Key Concepts

Below are the key concepts from each chapter of the book. This is an excellent study resource for student revision.

Chapter 2

  1. Adam Smith demonstrated that gains from specialization are possible when countries trade.
  2. A country that can produce more output of a good per unit of input than other countries can have an absolute advantage in producing that good and should export it. The country should import those goods where it has an absolute disadvantage and produces less per unit of input than other countries can.
  3. Trade makes it possible for world output and consumption to rise, even though individuals are working no harder than before trade.
  4. David Ricardo demonstrated that the basis for gains from trade is the existence of comparative advantage, not absolute advantage.
  5. A country that is less productive in producing both goods still gains from trade by exporting the good in which its relative disadvantage is smaller.
  6. A country that has an absolute advantage in both goods still gains from trade by exporting the good in which its relative advantage is greater.
  7. John Stuart Mill considered how an equilibrium price internationally is established. In a two-good world, a country's export supply of one good also represents its readiness to import the other good.
  8. An equilibrium price internationally must ensure that the quantity of a good that consumers in one country want to import exactly equals the quantity that producers in the rest of the world want to export.
  9. If we form the ratio of labor productivity in one country to labor productivity in another country for many different goods, the ratio of wages in the two countries allows us to distinguish goods that a country will export from those that it will import.
  10. Tests of the classical model based on labor productivities in different countries suggest that patterns of commodity trade can be explained by the principle of comparative advantage.
  11. Classical theory does not explain why labor productivities differ across countries.

Chapter 3

  1. Individuals can gain from trade when their relative valuations of two goods initially differ.
  2. Nations can experience potential gains from trade when their relative valuations of two goods initially differ, but actual gains in welfare depend upon whether individuals within the country who lose from trade are compensated by those who gain.
  3. The opportunity cost of one good, say shampoo, is the amount of another good that must be given up to produce or acquire an additional bottle of shampoo. This concept is more general than the labor theory of value used by the classical economists.
  4. A straight line production-possibility curve indicates a constant opportunity cost of obtaining additional output of a good, until the point of complete specialization in production is reached.
  5. A country gains from trade when the international price ratio differs from the initial opportunity cost of production domestically or from its marginal rate of substitution in consumption.
  6. When there are increasing opportunity costs of production, firms in an economy that trades will adjust their output so that the marginal rate of transformation in production just equals the international price ratio. The tendency to specialize in production is not as great as in the case of constant opportunity costs.
  7. An equilibrium relative price ratio internationally is reached when the quantity of a good that one country wants to export just equals the quantity that the other country wants to import.
  8. When countries become open to trade, their terms of trade (Px/Pm) are likely to improve the most when they face very elastic foreign demand and supply conditions, that is, a very elastic foreign offer curve.

Chapter 4

  1. The two-good H–O model predicts that a country will have a lower autarky price and therefore export the good that uses intensively the factor in which it is relatively abundant.
  2. If a country's endowment of its abundant factor increases, according to the Rybczynski theorem it will produce more of its export good and less of its import-competing good when it faces fixed prices internationally.
  3. As a country becomes more similar to the rest of the world, it will trade less.
  4. As trade equalizes prices of goods internationally, in the short run when all resources are immobile, those used in the country's export industry gain and those used in the import-competing industry lose.
  5. According to the Stolper–Samuelson theorem, in the long run trade raises the real return of the abundant factor used intensively in producing the country's export good and reduces the real return of the scarce factor used intensively in producing the import-competing good.
  6. If both countries continue to produce both goods in the 2 ∞ 2 ∞ 2 H–O model, trade will result in identical factor returns in both countries.
  7. In the specific factors model, an increase in a specific factor increases output of the good that uses it and reduces output of the other good, as in the case of the Dutch disease. An increase in the mobile factor increases output of both goods.
  8. In the specific factors model, an increase in the price of a good increases the return to the specific factor it uses and reduces the return to the other specific factor. The effect on the return to the mobile factor depends upon how much of the higher-priced good it buys.
  9. An early empirical test of the H–O model by Leontief found the unexpected result that U.S. exports were less capital intensive than its imports.
  10. Later tests find that the H–O framework predicts much more trade than is actually observed, especially with respect to flows of goods that require unskilled labor.

Chapter 5

  1. External economies of scale allow average costs in an industry to fall as the output of individual firms rises.
  2. Countries can gain from specialization and trade, even when there are no differences in autarky prices. How countries specialize is indeterminate theoretically, and the actual pattern may be the result of historical accident or government intervention.
  3. Internal economies of scale allow average costs of a firm to fall as its output expands. When these economies of scale are not so great that they create a major barrier to entry in an industry, there are likely to be many producers of differentiated products in the industry under monopolistic competition.
  4. Two-way intra-industry trade is likely under monopolistic competition. The gains from trade come from industry rationalization, as prices fall and a smaller number of producers within a country exhaust more economies of scale, and from a greater variety of products becoming available in an open world market.
  5. Internal economies of scale may be so great that only a few firms produce in an industry. Predicting trade in oligopoly industries requires predicting how a firm responds to the output or price decisions of another firm.
  6. Gains from trade include greater competition and lower prices, but the opportunity to shift oligopoly profits from one country to another makes net benefits less certain.
  7. Oligopolistic firms may collude by forming cartels to reduce competition among themselves. Cartels are difficult to maintain, because new entrants may be attracted by the higher profits, and members of the cartel have an incentive to cheat by increasing output above agreed levels.

Chapter 6

  1. For a small country that cannot affect international prices, levying a tariff reduces its national income by encouraging too much domestic production and discouraging domestic consumption.
  2. Tariffs can significantly redistribute income within a country. Producers' profits and government tariff revenue rise, but the loss to consumers from higher domestic prices is even greater.
  3. A quota limits the amount of goods that can be imported. Imposing a quota results in a larger net loss to the economy, compared to a tariff that yields the same reduction in imports, if foreigners gain the tariff-equivalent revenue created by the quota.
  4. The same expansion in domestic production achieved by a tariff or a quota can be accomplished at lower cost with a production subsidy that does not distort consumption choices.
  5. A country large enough to affect international prices may improve its terms of trade by levying a tariff. The price it pays to foreigners will fall more when the elasticity of demand for imports is large relative to the foreign export elasticity of supply.
  6. The effective rate of protection indicates how much higher value-added in an industry can be compared to free trade. The ERP often exceeds the nominal rate of protection for many finished manufactured goods, but it is likely to be negative for export goods.
  7. Export subsidies hurt domestic consumers and help domestic producers. In a competitive industry, the export subsidy reduces national welfare.
  8. Export taxes help domestic consumers and hurt domestic producers. Their effect on foreigners is similar to a tariff: domestic welfare may increase at the expense of foreigners.

Chapter 7

  1. Claims that protection will raise domestic employment or eliminate a trade deficit ignore important macroeconomic relationships in the economy.
  2. A refusal by high-wage countries to trade with low-wage countries ignores the fact that high-wage countries are more productive. In some industries, the productivity advantage will be so great that firms can export in spite of high wages, while in other industries, where the productivity advantage is not as great, the country will be a net importer.
  3. Trade barriers raise the real income of scarce factors, which gives them a big incentive to lobby for protection.
  4. A country large enough to affect international prices can improve its terms of trade by imposing a tariff or an export tax. Retaliation by trading partners may leave all countries worse off.
  5. Protection for an infant industry may allow it to cover fixed costs of entry and learn enough to become competitive eventually.
  6. Strategic trade policy to subsidize exports may allow a country to shift monopoly profits to its own producers, or to benefit from lower costs and greater productivity with higher domestic production. How easily a government can identify appropriate industries and design effective policies remains controversial.
  7. A firm with market power can maximize its profits by charging a lower price in the export market than it does at home. International trading rules allow governments to offset such dumping when it hurts domestic producers.
  8. Governments are more likely to grant protection to industries where the benefits are more concentrated than the costs imposed on others.

Chapter 8

  1. Mobility of labor and capital internationally reduces differences in wages and rates of return across countries.
  2. Factor flows redistribute income within countries. For example, an inflow of capital into a capital-scarce country raises labor productivity and wage rates, while returns to capital decline.
  3. An inflow of labor may raise national income but reduce income per capita in the host country if immigrants bring little human capital and attract little financial capital.
  4. A primary motive for firms to become multinational corporations is the opportunity to exploit their special expertise through expanding production and sales internationally.
  5. Much MNC investment is horizontal, intended to serve a local market. This strategy is more attractive when the costs of establishing a plant in a new location are a small share of total costs and when transport costs and trade barriers are high. A large host country market attracts more horizontal investment.
  6. Vertically integrated MNCs break a production process into stages and choose the lowest-cost location for each stage. The size of the host country market is not so relevant, but high transport costs and trade barriers discourage this form of investment.
  7. MNC operations generally increase world production by introducing technology and managerial expertise that allow greater output from the same inputs. Economists have had limited success in measuring when and how much domestic firms benefit from greater MNC operations.

Chapter 9

  1. Preferential trade liberalization may or may not increase the welfare of all members of the group or the efficiency of the world trading system.
  2. Trade creation arises when prices of imports fall and consumption of the protected good increases. It benefits both the importing country and world efficiency. Trade diversion arises when imports from more efficient non-members decline. World efficiency falls and the importing country loses tariff revenue.
  3. Preferential trade blocs may alter the terms of trade in their favor, a benefit that comes at the expense of non-members and therefore does not improve world efficiency.
  4. Achieving economies of scale in larger, more competitive markets may benefit members. Projections of these effects from simulation models indicate that for small countries they are quite large relative to trade-creation gains.
  5. The European Union, composed of 27 countries, imposes a common external tariff and promotes the free movement of goods, services, capital, and people among its members.
  6. NAFTA is a free-trade agreement between Canada, Mexico, and the United States that also promotes free investment flows. Because more trade with Mexico is based on differences in factor endowments, potential effects on U.S. income distribution have been more prominent than in E.U. debates over expansion.

Chapter 10

  1. Compared to unilateral tariff reductions, countries generally find multilateral reductions more attractive, because terms-of-trade declines are smaller and political support of exporters can be mobilized.
  2. During the nineteenth century, Great Britain unilaterally adopted a policy of free trade, which many other countries subsequently followed.
  3. High tariffs adopted by the United States and other countries in the 1930s contributed to a major reduction in trade and production worldwide.
  4. The General Agreement on Tariffs and Trade, founded in 1948, established a set of rules for international trade. It encouraged negotiations to reduce trade barriers on a nondiscriminatory basis.
  5. The Uruguay Round, completed in 1994, reduced tariffs but also addressed important items that had escaped GATT discipline (agriculture and textiles) and reached agreements in several new areas (services, intellectual property, and investment requirements).
  6. The Uruguay Round also established the World Trade Organization as a successor to the GATT. An important feature of the WTO was a more rigorous dispute resolution mechanism.
  7. Whether GATT membership benefits developing countries remains controversial.

Chapter 11

  1. If growth at constant prices results in a disproportionately large increase in output of the export good, but consumers wish to spend their extra income on the import good, then the increase in the country's export supply will be especially large.
  2. If a country is large enough to affect world prices, growth that results in a large increase in the supply of exports may result in a sufficiently large decline in the relative price of the export good to leave the country worse off.
  3. Growth likely causes smaller changes in the terms of trade when it results from the introduction of new varieties of goods.
  4. Developing countries that depend on the exportation of primary products are hurt by the volatility of those prices and by long periods of decline in those prices.
  5. Import-substitution industrialization reduced the reliance of developing countries on primary exports, but it became quite costly when countries chose to permanently protect capital-intensive industries.
  6. Export-led growth has been a successful strategy for countries that exported labor-intensive goods initially, but later shifted to more technologically advanced goods as they acquired more physical and human capital.
  7. Industrialized countries have chosen to impose more stringent environmental standards than developing countries, but the expansion of dirty industries in the developing countries has more to do with their accumulation of capital.

Chapter 12

  1. The balance of payments keeps track of all the transactions between a country and the rest of the world during a year.
  2. In the BoP, sales of goods and services are credits and purchases are debits. Therefore exports are credits (+) and imports are debits (−).
  3. Financial account sales are increases in foreign-owned assets in the U.S. (i.e. sales of U.S. assets to the rest of the world resulting in financial inflows). By analogy to current account sales (exports thus credit), increases in foreign-owned assets in the U.S. are credit (+) entries.
  4. Financial account purchases are increases in U.S.-owned assets abroad (i.e. U.S. purchases of foreign assets resulting in financial outflows). By analogy to current account purchases (imports thus debit), increases in U.S.-owned assets abroad are debit (−) entries.
  5. In the balance of payments, the financial accounts refer to financial flows (in or out) overtime, i.e. to change in stocks of assets. At the end of the year the new level of the stocks of assets owned by the U.S. overseas and the stocks of assets owned by foreigners in the U.S. are recorded in a table entitled the ‘International Investment Position of the U.S.’. published by the Bureau of Economic Analysis.
  6. The exchange rate is the relative price of two currencies; it can always be quoted by one number or by its inverse.
  7. The standard approach is to quote the exchange rate from the point of view of the domestic economy as the price of one unit of foreign currency.
  8. When we mention appreciation or depreciation, we must always specify the currencies involved, since the appreciation of one currency must necessarily correspond to the depreciation of the other currency.
  9. In the short run with fixed prices, nominal and real exchange rates are equivalent.
  10. With bilateral exchange rates, a depreciation of the domestic currency is an increase in the exchange rate (more units of domestic currency needed to buy one unit of foreign currency). With multilateral exchange rates, a depreciation is a decrease in the index measuring the overall exchange rate of the domestic currency with respect to its trade partners' currencies.

Chapter 13

  1. Foreign exchange is just like any commodity: there is a supply of and a demand for foreign exchange and their interaction will simultaneously determine its price (the exchange rate) — assuming no interference by the government — and the quantity of foreign exchange traded.
  2. Countries can choose between several different exchange rate regimes. At one end of the spectrum, the exchange rate is free to fluctuate to see its price determined by market forces — this corresponds to a flexible (floating) exchange rate. At the other end of the spectrum, the central bank sets the exchange rate — this corresponds to a fixed (pegged) exchange rate.
  3. In a flexible exchange rate regime, an increase in the exchange rate is a depreciation of the domestic currency while a decrease is an appreciation. With a fixed exchange rate regime, these terms are replaced respectively by devaluation and revaluation.
  4. The adjustment mechanisms to changes in supply of or demand for foreign exchange are fundamentally different under fixed and flexible exchange rate regimes.
  5. With a flexible exchange rate regime, the balance of payments is always balanced through changes in the exchange rate.
  6. With a fixed exchange rate regime, central bank must intervene constantly to equate the supply of and demand for foreign currency. It does so by buying and selling foreign currency reserves.
  7. Interventions in the foreign exchange market on the part of the central bank affect the money supply.
  8. The central bank can neutralize the effect that its foreign exchange intervention has on the money supply through sterilization, i.e. performing an open-market operation to change domestic credit and offset the impact of the foreign exchange intervention.
  9. When foreign prices or the exchange rate change, the values of consumption, investment, and the trade balance are also going to be altered — and this affects domestic income, too.
  10. The Marshall–Lerner condition tells us in what direction the trade balance changes when the exchange rate changes. It depends crucially on the magnitude of the export and import elasticities.
  11. The J-curve shows that the short-run and long-run response of the trade balance to a change in the exchange rate may be fundamentally different.

Chapter 14

  1. A crucial determinant of trade deficits is a country's lack of national saving. If the demand for investment exceeds national saving, a country must import goods from abroad to meet investment demand.
  2. Since national saving is the sum of private and government savings (the budget surplus), both private citizens and government entities are to blame for a national saving shortfall.
  3. Under fixed exchange rates, fiscal and monetary expansions stimulate output in the open economy, but they also cause a deterioration in the trade balance.
  4. Since part of domestic income is spent on foreign goods, expansionary fiscal and monetary policies are not as effective as in the closed economy under fixed exchange rates. The small open-economy multiplier is smaller than the closed-economy multiplier.
  5. A devaluation improves a small country's balance of trade and consequently stimulates its economy.
  6. A flexible exchange rate regime insulates small open economies from foreign originated disturbances.
  7. The impact of fiscal and monetary policy is greater with flexible exchange rates than with fixed exchange rates because economic policies are enhanced by simultaneous depreciations or appreciations of the domestic currency.

Chapter 15

  1. Trade imbalances can be corrected with expenditure-switching or expenditure-reducing policies.
  2. Expenditure-switching policies redirect domestic demand from foreign to domestic goods to stimulate foreign demand for domestic goods.
  3. Expenditure-reducing policies lower the demand for imports by reducing total domestic demand.
  4. These policies are limited as they may either aggravate the international community or have undesirable effects on the domestic economy. Eventually chronic trade imbalances cannot be sustained under fixed exchange rates.
  5. There is a recourse: if a country commits to non-sterilization, no policy is needed to attain balanced trade. Eventually, an automatic adjustment will take place under the monetary approach to the balance of payments.
  6. A country that wants to achieve balanced trade (external balance) and full-employment income (internal balance) requires two policies, for example fiscal expansion and a devaluation. These policy options are summarized in the Swan diagram.
  7. The economies of large countries are linked through their balance of trade. Policies then have international repercussions in the sense that domestic fiscal expansions also affect output of the trade partners.
  8. The fiscal multiplier in the large open economy is still smaller than in the closed economy, but it is larger than in the small open-economy case, due to the repercussions. Overall fiscal policy under fixed exchange rates without capital mobility is less effective than under either flexible exchange rates or in the closed economy.
  9. In the two-country model, expansionary fiscal policy will affect both countries' income in the same direction, but a devaluation/revaluation in one country will have the opposite impact on the other country's output.

Chapter 16

  1. The massive expansion of international capital flows is due to the fall of the Bretton Woods system, financial market deregulations, and the rise of euro-currencies.
  2. The daily flows of foreign exchange are approximately 100 times larger than the daily flows of merchandise trade.
  3. Nine out of ten international financial transactions involve the U.S.$. The euro is a distant second with 36 percent of the transactions.
  4. More than half of American treasury bills are held by foreigners who also hold about 20 percent of U.S. long-term securities.
  5. Strong currencies can be bought and sold on a forward and futures markets at 1 month, 3 month, or 6 month. The forward markets allow companies to insure their international financial transactions against foreign exchange risk.
  6. Currency futures and options are financial derivatives that multinationals and banks use to insure against currency risk.
  7. Speculators do not insure against risk, instead they seek to assume risk for profit.
  8. Technical analysis evaluates asset prices to understand minute-by-minute changes in the market. It uses statistics generated by market activity, past prices, and volume.
  9. In the short run traders look for patterns in charts to determine the direction of any future movement in the price without any attempt to estimate its intrinsic price.

Chapter 17

  1. Investors' goal is to maximize the returns on their portfolio. They compare the returns from investing at home to the returns from investing abroad. If they believe that the returns are higher abroad, they will invest in foreign assets.
  2. Investing abroad involves not only the purchase of foreign assets, but also two foreign exchange transactions, one now and the other in the future.
  3. Risk is an intrinsic part of investing abroad, since future exchange rates are unknown at the time an investor buys foreign assets. A simple way for an investor to protect investments from exchange rate risk is to use the forward market for the future foreign exchange transaction.
  4. Uncovered interest arbitrage exposes investors to exchange rate risk, while covered interest arbitrage insulates foreign investments from foreign exchange risk by using the forward exchange market.
  5. Ultimately international flows of capital depend on the different returns and also on the different risk levels involved in investing in various countries.
  6. The external balance can be illustrated in the interest and income space. The external balance is upward sloping since current account deficits can be offset by capital inflows (a.k.a. financial account surpluses).
  7. The extent of the controls on capital mobility determines how extensive a change in the interest rate needs to be to trigger the capital flows necessary to offset specific current account imbalances. The slope of the external balance line reflects the degree of capital mobility.
  8. Since the international financial flows depend crucially on the capital controls and foreign exchange risk, our model of the financial account includes the degree of capital mobility (k) and risk (R).
  9. The position of the external balance line is determined by the exchange rate. A change in the exchange rate results in a shift of the line (ceteris paribus).

Chapter 18

  1. With a fixed exchange rate, any policy that impinges on the foreign exchange market equilibrium requires intervention by the central bank to neutralize these effects.
  2. The Mundell–Fleming model combines the goods and money market of the ISLM model with the external balance, BP=0, developed in Chapter 17.
  3. All three markets (the goods, money, and foreign exchange market) must clear for the economy to be in equilibrium.
  4. While fiscal policy can have a lasting effect on output, monetary policy can only have a temporary effect under fixed exchange rates.
  5. The higher the degree of capital mobility, the more effective fiscal policy will be.
  6. The greater the degree of capital mobility, the faster the adjustment of the economy takes place.
  7. If a country chooses to use devaluation as a means to stimulate its economy, the process will involve an intervention in the foreign exchange market followed by an adjustment in the money supply. The devalued exchange rate improves the trade balance, and the increase in the money supply stimulates the economy.
  8. A devaluation can be used either to acquire a competitive edge or to acknowledge the fact that a currency may be too strong, causing chronic balance-of-payments deficits that are not sustainable.
  9. If a country wishes to achieve full employment (internal balance) at the same time as external balance (BP=0) using two policy instruments, monetary and fiscal policies, it must assign a specific policy to a specific target to be successful.

Chapter 19

  1. The primary difference between fixed and flexible exchange rates lies in the adjustment to a balance-of-payments imbalance. While this is the domain of the central bank (through intervention) with fixed exchange rates, market forces alone determine the price of foreign currency in a flexible exchange rate regime.
  2. All adjustment mechanisms in the case of flexible exchange rates are ultimately driven by currency depreciations or appreciations. These changes in the price of foreign currency imply shifts of the IS curve (due to changing exports and imports) and of the BP curve.
  3. Monetary policy under flexible exchange rates is very effective in raising output, and its effectiveness increases with the degree of capital mobility. Under fixed exchange rates monetary policy is ineffective in raising output.
  4. Fiscal policy under flexible exchange rates becomes less and less effective as the degree of capital mobility increases. This result is exactly opposite to the effect of fiscal policy under fixed exchange rates.
  5. A large open economy has the power to change the world interest rate. Two large countries without capital controls are linked inextricably through their current and financial accounts.
  6. With perfect capital mobility, expansionary monetary policy in one large open economy results in a depreciation in that country's exchange rate. In a type of beggar thy neighbor policy, the depreciations associated with the monetary expansion improve the domestic balance of trade, but hurt the foreign goods market. As the foreign currency appreciates, foreign exports become less competitive. The overall result is an expansion for the domestic economy and a contraction for the partner as well as a lower world interest rate.
  7. With perfect capital mobility, expansionary fiscal policy in one country triggers massive capital inflows and an appreciation of the domestic currency. The overall result is an expansion for both economies as well as a higher world interest rate.
  8. If we allow for medium-run price flexibility, the open-economy aggregate demand (AD) and aggregate supply (AS) model can be used to show that neither fiscal nor monetary policy is effective in raising output if the economy is already at full employment.
  9. Medium-run price flexibility does, however, support economic policies designed to move the economy from a recession to full employment (at the expense of an increase in the price level).

Chapter 20

  1. The Law of One Price states that if prices are fully flexible, identical goods should be identically priced on the world markets when their prices are converted into the same currency with the nominal exchange rate.
  2. The notion is extrapolated to a basket of goods and services, the CPI (or price level). This is the basis for the concept of Purchasing Power Parity (PPP).
  3. If it is true that the price of the basket is identical in various countries, then we can derive the nominal exchange rate as the ratio of the price levels.
  4. All these statements are based on the assumption of perfect price flexibility at all times. There are so many reasons why this is not the case in the real world that PPP never holds in the short run: in fact, exchange rates are very volatile and follow a random walk.
  5. Notwithstanding its many problems, PPP is used extensively for international levels of living comparisons.
  6. However, in the long run, PPP is not to be dismissed, although it takes a long time for the exchange rate to converge towards the PPP estimates. PPP can thus be considered as an estimate of the long-run exchange rate.
  7. A more realistic model might consider prices as sticky in the short run and flexible in the long run.
  8. The Dornbusch overshooting model is based on such premises. The model states that, as a result of a monetary disturbance, the exchange rate will immediately overshoot its long-run equilibrium as prices do not contribute to the adjustment in the short run. A correction will have to take place when prices start to adjust in the long run. This model explains partially the high volatility of exchange rates in the short run.

Chapter 21

  1. The evolution of the standard from a bi-metallic standard (silver and gold) to a pure gold standard was achieved by the end of the nineteenth century.
  2. With the gold standard, the value of national paper currencies would be defined in term of the weight of gold they could exchange for paper currency at the central bank. Since all currencies were defined likewise, their exchange rate or mint parity was simply the ratio of these weights of gold.
  3. Central banks had to back any amount of currency in circulation by gold reserves and be ready to redeem the paper currency for gold.
  4. In order to settle trade imbalances, gold could be freely traded internationally and the adjustment mechanism was crucially dependent on price and wage flexibility.
  5. A deficit country would lose its gold reserves, resulting in a decrease in the money supply. With perfectly flexible prices, prices would drop and the country would regain its international competitiveness.
  6. Under the rules of the game, not only were central banks not supposed to sterilize reserves changes, but they were expected to enhance the impact of the adjustment mechanism through credit loosening (surplus country) or tightening (deficit country).
  7. From 1880 to 1914, the gold standard was quite successful at stabilizing its members' economies. Trade, as well as international capital flows, was not impeded by much control during the period.
  8. The attempt to return to the gold standard after World War 1 was not successful and the industrialized nations fended off disastrous depressions in the thirties. The consequence was a resort to protection and competitive devaluations to try to solve domestic problems.
  9. Aware of the importance of a stable world economic order as a crucial foundation for peace, the Bretton Woods arrangement was entered into by 44 countries at the end of World War 2. The International Monetary Fund was to manage the system.
  10. With Bretton Woods, the dollar was defined in terms of gold while the other currencies had to uphold a fixed exchange rate with the dollar. They did not need to hold reserves in terms of gold. This was a gold-exchange standard.
  11. The dollar was the anchor in this system. As long as the U.S. economy was doing well, the system worked smoothly and was significant in helping the other countries rebuild their war-shattered economies. In the sixties, circumstances had changed and by the early seventies, for various reasons, Bretton Woods fell apart.
  12. Efforts at salvaging the system were doomed and the world abandoned fixed for floating exchange rates.
  13. Both nominal and real exchange rates have been far more volatile than had been expected when floating rates were adopted, and this volatility has been very disruptive, the 1981–5 appreciation of the dollar being particularly harmful to the tradable sector of the United States.
  14. After the demise of Bretton Woods, the role of the IMF was recast towards “surveillance, financial assistance, and technical assistance” as world economic conditions evolved.
  15. A new financial architecture, Basel 1 and 2, has also been designed under the umbrella of the International Bank of International Settlements (BIS).

Chapter 22

  1. In its first 15 years, the Bretton Woods international exchange rate system was successful in stabilizing the war-torn European economies. By the sixties, the system, with its blatant asymmetries, started to have detrimental impacts on some of its European members. The system eventually collapsed in the early seventies.
  2. The Europeans favor pegged exchange rate systems because these systems impart stability when countries trade a lot between each other. So they introduced, in the seventies, their own pegged system to replace Bretton Woods, the so-called snake. The oil shocks of the period, coupled with the inability of some of the members to use correct policies to deal with supply shocks, resulted in stagflation (high inflation and high unemployment). The demise of the snake led to the design of a better exchange rate system, the ERM, under the auspices of the new European Monetary System.
  3. In the eighties, the new system was eventually successful in bringing inflation down towards Germany's low rates. Countries were pegging their exchange rates on each other and these fixed parities could only hold if the members harmonized their monetary policy. So exchange rate pegging was driving the monetary policy of the members who shadowed the German Bundesbank. The system had good financing facilities to help countries with temporary balance-of-payments difficulties as long as speculators were not permitted to enter the international capital markets. This was done through strict capital controls.
  4. By the end of the eighties, further integration within the countries of the European Community hinged on the removal of the capital controls, thus putting the system at risk. Aware of the potential problems, the European leaders designed a new system, a monetary union with one common currency and one central bank to carry the monetary policy. Such a system would obviously eradicate any possibility of currency crisis.
  5. The capital controls were dismantled, but the new system could only be introduced in stages, with 1999 as the completion date. In the meantime, various upheavals, political and economic, resulted in the dreaded currency crises of the early nineties. Amazingly, the project survived and the common European currency, the euro, was introduced in 1999 as scheduled.
  6. In its first ten years, the system, now encompassing 15 countries, has been resilient. There is a body of economic literature describing the basic conditions that a monetary union has to meet to be optimum. These conditions include similar economic structure, high mobility of labor and capital, and fiscal federalism to help countries affected by an asymmetric shock. Unfortunately, the European labor markets are notable for their rigidities and the E.U. budget is much too small to be of much help. So the question must be reframed by asking whether the EMU will become an optimum currency area in the future.

Chapter 23

  1. Fluctuations in the price of oil (or other key items such as grain or rice) can generate current account fluctuations that may lead to balance-of-payments and debt crises.
  2. Almost all major Latin American countries experienced a debt crisis in the early 1980s. Many defaulted on their foreign debt because their total exports were at times smaller than the interest payments on their debt.
  3. The debt crisis of the 1980s was resolved by the Brady Plan that forced concessions (debt and interest reductions) from commercial banks in exchange for a return in Latin American countries' debt service.
  4. The Brady Plan also restored international lending by guaranteeing part of the countries' foreign debt and by amortizing the debt payments over longer time horizons.
  5. Prior to the 1997 Asian crisis, emerging markets had received huge capital inflows. When growth slowed in the late 1990s, investors withdrew their funds only to find out that a number of financial institutions (particularly banks) had already been in precarious financial conditions.
  6. After the Asian crisis, many Asian countries sought to ‘self insure’ themselves against dramatic capital outflows. This implied a massive accumulation of reserves, which have risen to unprecedented levels in Asia.