goods that
it successfully introduces per unit of time) and of the speed with which it
imitates foreign innovations.
When, in a two-country model, one is much more dynamic than the other,
the less dynamic country will have to pay for its imports of new goods by
exports of traditional goods at less and less favourable prices, and thus will
not be able to carry out the massive investment (so as to modernise plants,
etc.) required to increase its own dynamism. In other words, the less dynamic
country remains trapped in its low level of dynamism.

On the contrary, when various countries have a very similar dynamism,
international trade can stimulate a general growth process thanks to the fact
that the innovations introduced in any country are rapidly imitated by the
others. According to some authors, this is the phenomenon that occurred
in the "golden age" of the European Economic Community (now European
Union).
17.3.3 The Product Cycle

According to this theory, due to Hirsch (1967) and Vernon (1966), in the life
cycle of a product it is possible to distinguish various phases: the introduction
of the new good, its maturation, and its standardization, which together
constitute the product cycle, with important effects on international trade.
The starting point is that equal access to scientific principles in all the
advanced count ries does not mean equal probability of the application of
these principles in the production of new goods. According to Vernon, in
fact, there are good reasons (for example, information costs) to believe that
entrepreneurs' ability to get to know of new opportunities and to respond
to them is a function of ease of communication with the market, which in
turn depends on geographical proximity. As a consequence, firms generally
introduce new 'products which are likely to satisfy the demand of the national
market in which they seIl. In the first phase, then, the production of the new
good will be located in the country where the innovating firm operates, and
the domestic market will be served.
When the new product has gained a hold upon the domestic market, the
producer will begin to get into foreign markets, initially by exporting the
good to them. In this phase of maturation the motives underlying the initial
location disappear, and the firm will begin to examine the best way of serving
foreign demand. On the one hand, the firm can continue to produce all the
output at home and export the amount demanded abroad. On the other, the
firm can licence foreign producers, or directly engage in producing the good
in plants located in foreign countries where a demand exists; in this phase,
the countries concerned will usually be advanced countries.
According to Vernon, in the case of new goods the licensing alternative
is an inferior choice due to the inefficiencies and imperfections in the inter-
national market for technology (patents, licences, etc.). The firm having a
monopolistic power thanks to the introduction of the new good will try to
exploit this power also by way of price discrimination. As it is usually im-
possible to satisfy the conditions for optimal discrimination by using licences,
to produce on one's own (either domestically or abroad) is a superior choice.
To choose rationally between producing for exports at home or setting up
producing subsidiaries abroad, the firm will compare the marginal cost of
producing for exports at home, augmented by transport costs and tariffs (if
any) levied by importing countries, with the unit cost of producing in a for-
eign subsidiary. A possible triggering event that induces the firm to set up a
subsidiary abroad is the appearance in the foreign importing countries of 10-
cal producers of the good. Another important element is the danger that the
governments of importing countries, to protect their industries, may impose
rigid restrietions such as quotas on the imports of the new product.
In the second phase, therefore, it is likely that the innovating firm will set
up producing subsidiaries abroad, in developed countries. Thus, the export
from the innovating country to these count ries will dwindle away to zero,
whilst it will continue to export to developing countries.
Finally, in the third phase of the cycle, we have advanced standardiza-
tion of the good, hence the central, if not exclusive, importance of the cost of
production in determining profit ability. In this phase it may become advan-
tageous to locate production units in less-developed countries because of the
low cost of labour there. It may seem strange that this advantage makes itself
feIt also in the case of capital-intensive goods, but a less-developed country
may offer competitive advantages as a location for the production of these
goods , because the cost of capital may be less important than other factors
(e.g., the marketing of the product, or such a low cost of labour to more than
offset the greater capital intensity).
In the third phase, according to Vernon, in the country where the com-
modity originated, production dwindles whilst demand keeps increasing, so
that this country gradually becomes an importer of the commodity, from
other industrialised count ries to begin with, then from less-developed coun-
tries.
The product cycle model also implicitly offers an explanation of the local-
ization of production in different parts of the world and of the changes in this
localization, hence it can also be considered as aprecursor of the 'economic
geography' models (see Sects. 18.2.1 and 18.2.2).
17.3.4 Income Effects: Linder's Theory

Among the theories which first focused on demand and income we mention
that due to Linder (1961). According to this theory, while the Heckscher-
Ohlin theory is well suited to explain the pattern of trade in primary goods
and, generally, in products intensive in natural resources, it is inadequate to
explain the pattern of trade in manufactures. The alternative theory that
Linder suggests starts from the concept of potential trade (potential exports
and potential imports) of a country.
Potential exports are determined by domestic demand. More precisely,
Linder's basic proposition is: a necessary (albeit not a sufficient) condition
for a product to be a potential export is that this product should be used
as a consumption or investment good in the horne country. i.e. that a
representative domestic demand far the product exists. All this amounts to
what businessmen call "the support of the domestic market".

As regards potential imports, it is domestic demand that determines
which commodities may be imported. It follows that the range of poten-
tial exports coincides with, or is a subset of, the range of potential imports.
From this basic proposition it follows that the more similar the demand
structures of two count ries are, the more intense the potential trade between
them will be. As an index of this similarity Linder takes the similarity of
per capita income levels, since, in his opinion, there is a strong relationship
between per-capita income and the types of commodities that are demanded:
for example, as per-capita income increases, higher-quality consumer goods
will be demanded.
So far we have dealt with potential trade; we must now examine the forces
that cause actual trade. Let us begin with an extreme case, in which two
countries have identical per-capita income and so identical potential trade,
for the potential exportables and importables are the same in both countries.
Why then should there be (actual) trade between these countries? The an-
swer is simple. When entrepreneurs broaden their horizons to the interna-
tional market, they discover that they can expand into each other's country
thanks to product differentiation. As Linder remarks, "the almost unlimited
scope for product differentiation-real or advertised--could, in combination
with the seemingly unrestricted buyer idiosyncrasies, make possible flourish-
ing trade in what is virtually the same commodity" .
As regards countries with different per capita income, it is plausible to
think that the same forces are at work, with the difference that the number
of commodities for which the demands overlap will be lower and so actual
trade will also be lower.
It goes without saying that growth induces increases in the per capita
income of a country and so the structure of demand changes. As a conse-
quence, the range of potential exports (and so of actual exports) is changing
through time in a gradual and predictable way: "If Japan has been an im-
porter of cars and exporter of bicycles, she might, within a decade, export
cars and import bicycles" (Linder, 1961, p. 106). This is a prediction that
hit the nail on the head.
Side by side with the forces that foster actual trade, there are forces
that put a brake on it, for example distance (which comes into play in the
form not only of transport costs, but also of other elements such as the
imperfect knowledge of faraway markets), tariffs and other impediments to
trade. Therefore, the braking forces will make actual trade-which, in their
absence, would coincide with potential trade-smaller than the latter.
17.3.5 Intra-industry Trade: First Explanations

Let us recall from Sect. 17.1 that intra-industry trade is defined as the si-
multaneous export and import of products belonging to the same industry,
Table 17.2: Example of SITC Classification

Digits IteIDS
8 Miscellaneous manufactured articles
... ...
85 Footwear
851 Footwear
... ...
851.01 Footwear with outer soles and uppers of rubber or artificial plastic
material
851.02 Footwear with outer soles of leather or composition leatherj
footwear (other than footwear falling within heading 851.01) with
outer soles of rubber or artificial plastic material.
which gives rise to an exchange of goods within, rather than between, indus-
tries. Empirical studies show an increasing quantitative importance of this
phenomenon.
To begin with, it should be observed that-apart from problems of phys-
ical homogeneity, which will be dealt with presently-internationally traded
goods are usually classified in categories according to the Standard Interna-
tional Trade Classification (SITC). This classification starts from a limited
number of very broad basic classes, distinguished by one digit: for example,
section 1 is "beverages and tobacco", section 8 is "miscellaneous manufac-
tured articles". Within each of these, more detailed categories are distin-
guished by two digits; each two-digit category is in turn disaggregated into
various three-digit categories, and so on up to five digits. It should be noted
that SITC, as internationally adopted, arrives at five digits; for further dis-
aggregation, the individual count ries are free to choose their own description
and coverage. In practice the maximum disaggregation used arrives at seven
digits. It is clear that the higher the number of digits of an item the more
precisely defined the set of similar goods included in that item. In Table 8.2
we give an example of the SITC classification, in which we have considered
only a few disaggregations.
Obviously, if one considers the two-digit items only, the phenomenon of
intra-industry trade is not a surprise, for we are dealing with classes so broad
as to include heterogeneous goods.
Intra-industry trade would then be a spurious phenomenon, due to sta-
tistical aggregation. But since intra-industry trade is also observed in higher-
digit items, even going as far as the seven-digit ones, it cannot be neglected
from the theoretical point of view. Grubel and Lloyd (1975) were among the
first systematically to examine the problem. From the theoretical point of
view we must distinguish between the case of identical goods and the case of
non-identical (though belonging to the same industry) goods.
In the case of identical goods the orthodox theory can supply various
explanations, that we have already mentioned in the introduction to this

chapter.
To examine intra-industry trade in differentiated products, it is conve-
nient to follow a classification introduced by Grubel and Lloyd, based on
similarity of input requirements and substitutability in use.
The first group contains commodities with similar input requirements but
low substitutability in use, such as bars and sheets of iron.
The second group includes commodities with low similarity in input re-
quirements but high substitutability in use, such as wood and plastic chairs.
The third group contains commodities with similarity in input require-
ments and high substitutability in use, such as cars with similar characteris-
tics, but manufactured by different producers.
It goes without saying that the group of commodities with low similarity
in input requirements and high substitut ability in use does not come into
consideration, for these commodities belong to different SITC classes and no
intra-industry trade will be observed.
Intra-industry trade in commodities belonging to the first group can be
explained by the orthodox theory, for their low substitutability in use makes
them different commodities from the point of view of demand. Intra-industry
trade is simply a phenomenon due to statistical aggregation.
Intra-industry trade in commodities belonging to the second group can
also be explained by the orthodox theory, for the dissimilarity in their input
requirements means that they have to be considered as different commodities
from viewpoint of production: intra-ip.dustry trade is, again, a phenomenon
due to statistical aggregation.
We are left with the third group in which we may further distinguish two
cases.
The first one is when the commodities are so similar (as regards both
input requirements and substitut ability in use) that they can be considered
as homogeneous for all practical purposes, and we are back in the situation
examined in the previous section.
The second case is the relevant one: the commodities, though very similar,
have to be considered different from the economic point of view, because
of technological differences in production and/or because consumers believe
them to be different (for reasons of brand, design, advertising, etc.) even if
they are perfectly substitutable in use and with identical inputs (toothpastes
or medicines with the identical chemical composition are an example). In
fact, most of the traditionalliterature on intra-industry trade has been based
on this type of differentiation. We might state, in conclusion, that most of
the precursor models examined in the previous sections can be considered as
models of intra-industry trade.
17.4. Neo-Heckscher-Ohlin Theories 295
17.4 N eo-Heckscher-Ohlin Theories

This designation derives from the fact that in these theories (also called neo
factor proportions) the departure from the orthodox theory is kept to a min-
imum (in particular, the assumption of perfect competition is maintained),
and the conclusion is obtained that intra-industry trade conforms (with due
modifications) to the traditional statement of the Heckscher-Ohlin theorem.
The model that we examine is due to Falvey (1981), who starts from
the idea that each industry does no longer produce a single homogeneous
output, but instead can produce a range of products differentiated by quality
(each quality is produced by many competing firms). Thus, according to
the terminology introduced in Sect. 17.1, we are in the case of vertical
differentiation. The second point of departure from the orthodox theory is
the nature of capital: the capital stock is no longer homogeneous, but consists
of capital equipment specific to each industry. Because of its specificity the
capital stock is immobile among industries, but of course freely mobile in the
production of the various qualities within each industry. The labour force
is-like in the orthodox theory-homogeneous and hence mobile also among
industries.
For simplicity, the analysis is limited to a single industry (hence we are
in a partial equilibrium context). This industry owns a certain amount of
specific capital (whose rate of return, R, adjusts so as to maintain the fuH
employment of the capital stock) and can employ any amount of labour at
the current wage rate W. The industry under consideration produces a con-
tinuum of different qualities of the product (the assumption of the production
of a continuum of qualities is made for mathematical convenience), with a
constant-returns-to-scale technology. The problem now arises of defining the
quality. Für this purpüse Falvey introduces a numerical index a such that
greater values üf a correspünd to higher qualities, and assurnes that the pro-
duction of higher-quality güods requires a cürrespondingly higher quantity of
capital per unit of labüur. It is now possible to define the measurement units
in such a way that the production of a good of quality a requires the input
of one unit of labour and a units of capital. Given the assumption of perfect
competition, for any quality the price equals the unit cost of production,
namely
Pl(a) = W 1 + aR b
(17.1)
P2(a) = W2 + aR2,
where the subscripts 1 and 2 refer as usual to the two countries, whose
technology is assumed identical (again in agreement with the Heckscher-
Ohlin framework).
Without loss of generality we can assurne that W 1 > W 2 . It foHows that
international trade requires R 1 < R2 : in the opposite case, in fact, we see
from Eqs. (17.1) that country 2 could produce any quality ofthe commodity
at a cost (and hence price) which is lower than in country 1, so that there
would be no scope for international trade. Assuming then R1 < R2 , it follows

that a certain subset of qualities will be produced in country 1 at a lower
cost than in country 2, and vice versa for the other subset. In order to
identify these two subsets, let us use a diagram (Fig. 17.2), where we have
drawn the two linear price-cost relationships given in Eqs. (17.1). Let us
p (a)
P2 (a)
PI (a)
o a
Figure 17.2: Vertical differentiation and international trade
note that R;(i = 1,2) is the slope of line Pi, hence the P2 line is steeper
than Pb since R 2 > R 1 . We see from the diagram that prices are equal
in the two countries in correspondence to the "marginal" quality a o , while
country 2 has a comparative cost advantage over country 1 for lower-quality
products (a < a o ); conversely, country 1 has a comparative cost advantage
for higher-quality products (a > a o ).
If we now make the plausible assumption that in both countries there is
a demand for both lower-quality and higher-quality products, it follows that,
in the typical situation of free trade with no transport costs, there will be
international trade in the products of the industry considered: country 1 will
export higher-quality products to (and import lower-quality products from)
country 2. Since we are dealing with products of the same industry, what
has taken place is indeed intra-industrial trade.
What is more, such a trade follows the lines of the Heckscher-Ohlin
theorem, as can be easily shown. Given the assumptions made on the re-
turns to the factors of production, we have Rt/W1 < RdW2 , which means
that country 1 is capital abundant relative to country 2 according to the
price definition of relative factor abundance (see Sect. 13.2.2). Now, since
higher values of a mean both higher qualities and higher values of the capi-
tal/labour ratio, we observe that country 1, the capital-abundant country, ex-
ports capital-intensive products (conversely country 2, the labour-abundant
17.5. Monopolistic Competition and International Trade 297
country, exports labour-intensive products).

In a subsequent model (Falvey and Kierzkowski, 1987) two industrial
sectors have been introduced, one of the type treated above and the other
traditional, namely producing a single homogeneous commodity. This model
is able simultaneously to generate inter-industrial and intra-industrial trade
along the lines of Heckscher-Ohlin theorem, in a context of perfect competi-
tion and very similar to the orthodox one.
It is finally worthwhile emphasizing the fact, mentioned at the beginning
of this section, that a plausible model of intra-industry trade has been pro-
duced with a minimum of departure from the orthodox theory: apart from
product differentiation, it has not been necessary to introduce economies of
scale or monopolistic competition as other models do. This does not mean
that these features are unimportant or uninteresting, it simply stresses that
the phenomenon of intra-industry trade can be made to fit into the orthodox
theory, with results similar to those of the Heckscher-Ohlin model.
17.5 Monopolistic Competition

and International Trade
We recall from microeconomics that monopolistic competiiion is a market
form characterized by the fact that each firm produces a horizontally differ-
entiated commodity (from now on we shall use "differentiation" in the sense
of horizontal differentiation), that is to say a commodity having (real or pre-
sumed) characteristics-apart from quality-that make consumers consider
it different from the commodities produced by the other firms operating in
the same sector . Therefore each firm is like a monopolist as regards the com-
modity it produces and so it can choose the selling price so as to maximize
profits by applying the rule marginal cost = marginal revenue. Given how-
ever freedom of entry, if the profits of the firms operating in the industry
under consideration are deemed higher than normal, new firms will enter
and supply similar products, competing with the existing firms. This will
reduce the demand for the products of the existing firms and hence their
profits. The entrance of new firms will continue until profits fall to their
normal level. This process gives rise to a market form in which many small
monopolists exist, none of which is however able to earn monopolistic profits.
While the aspects concerning the supply side have been perfectly clear
for a long time, the same is not true as regards the aspects concerning the
demand side, in particular the theoretical reasons why consumers demand
differentiated commodities. It was in fact only in the 1970s that two alterna-
tive explanations for this phenomenon were introduced. These, in addition
to giving a rigorous foundation to the treatment of demand under monopo-
listic competition, made it possible to extend to international economics in
general (and to intra-industry trade in particular) the analytical apparatus

of monopolistic competition.
According to Dixit and Stiglitz (1977) and Spence (1976), behind the
demand for differentiated goods there is simply the desirability of variety as
such, which is implicit in the traditional indifference curves convex to the ori-
gin. If a consumer is indifferent between two goods-namely if the combina-
tions (1,0) and (0,1) of these goods lie on the same indifference curve-then
an intermediate combination like (1/2,1/2) is preferred to both extremes.
This is so because the intermediate combination lies on the straight line seg-
ment which joins the two extreme combinations, hence this combination will
lie on a higher indifference curve. This can easily be formalized introducing
a utility function such that the utility index increases, ceteris paribus, as the
number of goods consumed increases. Therefore each consumer demands all
the existing varieties of a differentiated good.
The preferences a la S - D - S (Spence-Dixit-Stiglitz) have been used by
Krugman in several works in which he builds a theory of international trade
in differentiated goods based on monopolistic competition (which has been
named neo-Chamberlinian monopolistic competition because it is nearer to
the original vision of Chamberlin himself).
A second line of analysis of the demand side has been taken by Lancaster
(1980), who observes that for all the varieties of a differentiated product to be
demanded at the aggregate level it is not necessary that such a demand also
exists at the individual level: it is, in fact, sufficient that each consumer (or
group of consumers) has different tastes and so demands a different variety of
the product. He starts from an intuition of Hotelling (hence the name of neo-
Hotelling monopolistic competition given to Lancaster's approach) and ap-
plies his own goods-characteristics approach to demand, arriving at a model
of monopolistic competition that he extends to international trade. The Lan-
caster approach starts from the assumption that the consumer does not want
the commodities as such, but the characteristics embodied in the commodi-
ties. It follows that the demand for the commodities is an indirect or derived
demand that depends on the preferences with respect to the characteristics
and on the technical properties that determine how the characteristics are
embodied in the different commodities. The different individual reactions of
different consumers with respect to the same commodity are then seen as the
result of different individual preferences with respect to the characteristics
(which are perceived in the same way by all consumers) embodied in that
commodity rather than the result of a different individual perception of the
properties (= characteristics) of the same commodity.
Lancaster's demand theory is more sophisticated and flexible than the
S-D-S preferences, but to explain international trade (and intra-industrial
trade in particular) the reason why at the aggregate level all the varieties
of a horizontally differentiated good are demanded does not make much dif-
ference. Both approaches lead to a monopolistically competitive equilibrium
17.6. Oligopoly and International Trade 299
in which several differentiated goods are produced by different firms all of

which have monopolistic power but none of which earns monopolistic profits.
Given this, it is intuitive that the different evaluation of the commodities
by the consumers belonging to different count ries can give rise to a cross de-
mand for commodities that are similar but horizontally differentiated. Con-
sumers in country i demand cars produced in country j and consumers in
country j demand the same type of cars produced in country i. More gener-
ally, we can say that-as a consequence of economies of scale in the produc-
tion of each variety of the horizontally differentiated commodity A-no coun-
try can produce all the range of varieties of this commodity, but only part.
Therefore, even if both count ries produce manufactures, each will produce
different varieties; which country pro duces which varieties cannot be deter-
mined, but this is not important for our analysis. In fact-independently of
the hypothesis made on preferences--consumers in each country are assumed
to demand all varieties. Thus, to satisfy domestic demand, country 1 will
import from country 2 the varieties that it does not produce, and export to
country 2 the varieties that it produces, to meet country 2's domestic de-
mand. There is, consequently, intra-industry trade, which will coexist with
inter-industry trade.
17.6 Oligopoly and International Trade

17.6.1 Introduction
In the previous sections, we have considered models based on market forms
that might be called "structurally competitive", namely where the number
of firms is sufliciently high for no firm influencing, with its own decisions, the
decisions of the other firms. On the contrary, we consider here models based
on oligopolistic markets, where the problems of strategie interdependence
among a limited number of firms become essential.
As we know from microeconomics, there does not exist a general model of
oligopoly. Oligopolistic firms can act in collusion, tacit or explicit (as in car-
tels) or in a non-cooperative manner. When they do not cooperate, the result
of their interaction depends on several factors: the decision variable of the
firm (price or quantity), the nature of the firms' conjectural variations (i.e.,
of the assumptions that each firm makes as regards the other firms' reactions
to its price or quantity changes), the specification of the product, the nature
of the market (i.e., whether it is segmented or not), etcetera. Thus it not
possible to give a general analysis of the effect of oligopoly on international
trade. It is however possible-through the study of specific cases-to obtain
interesting results especially as regards intra-industrial trade. In what follows
we have set up our treatment according to the product type, in agreement
with the classification in Table 17.1.
17.6.2 Homogeneous Commodities

Intra-industry trade in homogeneous goods, that we have already treated in
Sect. 17.3.5, is explained by Brander (1981) as the result of the interaction
among oligopolistic firms in different countries. Let us consider the simplest
case of duopoly: one firm in country 1 and one in country 2, both producing
the same homogeneous commodity. The decision variable is assumed to be
the quantity, so that each firm has to decide how much of its output to seIl
at horne and how much abroad (the whole output is produced domestically).
Transport costs are modelled according to the iceberg assumption 1 , are borne
by the producers, and are assumed to be symmetrical-that is to say, the
unit transport cost of the output of firm 1 to (the market in) country 2 is
equal to the unit transport cost of firm 2's output to country 1. To make the
model as simple as possible the technology is assumed internationally identi-
cal with identical production costs (marginal costs are constant); the demand
functions are also internationally identical. The two markets are assumed to
be segmented, so that firm i can seIl at a different price at horne and abroad.
Naturally, since the product is homogeneous, in a given market the price will
be identical for both the domestically produced and the imported good.
The strategie interaction between the firms is modelled following the
Cournot hypothesis, according to which each firm maximises profit choos-
ing its decision variable (the quantity) on the assumption that the quantity
supplied by the other firm remains the same. The only (but important)
difference between the conventional Cournot duopoly and the case under ex-
amination is that here each firm acts in two different markets, in each of
which it employs a Cournot strategy as regards the other firm's supply to
the same market. To be precise, ifwe denote by qij (i,j = 1,2) the quantity
offered by firm i on market j, we have that firm 1 chooses qll and q12 so as to
maximise profit, assuming that q21 and q22 remain the same; similarly firm 2
will choose q21 and q22 so as to maximize profit, taking qll, q12 as constant.
In calculating its profit each firm must take account of transport costs on the
part of its total output sold abroad, namely q12 for firm 1 and q21 for firm 2.
As we know from microeconomics the equilibrium point in Cournot's
duopoly can be determined employing the reaction curves (or best-reply
functions, as they are sometimes called). Areaction curve shows the optimal.
quantity supplied by a duopolist for any given quantity supplied by the other
one. In our case, we have two couples of such curves, namely one couple in
each market, that we indicate by ~j (reaction curve of firm i on market
j). In Fig. 17.3 we have drawn the two couples of reaction curves, that
for simplicity's sake we have assumed linear. They are also assumed to be
1 In 1954, Samuelson assumed that only a fraction of exports reaches the country of
destination as imports, just as only a fraction of ice exported reaches its destination as
unmelted ice. The Samuelson ice similitude was subsequently called in the literat ure the
iceberg assumption.
q21 q22
Ru
E
B q22
I
E I I E,
q21 ---T-r---
I I I
I I
I I
I I
0 A A' E q/l 0 E q,2

q/l q,2
Figure 17.3: Homogeneous duopoly and reciprocal dumping
separable, namely the reaction curve of a firm in a market only depends on

the quantities being supplied (by the firm under consideration and by the
riYal) in that market, and not on the quantities being supplied in the other
market. Thus, for example, Ru does not shift as q22 and qI2 change. This
very convenient property depends from the assumption that the marginal
cost is constant.
It can now be shown, through the usual dynamic mechanism underlying
Cournot reaction curves, that the equilibrium point is stable in both markets.
Consider for example market 1, and take an arbitrary initial situation in
which the local firm offers OA. The foreign firm, given its reaction curve
R 217 will offer OB (the ordinate of point P). The domestic firm, given the
supply OB from the foreign firm, will then offer OA' (the abscissa of point
P' on the domestic firm's reaction curve), and so forth. The dynamic path
clearly converges to the equilibrium point EI. A similar reasoning can be
applied to market 2 to show that the equilibrium point E 2 is stable.
Given the assumptions made (identical size of the two markets, identical
production costs, identical demand, identical transport costs), the two equi-
librium solutions are symmetrieal, i.e. qfi = q~ and qfiz = q~. Furthermore,
owing to the presence of transport costs, qii > Qji, namely in each country
the share of demand satisfied by the domestic firm is greater than the share
satisfied by the foreign firm.
This form of intra-industry trade due to oligopolistic interaction can be
seen as a form of dumping or reciprocal dumping, as Brander and Krugman
(1963) called it. To show this, let us begin by observing that, due to the
symmetry property, the overall quantity supplied to each market will be
the same in both markets and hence. since the demand functions have been
302 Chapter 17. The new Theories ofInternational Trade
assumed identical, the price also will be identical in the two markets. It
follows that, due to transport costs, for each firm the f.o.b. price of exports
is lower than the domestic price of the same commodity, and therefore there
is a kind of reciprocal dumping.
17.6.3 Vertically Differentiated Goods

Let us recall that we are in the case in which goods differ only in quality.
In the neo-Heckscher-Ohlin model of Sect. 17.4, quality was assumed to
be an increasing function of capital intensity; here, we assume that it is the
expenditure on R&D (Research and Development) to enable firms to produce
a better good. An additional important consideration is why in this section
we assume an oligopolistic market rather than a competitive one like in the
neo-H-O model. The reason is that when the burden of quality improvement
falls on high fixed costs such as R&D expenditure, there is an upper limit
to the number of firms that can profitably operate (for simplicity's sake we
assume that each firm produces only one quality). Such a situation-i.e., very
high fixed costs with respect to variable cost-is called natural oligopoly by
Shaked and Sutton (1984) and other authors that have examined it. These
studies, initially referred to a closed economy, were then extended to open
economies.
On the demand side, we assume consumers with identical tastes but with
different incomes: those with a higher income are willing to pay more for a
higher-quality product. Thus the market is divided in a fairly simple manner:
the highest quality supplied is bought by all consumers with an income above
a certain criticallevel; the next to highest quality is bought by all consumers
in the immediately lower income bracket, and so forth.
In studying international trade, the authors start from initially closed
economies, amongst which trade is subsequently opened, and distinguish be-
tween the short and the long run. In the short run, given the upper bound to
the number of firms that can coexist, the opening of international trade will
in any case bring about a reduction in the number of firms existing in the
combined economy (country 1 and 2 form now a single world market). If we
examine for example the extreme case of two equal countries, let B denote
the maximum number of firms (and so of goods) that can coexist in each of
them separately considered. In the combined market still B firms at most
can coexist, which means that some firms will be eliminated from the markets
through price competition (the assumption is that the oligopolistic interac-
tion does not take place through the quantity, like in the Cournot model
used in Sect. 17.6.2, but through prices, like in the Bertrand-Edgeworth
oligopoly model). Hence, in the post-trade situation consumers will be bet-
ter off thanks to lower prices, and intra-industry trade will occur because
consumers will continue demanding the B varieties of the commodity, which
are now produced partly in country 1 and partly in country 2.
When the two autarkie eeonomies are different (the diversity being mea-
sured by a different ineome distribution), a greater number of firms ean
eoexist in the eombined world eeonomy when trade is opened UPi but this
number becomes smaller as the ineome distributions get nearer.
Let us now eome to the long run , always starting from two initially au-
tarkie eeonomies. The Shaked and Sutton model shows that the number of
firms that ean survive in eaeh eountry is only two, and that other firms that
tried to enter the market would suffer losses (henee they do not enter). What
happens when international trade is opened? We must as before distinguish
two eases, that in which the two eeonomies are identical, including ineome
distribution, and that in whieh they are different as regards ineome distri-
bution. In the former ease the same result as in the two autarkie eeonomies
will eontinue to hold for the eombined world eeonomy, namely no more than
two firms producing two different qualities will survive. The model eannot
however forecast which are these firms, so that it might happen that the two
surviving firms belong to the same eountry. In this ease there would be one-
way trade, for the other eountry would have to import both eommoditiesi
of eourse there will have to exist other seetors in which sueh eountry ean
export, beeause in the eontext of the pure theory no eountry ean be only an
importer. When, on the eontrary, the two surviving firms belong to different
eountries, sinee the eonsumers in both eountries demand both eommodities,
there will be intra-industry trade with the simultaneous import and export
of different qualities of the eommodity. Finally observe that, sinee eaeh firm
will serve not only the domestic but also the foreign market, the eeonomies
of seale will allow aprice reduetion, henee an inerease in eonsumers' welfare
(the gains from trade).
If ineome distribution is different in the two autarkie eountries, the num-
ber of firms that ean eoexist in the world economy is greater; but for our
purposes it is suffieient to observe that the result will be in any ease the
ereation of intra-industry trade to satisfy eonsumers' demands in both eoun-
tries.
17.6.4 Horizontally Differentiated Goods

Eaton and Kierzkowski (1984) eonsidered the ease of an eeonomie system
where two goods are produeed: a homogeneous eommodity (good A, pro-
dueed under eonstant returns to seale) and a horizontally differentiated eom-
modity (good B, produeed under inereasing returns to seale). While the
market for good A is perfeetly eompetitive, market B is oligopolistie.
The firms in seetor B first ehoose the variety of the good to be produeed
(eaeh firm is assumed to produee only one variety) and then decide the priee.
More precisely, the assumption here is that a firm ineurs the fixed cost when
it ehooses a variety to produee, before it decides on the level of output and
priee. Thus, the decisions eoncerning entry and priee are taken sequentially
304 Chapter 17. The new Theories of International '!'rade
rather than simultaneously. According to the authors, this is consistent with

the views of Linder (see Sect. 17.3.4), who holds that production is typically
first developed for the domestic marketj international trade takes place only
later, when firms have already selected their models and incurred fixed costs.
Oligopolistic interaction takes place through prices, according to a mod-
ified Bertrand assumption. More precisely, when a firm contemplates price
reductions it assumes that the other firms will not change their price, while
when it considers price increases it antieipates that the competitors wililower
their price.
The demand for the differentiated commodity follows Lancaster's ap-
proach based on characteristics (see Sect. 17.5). We must add that con-
sumers will be willing to demand the differentiated good provided that the
price of the variety they desire is not higher than a certain critical level,
above which they will demand the homogeneous good only.
The opening of trade between such economies will give rise to a vast
number of short-run and long-run effects, partly depending on the number
of firms existing in the two count ries before and after trade. Thus the au-
thors are compelled to adopt a taxonomic approach. Among the several cases
they examine there is that in which free trade is not the best situation for a
country, which, on the contrary, can improve its welfare levying a tariff on
imports of the differentiated good. To show this let us assume that in the
pre-trade situation commodity B is not produced in country 2, for example
because its price would be higher than the critical level, so that consumers
do not demand it and spend all their income on the homogeneous commod-
ity. In country 1, on the contrary, consumers demand both the homogeneous
commodity and commodity B (only one variety, produced by a single firm,
is assumed to exist) because their critical price is higher than that of country
2's consumers. Let us limit ourselves to the short-run effects, so that the
productive situation remains unchanged. With the opening of trade country
l's producer of good B will try to seIl also in country 2's market by lower-
ing the price. But since no market discrimination is assumed to exist, this
producer will have to lower the price also in the domestic market. Country
l's consumers will benefit, and the producer will get higher profits. It is
in fact obvious that the producer under consideration, who already earned
monopoly profits in country l's market before the opening of trade, will de-
eide to seIl also in market 2 by redueing the price only if the elastieity of
the twö countries's combined demand shows this deeision to be the superior
alternative.
Let us now ask what happens to country 2. Local consumers will have
no benefit, because the monopolist producer of commodity B will be able to
charge a price that in the margin willleave country 2's consumers indifferent
between consuming the homogeneous commodity only (like in autarky) or
consuming both the homogeneous and the differentiated commodity. Thus
we conclude that free trade benefits country 1 but leaves unchanged the
17.7. Strategie Trade Poliey 305
welfare of country 2, contrary to the result of the orthodox theory, according

to which, as we know, free trade is beneficial to both countries.
17.7 Strategie Trade Poliey

The new theories introduce new arguments in the old debate on free trade
versus protectionism (see Chap. 15). These new arguments, however, instead
of leading the debate towards a conclusion, have complicated it further. The
orthodox theory had a set of precise results on the preferability of trade
to autarky and, if we exclude second-best situations, on the preferability
of free trade to restricted trade. The new theories, conversely, give rise
to contradictory results: the reason is due to competing assumptions that
characterize these models and that do not allow unequivocal conclusions ..
We now come to strategie trade policies. The adjective strategie hints to
the presence of some form of interaction between the firms involved in inter-
national trade, when the action taken by any one firm may have significant
effects on other firms. This interaction is certainly absent in perfect eompe-
tition, and is certainly present in oligopoly, so much so that strategie trade
policies and oligopolistic models of international trade go hand in hand. This
is why the theory of strategie trade policy has been developed in the context
of the new theories of international trade, as by definition no strategie trade
poliey may arise in the context of the orthodox theory.
Sometimes the meaning of strategie trade policies is extended to include
the ease in which the interaction arises between governments pursuing op-
timal (for each) trade policies rather than between the firms involved in
international trade. The analysis of trade in oligopolistic markets has led
to new arguments for trade intervention. A strategie trade poliey consists
of government measures that would increase the global market share (and
the proportion of oligopoly profits) of domestic firms at the expense of for-
eign firms. However, strategie trade polieies may also arise in the context of
the orthodox theory: the optimum tariff (see Sect. 15.1) would be a typieal
example.
In the eontext of the new theories strategie trade policy may give rise to
results strikingly different from those of the orthodox theory.
For example, in the context of the Eaton-Kierzkowski model examined
in Sect. 17.6.4 we can show that the imposition of a tariff by country 2 on
its imports of commodity B will improve country 2's welfare. We have seen
that the price charged by country l's monopolistic producer is at the limit of
indifference for country 2's consumers. It follows that, because of the tariff,
this producer will have to reduce the export price to country 2 in such a way
that the final price (export priee+tariff) to eountry 2's consumers does not
increase; otherwise there can be no export. The firm under eonsideration
will be willing to aceept such a reduction insofar as its profits, though lower
than before, are still greater than those that it would obtain giving up any
export to country 2 and only producing for its domestic market like in the
pre-trade situation.
BOX 17.2 Strategie trade poliey: Boeing vs Airbus
The aireraft seetor provides a textbook example of governmental startegie trade
poliey, namely an industry in which trade poliey eould affeet the strategie interac-
tion between a domestie and an international rival: by subsidizing produetion, the
government ean affect the outeome of the eompetitive game in such a way as to shift
rents in favour of the domestie firms as argued by Brander and Speneer (1985). In
the eommercial aerospace industry the produetion has been direetly and indirectly
supported by using the market failure argument. The aerospace industry is surely
subject to market failure, notably beeause of large seale eeonomies in produetion
and the importanee of research and development. Given this industry's market
structure it is diflicult for individual eountries to face international eompetition, so
aireraft industry has given rise to signifieant international cooperation. One of the
most famous ease of such cooperation is the European Airbus Consortium which
was formed in the late 19608 to challenge the dominance of the Boeing Corporation
in international world markets. The publie support to Airbus has mostly taken the
form of a reduetion in fixed development eost.
Although not reeent, the ease of Boeing VB. Airbus eontains useful background
information on the subsidy issue. Boeing has long been the leader in the world
aviation industry and when Airbus was created the eommercial aireraft was almost
eontrolled by US firms. Airbus slowly but steadily expanded its market share during
the first two decades of its existenee and with other eompetitors out of the pieture
(Lockheed and MeDonnel Douglas) the battle for market share in the 19908 and
beyond is being waged direetly at Boeing's expense.
Boeing and MeDonnell Douglas accused Airbus to be state-supported with virtu-
ally unlimited (henee unfair) financial resourees in the form of cheap loans, the
repayment of whieh was eontingent on Airbus's profits. On the other side the Eu-
ropeans argued that Ameriean aireraft manufactures received indireet government
subsidies-from the Department of Defense and NASA-of eomparable magnitude.
The battle over the appropriateness of subsidies raged for the first twenty-two years
of Airbus' presenee. The US government lodged a eomplaint against Airbus under
the GATT and in 1992, an "Airbus Agreement" was signed between the United
States and the European Community. This agreement eontained three main points:
- Direet government subsidies for aireraft were eapped at 33% of developments eosts.
Loans made to the eonsortium were to be repaid aceording to striet scheduling and
interest-rate requirements.
- Indirect subsidies were limited to 3% of the turnover of civil aircraft manufacturers;
- A bilateral panel would monitor compliance of the previous two points, and inerease
the ''transpareney'' of the eommercial aireraft industry.
Strategie trade poliey emphasizes its results in the presenee of oligopoly: any exter-
nal intervention alters the strategie interaction between players on the market. If a
domestie firm is apart of an international oligopoly and reeeives any kind of sup-
port from its government, it eompetes suecessfully. There seems to be little doubt
that the Airbus projeet would not be in a position of sueh prominenee without
government support.
In such a situation the government of country 2, being aware of the strategie
interaction, may even calculate (and impose) a tariff that takes away from
the foreign firm all profits in excess of profits this firm earns by selling only
to consumers in country 1. In such a case this firm is indifferent between
selling only in the domestic market or exporting as weil. Be it as it may,

country 2 will be better off because-although there is no welfare increase
for the consumers, who pay the same price as before-there is the benefit
of the increase in the fiscal revenue (the revenue of the tariff) of country
2's government at no cost. This is contrary to orthodox theory, according
to which the imposition of a tariff does in general cause social costs. The
difference in results is clearly due to the different market form assumed as
weil as to the particular nature of demand.
In general the results of the theory of strategie trade policy are contradic-
tory and heavily model-dependent, hence it is no surprise that this literature
is not a useful guide to government policy at this time.

Balassa, B., 1965, Trade Liberalization and Revealed Comparative Advan-
tage, The Manchester School 0/ Economic and Social Studies 33, 99-
123.
Brander, J.A., 1981, Intra-industry Trade in Identical Commodities, Journal
0/ International Economics 11, 1-14.
Brander, J. and P. Krugman, 1983, A Reciprocal Dumping Model of Inter-
national Trade, Journal 0/ International Economics 15, 313-21.
Brander, J. and B. Spencer, 1985, Export Subsidies and Market Share Ri-
valry, Journal 0/ International Economics 18, 83-100.
Dixit, A.K. and J.E. Stiglitz, 1977, Monopolistic Competition and Optimum
Product Diversity, American Economic Review 67, 297-308.
Eaton, J. and H. Kierzkowski, 1984, Oligopolistic Competition, Product Va-
riety and International Trade, in: H. Kierzkowski (ed.), 1984, 69-83.
Falvey, R.E., 1981, Commercial Policy and Intra-Industry Trade, Journal 0/
International Economics 11, 495-511.
Falvey, R.E. and H. Kierzkowski, 1987, Product Quality, Intra-industry
Trade and (Im)perfect Competition, in: H. Kierzkowski (ed.), 1987,
143-61.
Gabel, H.L. and D. Neven, 1988, Fair Trade in Gommercial Aircraft: The
Gase 0/ Boeing vs. Airbus Industry, INSEAD.
Grossman, G.M. (ed.), 1992, Imperfect Gompetition and International 'Irade,
Cambridge (Mass.): MIT Press.
Grubei, H.G., 1967, Intra-industry Specialization and the Pattern of Trade,
Ganadian Journal 0/ Economics and Political Science 23, 347-88.
Grubei, H.G. and P.J. Lloyd, 1975, Intra-industry Trade: The Theory and
Measurement 0/ International Trade in DijJerentiated Products, Lon-
don: Macmillan.
Hirsch, S., 1967, Location of Industry and International Competitiveness,
Oxford: Oxford University Press.
Hutbauer, G.C., 1956, Synthetic Materials and the Theory of International

Trade, Harvard University Press.
Kierzkowski, H. (ed.), 1984, Monopolistic Competition and International
Trade, Oxford: Oxford University Press.
Kierzkowski, H. (ed.), 1987, Protection and Competition in International
Trade: Essays in Honor of W.M. Corden, London: Basil Blackwell.
Kravis, I.B., 1956, "Availability" and other Infiuences on the Commodity
Composition of Trade, Journal of Political Economy 64, 143-55.
Krugman, P.R., 1979, Increasing Returns, Monopolistic Competition, and
International Trade, Journal 0/ International Economics 9, 469-479.
Krugman, P.R., 1990, Rethinking International Trade, Cambridge (Mass):
MIT Press.
Lancaster, K., 1980, Intra-Industry Trade under Perfect Monopolistic Com-
petition, Journal 0/ International Economics 10, 151-75.
Linder, S.B., 1961, An Essay on Trade and Transformation, New York:
Wiley.
Posner, M.V., 1961, International Trade and Technical Change, Oxfom Eco-
nomic Papers 13, 323-41.
Shaked, A. and J. Sutton, 1984, Natural Oligopolies and International Trade,
in: H. Kierzkowski (ed.), 1984,34-50.
Spence, A.M., 1976, Product Selection, Fixed Costs, and Monopolistic Com-
petition, Review 0/ Economic Studies 43, 215-35.
United Nations, 1975 (and subsequent revisions), Standard International
Trade Classification, New York, UNo
Vernon, R., 1966, International Investment and International Trade in the
Product Cycle, Quarterly Journal 0/ Economics 80, 190-207.
Chapter 18
Growth, Trade, Globalization
18.1 Endogenous Growth and International

'Irade
Equilibrium growth in the basic neoclassical growth model is exogenous: the
steady state path, in fact, depends on factors such as the rate of growth of
the labour force and technical progress. Both are exogenous: the labour force
grows according to exogenous demographie factors, and technical progress is
no more than an exogenous time trend.
The theory of endogenous growth stresses the endogenous determination
of technical progress, which actually means an endogenous determination of
the main source of growth (hence the name of endogenous growth theory).
The basic ideas were already present in the orthodox neoclassical growth
theory, but in endogenous growth theory they are at the centre of the stage.
Another point eonsidered by endogenous growth theory is the absence of
decreasing returns to capital. Hence from the point of view of the interre-
lations with international trade, endogenous growth is often associated with
the 'new' trade theories, that usually take increasing returns and imperfect
competition as their points of departure (see Chap. 17)
In the 2x2 classification given in Table 18.1,the, names of the authors
Table 18.1: Growth theories and trade theories

Growth theory International Trade Theory
Orthodox New
Orthodox Oniki-Uzawa
Endogenous Findlay Grossman-Helpman
are merely exemplificative. Models in which the orthodox theory of growth

is combined with the orthodox theory of trade are nowadays relatively uu-
interesting, hence we shall only consider models that fall into positions (2,1)
and (2,2).
309
310 Chapter 18. Growth, 'Irade, Globalization
BOX 18.1 Trade and LDCs growth

International trade can increase a country's growth rate and help to alleviate poverty.
It can enhance a country's access to a wider range of goods and services, technologies
and knowledge. Above all, foreign knowledge spillovers may be important to the
growth process, with trade being one mechanism through which spillovers occur.
However, for trade to playa central role in poverty reduction it needs to be an
integral part of a country's development strategy.
Over the last four decades, there has been a marked, steady decline in the mar-
ket share of LDCs in world trade. To support LDC governments in trade capacity
building and integrating trade issue into overall national development strategies,
a process called Integrated Framework (IF) was established. The IF was formally
launched at the High Level Meeting on Integrated Initiatives for LDCs' 'Irade De-
velopment organized c/o WTO (World 'Irade Organization) in October 1997 by six
core agencies: IMF (International Monetary Fund), ITC (International 'Irade Cen-
tre), UNCTAD (United Nations Conference on 'Irade and Development), UNDP
(United Nations Development Programme), the World Bank and WTO. IF is a
form of cooperation linking trade to poverty, infrastructure and governance. The
agencies combine their efforts with those of least developed countries and donors to
respond to the trade development needs of LDCs. To enable LDCs to be full and
active players in the multilateral trading system three issues were identified that
need solution: a) elimination of market access restrictions; b) resolution of domestic
supply-side and capacity inadequacies, and c) consistent pursuit of domestic policy
reforrns by LDCs.
IF is a four-part process: 1) Awareness-building on the importance of trade for de-
velopment. 2) Diagnostic for a Trade Integration Strategy to identify constraints to
traders, sectors of greatest export potential and a plan of action for integrating into
the global trading system. 3) Integrating the plan of action into the national devel-
opment plan, such as the Poverty Reduction Strategy Process. 4) Implementation
of a plan of action (including policy reform measures, trade related assistance need,
sectorial plans, etc.) in partnership with the development cooperation community.
The Diagnostic Trade Integration Study, that is the first step in the IF process, anal-
yses trade relations, trade structures, and other issues. It is a tool the country may
use to ex amine the wealmess of its trade policy, export potential and macroeconornic
environment and to identify the supply side bottlenecks. All LDCs are eligible for
the IF process and would be selected after an extensive screening process.
Progress of the IF was limited and this resulted in a review of the IF in 2000 (World
'Irade Organization, LDC Unit, in http://www.wto.org). Despite reforms, LDCs
continue to be marginalized in world trade.
18.1.1 A Small Open Economy with Endogenous

Technical Progress
The endogenization of technical progress can be performed in several ways,
such as the accumulation of experience in the form of Iearning by doing, or
the allocation of resources to R&D (Research and Development). Here we
consider the second option.
The model (Findlay, 1995) is an extended Heckscher-Ohlin model with
three sectors, in which growth is entirely due to technical progress while the
amounts of the primary factors (capital and labour) are assumed constant.
Two of the three sectors produce two final goods, say A and B, which can be
18.1. Endogenous Growth and International Trade 311
traded along the lines of the Heckscher-Ohlin model; since the economy under
consideration is assumed to be a small open economy, the terms of trade
or relative price PB/PA is exogenously given by the international market.
Production takes place using capital and labour under constant returns to
scale and neutral technical progress.
The third sector produces a nontradable good, say Z, and is the cru-
cial one. It is the R&D sector, which can be considered as the sector that
"produces" technical progress by using primary factors. More precisely, this
sector employs capital and labour to provide R&D services to the traded
goods sectors to increase their efficiency. Technical progress is purely 'local',
as it only accrues to domestic firms, with no international spillovers.
The production of R&D services takes place under constant returns to
scale, but the increase in efficiency that accrues to the tradables when there is
an increase in these services is subject to diminishing marginal productivity.
Since the same primary factors are used to produce the three goods, and
production functions are homogeneous of the first degree, it follows that at
some initial time to (in which we can take the index of technological efficiency
as equal to one) the relative price of the nontradable, pz, is also determined
by the international market for traded goods.
We are now facing a problem of optimal allocation of resources, whose
solution will yield the rate of endogenous technical progress. In fact, there is
a trade-off between current and future outputs of tradable goods (on which
social welfare ultimately depends). Since the amount of primary factors is
given and constant through time, if more factors are allocated to the R&D
sector , there will be less current output of tradables but more output of
them in the future due to the higher rate of technical progress. If less factors
are allocated to R&D, there will be more current output but less future
output of tradables. Let v be the value of the output of tradables and v its
instantaneous change, a function of z, the per-capita output of R&D services.
As in all optimization problems involving trade-offs, we can apply the
usual optimization rule that equates the marginal benefit to the marginal
cost of an incremental expenditure on R&D. The instantaneous marginal
benefit is dzi/dz, namely the increment in zi due to an increment in z. Since
this benefit accrues from now to infinity, we must calculate its present value.
In general, the present value of an infinite stream having a constant value in
each unit of time is obtained dividing such a constant value by the discount
rate. Thus the present value we are looking for is (dzi / dz) /6, where 6 is a
discount rate (the interest rate or the social discount rate). This represents
the marginal benfit to be compared with the marginal cost, which is simply
pz, the relative price of the non-traded good. Marginal benefit and cost are
equated when (dzi/dz)/6 = pz, namely dzi/dz = 6pz.
The result can be shown in Fig. 18.1, taken from Findlay (1995, p.
89). The curve OF shows zi(z), the increase in value of tradable output as
a function of z. This curve embodies the trade-off between the reduction
312 Chapter 18. Growth, Trade, Globalization
v H
Figure 18.1: Orthodox trade theory and endogenous growth
in current output of tradables and the enhancement of technology. As z

increases, the technological improvement more than offsets the decrease in
current tradable output, but only up to a certain point, after which further
allocation of resources to the R&D sector will have a negative efIect.
The ray OH, whose slope is 6pz, shows the interest cost of z, which is
6pzz. Marginal benefit and cost are equated when the slope of the OF curve
(namely dzi/dz) equals the slope of OH, an equality that occurs at point
E. The endogenously determined (optimal) per-capita output of R&D is
z*, which determines the rate of technological progress and hence of growth.
This shows that the growth rate of the economy is endogenous.
18.1.2 Endogenous Growth, North-South Trade and

Imitation: A new Version ofthe Product Cycle
Just as there is a wealth of endogenous growth models in closed economies, so
there is a wealth of models of endogenous growth in open economies. These
are often associated with the new theories of international trade, although
this is not a necessity.
In this section we present a model due to Grossman and Helpman (1991a,b,
c), that formalizes the ideas set forth in the Hirsch-Vernon product cycle (see
Sect. 17.3.3) and in Posner's technological gap (see Sect. 17.3.2).
Consider, for example, the product cycle of the personal computer in the
1980s and 1990s. This has been characterized not only by an increasing ofI-
shore production in South by the Northern innovating (multinational) firm
that invented the product-as predicted by the product cycle-but also by
the introduction of imitations or "clones" by competitors located in NIes
18.1. Endogenous Growth and International Trade 313
(newly industrialized countries) of South-as predicted by Posner's theory.

Product innovation can take place through the development of new vari-
eties of horizontally differentiated goods or through the improvement in the
quality of a set of vertically differentiated goods. Both cases are considered by
Grossman and Helpman; we examine the second model because it allows the
study of some additional aspects of actual North-South trade with imitation
not considered in the first model. In fact, taking up again the illuminating
example of the pe, the clones of the original machine (which was based on
the 8086 microprocessor) were displaced by new and superior machines de-
veloped in North, based on the 80286 microprocessor. These new machines
were subsequently imitated in South and then upgraded once more by firms
in North, and so on and so forth. This shows that there may be revers als
in the pattern of specialization when innovative products, after becoming
standardized and being copied, become obsolete due to the introduction of a
higher-quality type.
The basic model considers two countries, North (that has an absolute
advantage in innovation, namely new higher-quality products can only be
developed there) and South (that has an absolute advantage in production
costs, namely a lower wage rate, hence an absolute advantage in imitation).
Innovation in North does of course require the allocation of resources to R&D,
and is a risky process in the sense that when a firm devotes resources to R&D
it has a probability of success (i.e., of developing a higher-quality product)
proportional to the scale of its efforts but smaller than unity. Imitation in
South is also treated as a risky R&D process requiring resources with an
associated prob ability of success.
Three types of firms are distinguished:
(i) Northern leaders, namely firms that have exclusive ability to produce
some state-of-the-art product (this is the top-of-the-line product, namely
the currently highest quality of the commodity) and compete with another
Northern firm (a follower) that can produce the second highest quality;
(ii) Northern leaders competing with a Southern firm that can produce
the second highest quality;
(iii) Southern firms that can imitate and produce a state-of-the-art prod-
uct.
In the presence of imitation threats, we must distinguish two cases. When
imitation is successful, Northern leaders have the incentive to undertake re-
search leading to innovation, namely to the development of the next gen-
eration of products so as to regain market leadership. Due to the greater
accumulated knowledge, only Northern leaders do that. However, when a
product has escaped imitation (let us recall that imitation activity is not
always successful) also Northern followers have an incentive to undertake re-
search leading to the development of the next generation of products, as in
such a situation they stand to gain more from a research success than do
leaders.
The model is rather complex, and its results can be found only by a formal
analysis. They can be summarized as folIows.
In steady-state growth, two main types of equilibria may occur. In the
first type, followers are relatively efficient at innovation (though less so than
leaders), hence both leaders and followers engage in innovation. This equilib-
rium gives rise to a complex history of product cycles because at any moment
the market leadership can pass from one Northern firm to another (formerly
a folIower) or from North to South (when imitation in South is successful
and R&D in North fails to develop a higher-quality product). Product cycles
go back and forth.
The second type of equilibrium (the inefficient folIower case) occurs when
followers have a relatively large inferiority in the research lab with respect
to leaders, so that only these latter carry out R&D in the steady state. In
this case the outcome is more clear-cut, as there will be alternating phases
of production between North and South, with Northern firms developing
new products and being market leaders until Southern firms displace them
thanks to successful imitation, after which there will be another innovation
by a Northern firm and so on.
Grossman and Helpman (1991a, Chap. 12) also examine the consequences
on world growth and trade of subsidies to R&D by either the Northern or
Southern government. The results depend in an essential way on the type of
equilibrium that obtains.
In the inefficient follower case, technological progress and hence growth
is favourably affected by the introduction of a research subsidy by either
government. Not only a research subsidy by the Northern government to its
innovative firms fosters technological progress, but also a higher pace of imi-
tation (brought ab out by a subsidy by the Southern government to its firms)
has the same effect, causing Northern firms to increase their research efforts
to regain market leadership after losing it to Southern imitators. This result
is the same that can be obtained in a similar model of North-South trade
with imitation in which, however, product differentiation is of the horizontal
type, so that innovation consists of the development of new varieties of the
product (Grossman and Helpman, 1991a, Chap. 11).
Results of government intervention may however be strikingly different
in the efficient follower case: "In this case an expansion in the size of South
may slow down the rate of innovation in North, and policies that might be
used to promote domestic productivity gains spill over abroad with adverse
consequences for the foreign rates of technologieal progress" (Grossman and
Helpman, 1991a, p. 327). As in the ease of strategie policies in a statie
context, results of government intervention in a dynamic context are heavily
model dependent, which eomes as no surprise.
18.2. Globalization and the new Economic Geography 315
18.2 Globalization and the new Economic

Geography
"Globalization" is a much used and abused word. In the field of international
economics, globalization means different things to different people (see, for
example, Gupta ed., 1997). A by no means exhaustive list is:
a) the increase in the share of international and transnational transac-
tions, as measured for example by the share of world trade and world direct
investment in world GNP;
b) the integration of world markets, as measured for example by the con-
vergence of priees and the consequent elimination of arbitrage opportunities;
e) the growth of international transactions and organizations having a
non-eeonomie but politieal, eultural, social nature;
d) an inereasing awareness of the importanee of eommon global problems
(the environment, infeetious diseases, the presenee of international markets
which are beyond the eontrol of any single nation, ete.)
e) the tendeney to eliminate national differenees and to an inereasing
uniformity of cultures and institutions.
The debate on globalization usually eonsiders the following aspects:
1) the actual degree of integration of markets;
2) globalization as a proeess that undermines the sovereignty of the single
states, reducing their autonomy in poliey making;
3) the effeets of globalization on world ineome distribution, both within
and across countries;
4) the possible development of an international government to eope with
global problems.
Here we shall take "globalization" , as referred to international trade, to mean
the c10ser integration of world markets for commodities, services, and faetors,
partly due to the deerease in transport and communieation eosts (so ealled
"annihilation oE distance" ) .
The importanee of transport eosts and loeation was already stressed by
Ohlin himself: the title of the twelfth ehapter of his treatise (Ohlin, 1933)
is "Interregional Trade Theory as Loeation Theory", where he eonsiders the
role of loeation and transport eosts in both domestie and international trade.
Ohlin eame back on the same topic in the 1970s organizing a seminar in whieh
he brought together trade theorists and loeation theorists, hoping that they
would find a way to achieve the integration (Ohlin et al. eds., 1977). This
did not take plaee, and for various reasons loeation theory and international
trade theory are still separate fields.
The topic was taken up again by Paul Krugman (1991, p. 1), who de-
fined eeonomie geography as "the loeation of production in space; that is,
that braneh of eeonomies that worries about where things happen in relation
to one another". Under this definition, loeation theory is part of the mueh
broader field of economic geography, a field that would also indude interna-
tional trade theory as a special case. It would then seem quite natural to
observe a dose integration between international trade theory and location
theory in the broader context of economic geography, but this has not been
the case, for several reasons examined for example by Krugman (1991, 1993).
The present section briefly examines the relations between location of
production, cost of transport, and international trade in the context of both
the orthodox and the new theories of international trade.
18.2.1 Transport Cost, Location Theory, and

Comparative Advantage
Location theorists dassify industries into "materials (or resource) oriented"
and "market oriented" according as to whether transportation costs impose
location dose to the source of raw materials or to the final consumer.
The original sites of the heavy industry (Pittsburgh in the United States,
Birmingham in England, the Ruhr in Germany) illustrate the need for the
production of iron and steel to be carried out dose to the iron-ore and coal
fields. Hence it is no surprise that the heavy industry arose in those countries
that were well endowed with the necessary mineral resources, countries which
then became exporters of the products of the heavy industry. This is perfectly
in line with the standard factor proportions theory, as transport costs caused
those mineral resources to be almost immobile factors.
However, after the second world war the transport revolution involving
giant bulk carriers has drastically altered the situation. This has created a
pool of primary resources on which all countries can draw: the most striking
example is Japan, that became a top industrialized country using imported
raw materials from far-away locations. Thus the relevant factor endowments
are again capital (induding technology and human capital) and labour rather
than the endowment of primary resources, which is due to geological acci-
dents.
These ideas have been modelled by Findlay (1995, Chap. 6, Sect. 6.3),
who considers a three-commodity, three-factor model with constant-returns-
to-scale technology. The commodities are:
1) an "all purpose" commodity (A), that can be either consumed or in-
vested, namely added to the stock of capital, and is taken to be the numeraire;
2) a pure cOnsumer good (B);
3) a raw material (Z) that is used in fixed proportions in the production
of A.
The factors are:
i) land, or natural resources (N), specific to the production of Z;
ii) labour (L), used in the production of all three commodities;
iii) capital (K) used only for A and B.
18.2. Globalization and the new Economic Geography 317
While both N and L are in fixed supply, the supply of capital is endogenous.
Commodity A is assumed to be capital-intensive with respect to B, and turns
out to be also resource-intensive. To show this, we observe that commodity
A-apart from the amount of N directly used to produce Z which is specific
to A-indirectly requires more N with respect to B. In fact, since K embodies
the part of A that has been invested (hence K indirectly embodies N), it
follows that A, being capital-intensive with respect to B, indirectly requires
more N.
Consider now two identical count ries except for the endowment of natural
resources, which is larger in country 1. Since Nd LI is greater than N 2 / L 2 , we
speak of 1 and 2 as the resource-rich and resource-poor country, respectively.
The first step is the introduction of international trade in final goods
only. The raw material Z is assumed to be non traded due to prohibitive
transport costs when it is in unprocessed formj these costs disappear when it
is embodied in the capital-intensive final good A. With these assumptions the
model behaves like the standard 2 x 2 Heckscher-Ohlin model, hence country
1 will export the resource-intensive commodity A and import commodity
B, while country 2 will export commodity B and import commodity A. In
country 1 the A sector will expand and the B sector will contract, while the
opposite will take place in country 2.
Thus, when there is free trade in final goods only, what happens is a
higher extraction of the raw material input in the resource-rich countrYj this
entails an increase in the capital stock to meet the needs of the higher output
of the capital-intensive exportable commodity A. In the other country the
opposite will happen: the resource sector shrinks because of the reduction
in the output of the import-competing commodity A, with a corresponding
decrease in the long-run capital stock. As Findlay (1995, p. 168) notes,
"free trade clearly enhances the initial difference in wealth between the two
count ries based on the difference in natural resource endowment."
The second step is to allow free trade in all commodities, because a trans-
port revolution takes place so that the resource input Z Can be traded at
zero transport cost like the two final goods. We now have a model with three
traded goods (one of which is a factor of production) and three factors (one
of which is traded). Given the assumption of internationally identical tech-
nologies with constant returns to scale, if we further assume that all three
commodities are produced in both countries, factor prices will be equalized.
In the long-run equilibrium, agents must have the same per capita utility
level in both countriesj this implies that per capita income and per capita
wealth (and hence total wealth, given the assumption of identical labour
force) must also be equal. Total wealth is made up of two components, the
capital stock and the capitalized value of the rents from the natural resources
N used to produce Z.
Commodity- and factor-price equalization implies that the price of Z in-
creases (with respect to the pre-trade situation) in the resource-abundant
country 1 (where before trade it was lower than in the resource-scarce coun-
try) and decreases in the resource-scarce country 2. The resource sector
shrinks in country 2 and expands in country 1, which implies that, in the
long run equilibrium, the natural-resource component of wealth is greater in
country 1 than in country 2. This in turn entails a greater long-run equilib-
rium capital stock in country 2 than in country 1, as total wealth must be
equal in both countries.
The final result is that in the long-run equilibrium country 2 may become
the exporter of the capital-intensive commodity A.
"In other words, the possibility of sharing on equal terms in a global
pool for access to the intermediate input enables the resource-poor country
to build up its capital stock per head to such an extent that it leads to
areversal of its former comparative advantage in the labor-intensive good.
[... ] It is now the less naturally well endowed countries that will have a
higher proportion of physical capital per capita in their port folios and will
thus export the capital-intensive industrial goods on the basis of imported
intermediate inputs as, for example, in the case of Japan" (Findlay, 1995, p.
170 and p. 172).
18.2.2 Economic Geography, Globalization, and Trade

In the previous section we have shown how the transport revolution (involving
giant bulk carriers), by making a common pool of previously immobile bulky
raw materials available to all count ries , affected the localization of heavy
industries and hence brought about areversal in comparative advantage.
The product cyeIe (see above, Sects. 17.3.3 and 18.1.2) can be used to give
an explanation of the evolving localization of production in different countries
in the context of the new theories of international trade. In this context there
are several other "economic geography" models, that also consider the effects
of globalization (i.e., the eIoser integration ofworld markets) and the possible
development of core-periphery situations.
Similarly to the orthodox model of Sect. 18.2.1, the Krugman-Venables
(1995) model, building on earlier work by Krugman (1991), hinges on the
decline in transport costs, that leads to a growing integration of world mar-
kets. However, due to the interaction with economies of scale in a monopo-
listically competitive context, a core-periphery pattern spontaneously forms
from a world consisting of two initially equal regions. Countries that find
themselves in the periphery suffer a fall in real income, but further deeIine
in transport costs gives rise to a second stage in which real incomes again
converge (hence the peripheral count ries gain while the core nations may weIl
lose).
The basic model considers two regions, conventionally called North and
South, each producing two commodities: "agricultural" goods and "manu-
factured" goods. Agricultural goods are produced under constant return to
18.2. Globalization and the new Economie Geography 319
BOX 18.2 Specialization and concentration

The new economie geography approach views industrial loeation as the outcome of
the interaction between two forees. On the one hand, factor market supply (includ-
ing immobile factors of produetion) and the need to meet the demands of eonsumers
eneourage the dispersion of activity. On the other hand, there are forees eneourag-
ing the agglomeration of activity that derive from various types of geographieally
eoneentrated beneficial externalities.
In order for a partieular area to specialize, agglomeration effects have to be stronger
than the gain from being close to the market. Reduetions in trade or transport
eosts, by influencing the balance between dispersion and agglomeration forees ean
dramatieally affect the spatialloeation of economie activities. Most of the models in
the literature find a U-shaped relationship between transport eosts and specialization
and coneentration.
In the empiriealliterature, many measures of economie eoneentration have been pro-
posed. To assess the geographie distribution of firms in a given territory, economist
have traditionally employed cluster-based methods, Le. they measure spatial ag-
glomeration or spatial dispersion of eeonomie activity aceording to pre-defined geo-
graphie limits; indexes are eonstrueted by dividing up geographie space into regions
and eomparing the share of activity (measured by the number of firms, produetion,
or employment) in each region with a benchmak.
Kim (1995) is one of the first papers to empirieally investigate the evolution of spe-
cialization and loealization. He analyses the US regional specialization pattern over
a long time span (1860-1987), showing that industries have been highly loealized
when the US was becoming an integrated eountry before the First World War, and
then loeational clustering has been falling. Hanson (1996) finds evidenee that ag-
glomeration is assoeiated with inereasing returns and shows that integration with the
US has led to a reloeation of Mexican industry towards states with a good access to
the US market. In the EU there is evidenee that eountries are beeoming increasingly
specialized as European integration progresses. Brülhart (2001) and Brülhart and
Torstensson (1996) study the evolution of industrial specialization patterns in EU
and they find support for the U-shaped relationship between the degree of regional
integration and spatial agglomeration. Amiti (1999) argue that European industries
exhibit a positive eorrelation between changes in inereasing returns and changes in
spatial eoneentration between 1980 and 1990. A pattern of increasing specializa-
tion and wave shaped eoncentration has been reported by Midelfart-Knarvik et al.
(2000) for Europe, where the authors argue that many industries experienees impor-
tant changes in their loeation across EU during the period 1970-1997. Decreasing
regional eoneentration is reported by Hallet (2000). Empirieal results remain rather
ineonclusive, however, with evidenee showing a mixed pattern depending on the ge-
ographiealscale and the industries being eonsidered (Combes and Overman, 2003).
scale in a perfectly competitive setting with labour as the sole input. Manu-
factures are differentiated goods produced under increasing returns to scale
in a monopolistically competitive setting using labour and a composite man-
ufacturing intermediate good. Thus the manufacturing sector produces both
final consumer goods and intermediate goods to be used as inputs.
At the beginning, no trade exists because of prohibitive transport costs,
and all count ries produce both kinds of goods in autarky. It is assumed
that all countries are equal, in the sense that they are equally efficient in
the production of both types of goods, so that no region has any intrinsie
comparative advantage in manufacturing. However, one region (say, North)

has a larger manufacturing sector than the other.
Suppose now that transport costs are gradually reduced, so that the pos-
sibility of trade in manufactures arises. As we know from the monopolistic
competition model of international trade (see Sect. 17.5), there will be intra-
industry trade in manufactures, with no country becoming fully specialized in
manufactures. But as transport costs continue falling, a cumulative process
will arise due to locational factors of the following type.
The initially larger manufacturing sector in North offers a larger market
for intermediate goods, which makes this region (ceteris paribus) more advari-
tageous for the localization of the production of these goods. Such an effect
is called a demand, or ''backward'' linkage. The immediate consequence is
that a greater number of intermediate goods will be produced in North than
in South.
The availability of intermediate goods will then become better and better
in North with respect to South, which means (agam ceteris pari bus) lower
costs of production of final goods; this effect is called a cost, or "forward"
linkage. Hence further manufacturing production will be attracted to North,
and so forth: a tendency to agglomeration of manufacturing in North is
set into motion. There will be some critical value of transport costs such
that below it the world economy will self-organize into a deindustrialized
periphery and an industrialized core (hence the model explains the core-
periphery pattern of world development). What is important to note is that
this outcome is completely spontaneous, due to the self-organizing forces of
the global economy.
Assuming, as is plausible, that the manufacturing sector is sufficiently
large, the higher labour demand in the industrializing region (the core) will
drive up real wages, while the falling demand for labour in the deindustri-
alizing region (the periphery) will cause a decline in real wages there. In a
nutshell: globalization leads to inequality.
However, this is not the end of the story, as a further decline in trans-
portation costs has striking effects. In fact, the importance of being elose to
suppliers of intermediate goods and to markets for final goods (the backward
and forward linkages) declines in concomitance with the decline in transport
costs. On the other hand, the lower wage rate in the periphery is an impor-
tant factor in production-cost calculations. Hence there will be a sufficiently
low value of transportation cost at which the lower wage rate in the periphery
more than offsets the distance factor (i.e., the disadvantage of being far from
suppliers and markets). When this value is reached, manufacturing will find
it profitable to relocate in the periphery. The higher labour demand there,
and the lower demand for labour in the core, will bring about a convergence
of real wages.
Thus, after the initial formation of a core-periphery pattern, whereby
globalization (due to declining transport costs) brings about a division of
the world into rich and poor nations, further integration of world markets
will bring about a eonvergenee in ineomes and eeonomie strueture.
Further developments are eontained in Fujita, Krugman, and Venables
(1999).

Aghion, P. and P. Howitt, 1998, Endogenous Growth Theory, Cambridge
(Mass.): MIT Press.
Amiti, M., 1999, Specialisation Patterns in Europe, Weltwirshaftliches Archiv
134, 573-93.
Barro, R.J. and X. Sala-i-Martin, 1995, Economic Growth, New York: McGraw-
Hill.
Brülhart, M., 2001, Evolving Geographical Coneentration of European Man-
ufacturing Industries, Weltwirshaftliches Archiv 137, 215-43.
Brülhart, M. and J. Torstensson, 1996, Regional Integration, Scale Economies
and Industrial Economies, Center for Eeonomie Poliey Research, Dis-
eussion Paper No. 1435.
Combes, P.P. and H. Overman, 2003, The Spatial Distribution oE Economic
Activities in the European Union, in Handbook of Urban and Regional
Economics, vol. 4, V. Henderson and J. F. Thisse (eds.), Amsterdam:
Elvesier-North Holland.
Findlay, R., 1995, Factor Proportions, 'nade, and Growth, Cambridge
(Mass.): MIT Press.
Fujita, M., P. Krugman, and A.J. Venables, 1999, The Spatial Economy:
Cities, Regions, and International 'nade, Cambridge (Mass.): MIT
Press.
Grossman, G.M. and E. Helpman, 1991a, Innovation and Growth in the
Global Economy, Cambridge (Mass.): MIT Press.
Grossman, G.M. and E. Helpman, 1991b, Endogenous Produet Cyc1es, Eco-
nomic Journal 101, 1214-29.
Grossman, G.M. and E. Helpman, 1991e, Quality Ladders and Produet Cy-
c1es, Quarterly Journal oE Economics 106, 557-86.
Gupta, S.D. (ed.), 1997, The Political Economy oE Globalization, Dordrecht:
Kluwer Aeademic Publishers.
Hallet, M., 2000, Regional Specialization and ConcelJtration in the EU, Eco-
nomie Paper 141, European Commission.
Hanson G., 1996, Loealization Eeonomies, Vertieal Organization and Trade,
American Economic Review 86, 1266-78.
Kim, S., 1995, Expansion ofMarkets and the Geographie Distribution ofEco-
nomic Activities: The Trends in U.S. Regional Manufacturing Strue-
ture, 1860-1987, Quarterly Journal oE Economics 110,881-908.
Krugman, P., 1991, Geographyand 'nade, Cambridge (Mass): MIT Press.
Krugman, P., 1993, On the Relationship between Trade Theory and Location
Theory, Review oE International Economics 1. 110-22.
Krugman, P. and A.J. Venables, 1995, Globalization and the Inequality of
Nations, Quarterly Journal oE Economies 110, 857-80.
Midelfart-Knarvik, K.H., H.G. Overman, S.J. Redding and A. Venables,
2000, The Location oE European Industry, European Commission, Brus-
sels.
Ohlin, B., 1933, Interregional and International 'Irade, Harvard University
Press.
Ohlin, B., P. Hesselborn and P.M. Wijkman (eds.), 1977, The International
Allocation oE Economic Activity, London: Macmillan.
Stiglitz, J.E., 2002, Globalization and Its Discontents, New York and London:
W.W. Norton.
Index
A equilibrium and disequilibrium,

Absolute advantage, 208 63-64
Absorption, 68 standard components, 59
Absorption approach, 145 Balance of trade, 64
Accounting principles in the bal- Balance on goods and services, 64
ance of payments, 58 Balance sheet models of currency
Adjustable peg, 33 crises, 122
Adjustment lag, 77 Balance-of-payments adjustment, 4
Adjustment speeds, 54 absorption approach, 145
Administered protection, 275 elasticity approach, 74
Administrative cost of tariffs, 242 intertemporal approach, 150, 152
Advance-deposit requirements, 250 multiplier approach, 81
Alexander, S.S., 145 Mundell-Fleming approach, 90,
American option, 26 93
Antidumping, 278 price-specie-flow mechanism, 101
Arbitrage Barriers to trade, 237, 242, 250,
on commodities, 126 267
on currencies, 14 Basic balance, 64
on interest, 49, 51 Basket currency, 37, 169
three point or triangular , 16 BB schedule under perfect capital
two point, 15 mobility, 96
ASEAN, 265 BB schedule, derivation of, 89
Asian crisis, 43-44, 121 Bear, 23
Asset market approach, 128 Benign neglect, 182
Asset substitut ability Bertrand, J., 302
and capital mobility, 55 Best-reply functions, 300
perfect and imperfect, 55 Bhagwati, J. (N.), 275
Availability, 288 Bickerdicke-Robinson condition, 76
Bid-offer spread, 10
B Bipolar view, 123
Backward linkages, 320 BIS (Bank for International Settle-
Backwardation, 20 ments),47
Balance of indebtedness, 61 Border tax adjustments, 252, 280
Balance of payments Brander, J.A., 300-301
accounting, 58 Branson, W.H., 106
definition, 57 Bretton Woods
323
324 Index
agreement, 32 trade balance equilibrium, 211

collapse, 38-40 Composition
system, 32, 34, 38 of portfolio, 106
Brock, W.A., 274 Condition of neutrality
Bubble,118 in covered interest arbitrage, 50
Budget constraint, 67-68 in exchange rate arbitrage, 15
Budget constraint(s), 220 Conjectural variations, 299
Budget deficit, 67 Constant returns to scale, 213, 228,
financing of, 68 286,303,311
Maastricht criteria for, 176 Consumers' surplus, 240, 261, 269,
BuH, 23 279
Burden of interest payments, 178 Consumption ef!ect of a tarif!, 240
Consumption point, 225
C Consumption tax equivalent to a
C.i.f. and F.o.b., 59 tarif!, 240
Capital account, 60 Contango, 20
Capital and financial account, 60 Contingent protection, 275
Capital mobility and asset substi- Cooper, R.N., 191
tutability, 55 Coordination of economic policies,
Capital movement accounting, 58 186
Cartels,245 Corden, W.M., 156
Cassel, G., 125 Core-periphery models, 318, 320-
CBOE (Chicago Board Options Ex- 321
change), 24 Countervailing duty (CVD), 280
Chamberlin, E.H., 298 Country risk, 55
Characteristics of goods, 287-289, Cournot, A., 275, 300, 302
297 Covered interest arbitrage, 22, 49
and oligopolistic interaction, 304 Covering alternatives, 19
CIP (Covered Interest Parity), 49- Crawling band, 36
50 Crawling peg, 35
Collapse time, 119 Credibility, 166, 200, 202
Commercial balance, 64 Cross border bank assets&liabilities,
Commercial Policy, 237 29
Commercial policy, 267, 305 Cross hauling, 284
Common market, 259 Currency areas, 156
Comparative advantage, 209 Currency basket, 37, 169
Comparative cost Currency board, 32
defined, 209 Currency competition, 167
graphie representation of, 211 Currency contract period, 77
Comparative cost theory, 207 Currency crises, 97, 119
Comparative cost, 208 and IMF plans, 122
necessary condition, 208 balance sheet, 122
specialization, 212 financial fragility, 122
sufficient condition, 209 first generation models, 119
Index 325
moral hazard, 122 in domestic factor markets, 256

second generation models, 119 in domestic goods markets, 256
Currency derivatives, 24 Dixit, A., 298
futures and forwards, 25 Dollar standard, 35, 40
options, 26 Dollarization, 32
swaps, 27 Dornbusch, R., 130
Current account, 59 Double entry bookkeeping, 58
Current account balance, 64 Duesenberry, J.S., 289
Cushman, D.O., 137 Dumping, 277
Customs clearance formalities, 252 reciprocal, 301
Customs union Dunning, J.H., 115
defined, 259 Dynamism, 289
effects of, 260
empirical studies, 263 E
trade creation, 260-261 Eaton, J., 303
trade diversion, 260, 262 ECB (European Central Bank), 172
Executive Board, 172
D Governing Council, 172
Data sources, 70 General Council, 172
Leamer, E.E., 217 Ecofin (Council of the economic and
De Grauwe, P., 40 financial Ministers of the Eu-
Deardoff, A.V., 82 ropean Union), 181
Debt crisis, 43, 193 Economic geography, 315, 318, 320
Deficitjsurplus in the balance of pay- Economic integration, 259
ments, 63 Economic union, 259
Delors Report, 170 ECU (European Currency Unit) , 169
Demand for variety and international Edgeworth, F. Y., 302
trade, 287, 298, 303 EEC (European Economic Commu-
Demand-and-supply curves, 223 nity), 259, 263
Demonetization of gold, 41 Effective exchange rate, 14
Demonstration effect, 289 Elasticity of demand
Differentiated products and inter- and markup, 278
national trade, 287-288, 295, Elasticity approach, 74
302 Elasticity of demand
Direct investment, 60, 113 and cartels, 245, 247
Dirty float, 36 and dumping, 277
Discrimination in international trade, and oligopoly, 304
237 Elasticity of supply
government procurement poli- and cartels, 247
des, 252 Employment effects of a tariff, 242
in price, 277, 290 EMS (European Monetary System),
Distortions 43, 168
and tariffs, 256 EMU (European Monetary Union),
and theory of second best, 257 43, 170
326 Index
institutional aspects, 172 Exchange rate

Maastricht criteria, 175 appreciation and depreciation,
Maastricht Treaty, 170 10
stability and growth pact, 172 cross or indirect, 16
stages of, 170 definition of, 9
and the new theory of optimum efIective, 14
currency areas, 178 forward, 10
ECB (European Central Bank), increase and decrease, 10
172 price quotation system, 9
ESCB (European System of Cen- real, 11
tral Banks), 172 spot, 10
euro, 172, 180 swap,28
EMU (European Monetary Union; volume quotation system, 9
Economic and Monetary Union), Exchange rate determination
168 interaction between current and
Endogenous capital accounts, 132
tarifI determination, 273 overshooting model, 130
Endogenous growth and international portfolio model, 131
trade,309 purchasing power parity, 125
in the new theories, 312-314 traditional flow approach, 127
in the orthodox theory, 310-312 asset market approach, 128
Endogenous policy models of cur- balance of payments approach,
rency crises, 119 127
Entrepöt trade, 286 empirical studies, 137
Equivalent tariff rate, 243 exchange market approach, 136
ERM (Exchange Rate Mechanism), in macroeconometric models, 134
169 interest parity model, 128
Escape clause monetary approach, 129
and currency crises, 119 Exchange rate dynamics
and single currency in a mone- and overshooting, 130
tary union, 167 under rational expectations, 130
ESCB (European System of Cen- Exchange rate forecasting, 137
tral Banks), 172 Exchange rate overshooting, 130
EU (European Union), 259, 263, Exchange risk, 17, 52
281 Exogenous policy models of of cur-
Euro, 180 rency crises, 119
Eurocurrencies, 29 Expenditure reducing, 74
Eurodollar market, 29 Expenditure switching, 74
origins, 29 External economies and international
European Council, 170 trade,286
European option, 26
Excess demand F
and international trade, 222 F.o.b. and C.iJ., 59
and Walras' law, 221 f.o.b. and c.iJ., 277
Index 327
Factor abundance, 212 and monetary authorities' in-

physical definition, 214 tervention, 33
price definition, 214, 296 definition of, 9, 11
Factor endowments efficiency of, 53
as determinants of trade, 4, 212 forward, 17
Factor immobility, I, 212, 227, 232 spot, 14
Factor intensity, 212-214 transactors in, 22
revers al (defined), 214 Forward
Factor mobility, 232 covering, 18
Factor trade, 233 discount, 20
Factor-price equalization, 317 exchange market, 17
absolute and relative, 227 exchange rate, 10
Factors of production margin, 21-22
and currency areas, 157 parity,50
intermediate, 318-319 premium, 20
primary, 212, 218, 232, 310, 316 speculation, 23
produced, 233 Forward linkages, 320
specific, 233, 295, 316 Fragmentation, 116
Fair trade, 275 Frankel, J.A., 143
Falvey, R.E., 295, 297 Free trade vs protection, 242, 253,
257, 275, 304-305
Fama, E.F., 53
Free-trade area or association, 259
Feist, H., 179
Friedman, M., 117-118
Feldstein, M., 152, 178
FTAA, 266
Feldstein-Horioka puzzle, 152
Futures and forwards, 25
Ferrara, L., 82
Financial fragility models of cur- G
rency crises, 122 Gagnon, J.E., 77
Financial surplus of the private sec- Gains from trade, 2, 212, 225-226,
tor, 68 303
Findlay, R., 309-311, 317-318 Game theory, and international pol-
Fiscal policy icy coordination, 186, 189
under perfect capital mobility, Gandolfo, G., 202
96 GATS (General Agreement on 'Irade
Fiscal revenue effect of a tariff, 240 in Services), 47
Fischer, S., 124 GATT (General Agreement on Tar-
Fisher, I., 148 iffs and 'Irade), 46
Fixed exchange rates, 31 General equilibrium
Fixed vs flexible exchange rates, 138 in an open economy, 221
Fleming, J.M., 85, 105 Global monetary objective, 199
Flexible exchange rates, 31 Globalization, 315
Flexible vs fixed exchange rates, 138 Gold
Foreign affiliate, 115 demonetization of, in interna-
Foreign exchange market tional monetary system, 41
328 Index
pool, 40, 42 ICSID (International Center for Set-

price-specie-fiow mechanism, 101 tlement of Investment Dis-
two-tier market, 42 putes),46
Gold exchange standard, 31 IDA (International Development
limping,32 Agency),46
Gold pool, 40, 42 IFC (International Finance Corpo-
Gold standard, 31 ration), 46
mint parity, 31 IMF (International Monetary Fund),
Government procurement, 252 43
Gresham's law, 40 Board of Governors and Alter-
Grossman, G.M., 309, 312, 314 nates, 44
Growth and international trade Executive Board, 44
dynamic models, 310, 312 Managing Director, 44
endogenous, 310, 312 IMF plans and currency crises, 122
Growth-oriented adjustment programs, Imitation, 289
197 lag, 289
Grubel, H.G., 294 Impediments to trade, 242, 250
Implicit interest rate, 21
Import effect of a tariff, 240
H
Import equalization tax, 252
Hard peg, 32
Income effects in international trade
Hard pegs, 36
Linder's theory, 291
Harmonization, 275
vertical (or quality) differenti-
Heckscher, E.F., 5, 212, 214, 217,
ation, 287, 295, 302, 313
227,291,295-297,302,310, Income elasticity of demand, 213
317, 4-5 Inconsistent
Heckscher-Ohlin theorem, 212, 296 quartet, 166
empirical analyses of, 217 triad, 165
Hedging,18 Inconvertibility, de facto and de jure,
Helpman, E., 309, 312, 314 40, 35
Hirsch, S., 290, 312 Increase in factor endowments
Hooper, P, 77 effects on domestic relative price
Horioka, C., 152 of goods, 231
Horizontal differentiation, 287 and effects on terms of trade,
Horizontal trade, 284 231
Hotelling, H., 298 and Rybczynski's theorem, 230
Hub-and-spoke arrangements, 260 Increasing returns to scale, 286, 303,
Hudec, R.E., 275 309, 319
Hume's price-specie-fiow mechanism, Industrial organisation approach to
101 international trade, 283
Hume, D., 101 Infant industry, 255
Inflation rate differential, 53, 126,
I 176
Ieeberg transport costs, 300 Innovation, 289-290
Index 329
Inter-industry trade, 285 third country problem, 192

Interest rate differential, 22, 51-52, International propagation of distur-
86, 126, 132, 176 bances
Intermediate goods, 318-319 and fixed vs flexible exchange
Internal economies and international rates, 141
trade, 286 International reserves, 167
IBRD (International Bank for Re- definition of, 61
construction and Develop- International specialization
ment),45 index of, 284
International banking transactions, Intertemporal approach, 3
30 and absorption approach, 145
International consistency condition and real exchange rate, 153
on exchange rates, 15 Intertemporal budget constraint, 149,
on the balance of payments, 39, 151
64 Intertemporal trade, 149
International cooperation (coordi- Intertemporal transformation curve,
nation), 186 150
International economics Intra-industry trade
as a distinct subject, 1 as statistical phenomenon, 293
definitions and classifications, 2 definition of, 284
International investment, 233 in the new trade theories, 297,
direct and portfolio, 60, 113 301-303, 320
short and long term, 61, 113
index of, 284
International management of exchange
Intrinsic discount/premium, 50
rates rates
Investment income, 60
global monetary objective, 199
Invisible trade, 59
target zones, 200
IRPC (Interest Rate Parity Condi-
Tobin tax, 201
tions),49
International monetary system
CIP, 49
Bretton Woods, 32
current nonsystem, 36 real, 52
problems of, 185 VIP, 51
International policy coordination, VIP with risk premium, 52
186 IS schedule, derivation of, 86
advantages, 190, 193 ISDA (International Swap Dealers
cooperative solution, 190 Association), 27
Cournot-Nash solution, 189 ITO (International Trade Organi-
free rider problem, 192 zation),46
Hamada diagram, 187
obstacles, 191 J
policy reaction curves, 189 J-curve,77
problem of the reference model, Jamaica agreement, 38, 42
192 Jeanne, 0., 202
Stackelberg solution, 189 Johnson, H.G., 74
330 Index
Jump variables in rational expec- M

tations, 130 Machlup, F., 29
Magee, S.P., 77, 274
K Managed fioat, 36
Kelly, KH., 280 Margin, forward, 22
Kempa, B., 201 Marginal propensity to domestic ex-
Key currencies, 32, 161 penditure (demand), 80
Khan, M.S., 197 Marginal rate of transformation, 215
Kierzkowski, H., 297, 303 and comparative cost, 211
Knowledge capital, 115 Margins around parity, 33, 169
Kouri, P.J.K, 132-134 Market forms and international trade,
Kravis, LB., 288-289 287
Krueger, A.O., 263 Marshali, A., 4, 240
Krugman, P.(R), 288, 298, 301, 315, Marshall-Lerner condition, 76
318 MATIF (Marche A. Terme Interna-
tional de France), 25
Matrix of real and financial fiows,
L
65
Labour income, 60
Maturity criterion, 61
Labour mobility and currency ar-
McKinnon, RL, 199, 106
008, 157
Meade, J.E., 257
Lancaster, K, 298, 304 Meese, RA., 137
Lancaster-type preferences, 298, 304 MERCOSUR, 265
Lane, P.R, 145 MFN (Most Favoured Nation) c1ause,
Lanyi, A., 139 46, 267
Law of one price, 126 MIGA (Multilateral Investment Guar-
Leads and lags, 23 antee Agency), 46
Leamer, E.E., 217 Migrants' remittances, 60
Leaning against the wind, 36 Mill, J.S., 4
Leontief's paradox, 217 Monetary approach
Leontief, W.W., 217 to exchange rate determination,
Levinsohn, J.A., 217 129
LIFFE (London International Fi- to the balance of payments, 102
nancial Futures Exchange), Monetary authorities, 24
25 Monetary integration, 155
Limited fiexibility, 35 and common monetary policy,
Linder, S.B., 291-292, 304 164
LL schedule, derivation of, 108 and currency areas, 156
Lloyd, P.J., 294 and single currency, 166
LM schedule, derivation of, 87 degrees of, 155
Location theory and trade, 316 Monetary policy, 104
in the new theories, 318, 320 in a monetary union, 164
in the orthodox theory, 316-318 under perfect capital mobility,
Long position, 18 96
Index 331
Monopolistic competition and in- NTB (Non-Tariff Barriers to Trade) ,

ternational trade, 283, 289- 242, 250, 267
290,297
Montiel, P.J., 197 o
Moral hazard models of currency Oates, W., 106
crises, 122 Offer curves, 223
Morkre, M.E., 280 Offshore, 30
Multinational enterprises, 115 Ohlin, B., 4-5, 212, 214, 217, 227,
Multiplier approach, 81 291,295-297,302,310,315,
Mundell, R.A., 64, 85, 89, 96, 105, 317
156 Oil crisis, 41
Mundell-Fleming model Oligopoly and intra-industry trade
and perfect capital mobility, 96 differentiated goods, 302-303
under fixed exchange rates, 85 Oniki, H., 309
und er flexible exchange rates, Onshore, 30
93 OPEC (Organization of Petroleum
Exporting Countries ) car-
tel, 245, 249
N OPEC (Organization of Petrroleum
NAFA (Net Acquisition of Finan-
Exporting Countries ), 41
cial Assets) of the private Open economy macroeconomics, 2
sector,68
Open position, 18
NAFTA, 264 Opportunity cost, 215
Natural oligopoly and international and comparative cost, 211
trade, 302 Optimum currency areas, 156
Nelles, M., 201 and EMU, 178
Neo-factor-proportions theories, 295 cost benefit approach, 159
Neo-Heckscher-Ohlin theories, 286, new theory of, 162
295 third country problem, 163
Neoclassical ambiguity, 235 traditional approach, 157
Neoprotectionism, 267 Optimum tariff, 253, 257
Neutrality condition Options, 26
in covered interest arbitrage, 50 American and European, 26
in exchange rate arbitrage, 15 call, . 26
New open economy macroeconomics, counter currency, 26
3 expiry or maturity date, 26
New theories of international trade, holder, 26
283 premium, 26
and economic geography, 315 put, 26
and endogenous growth, 312 strike or exercise price, 26
and strategie trade policy, 305, underlying currency, 26
314 writer, 26
classification of, 286 Outright forward exchange rate, 20
North-South models, 313-314, 318 OTC (Over The Counter), 25
332 Index
Overall balance,· 64 administered, 275

Overlapping generations, 150 and preferential trading coop-
Overshooting of exchange rate, 130 eration, 259
and second-best theory, 257
p arguments for and against, 253
Padoa Schioppa, T., 166 contingent, 275
Padoan, P.C., 202 demand for and supply of, 273
Par value or parity, 32 new theory of, 267
Pareto, V., 257-258, 260, 272 non-tariff, 242
Pass through political economy of, 272
period, 77 strategie, 305, 314
Perfect traditional theory of, 237
asset substitutability, defined, Protective (or production) effect of
55 a tariff, 240
capital mobility, defined, 54 Public debt and Maastricht crite-
Perfeet capital mobility ria, 176
and policy effectiveness, 96 Pure exchange standard, 32
Petrodollars, 41
Portfolio approach Q
to exchange rates, 131 Quality of products and intra-industry
Portfolio investment, 61, 113 trade, 295, 302, 313
Potential trade, 291 Quantity adjustment period, 77
PPP (Purchasing Power Parity), 103 Quantity theory of money, 101
Prati, A., 174 Quota, 243
Preferential trade cooperation, 259 comparison with a tarifI, 243
Preferential trading club or agree- comparison with a VER, 269
ment, 259
Price undertaking, 279 R
Price-specie-fiow mechanism, 101 R&D activity, 289, 302, 310--314
Producers' surplus, 241, 270, 279 Raffer, K., 201
Product cycle, 290--291, 312-314, Random walk, 55, 137
318 Rational expectations, 130
Product differentiation, definitions and exchange rate overshoot-
of,287 ing, 130
Production (or protective) effect of Re-export trade, 286
a tariff, 240 Reaction curves and international
Production function trade, 300
well-behaved, 218 Real exchange rate
with fixed technical coefficients, definitions of, 11, 13
207 determination of, 153
Production point, 225, 230 NATREX approach, 153
Productive diversification and cur- Real interest parity, 52
rency areas, 158 Reciprocal demand curves, 223
Protection Reciprocal dumping, 301
Index 333
Recycling of petrodollars, 41 Small country or small open econ-

Redistributive effect of a tariff, 240 omy, defined, 239
Regulations and international trade, Small open economy, 5
252 Smith, Adam, 207
Regulatory protectionism, 252, 275 Social indifference curves, 226
Resident, 57 introduced, 226
Resource displacement cost of tar- Soft pegs, 36
iffs, 242 Specialization
Reversing trade, 25 complete, 212
Ricardo, D., 4, 207 incomplete, 227-228
Ricardo-Torrens theory, 4, 207 Specific factors model, 233
Risk premium, 52 Specific tariff, 239
Robson, P., 263 Speculation
Rogoff, K., 137 and currency crises, 119
Rotondi, Z., 82 bullish and bearish, 118
Rybczynski definition of, 23
theorem, 230 forward, 23
Rybczynski, T.M., 227, 230, 232 one-way option, 117
profitable, 118
S spot, 23
S-D-S preferences, 298 stabilizing and destabilizing, 116
Safeguard actions, 280 Spence, A.M., 298
Samuelson, P.A., 227, 229 Spot
Schinasi, G.J., 174 covering, 19
Schucknecht, 279 exchange market, 14
Schucknecht, L., 281 exchange rate, 10
SDR (Special Drawing Right), 44 Standardization, 290-291
SDR (Special Drawing Right) , SDR Static expectations, 55
(Special Drawing Right) Sterilization of balance-of-payments
definition of, 37 disequilibria, 91-92
Second best theory, 257 Stern, R.M., 82
Seignorage, 39 Stiglitz, J.E., 298
Services, 59 Stock and flow disequilibria, 4
Shaked, A., 302-303 Stolper, W.F., 227, 229
Shocks Stolper-Samuelson theorem, 229, 242
and currency areas, 163 Strategie trade policies, 305, 314
and EMU, 179 Structure of demand and Heckscher-
and exchange rate regimes, 141 Ohlin theorem, 213, 216
Short and long term capital move- Subsidies
ments, 61 export, 250, 270, 280
Short position, 18 import, 275
Sinn, H.-W., 179 production, 250, 271, 280
SITC (Standard International Trade to importables sector, 250, 271
Classification), 293 Subsidy equivalent to a tariff, 240
334 Index
Support points, 33 Trade creation, 260-261

Surplusjdeficit in the balance ofpay- Trade diversion, 260, 262
ments,63 Trade in factors, 233
Surveillance, 36 Trade, growth, and LDCs, 310
Sutton, J., 302-303 Transformation curve, 215
Swap transactions, 27 linear, 210
Transport cost
T prohibitive, 317, 319
Target zones, 200 Triffin dilemma, 39
Tariff TRIPS (Trade-Related aspects of
ad valorem and specific, 238 Intellectual Property rights),
comparison with quota, 243 47
comparison with subsidy, 271 Tsiang, S.C., 147
costs of, 240 Tuya, J., 174
effects of, in partial equilibrium, Two-way trade, 284
239
endogenous determination of, 272 U
in the new trade theories, 304 VIP (Uncovered Interest Parity), 51
prohibitive, 239, 261, 273 with risk premium, 52
Tariff equivalent to a quota, 243 ul Haq, M., 201
Tariff rate, 238-239 UNCTAD (United Nations Confer-
Tariff revenue, 240 ence on Trade and Devel-
Technical progress, 288 opment), 267
endogenous, 309, 311, 313 Underlying, 25
Technology and trade Uniformity of valuation, 59
in the new theories, 288-290, Unilateral (or unrequited) transfers,
311,314 60
in the orthodox theory, 4, 207, Uzawa, H., 309
218, 223
Technology gaps and trade, 289 V
Terms of trade, 225, 311 Venables, A.J., 318
definition of, 208 VER (Voluntary Export Restraints),
determination of, 217, 223-224 250
Terms of trade, and balance-of-payments Vernon, R., 290-291, 312
adjustment, 73, 146 Vertical differentiation, 287
Tied aid, 250 VIE (Voluntary Import Expansion),
Time preference, 148 250,269
Timing of recording in balance of Viner, J., 260
payments, 59 Visible trade, 59
Tobin tax, 201
Tobin, J., 201 W
Torrens, R., 4, 207 Walras' law, 108, 221
Trade balance, 64 Walras, L., 220-221
Trade balance equilibrium, 211 Wealth effect, 147
Index 335
Weinstein. D.E., 217

Werner Report, 155
Wider band, 35
Williamson, J., 36, 200
World Bank, 45
Board of Executive Directors,
45
Governors and Alternates, 45
WTO (World Trade Organization),
46
Wyplosz, C., 179
X
Xeno-currencies, 29
Xeno-markets, 30
Z
Zamalloa, L., 174
List of Figures
3.1 Monetary authorities' intervention to peg the exchange rate . 34
6.1 Exogenous increase in exports, the multiplier, and the balance

of payments. . . . . . . . . . . . . . . . . . . . . . . . . . ., 83
6.2 Mundell-Fleming under fixed exchange rates: the real equi-
librium schedule . . . . . . . . . . . . . . . . . . . . . . . .. 87
6.3 Mundell-Fleming under fixed exchange rates: the monetary
equilibrium schedule . . . . . . . . . . . . . . . . . . . . . . . 88
6.4 Shifts in the monetary equilibrium schedule . . . . . . . . . . 88
6.5 Mundell-Fleming under fixed exchange rates: the external
equilibrium schedule . . . . . . . . . . . . . . . . . . . . . .. 89
6.6 Mundell-Fleming under fixed exchange rates: macroeconomic
equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . .. 90
6.7 Mundell-Fleming under fixed exchange rates: dynamic anal-
ysis of the adjustment process. . . . . . . . . . . . . . . . .. 92
6.8 Perfeet capital mobility and fiscal and monetary policy under
fixed and flexible exchange rates . . . . . . . . . . . . . .. 96
7.1 Determination of portfolio equilibrium in an open economy . 109

7.2 Monetary policy, portfolio equilibrium and capital flows ... 110
9.1 Exchange-rate determination: interaction between the cur-

rent account and the capital account . . . 133
10.1 Intertemporal trade: pure consumption . 149

10.2 Intertemporal trade: production and investment. . 151
12.1 The Hamada diagram . . . . . . . . . . . . . . . . 188

12.2 The international policy game: Cournot-Nash, Stackelberg,
and cooperative solution . . . . . . . . . . 190
12.3 The integrated monetaryjgrowth model . . . . 198
13.1 Transformation curve and comparative costs . . 211

13.2 Transformation curve and the Heckscher-Ohlin theorem . 216
13.3 Transformation curve and supply of commodities . 219
13.4 Determination of international equilibrium . . 222
337
338 List of Figures
13.5 Offer curves and international equilibrium . . . . . . . . . . . 224

13.6 The gains from trade. . . . . . . . . . . . . . . . . . . . . . . 225
13.7 Social indifference curves and the gains from trade: consump-
tion and production gains . . . . . . . . . . . . . . 226
13.8 Rybczynski's theorem and relative price of goods . 230
13.9 The specific factors model . 235
14.1 Effects of a tariff . . . . 239

14.2 Effects of a quota . . . .243
14.3 The monopolistic cartel .246
14.4 A quasi-monopolistic cartel .247
15.1 Variations in the world price, and benefits of a tariff . 254

15.2 Intuitive graphie representation of the theory of second best . 258
16.1 Effects of a VER . . . . . . . . . . . . . . . . . . . 269

16.2 Effects of production and export subsidies . . . . . . 270
16.3 Effects of subsidies to the import-competing sector . 272
16.4 The optimal amount of lobbying . 273
16.5 Persistent dumping. . . . . . . . . . . . . . . . . . . 278
17.1 The cost of transport as adeterminant of intra-industry trade 285

17.2 Vertical differentiation and international trade . . 296
17.3 Homogeneous duopoly and reciprocal dumping . 301
18.1 Orthodox trade theory and endogenous growth . 312

List of Tables
5.1 An accounting matrix for real and financial fiows . . . . . .. 66
10.1 Effects of a devaluation according to the absorption approach 146
12.1 Payoff matrix of the international policy game. . 186

13.1 Example of absolute advantage . . .208
13.2 Example of comparative advantage .209
15.1 Effects of a customs union . . . . . . 261
17.1 Orthodox theory and the new theories of international trade . 287
17.2 Example of SITC Classification . . . 293
18.1 Growth theories and trade theories .309
339
List of Boxes
6.1 Does a devaluation help? The J curve ... 77

6.2 The empirical relevance of the multiplier . . 82
6.3 Applications of the Mundell-Fleming model 98
8.1 The main recent currency crises. . . . . . . · 120

9.1 Geologists, alchemists, and the exchange rate · 137
11.1 The international role of the euro . . · 182
12.1 The causes of Mexico's debt default · 194

12.2 The Paris Club . . . · 195
12.3 The HIPC initiative · 196
13.1 The Leontief paradox .217
14.1 Multilateral trade rounds .238

14.2 Ftegulatory protectionism · 251
15.1 European economic integration .265
16.1 Free or fair trade? . . . . . . .276

16.2 The US-EU dispute on steel . · 281
17.1 Measuring international specialization and IIT .284
17.2 Strategie trade policy: Boeing vs Airbus .306
18.1 Trade and LDCs growth . . . . . .310

18.2 Specialization and concentration · 319
341
nter:na ·onal.~_
Economics
G. Gandolfo G. Gandolfo G.Gandolfo
International Finance Economic Dynamics International

and Open-Economy Treating the mathematical Economics I
Macroeconomics methods used in the economie
The Pure Theory
dynamies. this book shows
This book deals with the finan- of International Trade
how they are utilised to build
dal side of international eeOnOm -
and analyse dynamical models. 2nd, rev. ed. 1994. XXIII, 344 pp.
iC$ and covers all aspeets of inter-
Accordingly, the foeus is on the 85 figs. Softcover € 24,95;
national finanee. ·Prof. Gandolfo
methods, and every new mathe- ,Fr 45,50; i 19,00
has written what will be a dassic
matical technique introdueed ISBN 3-540-58133-2
in international finance. His
is followed by its applieation to
erudition. expository and teehni-
seleet eeonom ic models. The
ca! skiUs are eombined to fuLfil
mathematieal methods covered
the nteds of undergraduate and G. Gandolfo
range from elementary linear dif-
graduate students. researehers.
ferenee and differential equations International
and staff members in interna-
and simultaneous systems to the
tional eeonomie organisations.
qualitative analysis of non-linear
Economics 11
The literary part is dear, and
dynamieal systems. Stability con- International Monetary
the underlying intuition of the siderations are stressed through- Theory and Open-Economy
arguments is stressed. This is fol-
out, induding many .dvaneed Macroeconomics
lowed by a mathematica! analysis.
topies. Bifurcation theory and
whieh uses the state of the art 2nd rev. ed. 1995. XXIV. 560 pp.
chaos theory are also dealt with.
techniques. In this manner the 54 figs. Softcover € 33,95;
The reader is guided through
reader can go from the intuition- ,Fr 62,00; ! 29.50
a step-by-step analysis of each
literary argument to the formal IOpic, be it a mathematical ISBN 3-540-58687-3
derivations and proofs. There
method Or an economie model .
are many books and anieles by
This "user-friendly" feature is
exponents of alternative points
also present in the exereises.
of view. I know of nO other book
that provides the scope, balance, 3rd completely rev. and enlarged
objeetivity and rigor of the book." ed. 1996. Corr. 2nd printing 1997.
(Professor Jerome L. tein. XXV, 610 pp. 65 fig'" 6 tab,.
Brown University) Hardcover € 139,95; ,Fr 237,00;
! 107.50
1" ed. 2001. 2nd printing 2002.
ISBN 3-540-60988· 1
XXII, 613 pp. 48 figs .. 3 tabs.
Hardcover E 99,95; sFr 169.00; i 77.00
ISBN 3·540-41730-3 springeronline.com
i
PlHse order from
Springer . Customer Service · Haberstr. 7 '69126 Heidelberg, Germany
Tel.: +49 (0) 6221 - 345 - O· Fax: +49(0) 6221 - 345 - 4229
e-mi!: ordel'[email protected] · or through JOUr booLts.ller
All Euro and GSP prices ar~ ne:t· prKes subj«' 10 locaJ VAT, e.g, in Ge:rmany "", VAT for booh.
Springer
Pneu and olh~r d~tails an 5ubjt:CI 10 chans~ withOut nOtlU_d&p ' BA 21133/1

Elements of International Economics-Springer-Verlag Berlin Heidelberg (2004)

Uploaded by

Copyright:

Available Formats

Elements of International Economics-Springer-Verlag Berlin Heidelberg (2004)

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Elements of International Economics-Springer-Verlag Berlin Heidelberg (2004)

Uploaded by

Copyright:

Available Formats

Elements of International Economics

Springer-Verlag Berlin Heidelberg GmbH

ISBN 978-3-642-05935-3 ISBN 978-3-662-07005-5 (eBook)

Bibliographic information published by Die Deutsche Bibliothek

and for courses given to Italian undergraduates in the Faculty of Economics.

Giancarlo Gandolfo (http://gandolfo.org)

3 Exchange-Rate Regimes and the International Monetary

3.2.1 The Monetary Authorities' Intervention 33

4 International Interest-Rate Parity Conditions 49

5 The Balance of Payments 57

11 International Finance and Open-Economy

6.1.1 Critical Elasticities and the Marshall-Lerner Condition 74

7 The Monetary and Portfolio Approaches 101

8 Capital Movements, Speculation, and Currency Crises 113

9 Exchange-Rate Determination 125

9.3.2.1 Sticky Prices, Rational Expectations, and

10 The Intertemporal Approach to the Balance of Payments 145

11 International Monetary Integration and European Monetary

11.6 Suggested Further Reading . · 183

12 Problems of the International Monetary System 185

III International Trade Theory and Policy 205

14 Tariffs, and Non-Tariff Barriers 237

15 Free Trade vs Protection, and Preferential Trade

16 The new Protectionism 267

17 The new Theories of International Trade 283

18 Growth, Trade, Globalization 309

List of Figures 337

List of Tables 339

List of Boxes 341

1.1 International Economics as a Distinct

the numeraire). A by-no-means secondary consequence of this assumption is

1.2 Structure of the Book

1.2.1 International Finance

aspects of the new international macroeconomics which cannot be neglected

1.2.2 The Theory and Policy of International Trade

even if technologies and factor endowments were completely identical between

1.2.3 Small and Large Open Economies

Consider, for example, the imposition of a tariff on imports by a country.

The Foreign Exchange Market

2.1 Introduction: The Exchange Rate

takes place is the exchange of drawings on demand deposits 1 denominated in

2.1.1 The Real Exchange Rate

where Px represents export prices (in terms of domestic currency), Pm import

of exports is required per unit of imports). It should also be noted that it is

With this definition an increase (decrease) in rR means a deterioration (im-

2.1.2 The Effective Exchange Rate

2.2 The Spot Exchange Market

which is our initial statement.

rates r2l,r3l, ... ,rnl. From Eq. (2.10) we have, letting i = 1,

2.3 The Forward Exchange Market

foreign currency. But, if we exclude the category of speculators, the average

2.3.2 Various Covering Alternatives; Forward Premium

forward rate of a currency, the proportional difference between them,

If we divide through by rx we have

whence, by subtracting unity from both sides,

2.4 The Transactors in the Foreign Exchange

already delivered (as exporters), then we are in the presence of speculative

2.4.3 Monetary Authorities

2.5 Currency Derivatives

(Chicago Board Options Exchange), the LIFFE (London International Fi-