International Economics

Sixteenth Edition

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International Economics

Sixteenth Edition

Thomas A. Pugel New York University

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Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2016 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2012, 2009, and 2007. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

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Library of Congress Cataloging-in-Publication Data

Pugel, Thomas A. International economics/ Thomas A. Pugel.—Sixteenth edition. pages cm ISBN 978-0-07-802177-0 (alk. paper) 1. Commercial policy. 2. Foreign exchange. I. Title. HF1411.L536 2016 337—dc23 2014040055

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

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In memory of my parents, Adele and Edmund, and my parents-in-law, Vivian and Freeman, with my deepest appreciation and gratitude for all that they did to benefit the generations that follow.

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About the Author

Thomas A. Pugel Thomas A. Pugel is Professor of Economics and Global Business at the Stern School of Business, New York University, and a Fellow of the Teaching Excellence Program at the Stern School. His research and publications focus on international industrial competition and government policies toward international trade and industry. Professor Pugel has been Visiting Professor at Aoyama Gakuin University in Japan and a member of the U.S. faculty at the National Center for Industrial Science and Technology Management Development in China. He received the university-wide Distinguished Teaching Award at New York University in 1991, and twice he was voted Professor of the Year

by the graduate students at the Stern School of Business. He studied economics as an undergraduate at Michigan State University and earned a PhD in economics from Harvard University.

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International economics combines the excitement of world events and the incisiveness of economic analysis. We are now deeply into the second great wave of globalization, in which product, capital, and labor markets are becoming more integrated across countries. This second wave, which began in about 1950 and picked up steam in the 1980s, has now lasted longer than the first, which began in about 1870 and ended with World War I (or perhaps with the onset of the Great Depression in 1930).

As indicators of the current process of globalization, we see that international trade, foreign direct investment, cross-border lending, and international portfolio investments have been growing faster than world production. Information, data, and rumors now spread around the world instantly through the Internet and other global electronic media.

As the world becomes more integrated, countries become more interdependent. Increasingly, events and policy changes in one country affect many other countries. Also increasingly, companies make decisions about production and product develop- ment based on global markets.

My goal in writing and revising this book is to provide the best blend of events and analysis, so that the reader builds the abilities to understand global economic developments and to evaluate proposals for changes in economic policies. The book is informed by current events and by the latest in applied international research. My job is to synthesize all of this to facilitate learning. The book

Combines rigorous economic analysis with attention to the issues of economic policy that are alive and important today.

Is written to be concise and readable. Uses economic terminology when it enhances the analysis but avoids jargon for

jargon’s sake.

I follow these principles when I teach international economics to undergraduates and master’s degree students. I believe that the book benefits as I bring into it what I learn from the classroom.

THE SCHEME OF THE BOOK The examples presented in Chapter 1 show that international economics is exciting and sometimes controversial because there are both differences between countries and interconnections among countries. Still, international economics is like other econom- ics in that we will be examining the fundamental challenge of scarcity of resources— how we can best use our scarce resources to create the most value and the most benefits. We will be able to draw on many standard tools and concepts of economics, such as supply and demand analysis, and extend their use to the international arena.

We begin our in-depth exploration of international economics with international trade theory and policy. In Chapters 2–7 we look at why countries trade goods and services. In Chapters 8–15 we examine what government policies toward trade would bring benefits and to whom. This first half of the book might be called international microeconomics.

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viii Preface

Our basic theory of trade, presented in Chapter 2, says that trade usually results from the interaction of competitive demand and supply. It shows how the gains that trade brings to some people and the losses it brings to others can sum to overall global and national gains from trade. Chapter 3 launches an exploration of what lies behind the demand and supply curves and discovers the concept of comparative advantage. Chapter 4 shows that countries have different comparative advantages for the fundamental reason that people, and therefore countries, differ from each other in the productive resources they own. Chapter 5 looks at the strong impacts of trade on people who own those productive resources—the human labor and skills, the capital, the land, and other resources. Some ways of making a living are definitely helped by trade, while others are hurt. Chapter 6 examines how actual trade may reflect forces calling for theories that go beyond our basic ideas of demand and sup- ply and of comparative advantage. Chapter 7 explores some key links between trade and economic growth.

Chapters 8–15 use the theories of the previous chapters to analyze a broad range of government policy issues. Chapters 8–10 set out on a journey to map the border between good trade barriers and bad ones. This journey turns out to be intellectu- ally challenging, calling for careful reasoning. Chapter 11 explores how firms and governments sometimes push for more trade rather than less, promoting exports more than a competitive marketplace would. Chapter 12 switches to the economics of trade blocs like the European Union and the North American Free Trade Area. Chapter 13 faces the intense debate over how environmental concerns should affect trade policy. Chapter 14 looks at how trade creates challenges and opportunities for developing countries. Chapter 15 examines the economics of emigration and immigration and the roles of global companies in the transfer of resources, including technology, between countries.

The focus of the second half of the book shifts to international finance and macroeconomics. In Chapters 16–21 we enter the world of different moneys, the exchange rates between these moneys, and international investors and speculators. Chapters 22–25 survey the effects of a national government’s choice of exchange- rate policy on the country’s macroeconomic performance, especially unemployment and inflation.

Chapter 16 presents the balance of payments, a way to keep track of all the eco- nomic transactions between a country and the rest of the world. In Chapter 17 we explore the basics of exchange rates between currencies and the functioning and enormous size of the foreign exchange market. Chapter 18 provides a tour of the returns to and risks of foreign financial investments. Exchange rates are prices, and in Chapter 19 we look behind basic supply and demand in the foreign exchange market, in search of fundamental economic determinants of exchange-rate values. Chapter 20 examines government policies toward the foreign-exchange market, first using description and analysis, and then presenting the history of exchange-rate regimes, starting with the gold standard and finishing with the current mash-up of different national policies. Well-behaved international lending and borrowing can create global gains, but Chapter 21 also examines financial crises that can arise from some kinds of foreign borrowing and that can spread across countries, a clear downside of globalization.

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Preface ix

Chapter 22 begins our explication of international macroeconomics by develop- ing a framework for analyzing a national economy that is linked to the rest of the world through international trade and international financial investing. We use this framework in the next two chapters to explore the macroeconomic performance of a country that maintains a fixed exchange-rate value for its currency (Chapter 23) and of a country that allows a floating, market-driven exchange-rate value for its currency (Chapter 24). Chapter 25 uses what we have learned throughout the second half of the book to examine the benefits and costs of alternatives for a country’s exchange-rate policy. While rather extreme versions of fixed exchange rates serve some countries well, the general trend is toward more flexible exchange rates.

In a few places the book’s scheme (international trade first, international finance second) creates some momentary inconvenience, as when we look at the exchange- rate link between cutting imports and reducing exports in Chapter 5 before we have discussed exchange rates in depth. Mostly the organization serves us well. The under- standing we gain about earlier topics provides us with building blocks that allow us to explore broader issues later in the book.

CURRENT EVENTS AND NEW EXAMPLES It is a challenge and a pleasure for me to incorporate the events and policy changes that continue to transform the global economy, and to find the new examples that show the effects of globalization (both its upside and its downside). Here are some of the current and recent events and issues that are included in this edition to provide new examples that show the practical use of our international economic analysis:

• The euro crisis that began in Greece in 2010 spread to several other countries in the euro area and during 2011–2012 seemed to threaten the continued existence of the euro itself. Still, in the face of continued weak economic performance in the euro area, Latvia adopted the euro at the beginning of 2014, bringing the number of countries in the euro area to 18.

• Beginning in 2007 the United States rapidly expanded its production of natural gas using horizontal drilling and hydraulic fracturing. A large number of U.S. firms sought approval to export natural gas, but a U.S. law prohibits export unless it is in the national interest. The U.S. government has been slow to act; as of mid-2014, only one U.S. facility had received full approval to export.

• Immigration continues to be a hot issue. In 2014 Swiss voters approved limitations on immigration into the country. Prime Minister Cameron pledged to greatly reduce immigration into Britain by 2015. In 2013 the U.S. government again failed to pass a revision of its immigration laws.

• Chinese government holdings of foreign exchange reserve assets reached $4 trillion in mid-2014, the result of continued official intervention to prevent the exchange- rate value of China’s currency from rising too quickly.

• Pressure from the growth of the countries’ exports led to rapidly rising wages for workers in China and in India.

• After nearly two decades of negotiations, Russia joined the World Trade Organization (WTO) in 2012.

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x Preface

• In 2013 the members of the WTO reached a new multilateral agreement on trade facilitation, but in 2014 its implementation was held up by a single coun- try, India.

• In response to rapidly growing imports, American steel producers sent a large number of new complaints to the U.S. government, alleging dumping by foreign producers and seeking hefty new antidumping duties.

• The WTO ruled that European governments had violated WTO rules by offering massive subsidies to Airbus and that the U.S. government had violated WTO rules by offering massive subsidies to Boeing. But, then, the situation seemed to reach a stalemate.

• After approval from the U.S. Congress, the United States implemented free-trade agreements with Colombia, South Korea, and Panama.

• In 2012, Venezuela became a member of MERCOSUR, the South American regional trade area.

• Croatia joined the European Union in 2013 as its 28th member country. • The first phase of the Kyoto Protocol was completed in 2012. For a number of

reasons, the effects were minor, and global warming continues as a major global environmental challenge.

• Led by increases in international financial investments and computer-driven trad- ing, the size of the foreign exchange market continued to grow, with trading of one currency for another reaching $5 trillion per day in 2013. Foreign exchange trading has more than tripled since 2004.

• The market-driven exchange-rate value of the Japanese yen increased during the week after a tsunami caused the nuclear disaster at Fukushima in 2011, prompting a large official intervention in the foreign exchange market.

• Starting in 2008, the International Monetary Fund (IMF) rapidly expanded its lend- ing to countries in crisis, with loans outstanding reaching $125 billion in mid-2014. Most of these IMF loans are to advanced countries—Iceland, Greece, Ireland, and Portugal—a sharp contrast to the lending to developing countries that had been predominant since 1980.

• The United States pursued a third round of quantitative easing during 2012–2014 as a continuation of unconventional monetary policy for an economy stuck in a liquid- ity trap. In this third round, the Fed bought about $1.5 trillion of Treasury securities and mortgage-backed securities, but this round seemed to have less effect on the exchange-rate value of the U.S. dollar than did previous rounds.

IMPROVING THE BOOK: TOPICS In this edition I introduce and extend a number of improvements to the pedagogical structure and topical coverage of the book. • The euro crisis that began in 2010 and intensified in 2011 and 2012 has had

profound effects on the member countries of the euro area—the countries that have replaced their national currencies with the euro in a monetary union.

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Preface xi

This edition interweaves the causes and impacts of the euro crisis across its chapters. The overview of the euro crisis in Chapter 1 shows that it began in different ways, as a fiscal crisis in Greece and as a burst housing-price bubble in Ireland that led to a banking crisis. Portugal then had a debt-driven crisis, and contagion spread the crisis pressures to Spain and Italy. The European Central Bank needed to play a key role, and a new program announced in July 2012 and adopted in September was the turning point in addressing the worst of the crisis. I then present discussions of important aspects of the crisis in a series of new shaded Euro Crisis boxes, which join the other six series of boxes: Global Crisis, Focus on China, Global Governance, Focus on Labor, Case Studies, and Extensions. For the Euro Crisis series, the new box in Chapter 16 shows how attention to current account balances and net international investment positions of the countries at the center of the crisis would have given signals of rising risk. Chapter 18 has a combination of a Global Crisis and Euro Crisis box, which shows how a key parity relationship among interest rates and exchange rates weakened under crisis conditions. The new box in Chapter 21 explains how the euro crisis was actually three interrelated crises that reinforced each other— sovereign debt or fiscal crisis, banking crisis, and macroeconomic crisis. While the sovereign debt and banking crises have calmed, the macroeconomic perfor- mance of the euro area remained very weak and Greece was in depression. The concluding section of Chapter 25 examines the benefits and costs of European monetary union, with special attention to fiscal policy. The euro area lacks area- wide taxation and government spending, National fiscal policies have a double edge, as both the principal remaining tool for national governments to address their macroeconomic performance problems and a potential source of instability that can threaten the entire union.

• The global financial and economic crisis that began in 2007 is the most important global trauma of the past 70 years, and it was a major contributor to the onset of the euro crisis. A new section of the text of Chapter 21 describes the global crisis, including the start of the crisis as the result of losses on sub-prime mortgages in the United States and on assets backed by these mortgages, and the terrible wors- ening of the crisis in 2008 with the failure of Lehman Brothers. This discussion of the global crisis also shows how the analysis of the series of financial crises that hit developing countries during 1982–2002 helps us to understand the causes and spread of the global crisis. The Global Crisis series of boxes examines other aspects of the crisis, including the collapse of international trade (Chapter 2), the avoidance of new protectionism (Chapter 9), the use of quantitative easing as nontraditional monetary policy once short-term interest rates are essentially zero (Chapter 24), and the increased use of currency swaps among central banks (Chapter 24).

• China continues its rise as a force in the global economy. The presentation of China’s global role, including the series of boxes Focus on China, continues to be a strength of the text. Chapters 1 and 20 discuss the development of China’s controversial policies toward the exchange-rate value of its currency. In the box in Chapter 9, the presentation of China’s rising involvement in the dispute settlement

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xii Preface

process at the World Trade Organization, both as a respondent (alleged violator) and as a complainant, has been updated and rewritten. Among other recent cases, the WTO ruled in 2014 that China’s restrictions on exports of rare earths were a violation of its WTO commitments.

• A major strength of the book remains in-depth analysis of a range of trade and trade-policy issues. The discussion of monopolistic competition and intra- industry trade in Chapter 6 has been expanded to incorporate the conclusions from research based on differences across firms in their cost levels. Opening to international trade favors the survival and expansion of lower-cost firms. This dis- cussion also includes an estimate of the global gains from greater product variety. The section on trade embargoes in Chapter 12 has been revised, with a current case, Iran, being used as the example of the effects of international sanctions on the target country. Estimates of national factor endowments presented in Chapter 5 are completely updated and include better data on physical capital stocks and more countries in total. Data on national intra-industry trade shares in Chapter 6 include new estimates for 2012.

• Chapter 13 on trade and the environment continues as a unique and powerful treatment of issues of interest to many students. The discussion of global warm- ing has been revised to incorporate data and projections from recent studies. The discussion of the Kyoto Protocol has been updated to include the outcomes from the first phase that ended in 2012 and the continued increase in global greenhouse gas emissions.

• The box on the fiscal effects of immigration in Chapter 15 has been substan- tially rewritten to incorporate the results of a recent Organization for Economic Cooperation and Development study of the effects of immigrants on government revenues and expenditures.

• In Chapter 18 a new section of text explains the definitions and uses of real exchange rates and effective exchange rates. The four ways to measure the exchange-rate value of a currency had previously been a box in the chapter, but the increasing importance of these concepts motivated the shift to a text section.

• Chapter 21 has been substantially revised. It incorporates the global financial and economic crisis into the text of the chapter and has a new box on the euro crisis. Some other aspects of the chapter have been streamlined. The short subsections on the Brazilian mini-crisis of 1999 and the Turkish crisis of 2001 have been removed, as has one of the two boxes on the International Monetary Fund.

• I used the latest available sources to update the wide range of data and informa- tion presented in the figures and text of the book. Among other updates, the book offers the latest information on international trade in specific products for the United States, China, and Japan; national average tariff rates; dumping and sub- sidy cases; levels and growth rates of national incomes per capita; trends in the relative prices of primary products; patterns of foreign direct investments broadly and by major home country; rates of immigration into the United States, Canada, and the European Union; the U.S. balance of payments and the U.S. international

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Preface xiii

investment position; the sizes of foreign exchange trading and foreign exchange futures, swaps, and options; levels and trends for nominal exchange rates; effective exchange-rate values for the U.S. dollar; evidence about relative purchasing power parity; the exchange-rate policies chosen by national governments; the flows of international financing to and the outstanding foreign debt of developing countries; and gold prices.

NEW QUESTIONS AND PROBLEMS In this edition I provide additional opportunities for students to engage with the book’s contents by adding new questions that students can use to build their facility in using the concepts and analysis of international economics.

• Forty-eight new questions and problems have been added, two new questions and problems to each of the chapters that have end-of-chapter materials. These new questions and problems are targeted to cover chapter topics that were previously underrepresented.

• A discussion question has been added at the end of each Case Study box, a total of 24 new questions that focus on the issues raised in the case studies.

FORMAT AND STYLE I have been careful to retain the goals of clarity and honesty that have made International Economics an extraordinary success in classrooms and courses around the world. There are plenty of quick road signs at the start of and within chapters. The summaries at the ends of the chapters offer an integration of what has been discussed. Students get the signs, “Here’s where we are going; here’s where we have just been.” I use bullet-point and numbered lists to add to the visual appeal of the text and to emphasize sets of determinants or effects. I strive to keep paragraphs to reasonable lengths, and I have found ways to break up some long paragraphs to make the text easier to read.

I am candid about ranking some tools or facts ahead of others. The undeniable power of some of the economist’s tools is applied repeatedly to events and issues without apology. Theories and concepts that fail to improve on common sense are not oversold.

The format of the book is fine-tuned for better learning. Students need to master the language of international economics. Most …

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