HarperCollinsCollegePublishers

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2 Contents Preface 1 Introduction l What Is International Economics About? 3 The Gains from Trade 3 The Pattern^f Trade 4 Protectionism 5 ' The Balance of Payments". 6 Exchange-Rate Determination 6 International Policy Coordination 7 The International Capital Market 7 International Economics: Trade and Money 8 PART ONE I INTERNATIONAL TRADE THEORY 9 )( 2 Labor Productivity and Comparative Advantage: The Ricardian Model 11 ' A One-Factor Economy 12 f Production Possibilities 12 Relative Prices and Supply 13» Trad in a One-Factor World 13 Determining the Relative Price after Trade 15 The Gains from Trade 17 A Numerical Example 18 Misconceptions about Comparative Advantage 20 Productivity and Competitiveness 20 The Sweatshop Labor Argument 21 Unequal Exchange 22 Comparative Advantage with Many Goods 22 Setting up the Model 22 Relative Wages and Specialization 23 Determining the Relative Wage in the Multigood Model 24

3 viii Contents Adding Transport Costs and Nontraded Goods 26 Empirical Evidence on the Ricardian Model 28 Summary 29 *Key Terms 30 ^Problems 30 *Further Reading 32 APPENDIX: A Ricardian Model with Very Many Goods 33 Technology and Specialization 33 Demand and Equilibrium 34 The Gains from Trade 35 An Application: Productivity Growth 36 3 Specific Factors and Income Distribution 38 The Specific Factors Model 39 Assumptions of the Model 39 Production Possibilities 40 Prices, Wages, and Labor Allocation 43 Relative Prices and the Distribution of Income 47 International Trade in the Specific Factors Model 49 Resources and Relative Supply 49 Trade and Relative Prices 50 The Pattern of Trade 51 Income Distribution and the Gains from Trade 53 The Political Economy of Trade: A Preliminary View 55 ' Optimal Trade Policy 55 BOX: Specific Factors and the Beginnings' of Trade Theory 56 Income Distribution and Trade Politics 57 Summary 58 APPENDIX: Further Details on Specific Factors 61 Marginal and Total Product 61 Relative Prices and the Distribution of Income 62 4 Resources and Trade: The Heckscher-Ohlin Model 64 A Model of a Two-Factor Economy 65 a Assumptions of the Model 65 Production Possibilities 66 " "" - -Goods Prices and Factor Prices 67 Allowing Substitution between Inputs 70 Effects of International Trade between Two-Factor Economies 71 Relative Prices and thepattern of Trade 72 Trade and the Distribution of Income 73 Factor Price Equalization 74 CASESTUDY: Pollution Rights as a Resource 75 ' * will appear in all subsequent chapters

4 Contents ix Empirical Evidence on the Heckscher-Ohlin Model 77 Testing the Heckscher-Ohlin Model 77 Implications of the Tests 78 Summary 79 APPENDIX: The Heckscher-Ohlin Model with Variable Coefficients 83 Choice of Technique 83 Goods Prices and Factor Prices 84 Allocation of Resources 85 5 The Standard Trade Model 87 A Standard Model of a Trading Economy 88 Production Possibilities and Relative Supply 88 Relative Prices and Demand 89 The Welfare Effect of Changes in the Terms of Trade 92 Determining Relative Prices 92 Economic Growth: A Shift of the RS Curve 92 Growth and the Production Possibility Frontier 93 Relative Supply and the Terms of Trade 94 Internation^tEffects of Growth 95 CASE STUDY: Foreign Growth and the U.S. Terms of Trade 96 International Transfers of Income: Shifting the RD Curve 98 The Transfer Problem 98 Effects of a Transfer on the Terms of Trade 99 Presumptions about the Terms of Trade Effects of Transfers 100 CASE STUDY: The Transfer Problem for the United States 102 Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD 102 Relative Demand and Supply Effects of a Tariff 103 Effects of an Export Subsidy 104 Implications of Terms of Trade Effects: Who Gains and Who Loses? 104 Summary 106 APPENDIX: Representing International Equilibrium with Offer Curves 110 Deriving ^Country's Offer Curve 110 International-Equilibrium 112 / 6 Economies of Scale, Imperfect Competition, and International Tracle 113 ~ Economies of Scale and International Trade: An Overview 114 Economies of Scale and Market Structure 115 The Theory of Imperfect Competition 116 Monopoly: A Brief Review 117 Monopolistic Competition 119 Limitations of the Monopolistic Competition Model 124 Monopolistic Competition and Trade 124 ' The Effects of Increased Market Size 125 Gains from an Integrated Market: A Numerical Example 125 Economies of Scale and Comparative Advantage 128

5 ; Contents The Significance of Intraindustry Trade 130 Why Intraindustry Trade Matters 131 CASE STUDY: Intraindustry Trade in Action: The North American Auto Pact 133 Dumping 134 The Economics of Dumping 134 BOX: Reverse Dumping 136 CASE STUDY: Antidumping as Protectionism 137 Reciprocal Dumping 138 ". BOX: A Concrete Example of Dumping 138 External Economies and International Trade 139 BOX: Examples of External Economies 140 External Economies and the Pattern of Trade 140 Trade and Welfare with External Economies 142 Dynamic Increasing Returns 143 Summary 145 APPENDIX: Determining Marginal Revenue International Factor Movements 149 International Labor Mobility 150 A One-Good Model without Factor Mobility 150 International Labor Movement 152 Extending the Analysis 153 BOX: International Labor Mobility in Practice: "Guest Workers" in Europe 154 International Borrowing and Lending 155 Intertemporal Production Possibilities and Trade 155 The Real Interest Rate 156 Intertemporal Comparative Advantage 157 BOX: Changes in the Pattern of Capital Movements in the 1980s 158 Direct Foreign Investment and Multinational Firms 159 The Theory of Multinational Enterprise 159 Multinational Firms in Practice < 161 CASE STUDY: Foreign Direct Investment in the United States 163 BOX: Japan in the Entertainment Business 165,t Summary 165 APPENDIX: More on Intertemporal Trade 169 \ 8 Regional Economic Issues 173 What is a Country? 174 How Governments Create National Economies 175 From International to interregional Trade 178 BOX: Food Fights in Europe 178 Comparing Regions and Nations I Specialization and Trade 179 ; Factfrr Mobility 181 Problems of Regional Economics 182 Absolute versus Comparative Advantage 182

6 Contents xi BOX: Anatomy of a Declining Region 183 Agglomeration and Uneven Development 184 Summary 187 PART TWO I INTERNATIONAL TRADE POLICY The Instruments of Trade Policy 195 Basic Tariff Analysis 195 Supply, Demand, and Trade in a Single Industry 196 Effects of a Tariff 197 Measuring the Amount of Protection 199 Costs and Benefits of a Tariff 201 Consumer and Producer Surplus 201 Measuring the Costs and Benefits 203 Other Instruments of Trade Policy 206 Export Subsidies: Theory 206 CASE STUDXpEurope's Common Agricultural Policy 207 Import Quotas: Theory 208 CASE STUDY: An Import Quota in Practice: U.S. Sugar 209 Voluntary Export Restraints 210 BOX: The Case of the Forbidden Phone Booths 211 CASE STUDY: A Voluntary Export Restraint in Practice: Japanese Autos 212 Iiocal Content Requirements 212 BOX: What's a Domestic Car? 213 CASE STUDY: A Local Content Scheme: The Oil Import Quota in the 1960s 214 Other Trade Policy Instruments 215 Summary 215 APPENDIX I: Tariff Analysis in General Equilibrium 219 A Tariff in a Small Country 219 f A Tariff in a Large Country 221 ' APPENDIX IlfTariffs and Import Quotas in the Presence of Monopoly 225 The Model with Free Trade 223 / The Model with a Tariff 224 The Model with an Import Quota 224 Comparing a Tariff and a Quota The Political Economy of Trade Policy 227 The Case for Free Trade 228 Free Trade and Efficiency 228 Additional Gains from Free Trade 229 Political Argument for Free Trade 230 National Welfare Arguments against Free Trade 230 CASE STUDY: The Gains from "1992" 230 The Terms of Trade Argument for a Tariff 231

7 xii Contents The Domestic Market Failure Argument against Free Trade 232 How Convincing Is the Market Failure Argument? 234 Income Distribution and Trade Policy 236 Weighted Social Welfare 236 Conservative Social Welfare 236 Collective Action 237 Who Gets Protected? 238 International Negotiations and Trade Policy 238 The Advantages of Negotiation 239 International Trade Agreements: A Brief History 241 BOX: Environmentalism or Protectionism? 242 Stresses on the Trading System 243 Preferential Trading Agreements 245 BOX: Do Trade Preferences Have Appeal? 246 BOX: The Oilseed Dispute 247 CASE STUDY: Recent Regional Trading Agreements 247 Summary 249 APPENDIX: Proving that the Optimum Tariff Is Positive 253 Demandjand Supply 253 The Tariff and Prices 253 The Tariff and Domestic Welfare Trade Policy in Developing Countries 256.Trade Policy to Promote Manufacturing 257 Why Manufacturing Is Favored: The Infant Industry Argument 257 How Manufacturing Is Favored: Import-Substituting Industrialization 259 Results of Favoring Manufacturing: Problems of Import-Substituting Industrialization 261 Another Way to Favor Manufacturing: Industrialization through Exports 262 BOX: Trade Liberalization and Economic Growth: The Case of China 263 Problems of the Dual Economy ^ 264 The Symptoms of Dualism 264 CASE STUDY: Economic Dualism in India 265 Dual Labor Markets and Trade Policy 266 ' Trade Policy as a Cause of Economic Dualism 268 ^Negotiations between Developing and Advanced Countries: The North-South * Debate 268 Are Poor Nations Exploited? 269 The Role of Foreign Capital and Multinational Firms in Development 270 Raising the Export Prices of Developing Countries: Commodity Export Cartels 271 CASE STUDY: OPEC 272 Summary Industrial Policy in Advanced Countries 277 Popular Arguments for Industrial Policy 278 Encouraging Industries with High Value Added Per Worker 278 Encouraging Linkage Industries 279

8 Contents xiii Promoting Industries with Future Growth Potential 280 Countering the Effects of Other Countries' Industrial Policies 280 Sophisticated Arguments for Industrial Policy 282 Technology and Externalities 282 Imperfect Competition and Strategic Trade Policy 284 Industrial Policy in Practice 287 The Industrial Policy of Japan 287 Industrial Policy in Other Countries 289 BOX: The HDTV Debate 290 Case Studies of Industrial Policy 292 CASE STUDY: Japanese Targeting of Steel (1960-Early 1970s) 292 CASE STUDY: European Support of Aircraft in the 1970s and 1980s 294 CASE STUDY: Japanese Targeting of Semiconductors (Mid-1970s to Date) 295 Summary 296 PART THREE I EXCHANGE RATES AND OPEN- ECONOMY MACROECONOMICS National Income Accounting and the Balance of Payments 301 The National Income Accounts 303 National Product and National Income 303 Capital Depreciation, International Transfers, and Indirect Business Taxes 305 Gross Domestic Product 305 National Income Accounting in a Closed Economy 306 Consumption 306 Investment 306 Government Purchases 307 The National Income Identity for a Closed Economy 307 An Imaginary Closed Economy 308 Implications for National Saving ' National Income Accounting for an Open Economy 309 The National Income Identity for an Open Economy 309 The Current Account and Foreign Indebtedness 311 Saving and the Current Account 312 Private and Government Saving 313 CASE STUDY: Do Government Budget Deficits Worsen the Current Account? 314 The Balance of Payment Accounts 317 The Current Account, Once Again 318 The Capital Account 320 The Statistical Discrepancy 321 Official Reserve Transactions 321 BOX: The'Mystery of the Missing Surplus 322 CASE STUDY: Is the United States the World's Biggest Debtor? 325 Summary 327

9 xiv Contents 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 332 Exchange Rates and International Transactions 333 Domestic and Foreign Prices 333 Exchange Rates and Relative Prices 336 The Foreign Exchange Market 337 The Actors 337 BOX: Making the Most of a Cheap Dollar 338 Characteristics of the Market 340 Spot Rates and Forward Rates 341 Foreign Exchange Swaps 343 Futures and Options 343 BOX: How Multinationals Manage Their Foreign Exchange Risks 341 The Demand for Foreign Currency Assets 344 Assets and Asset Returns 345 Risk and Liquidity 347 Interest Rates 347 Exchange Rates and Asset Returns 348 A Simple Rule 349 Return, Risk, and Liquidity in the Foreign Exchange Market 351 Equilibrium in the Foreign Exchange Market 352 Interest Parity: The Basic Equilibrium Condition 352 How Changes in the Current Exchange Rate Affect Expected Returns 353 The Equilibrium Exchange Rate 356 Interest Rates, Expectations, and Equilibrium 357 The Effect of Changing Interest Rates on the Current Exchange Rate 357 BOX: The Perils of Forecasting Exchange Rates 359 The Effect of Changing Expectations on the Current Exchange Rate 360 Summary 360 APPENDIX: Forward Exchange Rates and Covered Interest Parity 365 / 15 Money, Jnterest Rates, and Exchange Rates 368 } Money Defined: A Brief Review 369 Money as a Medium of Exchange 369 j. Money as a Unit of Account 369 «Money as a Store of Value 370 What Is Money? 370 How the Money Supply Is Determined 370 The Demand for Money by Individuals 371 Expected Return 371 Risk 372 Liquidity 372, Aggregate Money Demand 372 I The Equilibrium Interest Rate: The Interaction of Money Supply and Demand 374 Equilibrium in the Money Market 374 Interest Rates and the Money Supply 376 Output and the Interest Rate 377

10 Contents xv The Money Supply and the Exchange Rate in the Short Run 378 Linking Money, the Interest Rate, and the Exchange Rate 379 U.S. Money Supply and the Dollar/DM Exchange Rate 381 German Money Supply and the Dollar/DM Exchange Rate 382 Money, the Price Level, and the Exchange Rate in the Long Run 383 Money and Money Prices 384 The Lbng-Run Effects of Money Supply Changes 385 Empirical Evidence on Money Supplies and Price Levels 386 BOX: Money as a Weapon of War 387 Money and the Exchange Rate in the Long Run 388 Inflation and Exchange Rate Dynamics 388 Short-Run Price Rigidity versus Long-Run Price Flexibility 389 BOX: Money Supply Growth and Hyperinflation in Bolivia 390 Permanent Money Supply Changes and the Exchange Rate 392 Exchange Rate Overshooting 395 Summary Price Levels and the Exchange Rate in the Long Run 398 The Law of One Price 399 Purchasing Power Parity 400 The Relationship BetweenPPP and the Law of One Price 400 Absolute PPP and Relative PPP 401 A Long-Run Exchange Rate Model Based on PPP 402 The Fundamental Equation of the Monetary Approach 402 Ongoing Inflation, Interest Parity, and PPP 404 The Fisher Effect 405 Empirical Evidence on PPP and the Law of One Price 408 BOX: Some Meaty Evidence on the Law of One Price 412 Explaining the Problems with PPP 414 Trade Barriers and Nontradables 414 Departures from Free Competition,415 International Differences in Price Level Measurement 416 PPP in the Short Run and in the Long Run 416 CASE STUDY: Why Price Levels Are Lower in Poorer Countries 417 Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates 419 The Real Exchange Rate 419 Demand, Supply, and the Long-Run Real Exchange Rate 421 BOX: Productivity Growth and the Real Dollar/Yen Exchange Rate 422 Nominal and Real Exchange Rates in Long-Run Equilibrium 424 International Interest Rate Differences and the Real Exchange Rate 427 Real Interest Parity 428 Summary Output/and the Exchange Rate in the Short Run 435 Determinants of Aggregate Demand in an Open Economy 436 Determinants of Consumption Demand 436 Determinants of the Current Account 437

11 xvi Contents How Real Exchange Rate Changes Affect the Current Account 438 How Disposable Income Changes Affect the Current Account 438 The Equation of Aggregate Demand 439 The Real Exchange Rate and Aggregate Demand 439 Real Income and Aggregate Demand 439 How. Output Is Determined in the Short Run 440 Output Market Equilibrium in the Short Run: The DD Schedule 441 Output, the Exchange Rate, and Output Market Equilibrium 442 Deriving the DD Schedule 443 Factors That Shift the DD Schedule 443 Asset Market Equilibrium in the Short Run: The AA Schedule 446 Output, the Exchange Rate, and Asset Market Equilibrium 447 Deriving the AA Schedule 448 Factors That Shift the AA Schedule 449 Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together 450 Temporary Changes in Monetary and Fiscal Policy 451 Monetary Policy 452 Fiscal Policy 453 ^ Policiefto Maintain Full Employment 454 Some Problems of Policy Formulation 455 Permanent Shifts in Monetary and Fiscal Policy 456 A Permanent Increase in the Money Supply 456 Adjustment to a Permanent Increase in the Money Supply 457 A Permanent Fiscal Expansion 458 Macroeconomic Policies and the Current Account 460 CASE STUDY: U.S. Monetary and Fiscal Policy in Action, Gradual Trade Flow Adjustment and Current Account Dynamics 464 The J-Curve 464 The Beachhead Effect 466 Exchange Rate Pass-Through and Inflation 466 Summary 467 j APPENDIX I: The IS-LM Model and the DD-AA Model 472 APPENDIX II: The Marshall-Lerner Condition and Empirical Estimates of Trade Elasticities 476 ^ 18 Fixed Exchange Rates and Foreign Exchange Intervention 479 Why Study Fixed Exchange Rates? 480 Central Bank Intervention and the Money Supply 481 The Central Bank Balance Sheet 481 The Central Bank Balance Sheet and the Money Supply 482 Foreign Exchange Intervention and the Money Supply 483 Sterilization 484 l The Balance of Payments and the Money Supply 485 How the Central Bank Fixes the Exchange Rate 486 Foreign Exchange Market Equilibrium under a Fixed Exchange Rate 486

12 Contents xvii Money Market Equilibrium under a Fixed Exchange Rate 486 A Diagrammatic Analysis 487 Stabilization Policies with a Fixed Exchange Rate 489 Monetary Policy 489 Fiscal Policy 491 Changes in the Exchange Rate 492 Adjustment to Fiscal Policy and Exchange Rate Changes 493 Balance of Payments Crises and Capital Flight 494 Managed Floating and Sterilized Intervention 496 Perfect Asset Substitutability and the Ineffectiveness of Sterilized Intervention 497 Foreign-Exchange Market Equilibrium under Imperfect Asset Substitutability 498 The Effects of Sterilized Intervention with Imperfect Asset Substitutability 499 Evidence on the Effects of Sterilized Intervention 500 The Signaling Effect of Intervention 501 Reserve Currencies in the World Monetary System 501 The Mechanics of a Reserve Currency Standard 502 BOX: Games Governments Play 503 The Asymmetric Position of the Reserve Center 503 The Gold Standard 504 The Mechajiks of a Gold Standard 504 Symmetric Monetary Adjustment under a Gold Standard 505 BOX: Intervention Arrangements in the European Monetary System 506 Benefits and Drawbacks of the Gold Standard 506 The Gold Exchange Standard 508 Summary 508 / ^ APPENDIX I: Equilibrium in the Foreign Exchange Market with Imperfect Asset Substitutability 513 ' Demand 513 Supply 514 Equilibrium 514 APPENDIX II: The Monetary Approach to the Balance of Payments 516 APPENDIX III: The Timing of Balance of Payments Crises 518 / PART FOUR I INTERNATIONAL MACROECONOMIC POLICY The International Monetary System, Macroeconomic Policy Goals in an Open Economy 524 Internal Balance: Full Employment and Price Level Stability 524 External Balance: The Optimal Level of the Current Account 525 International Macroeconomic Policy under the Gold Standard, Origins of the Gold Standard 528 i External Balance under the Gold Standard 529 ' The Price"-Specie-Flow Mechanism 529 The Gold Standard "Rules of the Game": Myth and Reality 531 Internal Balance under the Gold Standard 531

13 xviii Contents BOX: Hume versus the Mercantilists 532 The Interwar Years, The German Hyperinflation 533 The Fleeting Return to Gold 533 International Economic Disintegration 534 The Bretton Woods System and the International Monetary Fund 535 Goals and Structures of the IMF 536 Convertibility, 537 Internal and External Balance under the Bretton Woods System 538 The Changing Meaning of External Balance 538 Speculative Capital Flows and Crises 539 Analyzing Policy Options under the Bretton Woods System 540 Maintaining Internal Balance 541 Maintaining External Balance 541 Expenditure-Changing and Expenditure-Switching Policies 542 The External Balance Problem of the United States 544 CASE STUDY: The Decline and Fall of the Bretton Woods System 546 The Calm before the Storm: The Vietnam Military Buildup and the Great Society: From-iHe Gold Crisis to the Collapse: 1968 T Worldwide Inflation and the Transition to Floating Rates 550 Summary 554 ' ' " ' ^\ 20 Macroeconomic Policy and Coordination Under Floating Exchange Rates 558 The Case for Floating Exchange Rates ' 559 Monetary Poliqy Autonomy 559 Symmetry 560 Exchange Rates as Automatic Stabilizers 561 The Case against Floating Exchange Rates 563 Discipline 564 / Destabilizing Speculation and Money Market Disturbances 564 Injury'to International Trade and Investment 565» Uncoordinated Economic Policies 566 The Illusion of Greater Autonomy 566 ^CASE STUDY: Exchange Rate Experience between the Oil Shocks, The First Oil Shock and Its Effects, ~" Rambouillet and Jamaica: Revising the IMF's Charter, The Weak Dollar, The Second Oil Shock, A Two-Country Model of Macroeconomic Interdependence under a Floating Rate 574 CASE STUDY: Disinflation, Recovery, and Global Slump, Disinflation and the Recession 577 \ Fiscal Policies, the Current Account, and the Resurgence of Protectionism 579! From the Plaza to the Louvre and Beyond: Trying to Manage Exchange Rates 582 Global Slump Once Again 584 What Has Been Learned Since 1973? 586 Monetary Policy Autonomy 586

14 Contents xix Symmetry 588 The Exchange Rate as an Automatic Stabilizer 589 Discipline 590 Destabilizing Speculation 590 International Trade and Investment 591 Policy Coordination 592 Directions for Reform 593 Summary 593 APPENDIX: International Policy Coordination Failures Optimum Currency Areas and the European Experience 600 Why Has Europe Favored Mutually Fixed Exchange Rates? 601 European Currency Reform Initiatives, The European Monetary System: From 1979 to the Present 603 German Monetary Dominance and Credibility Theory of the EMS 606 BOX: The EMS Currency Grid 608 Problems with Germany's Dominant Position 609 The EC "1 92" Initiative 610 " The Theory of Optimum Currency Areas 611 Economic Integration and the Benefits of a Fixed Exchange Rate Area: The GG Schedule 611 Economic Integration and the Costs of a Fixed Exchange Rate Area: The LL Schedule 611 The Decision to Join a Currency Area: Putting the GG and LL Schedules Together 615 What is an Optimum Currency Area? 617 CASE STUDY: Is Europe an Optimum Currency Area? 617 The Extent of Intra-European Trade 618 How Mobile is Europe's Labor Force? 618 Other Considerations 619 BOX: Can Europe Learn Lessons from America's Fiscal Federalism? 620 Summing Up 621 European Monetary Union 622 '* CASE STUDY: How European Macroeconomic Tensions Helped Derail Maastricht 623 German Reunification 624 Public Opinion and the Maastricht Treaty 625 Black Wednesday 626 Continuing Crisis 626 Summary 627 APPENDIX: How German Reunification May Have Deepened the European Recession of the Early 1990s The Global Capital Market: Performance and Policy Problems 634 The International Capital Market and the Gains from Trade 635 Three Types of Gain from Trade 635

15 xx Contents Risk Aversion 636 Portfolio Diversification as a Motive for International Asset Trade 637 The Menu of International Assets: Debt versus Equity 638 International Banking and the International Capital Market 639 The Structure of the International Capital Market 639 Offshore Banking and Offshore Currency Trading 640 Eurodollars and Other Eurocurrencies 642 How Big Is the Eurocurrency Market? 642 How Eurocurrencies Are Created 643 The Growth of Eurocurrency Trading 646 The Importance of Regulatory Asymmetries 647 Eurocurrencies and Macroeconomic Stability 649 BOX: Of Samurai and Sushi: Opening Japan's Financial Markets 651 Regulating International Banking 652 The Problem of Bank Failure 652 Difficulties in Regulating International Banking 654 International Regulatory Cooperation 655 BOX: The Banco Ambrosiano Collapse 656 CASE STUDY: The BCCI Affair 657 How Well Has the International Capital Market Performed? 658 The Extent of International Portfolio Diversification 659 The Extent of Intertemporal Trade 660 Onshore-Offshore Interest Differentials 660 The Efficiency of the Foreign Exchange Market 661.Summary Developing Countries: Debt, Stabilization, and Reform 670 Income and Wealth in the World Economy 671 Macroeconomic Features of Developing Countries 671 Undeveloped Financial Markets t 672 Government's Pervasive Role /673 Inflation-and the Government Budget 674 Pegged Exchange Rates, Exchange Controls, and Inconvertible Currencies 674 BOX: How Important Is Seigniorage? 676 _ The Structure of Developing Country Exports 677 Developing Country Borrowing and Debt 678 ' The Economics of Borrowing by Developing Countries 678 Alternative Forms of Capital Inflow 679 Government and Publicly Guaranteed Borrowing 680 CASE STUDY: Orthodox and Heterodox Stabilization Programs in Latin America 681 Developing Country Borrowing in Historical Perspective 683 Capital Flows to Developing Countries before The Interwar Period and Its Aftermathf Borrowing after 1973: Oil Shocks and Floating Interest Rates BOX: The Paris Club 687 Origins of the Developing Country Debt Crisis 689 Leading up to the Crisis 689

16 Contents xxi Developing Countries in the Worldwide Recession 691 Mexico: The Beginning of the Crisis 692 The Debt Crisis in Other Countries 693 The Economics of Sovereign Default 694 The Costs of Sovereign Default 694 The Benefit of Sovereign Default 695 When^Does a Debtor Choose to Default? 696 Managing the Debt Crisis 696 The First Phase: Concerted Lending 697 The Role of the IMF 698 The Second Phase: Trying to Muddle Through 698 BOX: Debts of the Eastern Bloc 699 The Brady Plan 701 Market-Based Debt Reduction 703 Third-Party Buybacks 703 Debt Forgiveness 704 Is the Debt Crisis Over? 704 The Effects of the Brady Plan 705 Renewed Capital Inflows 705 The Road Ahead 706 Summary International Economic Problems of Former Communist Countries 711 Trade in Eastern Europe before CMEA Trade under Communism 712 The Management of Trade within the Soviet Union 716 The Management of Trade among CMEA Nations 717 The Adjustment Problem in Eastern Europe 718 The Decline in Intra-CMEA Exports, 719 The Terms of Trade Shock 720 / How SevercWas the Shock? 721 Policy Options 722 y The Case for Policy Coordination 723 The Coordination Problem in the Soviet Union 725 Priclfe Controls, Central Planning, and Interregional Trade 725 Monetary Problems within the Former Soviet Union 728 Prospects for the Former Communist Countries 729 Summary 730 Mathematical Postscripts 735 Postscript^ Chapter 3: THE SPECIFIC FACTORS MODEL 737 Factor Prices, Costs, and Factor Demands 737 Factor Price Determination in the Specific Factors Model 739 Effects of a Change in Relative Prices 741

17 xxii Contents Postscript to Chapter 4: THE FACTOR-PROPORTIONS MODEL 742 The Basic Equations in the Factor-Proportions Model 742 Goods Prices and Factor Prices 743 Factor Supplies and Outputs 743 Postscript to Chapter 5: THE TRADING WORLD ECONOMY 744 Supply, Demand, and Equilibrium 744 World Equilibrium 744 Production and Income 744 Income, Prices, and Utility 745 Supply, Demand, and the Stability of Equilibrium 746 Effects of Changes in Supply and Demand 748 The Method of'comparative Statics 748 Economic Growth 748 The Transfer Problem 750 A Tariff 750 Postscript to Chapter 6: THE MONOPOLISTIC COMPETITION MODEL 752 Postscript to Chapter 22: RISK AVERSION AND INTERNATIONAL PORTFOLIO DIVERSIFICATION 754 An Analytical Derivation of the Optimal Portfolio 754 A DiagtfaThmatic Derivation of the Optimal Portfolio 755 The Effects of Changing Rates of Return 758 Index 763- At I '.