International Economics

Chapter 1
Taught by
CHAN BONNIVOIT
McGraw-Hill/Irwin
The World of
International
Economics
Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Introduction
International trade and finance
have never been more important.
Signs of globalization are
everywhere.
1-2
International Trade:
Questions
Well explore these questions:
What are the effects of trade?
What determines the basis of trade?
What determines the value and volume
of trade?
What factors impede the flow of trade?
What happens when policies impede
the flow of trade?
1-3
International Monetary
Economics: Questions
Well explore these questions:
What is a countrys balance of
payments?
How are exchange rates determined?
What makes capital flow between
countries?
What policies should countries pursue?
1-4
The Nature of
Merchandise Trade
The volume and value of world
exports have grown tremendously.
The value of global exports was
$15.8 trillion in 2008; it was $2
trillion in 1985.
Over the past 40 years, global trade
has grown faster than global
production.
1-5
Growth in World Production and Trade, 1963-2007 (average annual

percentage change in volume)
1963-73
Production
All commodities
Agriculture
Mining
Manufacturing
Exports
All commodities
Agriculture
Mining
Manufacturing
1970-79
1980-85
2000-07
6.0%
2.5
5.5
7.5
4.0%
2.0
2.5
4.5
1.7%
2.9
-2.7
2.3
3.0%
2.5
1.5
3.0
9.0%
14.0
7.5
11.5
5.0%
4.5
1.5
7.0
2.1%
1.0
-2.7
4.5
5.5%
4.0
3.5
6.5
1-6
Geographical Composition
of Trade
North America, Europe, and Asia
dominate global exporting and
importing.
These regions tend to trade with
other countries in the same region.
1-7
Merchandise Exports and Imports by Region, 2007 (billions of dollars)

Value of Exports
North America
$1,853.5
South and Central America
499.2
Europe
5,772.2
Commonwealth of Indep. States
510.3
Africa
424.1
Middle East
759.9
Asia
4,131.0
World
$13,950.0
Share
Value of Imports
Share
13.3%
3.6
41.4
3.7
3.0
5.4
29.6
2,707.5
456.0
6,060.8
377.6
358.9
479.3
3,804.3
19.0%
3.2
42.5
2.7
2.5
3.4
26.7
100.0%
$14,244.0
100.0%
1-8
Top 10 Merchandise Exporters, 2007

Value
$, billions,
Country
Germany
China
United States
Japan
France
Netherlands
Italy
United Kingdom
Belgium
Canada
$1,326.4
1,217.8
1,162.5
712.8
553.4
551.3
491.5
437.8
430.8
419.0
Percentage
Share
9.5%
8.7
8.3
5.1
4.0
4.0
3.5
3.1
3.1
3.0
1-9
Top 10 Merchandise Importers, 2007

Value
$, billions,
Country
United States
Germany
China
Japan
United Kingdom
France
Italy
Netherlands
Belgium
Canada
$2,020.4
1,058.6
956.0
621.1
619.6
615.2
504.5
491.6
413.2
389.6
Percentage
Share
14.2%
7.4
6.7
4.4
4.4
4.3
3.5
3.5
2.9
2.7
1-10
Regional Structure of Exports, 2007
N. America
So. And C.
America
Europe
CIS
Africa
Middle East
Asia
N.
America
South
and
Central
America
Europe
CIS
Africa Middle
East
Asia
Total
51.3%
30.3%
7.0%
24.4%
17.7%
21.2%
0.7%
1.3%
1.5%
2.7%
2.7%
1.8%
19.0% 100%
16.1% 100%
7.9%
4.6%
21.7%
11.0%
19.9%
1.4%
1.3%
3.4%
0.6%
2.4%
73.5%
56.3%
39.5%
14.3%
18.8%
3.3%
20.2%
0.2%
0.6%
2.1%
2.6%
1.3%
9.5%
3.6%
2.4%
2.6%
3.2%
2.5%
12.3%
4.0%
7.5%
11.7%
19.1%
52.3%
49.7%
100%
100%
100%
100%
100%
1-11
Commodity Composition
of Trade
Manufactures comprise 69.8% of
trade, with agricultural and miningrelated products making up the
balance.
1-12
Composition of World Merchandise Exports

(billions of U.S. $)
Product Category
Agricultural Products
Mining Products
Manufactures
Value in Share in Share in

2007
2007
1980
$1,128
$2,659
$9,500
8.3%
19.5%
69.8%
14.7%
27.7%
53.9%
1-13
Trade and the U.S.

The U.S. trades the most with our
NAFTA partners (Canada and
Mexico), followed by the European
Union.
Trade with Asia is also very
important. China is the second
largest trading partner of the
United States.
1-14
U.S. Merchandise Trade by Area and Country, 2007

(millions of dollars and %)
Exports to
value
share
Region or Country
European Union
Europe, non-EU
Canada
Mexico
Latin America (not
Mexico)
China
Japan
Other Asia
Middle East
Africa
Total
$242,244
38,601
249,712
135,962
107,101
24.5%
3.4%
21.7%
11.8%
9.3%
Imports From
value
share
$356,180
54,999
320,323
213,552
134,826
20.9%
2.8%
16.3%
10.9%
6.9%
65,073
5.7%
321,685
60,898
5.3%
146,037
182,277 15.9%
250,840
43,646
3.8%
77,405
22,966
2.0%
92,055
1,148,481 100.0% 1,967,853
16.3%
7.4%
12.7%
3.9%
4.7%
100.0%
1-15
Commodity Composition
of U.S. Trade
The U.S. tends to export capital
goods and industrial supplies.
The U.S. tends to import consumer
goods and industrial supplies.
1-16
Commodity Composition of U.S. Trade, 2007

(billions of dollars and %)
Exports to
value
share
Foods, feeds, beverages
Industrial supplies/materials
Capital goods (non-auto)
Automotive
Consumer goods
Other goods
Total
$84.3
7.3%
27.5%
316.4
447.4
39.0%
121.0
10.5%
146.1
12.7%
33.3
2.9%
1,148.5 100.0%
Imports From
value
share
$81.7
639.4
444.5
258.9
478.5
64.9
1,967.9
4.2%
32.5%
22.6%
13.2%
24.3%
3.3%
100.0%
1-17
Trade in Services
Over $3 trillion annually (2007).
About 20% of total trade (closer to
30% for U.S.).
1-18
Leading Exporters of
Commercial Services, 2007
Country
Value
(billions of $)
Share
$456.4
13.9%
United Kingdom
273.0
8.3%
Germany
205.8
6.3%
France
136.7
4.2%
Spain
128.3
3.9%
Japan
127.1
3.9%
China
121.7
3.7%
Italy
110.5
3.4%
India
89.7
2.7%
Ireland
89.0
2.7%
U.S.
1-19
Leading Importers of
Commercial Services, 2007
Country
Value (billions
of $)
Share
$335.9
10.9%
Germany
250.5
8.1%
United Kingdom
194.1
6.3%
Japan
148.7
4.8%
China
129.3
4.2%
France
124.1
4.0%
Italy
118.3
3.8%
Spain
98.4
3.2%
Ireland
94.5
3.1%
Netherlands
86.8
2.8%
U.S.
1-20
The Changing Degree on

Economic
Interdependence
The relative importance of trade
has grown for most countries.
The relative importance of trade for
all countries together has also
grown.
1-21
International Interdependence for Selected Countries and Groups of

Countries, 1970 2007 (exports as a % of GDP)
1970 2007
Industrialized Countries:
Australia
Belgium
Canada
France
Germany
Italy
Japan
Netherlands
United Kingdom
United States
Developing Countries:
Argentina
Chile
China
Czech Republic
India
Kenya
Mexico
Nigeria
14%
52%
23%
16%
NA
16%
11%
42%
23%
6%
21%
89%
36%
27%
47%
29%
16%
75%
26%
11%
9%
15%
3%
NA
4%
30%
6%
8%
25%
47%
42%
80%
21%
26%
28%
40%
1-22
Chapter 2
Taught by
CHAN BONNIVOIT
Early Trade
Theories:
Mercantilism and the
Transition to the
Classical World of
David Ricardo
McGraw-Hill/Irwin
Learning Objectives
Describe Mercantilist concepts and
policies.
Examine Humes price-specie flow
mechanism and its challenge to
Mercantilist thought.
Discuss Smiths ideas of wealth and
absolute advantage as foundations
of international trade.
2-2
Mercantilism
A collection of economic thought in
Europe during the period between
1500 and 1750.
Mercantilism is often called the
political economy of state building.
2-3
The Mercantilist
Economic System
A countrys wealth is measured by
its holdings of precious metals
(specie).
International trade is a zero sum
game.
A country should maintain a
positive trade balance (that is,
export more than it imports).
Mercantilism employed the labor
theory of value.
2-4
The Role of Government

Bullionism
Substantial regulation of the
domestic economy, including
governmental granting of monopolies,
and
controls of labor through craft guilds.
2-5
The Role of Government

Policies to ensure low wages,
including
policies to discourage importation and
encourage exportation, and
policies to discourage exportation of
specie.
2-6
The Paradox of
Mercantilism
To be rich, a country needed to have
a lot of poor people!
2-7
The Challenge to
Mercantilism by Early
Classical Writers
In the early 1700s, questions began
to emerge regarding the logic of
mercantilism.
2-8
Humes Challenge: the

Price-Specie Flow
Mechanism
Hume (mid-18th century): maintaining
a trade surplus forever is impossible.
Trade surplus inflow of specie
inflow of specie increased Ms
increased Ms higher prices (and
wages)
higher prices lower exports and
higher imports
2-9
Smiths Challenge:
Absolute Advantage
Smith believed trade to be a
positive-sum game.
Countries should export those
goods which they can produce
efficiently, and import those which
they cannot.
If countries trade according to this
principle, all will gain from trade
(trade will be mutually beneficial).
2-10
Absolute Advantage: An
Example
Corn
U.S.
Blankets
1 hour/bu 6 hrs/bl
Mexico 3 hrs/bu
5 hrs/bl
Autarky Price
Ratios (APRs)
1B = 6C,
1C = 1/6B
1B = 5/3C,
1C = 3/5B
2-11
Example
Suppose the U.S. and Mexico agree to
trade at a ratio of 1B = 4C (or 1C =
B).
Suppose further that Mexico will
specialize in blankets and the U.S. in
corn.
From the U.S.s perspective:
Can now buy blankets at a lower price
(1B = 6C in autarky, but 1B = 4C in trade).
Can sell corn at a higher price (1C = 1/6 B
in autarky, but 1C = B in trade).
2-12
Example
From Mexicos perspective:
Can now sell blankets at a higher price
(1B = 5/3C in autarky, but 1B = 4C in
trade).
Can buy corn at a lower price (1C = 3/5 B
in autarky, but 1C = B in trade).
2-13
Example
Bottom line: both countries gain
from trade, even if certain
industries (blanket industry in U.S.,
corn industry in Mexico) stand to
lose.
2-14
Limits to Smiths Thinking

If one country has an absolute
advantage in the production of both
(or all) goods, Smith would say that
that country cannot gain from
trade.
2-15
Absolute Advantage: The

Corn
U.S.
Blankets
1 hour/bu 5 hrs/bl
Mexico 3 hrs/bu
6 hrs/bl
Autarky Price
Ratios (APRs)
1B = 5C,
1C = 1/5B
1B = 2C,
1C = 1/2B
2-16

If one country has an absolute
advantage in the production of both
(or all) goods, Smith would say that
that country cannot gain from
trade.
But David Ricardos Principle of
Comparative Advantage (1817) took
Smiths work farther: even in the
above example, trade can be
mutually beneficial!
2-17
Chapter 3
Taught by
CHAN BONNIVOIT
McGraw-Hill/Irwin
The Classical
World of David
Ricardo and
Comparative
Advantage
Learning Objectives
Explain comparative advantage as
the basis of trade.
Identify the difference between
absolute and comparative
advantage.
Calculate gains from trade in a 2x2
model.
Illustrate comparative advantage
using production possibility
frontiers.
3-2
Assumptions of the
Ricardian Model
A 2-country, 2-commodity world

Perfect competition
No transportation costs
Factors mobile internally, immobile
internationally
Constant costs of production
Fixed technology for each country
All resources are fully employed
The labor theory of value holds
3-3
Notation
Let:
ax = labor time to produce 1 X in
country A
ay = labor time to produce 1 Y in
country A
bx = labor time to produce 1 X in
country B
by = labor time to produce 1 Y in
country B
3-4
Comparative Advantage
Defined
Country A has a comparative
advantage in good X if:
(Px/Py)A < (Px/Py)B OR if
ax/ay < bx/by OR if
ax/bx < ay/by
If country A has a comparative
advantage in good X, country B must
have a comparative advantage in
good Y.
3-5
Comparative Advantage:
An Example
Corn (X)
U.S. (A)
Blankets (Y)
1 hour/bu 5 hrs/bl
Mexico (B) 3 hrs/bu
6 hrs/bl
Autarky Price
Ratios (APRs)
1B = 5C,
1C = 1/5B
1B = 2C,
1C = 1/2B
3-6
Since the U.S.s APR for corn is
lower than Mexicos (1/5 < 1/2), the
U.S. must have a comparative
advantage in corn.
Since Mexicos APR for blankets is
lower than the U.S.s (2 < 5),
Mexico must have a comparative
advantage in blankets.
3-7
and the Total Gains from
Trade
Ricardos argument is that trade

will be mutually advantageous as
long as the two countries autarky
price ratios are different.
How do we know that this is true?
3-8
and the Total Gains from
Trade
The Production Possibilities

Frontier (PPF) is the set of all
combinations of goods that a
country is capable of producing,
given available technology and
resources.
Suppose in our example the U.S.
has 1000 hours of labor available
and Mexico has 1800.
3-9
U.S. Production
Possibilities
Corn
1000
Slope: rise/run = -1000/200 = -5
A
500
100
200
Blankets
3-10
Slope of the PPF

for this example, -5
Notice: the slope (in absolute
value) is the APR of the good on the
horizontal axis.
Therefore, the slope is the
opportunity cost of the good on the
horizontal axis.
The slope is also the marginal rate
of transformation.
3-11
Mexicos Production
Possibilities
Corn
600
Slope = -2,
or the opportunity cost of blankets
300
Blankets
3-12
Classical Model: The

Gains from Trade
Suppose that in autarky, the U.S. is
at point A, producing and
consuming 500 corn and 100
blankets.
Suppose that in autarky, Mexico is
at point B, producing and
consuming 300 corn and 150
blankets.
3-13
U.S. Production
Possibilities
Corn
1000
A
500
100
200
Blankets
3-14
Mexicos Production
Possibilities
Corn
600
300
150
300
Blankets
3-15
Classical Model: The

Gains from Trade
Suppose now that the U.S. and
Mexico agree to trade at an
exchange rate of 1B = 3.33C (or,
1C = .3B).
If the U.S. specializes in corn, how
many units of corn could it produce?
1000.
If Mexico specializes in blanket
manufacture, how many blankets
could be made? 300.
3-16
The Gains from Trade:

U.S.
If the U.S. wants to continue to

consume 500C, they will now have
500C to trade for blankets.
If the exchange rate is 1B = 3.33C
(or, 1C = .3B), how many blankets can
the U.S. get in exchange for 500C?
150
Therefore, the U.S. can consume
outside its PPF (to point C) by
trading!
3-17
U.S. Production
Possibilities
Corn
1000
500
100 150 200
Blankets
3-18
The Gains from Trade:

Mexico
If Mexico wants to continue to
consume 150B, they will now have
150B to trade for corn.
If the exchange rate is 1B = 3.33C
(or, 1C = .3B), how much corn can
Mexico get in exchange for 150B?
500
Therefore, Mexico can also move
outside its PPF (to point D) by
trading!
3-19
Mexicos Production
Possibilities
Corn
600
500
300
150
300
Blankets
3-20
The Gains from Trade

Note: In general, the Ricardian
model results in complete
specialization.
However, in trade between a small
and a large country the small
country may not be able to produce
enough to satisfy the large country;
the large country might then
partially specialize.
3-21
The Consumption
Possibilities Frontier
(CPF)
The CPF is a collection of points that
represent combinations of corn and
blankets that a country can consume
if it trades.
3-22
U.S. Consumption
Possibilities
Corn
1000
500
CPF
100 150 200
300
Blankets
3-23
The Consumption
Possibilities Frontier
(CPF)
The CPFs slope is the same as the
terms of trade.
The CPF pivots around the
production point.
If trade is to the benefit of a country,
the CPF lies outside the PPF.
3-24
Mexicos Consumption
Possibilities
1000
CPF
Corn
600
D
500
300
B
150
300
Blankets
3-25
The Limits to Mutually

Advantageous Trade
Exchange rate must be at least
as great as Mexicos APR.
Exchange rate must be no greater
than the U.S.s APR.
Bottom line: we still dont know
how the terms of trade will be
determined, but they must be
between the countries APRs if
trade is to be mutually beneficial.
3-26
The CPF and Small

Countries
The nearer are the terms of trade to
a countrys APR, the less that
country will gain from trade.
The farther away the terms of trade
are from a countrys APR, the more
that country will gain from trade.
Moral: to Ricardo, small countries
stand to gain a lot from trade, large
countries gain less.
3-27
Chapter 4
Taught by
CHAN BONNIVOIT
McGraw-Hill/Irwin
The Basis for

Trade: Factor
Endowments
and the
HeckscherOhlin Model
Learning Objectives
Examine how relative factor
endowments affect relative factor
prices.
Demonstrate how different relative
factor prices generate a basis for
trade.
Describe how trade affects relative
factor prices and income distribution.
Analyze how real-world phenomena
can modify Heckscher-Ohlin
conclusions.
8-2
Heckscher-Ohlin In
General
Heckscher, and his student Ohlin,
worked in the early part of the 20th
century.
Paul Samuelson refined their work
after WWII.
Closer attention is paid in this
model to each countrys resource
endowment.
8-3
The Hecksher-Ohline Theory
Eli Hecksher laid out the basic fundamentals of the

model of the patterns and determinants of international
trade in a paper first published in 1919.
This paper was written in Swedish and was not

translated into English for almost 30 years.
An English translation of this paper entitled the Effect

of Foreign Trade on the Distribution of Income
appears in Howard S. Ellies and Lloyd A. Metzler,
Reading in International Trade, Philadelphia: The
Blakiston Co., 1949.
8-4
The Hecksher-Ohlin (HO) Theory
Heckshers pupil, Ohlin, elaborated on the ideas

of Hecksher in his 1924 doctoral dissertation
(also in Swedish) and later in a book published
in English by Harward University in 1933.
Ohlins book is titled

international trade, in
University Press, 1933.
Ohlin has got the Nobel Price of Economic in

1977.
Interregional und
Boston: Harward
8-5
H-O-S Assumptions
2 countries
2 commodities
2 factors (labor and capital)
Perfect competition exists in all
markets.
Each countrys endowment of
factors is fixed.
Factors are mobile internally, but
immobile internationally.
8-6
H-O-S Assumptions
(contd)
Each producer has a wide range of options
as to how to produce X or Y
if K is cheap relative to labor, a
relatively capital-intensive method will
be adopted.
if K is expensive relative to labor, a
relatively labor-intensive method will be
adopted.
Each country has the same CRTS
technology.
Tastes and preferences are the same for
both countries.
8-7
Concepts and
Terminology
The capital-labor ratio for good X is simply
KX/LX, and for Y is KY/LY.
If KX/LX > KY/LY, production of good X is
capital intensive relative to production of
good Y.
For example, the amount of capital per
worker in the U.S. petroleum and coal
industry is $468,000.
The similar figure for apparel products is
$8,274.
Therefore, petroleum and coal is produced
in a relatively capital-intensive manner.
8-8
Concepts and
Terminology
Also, production of Y must be
relatively labor intensive (If KX/LX >
KY/LY, then LY/KY > LX/KX).
That is, clothing is produced in a
labor-intensive manner (as
compared to petroleum and coal).
8-9
The Hecksher-Ohlin (HO) Theory

Factor intensity, and factor endowments
e.g. Y = Cars and X = Textiles
K
L/K in Y = 2 or K/L in Y = 1/2
L/K in Y = 1/4 or K/L in Y = 4

8
L/K in X = 4 or K/L in X = 1/4 4
2
23
Country A (Mexico or China)
L/K in X = 2 or K/L in X = 1/2
1 2 3 4
Country B (US)
8-10
The Hecksher-Ohlin (HO)

Theory
PPF of both Countries base on assumption
Y = Cars
Y = Cars
X = Tex
Country A (Mexico or China)
X = Tex
Country B (US)
8-11

Theory
Taking PPF of both Countries into one panel

Car
(PC/PT) of US
PPF of US
Cars US
J
CIC0
Cars
Mexico
Tex US Tex Mexico

(c)
(PC/PT) of Mexico
PPF of Country Mexico
Tex
8-12
Relative Factor Intensities,

Selected Canadian Industries
(2006), in C$
Commodity
Petroleum and coal
Chemicals
Paper
Transportation equipment
Truck Transportation
Leather and products
Clothing
Capital per employee

$617,066
$144,029
$118,777
$92,315
$30,180
$12,573
$8,954
8-13
Concepts and
Terminology
Country A is said to be capital
abundant relative to Country B if
(K/L)A > (K/L)B.
For example, if the U.S. has a
capital stock of $4.8 trillion and a
labor force of 153 million, then K/L
is about $32,000.
K/L for Mexico works out to $328
billion/45 million = $7,282.
Therefore, the U.S. is K- abundant
relative to Mexico; Mexico is
relatively L-abundant.
8-14
Relative Factor
Endowments, Selected
Countries (2007), in U.S. $
Country
Japan
France
U.S.
Australia
Canada
Mexico
Capital per worker

$49,081
$31,810
$31,657
$30,792
$24,700
$7,282
8-15
Concepts and
Terminology
To summarize:
goods are produced relatively K
or L intensively.
countries are relatively K or L
abundant.
8-16
Concepts and
Terminology
The factor price of labor (the wage)
is denoted w.
The factor price of capital is
denoted r.
If labor is relatively expensive, w/r
will be a relatively big number.
If labor is relatively cheap, w/r will
be a relatively small number.
8-17
More on Factor Prices

What makes labor relatively
expensive?
If it is relatively scarce.
What makes labor relatively cheap?
If it is relatively abundant.
So: If (K/L)A is a relatively big
number (that is, capital is relatively
abundant), w/r will be a relatively big
number, reflecting the relative
scarcity of L and abundance of K.
8-18
A Review of Trade in the

Neoclassical Model
Suppose the U.S. is capital
abundant relative to Mexico.
This, of course, means that Mexico
is relatively labor abundant.
These differences affect the shape
of each countrys PPF.
Suppose that cars are produced rel.
K-intensively, and textiles labor
intensively.
8-19
Autarky in Mexico and the

U.S.
The relative price of textiles in
autarky is greater in the U.S. than
in Mexico.
That is, the U.S.s autarky price line
is steeper than Mexicos.
In symbols, (PT/PC)U.S. > (PT/PC)Mex.
This means that Mexico has the
comparative advantage in textiles.
8-20
Autarky in Mexico and the

U.S.
This also means that the relative
price of cars in autarky is lower in
the U.S. than in Mexico.
That is, (PC/PT)U.S. < (PC/PT)Mex.
This means that the U.S. has the
comparative advantage in cars.
8-21

Theory
PPF of both Countries base on assumption
Y =Car
Country Mexico (X)
Y = Car
X = Tex
Country US (Y)
X = Tex
8-22

Theory
Taking PPF of both Countries into one panel

Car
(PC/PT) of US
PPF of US
Cars US
J
CIC0
Cars
Mexico
Tex US Tex Mexico

(c)
(PC/PT) of Mexico
PPF of Country Mexico
Tex
8-23
Trade in the H-O Model

Cars
Y3
Y1
Mexico
Y5
C'
E
Y4
E'
Y2
X3X1
U.S.
Cars
e'
c'
Y6
X2 Textiles
X5 X4 X6
Textiles
8-24
The Result
The relatively capital abundant
country (U.S.) exports the relatively
capital intensive good (cars).
The relatively labor abundant
country (Mexico) exports the
relatively labor intensive good
(textiles).
8-25
The Heckscher-Ohlin
Theorem
A country will export the
commodity that uses relatively

intensively the factor that country
has in relative abundance.
A country will import the
commodity that uses relatively
intensively the factor that is
relatively scarce in that country.
8-26
The Source of
So it is a countrys relative factor
endowment that determines its
comparative advantage.
This is why the H-O-S model is also
called the factor proportions
theory.
8-27
Changes in Relative
Commodity Prices : Review
As we learned before,
(PT/PC)US falls as the U.S. moves
to trade. That is, the
international relative textile price
is lower than the U.S.s autarky
price.
(PT/PC)Mex rises as Mexico moves
to trade. That is, the international
relative textile price is higher
than Mexicos autarky price.
8-28
Changes in Factor Prices

In autarky, the K-intensive product
(cars) is less expensive to produce
in the U.S. as compared to Mexico.
This is because K is relatively
abundant in the U.S., which
makes the price of capital
relatively low.
As trade commences, r will rise
since demand for capital will rise.
8-29
Changes in Factor Prices

In autarky, the L-intensive product
(textiles) is more expensive to
produce in the U.S. as compared to
Mexico.
This is because L is relatively
scarce in the U.S., which makes
the price of labor relatively high.
As trade commences, w will fall
since demand for labor will fall.
8-30
Commodity and Factor

Prices In Trade: A Summary
In our example, (PT/PC)US falls as
trade commences.
(w/r)US also falls.
In Mexico, the opposite is
happening:
(PT/PC)Mex rises.
(w/r)Mex also rises.
Therefore relative commodity and
factor prices move together as trade
commences.
8-31
The Relative Cost Curve

PT/PC
(PT/PC)US
(PT/PC)Int
(PT/PC)Mex
Both relative commodity and

factor prices equalize in trade.
(w/r)Mex (w/r)Int (w/r)US
w/r
8-32
The Factor Price

Equalization Theorem
In equilibrium, with both countries
facing the same relative product
prices, relative costs will be
equalized. This can only happen if
relative factor prices are equalized
between countries.
8-33
H-O and the Distribution

of Income
The H-O theorem, together with the
FPE theorem, also tell us about how
the incomes of different groups
within a country change as trade
starts.
This provides insight into the
politics of free trade.
8-34
The Stolper-Samuelson
Theorem
As trade commences, the owners of
the relatively abundant factor will
find their real incomes rising; the
owners of the relatively scarce
factor will find their real incomes
falling.
8-35
H-O and the Distribution

of Income
According to the S-S theorem, if the
U.S. is a relatively K-abundant
country, who in America should
favor free trade?
Who in America should favor
protectionism?
8-36
Theoretical Qualifications
to H-O
Suppose we relax some of the
many assumptions. Will the
implications of the H-O-S
model still be the same?
8-37
Qualification #1: Demand

Reversal
Suppose we let demand conditions
differ.
Suppose domestic demand for the
good that uses relatively
intensively the relatively abundant
factor is very strong in each
country.
That is, suppose demand for cars is
very strong in the U.S., and that
demand for textiles is very strong
in Mexico.
8-38
Qualification #1: Demand

Reversal
Such strong demand makes the
autarky car price in the U.S. higher,
and the textile price in Mexico
higher.
In the extreme, demand reversal
could occur: (PC/PT)US > (PC/PT)Mex,
and
(PT/PC)US < (PT/PC)Mex
8-39
Bottom Line on Demand

Reversals
If demand reversals occur, the H-O
theorem no longer holds: the Kabundant country is exporting the
L-intensive good, and the Labundant country is exporting the
K-intensive good.
8-40
Qualification #2: Factor

Intensity Reversal
Implicitly, weve assumed that if
good X is K-intensive relative to
good Y at one factor price ratio, it
will be K-intensive at all factor
prices.
A FIR is when a good is relatively Kintensive at one set of factor
prices, but relatively labor intensive
at another.
8-41
Qualification #2: Factor

Intensity Reversal
FIRs occur when capital and labor
can be substituted more easily in
the production of one good than
another.
8-42
Factor Intensity Reversal:

Implications for Trade
Suppose France is K-abundant
relative to Germany (that is (K/L)F >
(K/L)G).
This means that (w/r)F > (w/r)G.
Suppose further that there is a FIR:
in France, at (w/r)F apples are
produced relatively K-intensively
but in Germany at (w/r)G apples are
produced in a relatively L-intensive
way.
8-43
Factor Intensity Reversal:

Implications for Trade
If trade begins, according to the HO theorem the relatively Kabundant country (France) will
export the rel. K-intensive good
(apples) and the rel. L-abundant
country will export the rel. Lintensive good (also apples).
H-O theorem breaks down.
8-44
Qualification #3:
Transportation Costs
In the real world, it is costly to
transport goods internationally.
How do the implications of our
model change if we allow for
transportation costs?
Consider the supply and demand
curves for textiles in Mexico and
the U.S.
8-45
Adding Transportation
Costs
Unless Mexico is the only seller in
the world, transportation costs will
be borne by both the consumer (the
U.S.) and the seller (Mexico).
How does this look on the graph?
8-46
Adding Transportation Costs

PT
U.S.
SText
PT
Mexico
SText
PIntl
t-costs
Exp.
PIntl
Imp.
DText
q1 q2
QT
DText
q1 q2
QT
8-47
Adding Transportation
Costs: the Bottom Line
In general, the H-O theorem will
still hold.
The FPE theorem breaks down,
since factor prices only equalize if
the commodity prices do.
Therefore, in the presence of
transportation costs, factor prices
have a tendency to move towards
each other, but we should not
expect equalization.
8-48
Relaxing Other
Assumptions
One can relax many other
assumptions and examine how the
implications of the model change:
perfect competition
CRTS
identical production technologies
lack of policy obstacles
factors being perfectly
transferable
8-49
Chapter 5
Taught by
CHAN BONNIVOIT PostHeckscher-
Ohlin Theories of
Trade and IntraIndustry Trade
McGraw-Hill/Irwin
Learning Objectives
Explain the basis of trade in
manufactures beyond HeckscherOhlin.
Discuss the roles of technology
dissemination, demand patterns,
and time in affecting trade.
Demonstrate how the presence of
imperfect competition can affect
trade.
Describe the phenomenon known
as intra-industry trade.
10-2
Vertical Specialization
Different stages of production
process may occur in different
countries.
If different parts of the production
process vary in terms of capital or
labor intensity, the production
process may be spread over
multiple countries.
10-3
Firm-Focused Theories
Stage theory: owners and managers
learn over time; this implies
exporting firms tend to be larger and
run by more experienced managers.
Resource-exchange theory: firms
internationalize because they cannot
generate all resources domestically.
Network theory: networking can
compensate for any lack of
experience or expertise.
10-4
The Linder Theory

In the H-O model, the pattern of
trade is determined by relative
resource endowments.
A model by Linder (1961) focuses
mainly on the demand side.
Basic idea is that a country
produces stuff to satisfy domestic
demand; these goods will be likely
exports (and imports, too).
10-5
The Linder Theory: An

Example
Suppose Country Is income pattern
is such that it produces goods A, B,
C, D and E.
Let Country I have a relatively low
per capita income level.
Suppose these goods are in
ascending order of sophistication:
A and B are fairly simple.
C, D, and E are slightly more
sophisticated.
10-6

Example
Suppose Country II has a higher
level of per capita income.
It therefore produces goods C, D,
and E (just like Country I), but also
F and G.
F and G are even more
sophisticated.
10-7

Example
Suppose Country III has an even
higher level of per capita income.
It therefore produces good E (just
like Country I), F and G (just like
country II), but also H and J.
H and J are even more
sophisticated.
Lets look at a diagram of these
countries:
10-8

Example
What products will I and
II trade?
I
A
C, D, and E.
II
F
III
E
10-9

Example
What products will II and
III trade?
I
A
E, F, and G.
II
F
III
E
10-10

Example
What products will I and
III trade?
I
A
E only.
II
III
E
10-11
The Linder Theory

So trade will involve goods for
which there is overlapping demand.
Implication: trade should be most
intense between countries with
similar levels of per capita income.
10-12
The Linder Theory

This theory would explain two
things that H-O cannot:
why most trade is between the
industrialized countries, which all
have (presumably) very similar
resource endowments.
why a country might import and
export the same product (intraindustry trade).
10-13
The Linder Theory

The theory has been subjected to a
barrage of tests.
Sailors, et al. (1973), Thursby and
Thursby (1987), and McPherson,
Redfearn and Tieslau (2000) and
others found evidence to support
the Linder theory.
Hoftyzer (1984), Kennedy and
McHugh (1983) and others found
evidence against the theory.
10-14
The Krugman Model

Incorporates economies of scale
and monopolistic competition.
Consider a graph:
The price of the good relative to the
wage (P/W) is on the vertical axis.
Per capita consumption (c) is on the
horizontal axis.
10-15
The Krugman Model

Two functions are on the graph:
The PP curve slopes upward, since P/W
increases as c increases.
The ZZ curve has a negative slope: as c
increases, average cost decreases (due to
economies of scale). To maintain the zeroprofit condition in monopolistically competitive
firms, price must be reduced.
10-16
The Krugman Model

P/W
Point E is the initial

equilibrium, with the
firm maximizing its
profit, and earning
zero economic profit.
(P/W)1
P
c1
c
10-17
The Krugman Model

Suppose this firm exists in country 1.
Let country 2 be identical to country 1 on
both the demand and the supply sides of
the economy.
Traditional trade theory posits that these
countries would not trade.
However, because trade effectively
increases the market size in each country,
economies of scale are realized in the
Krugman model.
Trade effectively shifts the ZZ curve to the
left.
10-18
The Krugman Model

P/W
Point E is the new

equilibrium; per capita
consumption and P/W
have both decreased as
a result of trade.
(P/W)1
(P/W)2
Z
c2 c1
c
10-19
The Krugman Model: The

Bottom Line
Although trade causes per capita
consumption (c) to fall, total consumption
of the firms output has risen.
P/W has decreased because of trade; this
also means that its reciprocal (W/P) rises.
This suggests that trade causes the real
wage of workers to rise.
Even owners of the relatively scarce factor
see a rise in real wages, suggesting that
the negative income distribution effects of
trade may not occur.
10-20
Other Trade Models

Reciprocal dumping model (Brander and
Krugman, 1983)
Because of imperfect competition, intra-industry
trade occurs in this model.
Welfare may increase due to increased
competition, but may decrease due to waste
involved with transporting identical products
internationally; the overall welfare effect is
unclear.
The gravity model

The focus is on explaining trade volume.
These models illuminate the underlying causes
of trade.
10-21
Intra-Industry Trade
Examples:
Japan imports and exports
computers.
The Netherlands imports and
exports beer.
The U.S. imports and exports
broccoli.
H-O-S is useless in explaining this theres no way a country could
export and import the same good.
10-22
Intra-Industry Trade:
Possible Explanations
Product differentiation
Transportation costs
Dynamic economies of scale
Degree of product aggegation
Differing national income
distributions
Differing factor endowments and
product variety
10-23
How Common is IntraIndustry Trade?

A recent study by Brlhart attempts
to measure IIT in several countries,
using an index:
an index value of 0 implies no IIT is
taking place.
an index value of 1 implies that a
countrys exports in one product
category exactly equal its imports.
10-24
Intra-Industry Trade:
Evidence from Brlhart
(2009)
Country
SITC 3-digit
Germany
0.570
U.S.
0.503
Japan
0.398
Brazil
0.373
China
0.305
Indonesia
0.291
Bulgaria
0.287
Morocco
0.150
Russian Fed.
0.146
Saudi Arabia
0.070
10-25
Chapter 6
Taught by
CHAN BONNIVOIT
The Instruments
of Trade Policy
McGraw-Hill/Irwin
Learning Objectives
Describe the different tax
instruments employed to influence
imports.
Discuss policies used to affect
exports.
Explain the problems encountered
in measuring the presence of
protection.
Summarize the different nontariff
policies used to restrict trade.
13-2
Tariffs in General
Tariffs are simply taxes a country
places on its imports.
Purpose of tariffs:
to protect domestic (import-competing)
industries
to raise revenue for the government
There are two sorts of tariffs:

specific and ad valorem.
13-3
Specific Tariffs
Specific tariffs involve charging a tax
per physical unit imported.
For example, the tariff on frozen
orange juice is 7.85 per liter.
Specific tariffs may be easier to
administer.
Specific tariffs are less likely to
maintain the same degree of
protection in times of high inflation.
13-4
Ad Valorem Tariffs
Ad valorem tariffs involve charging
a tax as a percentage of the value
of the good.
For example, the tariff on golf clubs
is 4.4%.
Ad valorem tariffs may be more
complicated to administer than
specific tariffs, but do hold their
protective value in the face of
inflation.
13-5
Preferential Duties and

the Generalized System of
Preferences (GSP)
Preferential duties: tariff rates vary
according to products geographic
source.
The GSP involves developing
countries paying lower (or zero)
tariffs when exporting to the
developed world.
13-6
Permanent Normal Trade

Relations Status
PNTR status is a way to achieve
non-discrimination in trade.
If the U.S. negotiates a lower tariff
with a PNTR country, U.S. tariffs
fall for all countries with which the
U.S. has a PNTR treaty.
This is also called multilateralism
(and once was called most favored
nation status).
13-7
Offshore Assembly
Provisions
With OAPs, the tariff applies only to
the foreign value added.
For example, if there is a tariff on
computers, the tariff is not applied
to the value of domestic-made
components.
13-8
Measuring Tariffs
How can we tell how much tariff
protection a country has on
average?
This is sometimes referred to as
the height of tariffs.
There are two ways to measure this
height:
Unweighted average
Weighted average
13-9
Unweighted Tariffs
Suppose there are 3 imported goods.
Good A has a 30% tariff
Good B has a 40% tariff
Good C has a 10% tariff
The unweighted average is the

simple average of the three:
(30%+40%+10%)/3 = 26.7%
Unfortunately, this doesnt account
for the fact that the quantities of
each good that are imported may
differ.
13-10
Weighted Tariffs
Suppose there are 3 imported goods.
Good A has a 30% tariff and 200 units
are imported
Good B has a 40% tariff tariff and 100
units are imported
Good C has a 10% tariff tariff and 400
units are imported
The weighted average is the simple

average of the three:
[(30%)(200)+(40%)(100)+(10%)(400)]/
(200+100+400) = 20%
13-11
Nominal and Effective

Rates of Protection
Nominal tariff rates apply only to
final products.
Effective tariff rates take into
account not only tariffs on final
products, but also those on inputs
into the final product.
Basic idea: a tariff on an
intermediate good (e.g., steel) raises
the cost of many final goods (cars);
this reduces the protection afforded
to auto makers.
13-12
Nominal Rate of
Protection (NRP)
First consider the nominal rate of
protection (NRP).
NRP = (PDt - PDFT)/ PDFT
NRP is always equal to the tariff on
the final product.
13-13
Effective Rate of
Protection (ERP)
First, lets define value added
VA = price of good - price of
inputs.
Now we can define effective rate of
protection
ERP = (VADt - VADFT)/VADFT.
13-14
Effective Rate of Protection

The effective rate of protection measures how
much protection a tariff or other trade policy
provides domestic producers.
It represents the change in value that an industry adds to
the production process when trade policy changes.
The change in value that an industry provides depends on
the change in prices when trade policies change.
Effective rates of protection often differ from tariff rates
because tariffs affect sectors other than the protected
sector, a fact which affects the prices and value added for
the protected sector.
13-15

(cont.)
For example, suppose that an automobile sells on the
world market for $8000, and the parts that made it are
worth $6000.
The value added of the auto production is
$8000-$6000
Suppose that a country puts a 25% tariff on imported
autos so that domestic auto assembly firms can now
charge up to $10000 instead of $8000.
Now auto assembly will occur if the value added is up
to $10000-$6000.
13-16

(cont.)
The effective rate of protection for domestic
auto assembly firms is the change in value
added:
($4000 - $2000)/$2000 = 100%
In this case, the effective rate of protection
is greater than the tariff rate.
13-17
Table 11.1 Characteristics of Industries in

Relation to Levels of Protection Given by U.S.
Tariffs
13-18
Does the tariff protect labor-intensive

industries?
The least-protected industries are indeed the least
labor intensive.
However, the most heavily protected industries are
not very labor intensive.
It does not confirm the prediction of the majority of
voters that tariffs favor labor-intensive industries.
13-19
Does the tariff protect lowskilled ?

If the politicians aim in part to redistribute income to
those poor, high tariffs should protect industries that
employ low-skill and low-wage labor.
Evidence: Low-wage industries do get the highest
protection.
However, their real income as consumers suffer
seriously.
13-20
ERP
When tariffs on inputs > tariffs on
final products, ERP < NRP.
When tariffs on inputs < tariffs on
final products, ERP > NRP.
When tariffs on inputs = tariffs on
final products, ERP = NRP.
13-21
Case of nominal rate and

effective rate of protection
The nominal rate of protection is the
percentage tariff imposed on a product
as it enters the country. For example, if
a tariff of 20 percent of value is
collected on clothing as it enters the
country, then the nominal rate of
protection is that same 20 percent.
13-22

The effective rate of protection is a more complex
concept: consider that the same product
clothingcosts $100 on international markets. The
material that is imported to make the clothing
(material inputs) sells for $60. In a free-trade
situation, a firm can charge no more than $100 for a
similar piece of clothing (ignoring transportation
costs). Importing the fabric for $60, the clothing
manufacturer can add a maximum of $40 for labour,
profit markup, rents, and the like. This $40
difference between the $60 cost of material inputs
and the price of the product is called the value
added.
13-23
Case of nominal rate and effective

rate of protection
The same situation may be considered with tariffs
say, 20 percent on clothing and 10 percent on
fabric. The 20 percent tariff on clothing would raise
the domestic price by $20 to $120, while a 10
percent tariff on fabrics would increase material
costs to the domestic producer by $6 to $66.
Protection would thus enable the firm to operate
with a value-added margin of $54the difference
between the domestic price of $120 and the
material cost of $66. The difference between the
value added of $40 without tariff protection and that
of $54 with it provides a margin of $14. This means
that the effective rate of protection of the domestic
processing activitythe ratio of $14 to $40would
13-24
be 35 percent.
Case of nominal rate and effective

rate of protection
The effective rate of protection derived35
percentis greater than the nominal rate of
only 20 percent. This will be the case
whenever the tariff rate on the final product
is greater than the tariff on inputs. Because
countries generally do levy higher tariffs on
final products than on inputs, effective rates
of protection are usually higher than nominal
ratesoften much higher.
13-25

The effective rate of protection also
depends on the share of value added in the
product price. Effective rates can be very
high if value added to the imported
commodity is a small percentage or very low
if value added is a large percentage of the
total price. Thus, effective protection in one
country may be much higher than that in
another even though its nominal tariffs are
lower, if it tends to import commodities of a
high level of fabrication with correspondingly
low ratios of value added to product price. 13-26
ERP: The Bottom Line

ERP gives an indication of the
effects of the whole tariff structure
on industries; NRP only looks at
particular goods.
ERPs have an impact on resource
allocation: resources flow out of
industries with low ERPs, and into
industries with high ERPs.
13-27
Export Taxes
An export tax is a tax a government
places on its own exporters.
Are applied for several reasons
to raise government revenue.
to encourage domestic
processing of raw materials.
13-28
Export Subsidies
Governments can encourage
exports by paying exporters a
certain premium per unit exported.
Export subsidies work like export
taxes in reverse.
13-29
Non-Tariff Barriers
Trade gets restricted in ways not
involving taxes:
import quotas,
voluntary export restraints
(VERs), and
other provisions.
13-30
Import Quotas
Many countries restrict the quantity
of certain imports allowed entry in
a given time period (usually a year).
Quotas affect the quantity directly
and the price indirectly; tariffs do
the opposite.
However, in most respects quotas
and tariffs have the same effects.
13-31
Voluntary Export
Restraints
Importing countries persuade

exporting countries to voluntarily
limit their exports.
Example: 1.68 million Japanese
cars permitted annually beginning
in 1981.
There is an implied threat of tariffs or
quotas if exporting country doesnt
comply.
VERs exist for political reasons, not
economically valid ones.
13-32
Government Procurement
Provisions
Some countries require their
government to purchase from
domestic suppliers unless the
imported version is substantially
cheaper.
Example: Buy American Act
requires many U.S. government
purchases to be from domestic
firms unless domestic bid is more
than 6% higher.
13-33
Domestic Content
Provisions
Some countries require that a
certain percentage of the value of a
good sold domestically must
consist of domestic components or
labor.
Example: NAFTA members do not
allow duty-free access to goods
unless at least 62.5% of the goods
value originates in NAFTA
countries.
13-34
European Border Taxes

European (and some other)
countries have value added taxes
that increase the prices of
domestically produced goods.
To compensate, European
countries impose tariffs on
imported products.
13-35
Other Non-Tariff Barriers
Administrative classification
Restrictions on trade in services
Trade-related investment measures
Exchange rate controls
Quality provisions
Packaging and labeling
requirements
13-36
Chapter 7
Taught by
CHAN BONNIVOIT
The Impact of
Trade Policies
McGraw-Hill/Irwin
Learning Objectives
Illustrate how tariffs, quotas, and
subsidies affect domestic markets.
Identify the winners, losers, and net
country welfare effects of
protection.
Explain how the effects of
protection differ between large and
small countries.
Demonstrate how protection in one
market can affect other markets in
the economy.
14-2
Consumer Surplus
Consumer surplus (CS) is a
measure of the overall well-being of
consumers.
CS is the area between the demand
curve and the price.
CS varies inversely with the price.
14-3
Consumer Surplus
P
P*
D
Q
14-4
Producer Surplus
Producer surplus (PS) is a measure
of the well-being of producers.
PS is the area between the supply
curve and the price.
PS varies directly with price.
14-5
Producer Surplus
P
S
P*
Q
14-6
Trade Restrictions in
Partial Equilibrium: The
Small Country Case
What happens when a country

imposes a tariff? Its domestic price
rises.
Therefore, tariffs:
benefit domestic producers
harm domestic consumers
generate tariff revenue for the
government
14-7
Tariffs: Small Country Case

CS falls by area a+b+c+d,
or $656.25.
S PS rises by area a, or $393.75.
Revenue rises by area c, or $175.
Deadweight loss is areas b+d,
or $87.50.
$1.35
a
$1
D
1000 1250 1750 2000
Q
14-8
Tariffs: Small Country Case

A tariff makes producers better off,
but overall, the small countrys
welfare falls.
14-9
Import Quotas: Small

Country Case
Recall that quotas and tariffs can be
designed to be equivalent.
The difference is that with quotas
there is no revenue collected.
Instead rent will be captured by
holders of import licenses or
the government if it auctions the
licenses, or
foreign suppliers, if they organize.
The welfare implications of the quota

are otherwise the same as for tariffs.
14-10
Production Subsidies:
Small Country Case
P
$6
a
S'
A $1 subsidy has the effect of

shifting the supply curve to the right.
CS doesnt change, because
consumers still pay $5.
PS rises by areas a+b
The cost of the subsidy is a+b+c
Deadweight loss is areas c.
b
c
$5
D
100 120
160
190
Q
14-11
Production Subsidies:
Small Country Case
Production subsidies lead to
deadweight loss because of the
expansion of relatively inefficient
production.
However, the DWL is less than would
have occurred if an equivalent tariff
or quota were used.
14-12
Export Taxes: Small

Country Case
Export taxes cause the price in the
imposing (i.e., exporting) country to
fall, since some of what had been
exported is not anymore.
Wed predict an increase in CS, a
decrease in PS, and a gain in
revenue.
14-13
Export Taxes: Small

Country Case
P
S
PFT
b
a
CS rises by area a.
PS falls by areas a+b+c+d.
Revenue rises by area c.
DWL is b+d.
PET
D
Q
14-14
Export Taxes: Small

Country Case
An export tax tariff makes
consumers better off, but overall,
the small countrys welfare falls.
14-15
Export Subsidies: Small

Country Case
Export subsidies cause the price in
the imposing (i.e., exporting)
country to rise, since more of what
is produced is now exported.
Wed predict an decrease in CS, an
increase in PS.
The subsidy will generate cost, not
revenue.
14-16

Country Case
P
S
PES
a
PFT
c
b
CS falls by area a+b

PS rises by areas a+b+c+d+e
Subsidy cost is b+c+d+e+f
Overall effect is a loss: b+f
D
Q
14-17

Country Case
An export subsidy tariff makes
producers better off, but overall,
the small countrys welfare falls.
14-18
Voluntary Export Restraints:

Small Country Case
Similar to tariffs or quotas, VERs
raise the domestic price which
lowers CS
raises PS
Rent, however, is captured by the
exporting country.
The imposing country will lose not
only the DWL triangles, but also the
rent rectangle; welfare falls.
14-19
Tariffs: Large Country

Case
In the previous analysis, the tariff
caused the imposing countrys
price to rise by the full amount of
the tariff.
This would mean that the imposing
country is small; if it imposes a
tariff, it is unable to affect the
world price.
What if a country is not small?
14-20
Tariffs: Large Country Case

P
PFT
b c
e
The tariff causes price

to rise in the importing
country; P falls in the
exporting country.
P
D
Q
Importing Country
D
Exporting Country
Q
14-21
Tariffs: Large Country Case

P
PFT
b c
e
Importing country CS falls by a+b+c+d

PS rises by area a.
Revenue increases by areas c+e
Overall effect: e(b+d)
P
S
D
Q
Importing Country
D
Exporting Country
Q
14-22
Tariffs: Large Country

Case
A large country could increase its
welfare by imposing a tariff if the
revenue extracted from the
exporting country (area e) is bigger
than the deadweight loss (areas
b+d).
This assumes that the exporting
country does not retaliate.
14-23
Import Quotas: Large

Country Case
As with the tariff, IQs cause prices
in the importing country to rise, and
prices in the exporting country to
fall.
As with the tariff, if enough of the
quota rent is transferred from the
exporting country to offset the
deadweight loss, a quota can
increase a countrys overall
welfare.
This also assumes no retaliation.
14-24
VERs: Large Country Case

As with the tariff and the quota,
VERs cause prices in the importing
country to rise, and prices in the
exporting country to fall.
However, unlike quotas rent
generated is captured by the
exporting country.
VERs are welfare-diminishing even
in the large country case.
14-25
Export Taxes: Large

Country Case
In the previous analysis, the export
tax caused the imposing countrys
price to fall by the full amount of
the tax.
If the exporting country is large, its
price will fall somewhat but the
price in the importing country will
also rise.
14-26
Export Taxes: Large

Country Case
P
The export tax causes the price to fall in the

exporting country and rise in the importing
country.
P
S
e
PFT
D
Q
Importing Country
D
Exporting Country
Q
14-27
Export Taxes: Large

Country Case
P
CS rises by area a.
PS falls by areas a+b+c+d
Revenue rises by areas c+e
P
S
e
PFT
D
Q
Importing Country
D
Exporting Country
Q
14-28
Export Taxes: Large

Country Case
A large country could increase its
welfare by imposing an export tax if
the revenue extracted from the
importing country (area e) is bigger
than the deadweight loss (areas
b+d).
This assumes that the importing
country does not retaliate.
14-29
Export Subsidies: Large

Country Case
CS falls.
PS rises.
But there is no revenue; instead
cost.
Overall, export subsidies are
welfare-diminishing for small
countries and for large countries.
14-30
Trade Restrictions in General

Equilibrium: The Small
Country Case
We can use general equilibrium
analysis to better understand the
economy-wide effects of
protection.
A tariff on imports of good Y will
stimulate domestic production.
The economy winds up on a lower
indifference curve.
14-31
Tariffs in General Equilibrium:

Small Country Case
Y
C0
C1
In free trade, producer equilibrium is

at B0, and consumer equilibrium is at
C0. The tariff changes production to
point B1;consumption moves to C1 (on
a lower indifference curve).
B1
B0
(Px/Py)0
Px/Py(1+t)
X
14-32
Trade Restrictions in
General Equilibrium: The
Large Country Case
To understand the effects of
protectionism in the large country
case we can use offer curve
analysis.
14-33
Tariffs or Export Taxes

Y
OCA' OCA
(PX/PY)t
(PX/PY)FT
OCB
Y1
Y2
By imposing a tariff or an export

tax, Country A decreases trade
volume, but improves its terms
of trade (note: Bs terms of trade
deteriorate).
X2 X1
14-34
Export Subsidies
Y
OCA
(PX/PY)FT
(PX/PY)ES
OCB
Y2
Y1
Country As terms of trade

deteriorate; volume rises.
X1
X2
14-35
Import Quotas
Y
OCFTA
(PX/PY)IQ
(PX/PY)FT
OCFTB
Y1
Y2
OCIQA
X2
X1
The quota causes the imposing

countrys terms of trade to
improve, and trade volume to
fall.
14-36
VERs
Y
OCFTA
(PX/PY)E
OCFTB
Y1
The quota decreases trade

volume, and causes As
terms of trade to deteriorate.
Y2
OCVERB
X1
14-37
Chapter 8
Taught by
CHAN BONNIVOIT
McGraw-Hill/Irwin
Political
Economy and
Cambodia
Trade Policy
The Political Economy of

Trade Policy
Q: If free trade has so many
economic benefits, why is there so
much protectionism?
A: The political economy of trade
policy must be considered.
Two main areas examine these
political factors:
the self-interest approach, and
the social objectives approach.
16-2
The Self-Interest
Approach to Trade Policy
The median-voter model: public
decision-makers can increase their
re-election chances by voting to
satisfy the median voter.
This should mean that the will of
the majority is followed.
However, if some parties do not
have full information, some policies
that benefit only a few may be
enacted.
16-3
The Self-Interest
Interest groups can have great
influence.
The benefits of protectionist
policies to interest group members
may be great; the costs to the
many other individuals may be so
diffuse that no one individual has
incentive to acquire information or
participate.
16-4
The Social Objectives

Some economists argue instead that
a government may conduct trade
policy in order to meet certain social
objectives, such as
avoiding loss of real incomes of certain
groups,
minimizing consumer loss, or
improving real incomes of disadvantaged
groups.
Govt must stick to its guns;

otherwise credibility suffers.
16-5
The rectangular Strategy of RGC
The core of the rectangular strategy is

good governance focused at four reform
areas:
Anti-Corruption
Legal and judicial reform,
Public administration reform, including
decentralization and de-concentration,
and
Reform of the armed forces, especially
demobilization
The integration of Cambodia into the
region and the world is a significant part
of the rectangular strategy of RGC.
16-6
The Integrate Framework of RGC
The Integrated Framework (IF) is the outcome of a

commitment made by six multilateral Agencies (IMF, ITC,
UNCTAD, UNDP, World Bank, and WTO) to coordinate their
assistance in the area of trade and investment integration
into the global economy among themselves and with other
multilateral and bilateral donors.
IF came about as a result of the High Level Meeting (HLM)

for LDCs organized by the WTO in October 1997 in Geneva.
The IFs strategy must be fully mainstreamed in the

countrys national strategy for poverty reduction. In other
words, the countrys trade sector strategy must be fully
support and coherent with national objectives of poverty
reduction.
In the donor community based in Cambodia, UNDP has

taken the lead to ensure effective implementation of IF
and coordination among local donors. UNDP-Phnom Penh
and the International Trade Center (Geneva) are
cooperating and working directly with RGC and others to
backstop work in this area.
16-7
The Integrate Framework of RGC

(cont)
The IF was undergoing some restructuring that include

the creation of an Integrated Framework Trust Fund (IFTF)
and the adoption of a Pilot Phase Work Program during the
Second IFTF Steering Committee Meeting held in New
York in late March 2001
The Pilot Phase Work Program is to be implemented by

the IF Agencies under the leadership of the World Bank in
a small number of Pilot Countries using IFTF and other
resources.
Cambodia has been designated as one of the Pilot

Countries.
The IF Pilot Phase Work Program seeks to provide

financial and technical support to the selected pilot
countries for the formulation of a full-fledged pro-poor
trade sector strategy that is fully mainstreamed into the
PRSP
16-8
The Pro-Poor Trade Strategy of RGC
Preliminary evidence examined suggests that trade is

making a significant positive contribution to economic
growth and poverty reduction and that such contribution
can be further enhanced and provided Cambodia to
become proactive in promoting trade for poverty
reduction.
Regarding this issue RGC established a Pro-Poor Trade

Strategy organized around tree basic concepts:
Shifting the balance of policy emphasis from issues of

market access and macro-reforms for trade to micro and
meso-level issues of supply capacity
Focusing strongly on the delivery of capacity-building
support at the export enterprise and export sector level;
and
Stressing
the
regionalization
and
geographical
decentralization of export business within Cambodia
16-9
The Pro-Poor Trade Strategy of

RGC (cont)
The early efforts of the RGC to formulate a pro-poor trade

sector strategy initially under the umbrella and with the
support of the Integrated Framework (IF) for Trade
coincides closely with the PRSP effort.
The pro-poor trade integration strategy will include:
(1) policy and institutional reforms to target key

bottlenecks and constraints that emerge from the
analysis;
(2) several action plans at the product-sector level

including project proposals to capitalize on major
opportunities identified in the strategy;
(3) assessment of technical assistance and capacitybuilding priorities to support implementation of the
trade strategy as well as recommended actions that
might be taken by high-income and regional partner
countries to improve access to their markets.
16-10
The Pro-Poor Trade Strategy of

RGC (cont)
The RGC has identified eight sectors with

current or potential opportunities for
expanding, diversifying, and developing
exports under the Pro-Poor Trade
Strategy. These are:
Specialty crops and agro-processing
Rice
Fresh water fish and seafood
Handicraft (including furniture making)
Tourism
Labor services
Garment and shoe manufacturing
Rubber, sawn timber and processed wood
16-11
Trade Sector wide Approach (SWAp)
SWAp is an instrument for better management,

coordination and effectiveness of resources.
Now RGC is willing to utilize SWAp in the
Trade Sector.
The Ministry of Commerce stands ready to

develop SWAp in order :
To include all initiatives, strategies, measures

and actions,
To strengthen partnerships for consensus
building and coordination with the private
sector, civil society and donors, and
To improve implementation and delivery.
16-12
Trade Sector wide Approach

(SWAp) (cont)
The Trade SWAp is lead by the Ministry

of Commerce in close cooperation with
other line Ministries, Cambodian Trade
Stakeholders and Development Partners.
The Trade SWAp is to be guided and

monitored
by
the
Sub-Steering
Committee on Trade Development and
Trade-Related Investment chaired by the
Ministry of Commerce.
16-13
Trade Sector wide Approach

(SWAp) (cont)
Sub-Steering
Committee
Development and Trade-Related
The
on
Trade
Investment
has endorsed the creation of three teams

responsible for formulating the three pillars of
the program aimed at implementing the broad
objectives of the Cambodias 2007 Trade
Integration Strategy.
The three pillars are:
Legal Reform and Cross-Cutting Issues

Product
and
Service
Export
Sectors
Development
Capacity Development for Trade
16-14
Integrating Cambodia into the

international Community
Cambodias membership in ASEAN (30-041999) and WTO (13-10-2004), as well as

cooperation within the framework of the
ASEM.
Cambodias membership in Great Mekong
Sub-Region,
the
Ayeyawadee-Chao
Phraya-Mekong Economic Cooperation
Strategy (ACMECS) and other Triangular
Developments at sub-regional level.
Integrating
Cambodia
into
the
international Community will provide
great
opportunities
to
reform
the
investment and foreign trade regime.
16-15
Schedules of Tariff Rate of

Cambodia in ASEAN
Country
Industrial and AgroIndustrial Products

IL
TEL
Agricultural Products
IL
TEL
SL
ASEAN-6
1993-2003
1996-2003
1996-2003
1997-2003
2001-2010
Vietnam
1996-2006
1999-2006
1999-2006
2000-2006
2004-2013
Laos & Myanmar
1998-2008
2001-2008
2001-2008
2002-2008
2008-2015
Cambodia
2000-2010
2003-2010
2003-2010
2004-2010
2008-2017
16-16
Cambodias Tariffs by Product

Groups for Accession into WTO
16-17
Cambodias Service Commitments for

Accession into WTO
Undertaken
market
access
and
national
treatment
commitments in at least one sub-sector under each of 11
different service which are communications services,
construction and related engineering services, distribution
services, education services, environmental services, financial
services, health-related services, tourism and travel services,
recreational services and transport services.
Allowing foreign firm to operate in the areas of legal services

(with some exceptions), accounting, auditing, bookkeeping,
banking, management consulting, telecommunication and
transport, but some conditions were attached to market
access in areas of financial services (banking and insurance)
and telecommunication services.
Allowing foreign firms to provide higher education and adult

education services.
Reserving part of a market for Cambodian small and medium

sized enterprise in areas such as banking, tourism and courier
service (tourist guides services; opening hotel market only for
hotels of three stars or higher; and allowing foreign supply of
retailing services only a small number of specific items or for
very large supermarkets or department stores.
16-18
Modes of supply: 1) Cross-Border supply

Sector or sub-sector
2) Consumption abroad
3) Commercial presence
Limitations on market access
B.
SECTOR-SPECIFIC COMMITMENTS
I.
BUSINESS SERVICES
1.
Professional Services
4) Presence of natural persons
Limitations on national treatment
(a)
Legal services
(CPC 861):
(1)
None
(2)
None
(3)
In commercial association with
Cambodian law firms[1], and may not
directly represent clients in courts.
(4)
Unbound, except as indicated in
the horizontal section.
(1)
None
(2)
None
(3)
None
(4)
Unbound, except as indicated
in the horizontal section.
Foreign legal consultancy

on law of jurisdiction where
service supplier is qualified as a
lawyer (including home country
law, third country law, and
international law)
(1)
None
(2)
None
(3)
None
(4)
the horizontal section.
(1)
None
(2)
None
(3)
None
(4)
(b)
Accounting, auditing,
bookkeeping
(CPC 86211, 86212, 86220)
(1)
None,
except
must
have
commercial presence in Cambodia for
auditing services.
(2)
None
(3)
None
(4)
the horizontal section
(1)
None
(2)
None
(3)
None
(4)
Additional commitments
16-19
Trade related to Investment:

Investment Protection
Equal treatment of all investors

No nationalization adversely affecting
the property of investors
No price controls on products or
service
No restriction on foreign equity
participation
No restriction on foreign convertibility
Remittance of foreign currencies
abroad
16-20
GATT and Multilateralism

General Agreement on Tariffs and
Trade (GATT) was born in 1947.
GATT involved multilateral
negotiations to lower trade
barriers.
In general GATT espoused nondiscrimination in trade.
GATT established of the MostFavored Nation principle (now
called Normal Trade Relations).
16-21
GATT: Early Rounds

Negotiations (called rounds)
occurred every few years.
The first two rounds were:
Geneva (1947), and
France (1949).
These first rounds were very
successful, mainly because
protectionist groups within each
country hadnt gotten organized.
16-22
GATT: Early Rounds

Other early rounds:
England (1951)
Geneva (1956)
Dillon Round (Geneva, 1962)
These rounds were less successful
than the first two, but progress was
made.
16-23
GATT: The Kennedy

Round
In 1962, Congress passed the Trade
Expansion Act (TEA).
President was authorized to make tariff
cuts across the board, not just item-byitem.
Trade Adjustment Assistance:
industries damaged by imports could
receive unemployment compensation
and retraining for workers.
16-24
GATT: The Kennedy

Round
70 countries participated in the
Kennedy round.
Negotiations went from 1964-1967,
and were named in memory of
President Kennedy.
Tariffs on manufactured goods
were reduced by one-third.
16-25
GATT: The Tokyo Round

The Trade Reform Act (TRA): 1974
President authorized to
complete further tariff
reductions of 60%.
get rid of any tariff under 5%
(nuisance tariffs).
The Tokyo round ended in 1979,
with average tariff reductions of
30%.
16-26
GATT: The Uruguay Round

Tariff levels were by this time quite
low.
Negotiations began in earnest in
1986.
16-27
The Uruguay Round:

Agenda
Further tariff reductions
Reductions in non-tariff barriers
Negotiations regarding the MultiFiber Agreement (MFA)
Trade in services
Anti-dumping duties
Agricultural protection
Intellectual property rights
16-28
Uruguay Round: Actions

Most tariffs to be cut another 34%; others
eliminated.
MFA to be phased out over 10 year period.
Many remaining quota to be converted to
tariffs.
Patent protection to be tightened
somewhat.
Very little progress was made with services.
Agricultural subsidies to be cut over a 6 - 10
year period.
16-29
The World Trade

Organization (WTO)
The Uruguay round was the end of
GATT.
GATTs successor, the WTO, was
approved during the Uruguay round.
WTO was established January 1,
1995.
WTO has 148 member countries
(Cambodia most recently).
In theory, WTO has a stronger
dispute-settling mechanism.
16-30
Trade Policy Issues After

the Uruguay Round
Many countries wanted further
relaxation of protectionism in
agriculture.
Developed countries wanted to
discuss labor and environmental
standards.
Other issues being discussed
included trade in services, antitrust policy, the Multi-Fiber
Agreement phase-out, and others.
16-31
WTO and the Doha Round

WTO trade ministers met in Seattle in
1999 to set an agenda; no agreement
was reached due in part to anti-trade
demonstrations.
WTO members met in Doha, Qatar in
November of 2001 to set an agenda
for the round.
An attempt at meeting in Mexico City
ended bitterly in 2003.
Negotiations still havent started.
16-32
WTO and the Doha Round

The agenda will include continued
reductions in trade barriers, cutting
farm subsidies, patent laws, and
other issues.
Doha is supposed to be the round
that addresses developing
countries concerns.
16-33
The Conduct of Trade

Policy
Should trade policy be rulesbased or results-based?
Rules-based policies follow rules
embodied by the WTO and similar
organizations.
These embrace the normal trade

relations concept.
These follow WTO standards on antidumping duties, countervailing duties,
etc.
16-34
The Conduct of Trade

Policy
Results-based policies suggest
aggressive unilateral action to
ensure that certain results are
achieved.
For example, the U.S. may demand

penetration of a particular foreign
market of a certain percentage.
Failure by the trading partner to
comply would result in trade sanctions.
This notion is also referred to as

industrial policy or managed
trade.
16-35
Chapter 9
Taught by
CHAN BONNIVOIT
Economic
Integration
McGraw-Hill/Irwin
Learning Objectives
Differentiate among the four basic
levels of economic integration.
Identify the static and dynamic
effects of economic integration.
Analyze the real-world impact of
economic integration on countries in
the EU and NAFTA.
Summarize current economic
integration efforts in the world.
17-2
Economic Integration
Economic integration occurs when
two or more countries come
together for purposes of trade
and/or economic coordination.
Greater integration may yield
additional benefits, but it may also
involve giving up increasing
sovereignty.
17-3
4 Types of Integration
Free Trade Areas (FTAs)

Customs Unions (CUs)
Common Markets
Economic and/or Monetary Union
17-4
Free Trade Areas

Members remove tariffs and other
trade barriers on each other.
Each member maintains its own
tariff structure for non-members.
Possible problem: transshipment
Example: NAFTA
17-5
Customs Unions
Tariffs between members are
eliminated (just like a FTA), but
also:
members agree to a common set
of external tariffs and other trade
barriers, and
members speak with one voice in
external trade negotiations.
Example: Southern African Customs
Union (SACU)
17-6
Common Markets
eliminated, a common external tariff
is established (all of the features of
CUs) plus free movement of labor
and capital.
Example: European Community
(1957 1993)
17-7
Economic and/or
Monetary Union
Similar to a common market:
eliminated.
A common external tariff is
established.
Factors can move freely between
member countries.
But economic policy is coordinated
by a supranational institution in the
economic and/or monetary union.
17-8
Welfare Effects of
Integration: Static Issues
Jacob Viner argued that integration
leads to two welfare effects:
trade creation: increases a
countrys welfare
trade diversion: decreases a
countrys welfare
Whether economic integration is
welfare-enhancing depends on
which effect is larger.
17-9
Trade Creation and Trade

Diversion: An Example
Suppose we have three countries:
Uganda, Sudan, and Kenya.
Initially, Uganda imports textiles
and applies a 50% tariff to textiles
from both Sudan and Kenya.
Suppose that Sudan is able to
produce a unit of textiles for $1,
whereas it costs Kenyan producers
$1.20 per unit.
17-10

Production
Costs
Price with
50% Tariff
Sudan
$1.00
$1.50
Kenya
$1.20
$1.80
17-11

Prior to integration, Uganda imports
from the most efficient supplier,
Sudan.
Suppose now that Uganda enters
into a free trade agreement with
Kenya, but not Sudan.
That is, Sudanese textile imports
are dutiable, but Kenya textiles can
enter duty-free.
17-12

Production
Costs
Price with
50% Tariff
Price with
FTA
Sudan
$1.00
$1.50
$1.50
Kenya
$1.20
$1.80
$1.20
17-13

Notice that Uganda will now import
from Kenya, although Sudan is the
more efficient producer.
Uganda loses tariff revenue, but
reverses some of the deadweight
loss caused by the protectionism.
17-14

P
PS rises as a
result of initial
protection.
$1.50
Tariff price
$1.00
Free trade price

D
160
200
17-15

P
CS falls as a result
of the initial protection.
$1.50
Tariff price
$1.00
Free trade price

D
160
200
17-16

P
Revenue rises as a result
of the initial protection.
$1.50
Tariff price
$1.00
Free trade price

D
160
200
17-17

P
Welfare declines
overall by the DWL
triangles.
$1.50
Tariff price
$1.00
Free trade price

D
160
200
17-18

P
With FTA, CS rises.
S
Tariff price
$1.50
FTA price
Free trade price
$1.20
$1.00
D
160
200
17-19

P
With FTA, PS falls.
S
Tariff price
$1.50
FTA price
Free trade price
$1.20
$1.00
D
160
200
17-20

P
With FTA, revenue falls.
S
Tariff price
$1.50
FTA price
Free trade price
$1.20
$1.00
D
160
200
17-21

P
Lost revenue transferred back
S
to domestic consumers
Lost revenue not transferred
back to domestic consumers
Tariff price
$1.50
FTA price
Free trade price
$1.20
$1.00
D
160
200
17-22

P
Overall, we must compare

the gain in welfare (trade creation)
with the lost revenue (trade diversion).
S
trade creation
trade diversion
Tariff price
$1.50
FTA price
Free trade price
$1.20
$1.00
D
160
200
17-23

Diversion
When is it likely that trade
diversion outweighs trade creation?
When the excluded countries are
much more efficient than the
included countries.
When there are only a few
members of the FTA (consider a
global FTA: there would be no
trade diversion because no
country would be excluded).
17-24
Dynamic Welfare Effects

In the long run, integration may
increase a countrys welfare
because:
increased competition may occur,
leading to lower prices,
larger markets may allow economies of
scale to be realized,
more investment may be attracted, and
increased factor mobility may lead to
greater efficiency.
17-25
The European Community:

A Brief History
1951: France, Italy, West Germany,
and Benelux countries form
European Coal and Steel
Community.
1958: ECSC expanded to all
products; name changed to
European Economic Community
(EEC).
17-26
The European Community:

A Brief History
Other countries joined over the
years:
1973: Denmark, Ireland, U.K.

1981: Greece
1986: Portugal and Spain
1995: Austria, Finland, Sweden
Recent additions: Bulgaria, Cyprus,
Czech Republic, Estonia, Hungary,
Latvia, Lithuania, Malta, Poland,
Romania, Slovakia, Slovenia
17-27
EC 92
During the 1980s, there were still
various and sundry barriers to trade
between member countries.
1985: Single European Act
(commonly called EC 92):
elimination of all barriers to the
flow of goods, services, people, and
capital by 1992.
It wasnt 1992, but it eventually
happened.
17-28
Further Integration:
Monetary Union
1999
Accounts could be stated in
terms of euros, but member
countries currencies remained
legal tender.
Each members exchange rate
was fixed in terms of euros.
Monetary policy was made by the
ESCB; each member no longer
controlled its own money supply.
17-29
Further Integration:
Monetary Union
2002
In January, euro notes and coins
were issued by the ECB.
In July, national currencies were
withdrawn.
Members: Austria, Belgium, Finland,
France, Germany, Greece, Ireland,
Italy, Luxembourg, Monaco,
Netherlands, Portugal, San Marino,
Slovenia, Spain, and the Vatican
17-30
NAFTA
On January 1, 1994 the North
American Free Trade Agreement
came into being.
It allows for a dismantling of trade
barriers between Canada, Mexico,
and the U.S.
It created a market comparable in
size to the EU and EFTA combined.
17-31
NAFTA: Some Provisions

Many tariffs were eliminated
immediately; others will be phased
out over 5, 10, or 15 years.
Restrictions on trade in services
(esp. banking) phased out.
All U.S. environmental standards
will remain in force.
17-32
Worries Over NAFTA

GDP
Most studies estimate a sizeable
increase in Mexican GDP, with more
modest (but positive) effects on
Canadian and U.S. GDP.
Employment
There were some dire forecasts of job
loss, but U.S. employment has risen.
Wages
NAFTA has shifted low-skill employment
to Mexico.
U.S. wages have continued to grow.
17-33
Worries Over NAFTA

There have also been concerns about
environmental degradation, and
Mexicos lower labor standards.
17-34
Recent Discussions of
NAFTA
In the 2008 presidential campaign,

both Hillary Clinton and Barack
Obama called for revisions to NAFTA.
However, it appears the Obama
administration plans to move forward
with new free trade agreements.
17-35
Other Major Economic

Integration Efforts
MERCOSUR
U.S.-Central America Free Trade
Agreement Dominican Republic
(CAFTA-DR)
Free Trade Area for the Americas
(FTAA)
Chilean trade agreements
Asia-Pacific Economic Cooperation
(APEC)
17-36
Chapter 10
Taught by
CHAN BONNIVOIT
McGraw-Hill/Irwin
The Balance-ofPayments
Accounts
Learning Objectives
Explain what is meant by a countrys
balance-of-payments statement
and how it is constructed.
Analyze the difference between
alternative accounting balances
within the balance-of-payments.
Describe the recent balance-ofpayments experience of the U.S.
Define the international investment
position of a country.
19-2
Balance-of-Payments
Balance of payments accounts are
a way of keeping track of all
economic transactions between the
home country and the rest of the
world over a specific time period
(usually one year).
19-3
Recent Growth of Trade

and Capital Movements
The value of trade in goods and
services has increased from $582
billion in 1973 to $15.8 trillion in
2008.
International transactions of the
monetary sort have also grown very
rapidly over the last few decades.
19-4
Credit and Debits in

Balance-of-Payments
Accounting
Credit items reflect transactions that
give rise to payments flowing into the
home country.
e.g., exports, foreign investment inflows,
interest payments on earlier investments
Debit items reflect transactions that

give rise to payments flowing out of
the home country.
e.g., imports, foreign investment outflows,
interest payments to foreigners
19-5

Balance-of-Payments
Accounting
The IMF groups items into four
categories
Category I: Current account,
Category II: Direct investment and other
long-term financial flows,
Category III: Short-term nonofficial
financial flows, and
Category IV: Changes in reserve assets of
official monetary authorities (central
banks).
19-6

Balance-of-Payments
Accounting
Category I: Current account
Credit items include exports of goods and
services, interest and dividends from
investments abroad, wages earned
abroad, and gifts from abroad.
Debit items include imports of goods and
services, interest and dividends paid to
investors abroad, wages paid to
foreigners, and gifts sent abroad.
19-7

Balance-of-Payments
Accounting
Category II: Direct investment and
other long-term financial flows
Credit entries: anything that causes a net
increase in the holdings of assets in the
home country by the foreign country.
Debit entries: anything that causes a net
increase in the holdings of assets in a
foreign country by the home country.
19-8

Balance-of-Payments
Accounting
Category III: Short-term nonofficial
financial flows
These are mainly private flows, with
maturities under one year.
Credit items: any increase in foreign
holdings of such assets in the home
country.
Debit items: any increase in home country
holdings of such assets in the foreign
country.
19-9

Balance-of-Payments
Accounting
Category IV: Changes in reserve
assets of official monetary authorities
(central banks)
Credit items: whenever the foreign
country central bank acquires home
country assets (such as bank accounts).
Debit items: whenever the home country
central bank acquires foreign country
assets.
19-10
Sample Entries in the

Balance-of-Payments
Accounts
In general, balance-of-payments
accounting relies on double-entry
bookkeeping.
This means that any transaction
must be added as a credit and a
debit.
This implies that the sum of all
credits must equal the sum of all
debits, and the total BOP is always
in balance.
19-11

Balance-of-Payments
Accounts
#1: Exporters in the U.S. send $6,000

of goods to Canada, receiving a
short-term bank deposit of $6,000
from Canada.
Credit: Category I: Export of goods
+$6,000
Debit: Category III: Increase in shortterm private assets abroad -$6,000
19-12

Balance-of-Payments
Accounts
#2: Consumers in the U.S. buy

$10,000 of goods from Canada,
paying with a short-term bank
deposit of $10,000.
Debit: Category I: Imports of goods

-$10,000
Credit: Category III: Increase in foreign
short-term assets in the U.S. +$10,000
19-13

Balance-of-Payments
Accounts
#3: U.S. residents send $5,000 to

Mexico as gifts.
Credit: Category I: Exports of +$5,000

Debit: Category I: unilateral transfer of
-$5,000
19-14

Balance-of-Payments
Accounts
#4: An American firm provides $2,000

of shipping services to a Canadian
company, which pays by
transferring money into its U.S.
account.
Credit: Category I: export of services
+$2,000
Debit: Category III: Decrease in shortterm private assets in the U.S.: -$2,000
19-15

Balance-of-Payments
Accounts
#5: A Canadian company sends

$8,000 in dividends to bank
accounts of American
stockholders.
Credit: Category I: investment receipts

from abroad +$8,000
Debit: Category III: Decrease in shortterm private assets in the U.S.: -$8,000
19-16

Balance-of-Payments
Accounts
#6: An American buys a long-term

bond from a Mexican company for
$2,000; transfers payment from her
U.S. bank account.
Debit: Category II: increase in longterm asset abroad -$2,000
Credit: Category III: Increase in shortterm private assets in the U.S.: +$2,000
19-17

Balance-of-Payments
Accounts
#7: Canadian banks wish to reduce

holdings of dollars in U.S. banks by
selling $800 to the Federal Reserve.
Debit: Category III: Decrease in shortterm private assets in the U.S.: -$800
Credit: Category IV: Increase in foreign
short-term official assets in the U.S.:
+$800
19-18
Assembling a BOP
Summary Statement
Debits
Credits
#1
Increase in short-term
private assets abroad
-$6,000
Exports of goods
#2
Imports of goods
-$10,000
Increase in foreign short- +$10,000

term private assets in US
#3
Unilateral transfers
-$5,000
Exports of goods
+$5,000
#4
Decrease in foreign short- -$2,000

term assets in U.S
Exports of services
+$2,000
#5
Decrease in foreign short- -$8,000

term assets in U.S
Investment income from

abroad
+$8,000
#6
Increase in long-term
assets abroad
Increase in foreign short- +$2,000

term private assets in US
#7
Decrease in short-term
-$800
private assets in the U.S.:
-$2,000
-$33,800
+$6,000
Increase in foreign short- +$800

term official assets
+$33,800
19-19
BOP Summary
Category
I
Exports of Goods
+$11,000
Imports of goods
-$10,000
Merchandise trade balance
+$1,000
Exports of services
+$2,000
Imports of services
-$0
Balance of goods and services
+$3,000
Factor income receipts from abroad
+$8,000
Factor income payments abroad
$0
Balance on goods, services, and investment income +$11,000

Unilateral transfers received
+$0
Unilateral transfers made
-$5,000
CURRENT ACCOUNT BALANCE
+$6,000
19-20
BOP Summary (contd)

Category
II
III
IV
Net increase in foreign long-term assets in U.S.
+$0
Net increase in long-term assets abroad
-$2,000
BASIC BALANCE
+$4,000
Net increase in foreign short-term private assets in

U.S.
+$1,200
Net increase in short-term private assets abroad
-$6,000
OFFICIAL RESERVE TRANSACTIONS BALANCE
-$800
Net increase in foreign short-term official assets in

U.S.
+$800
Net increase in official assets abroad
-$0
TOTAL
$0
19-21
Statistical Discrepancy
The current account balance may
not exactly equal the financial
account balance due to incomplete
or imperfect data, illegal activities,
and mismatches on the timing of
data collection.
To account for these, a category
called statistical discrepancy is
included in the BOP.
19-22
U.S. International Transactions,

2007 (billions of $)
Exports of Goods
+$1,148.5
Imports of goods
-$1,967.9
Merchandise trade balance
-819.4
Exports of services
+$497.2
Imports of services
-$378.1
Balance of goods and services
-700.3
Factor income receipts from abroad
+$817.8
Factor income payments abroad
-$736.0
Balance on goods, services, and investment income -$618.5

Unilateral transfers, net
-112.7
CURRENT ACCOUNT BALANCE
-$731.2
19-23
U.S. International Transactions,

2007 (billions of $)
Capital account, net
-$1.8
U.S. official reserve assets, net
+$0.1
U.S. government assets abroad (other than

reserves), net
+$22.3
U.S. private assets abroad, net
-$1,267.5
Foreign official assets in the U.S., net
+$411.1
Other foreign assets in U.S., net (incl. financial

derivatives)
+$1,653.1
Statistical discrepancy
+$41.3
19-24
International Investment
Position of the U.S.
The BOP accounts are flow
concepts they represent changes
over a time period.
The international investment
position is a stock concept it
involves totals up to the present.
If foreign assets outweigh foreign
liabilities, a country is a net
creditor; otherwise it is a net
debtor.
19-25
Intl Investment Position of the

U.S. (end of 2007) billions of $
A. U.S.-owned assets abroad
U.S. official reserve assets
$277.2
U.S. govt assets (not reserve assets)
94.5
Financial derivatives
2,284.6
U.S. private assets abroad
14,983.7
direct investment abroad
$3,332.8
foreign bonds
1,478.1
foreign corporate stocks
5,170.6
U.S. claims on foreigners by U.S. banks and

nonbanks not reported elsewhere
TOTAL U.S. ASSETS ABROAD
5,002.2
$17,640.0
19-26
Intl Investment Position of the

U.S. (end of 2007) billions of $
B. foreign-owned assets in the U.S.
Foreign official assets in the U.S.
$3,337.0
Financial derivatives
2,201.1
Other foreign assets in the U.S.
14,543.7
foreign direct investment
$2,422.8
U.S. Treasury securities
734.8
U.S currency
272.0
Corporate and other bonds
3,299.3
Corporate stocks
2,833.1
U.S. liabilities to foreigners not reported

elsewhere
4,981.7
TOTAL FOREIGN ASSETS IN THE U.S.
$20,081.8
Net international investment position of the U.S.
-$2,441.8
19-27
International Investment
Position of the U.S.
The U.S. is a net international debtor.
No other country in the world is as
indebted.
Disadvantages
We must transfer future goods and
income abroad.
Foreign ownership may threaten U.S.
sovereignty.
Still, productive investments should

allow repayment.
19-28
Chapter 11
Taught by
CHAN BONNIVOIT
McGraw-Hill/Irwin
The Market for

Foreign
Exchange
Copyright 2010 by The McGraw-Hill Companies, Inc. All rights
Chapter Objective:
This chapter serves to introduce the student to
the institutional framework within which
exchange rates are determined.
This chapter lays the foundation for much of
the discussion throughout the remainder of the
text, thus it deserves your careful attention.
5-1
Function
Structure
ofofthe
Function
and
Structure
the
FXMarket
Market
Functionand
and
Structure
ofFX
the
FX Market
FX
Market
Participants
The
Spot
Market
The
Spot
Market
The Spot Market
Banking Relationships
Correspondent
Spot
Rate Quotations
The
Forward
Market
The
Forward
Market
The
Forward
Market
The
Spot
Market
Bid-Ask
Spread
The
Forward
Rate
Quotations
Exchange-Traded Currency Funds
FX
Exchange-Traded
Currency
The
Forward
Market
Spot
Long
andTrading
Short
Forward
Positions Funds
Exchange
Rate
Quotations
Cross
Forward
Cross-Exchange
Rates
Exchange-Traded
Currency
Funds
5-2
Triangular
Arbitrage
Swap Transactions
Spot
Foreign
Exchange Market Microstructure
Forward
Premium
The
Forward Market
Exchange-Traded
Currency Funds
Function and Structure of the FX Market

FX Market Participants
Correspondent Banking Relationships
5-3
FX Market Participants
The FX market is a two-tiered market:

Interbank Market (Wholesale)
About 100-200 banks worldwide stand ready to make a

market in foreign exchange.
Nonbank dealers account for about 40% of the market.
There are FX brokers who match buy and sell orders but
do not carry inventory and FX specialists.
Client Market (Retail)
Market participants include international

banks, their customers, nonbank dealers, FX
brokers, and central banks.
5-4
Market participants
Banks: The interbank market caters for both the majority of
commercial turnover and large amounts of speculative trading every
day. A large bank may trade billions of dollars daily.
Commercial companies: An important part of this market comes from
the financial activities of companies seeking foreign exchange to pay
for goods or services. Commercial companies often trade fairly small
amounts compared to those of banks or speculators
Central Bank: National central banks play an important role in the
foreign exchange markets. They try to control the money supply,
inflation, and/or interest rates and often have official or unofficial
target rates for their currencies. They can use their often substantial
foreign exchange reserves to stabilize the market.
Hedge funds as speculators: About 70% to 90% of the

foreign exchange transactions are speculative. In other
words, the person or institution that bought or sold the
currency has no plan to actually take delivery of the
currency in the end; rather, they were solely speculating
on the movement of that particular currency.
Investment management firms: Investment
management firms (who typically manage large
accounts on behalf of customers such as pension funds
and mutual funds) use the foreign exchange market to
facilitate transactions in foreign securities.
Retail foreign exchange brokers: There are two types of

retail brokers offering the opportunity for speculative
trading: retail foreign exchange brokers and market
makers. Retail traders (individuals) are a small fraction
of this market and may only participate indirectly
through brokers or banks.
Non-bank foreign exchange companies: Non-bank
foreign exchange companies offer currency exchange
and international payments to private individuals and
companies. These are also known as foreign exchange
brokers but are distinct in that they do not offer
speculative trading but currency exchange with
payments.
Money transfer/remittance companies: Money

transfer companies/remittance companies
perform high-volume low-value transfers
generally by economic migrants back to their
home country. In 2007, the estimated that
there were $369 billion of remittances (an
increase of 8% on the previous year). The
largest and best known provider is Western
Union with 345,000 agents globally.
Circadian Rhythms of the FX Market

Electronic Conversations per Hour
average
peak
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
07:00 9:00
5:00
3:00
1:00
Asia
10 am in Lunch Europe
going out
Tokyo hour in coming in
Tokyo
5-9
15:00 5:00 19:00 9:00 11:00

11:00 1:00
New 6 pm in
Lunch Americas
London
Zealand NY
hour in coming in
going out
coming in
London

Large commercial banks maintain demand deposit
accounts with one another which facilitates the
efficient functioning of the FX market.
5-10
Bank A is in London, Bank B is in New York.

The current exchange rate is 1.00 = $2.00.
A currency trader employed at Bank A buys 100
from a currency trader at Bank B for $200m
settled using its correspondent relationship.
Bank A
London
5-11
$200
100
Bank B
NYC

Bank A buys 100m from Bank B for $200m
Bank A
London
Assets
100
Liabilities
deposit at B 300m Bs Deposit $1,000m

400m
$1,200m
$ deposit at B $800m Bs Deposit
200m
$600m
Other Assets 600m Other L&E
100m
600m
Total Assets 1,300m Total L&E 1,300m
5-12
Bank B
$200
NYC
Assets
Liabilities
$ deposit at A $1000m
$1200m
deposit at A 200m
100m
As Deposit 300m
400m
As Deposit $800m
$600m
$800m
Other L&E $800m
Total Assets $2,200m
Total L&E $2,200m
Other Assets
You can check your work: make sure that

1,300m = $1,200x(1/$2) +100 + 600

International commercial banks communicate
with one another with:
SWIFT: The Society for Worldwide Interbank
Financial Telecommunications.
CHIPS: Clearing House Interbank Payments System
ECHO Exchange Clearing House Limited, the first
global clearinghouse for settling interbank FX
transactions.
5-13
The Spot Market
5-14
Spot Rate Quotations

The Bid-Ask Spread
Spot FX trading
Cross Rates

Direct quotation
the U.S. dollar equivalent
e.g. a Japanese Yen is worth about a penny
Indirect Quotation
the price of a U.S. dollar in the foreign currency
e.g. you get 100 yen to the dollar
See exhibit 5.4 in your textbook.
5-15
1
.5072=
1.9717
January 4, 2008
Currencies
U.S.-dollar foreign-exchange rates in late New York trading.
--------Friday-------
--------Friday-------
The direct quoteinfor

the pound
US$
per US$
is: 1 = $1.9717.9984
Canada dollar
1.0016
Country/currency
in US$
per US$
Euro area euro
1.4744
.6783
1-mos
The forward
indirect
.9986
quote
for the1.0014
3-most forward
pound is: .5072.9988
= $1 1.0012
1-mos forward
1.4747
.6781
3-most forward
1.4744
.6782
6-mos forward
6-mos forward
1.4726
.6791
UK pound
1.9717
.5072
1-mos forward
1.9700
.5076
Country/currency
.9979
1.0021
Noteyen
that
Japan
the direct
quote108.46
is the
.009220
reciprocal
indirect108.11
quote:
1-mos
forward of the.009250
3-most forward
1
.009306
107.46
3-most forward
1.9663
.5086
6-mos forward
.009378
.5072
106.63
6-mos forward
1.9593
.5104
1.9717 =
5-16
The Bid-Ask Spread

The bid price is the price a dealer is willing to
pay you for something.
The ask price is the amount the dealer wants
you to pay for the thing.
It doesnt matter if were talking used cars or
used currencies: the bid-ask spread is the
difference between ask prices and the bid price.
5-17
The Bid-Ask Spread

A dealer could offer
bid price of $1.4739 per
ask price of $1.4744 per
While there are a variety of ways to quote that,

the bid-ask spread represents the dealers
expected profit.
5-18
Ask Price Bid Price

Percent Spread =
100
Ask Price
$1.4744 $1.4739
0.0339% =
x 100
$1.4744
The Bid-Ask Spread

big
figure
USD Bank
Quotations
Pounds
small figure
American Terms
European Terms
Bid
Ask
Bid
Ask
1.9712
1.9717
.5072
.5073
A dealer pricing pounds in terms of dollars would likely quote

these prices as 1217.
Anyone trading $10m knows the big figure.
5-19
The Bid-Ask Spread

USD Bank
Quotations
Pounds
American Terms
European Terms
Bid
Ask
Bid
Ask
1.9712
1.9717
.5072
.5073
Notice that the reciprocal

of the S($/) bid is the
S(/$) ask.
.5073
1.00
=
$1.00
$1.9712
5-20
Currency Conversion with Bid-Ask Spreads

A speculator in New York wants to take a $10,000
position in the pound.
After his trade, what will be his position?
Dealer will pay $1.9715 for 1

1.9715 20 GBP; he is asking $1.9720.
.5071 72 He will pay .5071 for $1
and will charge .5072 for $1
Bid
S($/)
S(/$)
5-21
Ask
1
$10,000
= 5,071
$1.9720
Sample Problem
A businessman has just completed transactions in
Italy and England. He is now holding 250,000 and
500,000 and wants to convert to U.S. dollars.
His currency dealer provides this quotation:
GBP/USD 0.5025 76
USD/EUR 1.4739 44
5-22
Assuming no other fees, what are his proceeds

from conversion?
Sample Problem Solution

When he sells 250,000 he will trade with a dealer
at the dealers bid price of $1.4739 per :
USD/EUR
1.4739 44
$1.4739
250,000 x
=$368,475
1.00
When he sells 500,000 he will trade with a dealer
at the dealers ask price of 0.5076 per $:
GBP/USD
5-23
0.5025 76
$1.00
500,000 x
.5076
=$985,027.58
$1,353,502.58
Spot FX trading
In the interbank market, the standard size trade
is about U.S. $10 million.
A bank trading room is a noisy, active place.
The stakes are high.
The long term is about 10 minutes.
5-24
Cross Rates
Suppose that S($/) = 1.50
i.e. $1.50 = 1.00
and that S($/) = 2.00

i.e. 1.00 = $2.00
What must the / cross rate be?

$1.50 1.00 0.75
=
1.00 $2.00 1.00
1.00 = 0.75
Pay attention to your currency algebra!

5-25
Cross Rate Bid-Ask Spread

USD Bank
Quotations
American Terms
European Terms
Bid
Ask
Bid
Ask
Pounds
1.9712
1.9717
.5072
.5073
Euros
1.4738
1.4742
.6783
.6785
To find the / cross bid rate, consider a retail customer who:

Starts with 10,000, sells for $, buys :
.6783
$1.9712
10,000
$1.00 = 13,370.65
1.00
He has effectively sold at a / bid price of 1.3371/
5-26

USD Bank
Quotations
American Terms
European Terms
Bid
Ask
Bid
Ask
Pounds
1.9712
1.9717
.5072
.5073
Euros
1.4738
1.4742
.6783
.6785
To find the / cross ask rate, consider a retail customer who:

Starts with 10,000, sells for $, buys :
1.00
$1.00
10,000
$1.9717 = 7,474.96
.6785
He has effectively bought at a / ask price of 1.3378/
5-27
:$
direct
American Terms
Bid
Ask
$1.9712 $1.9717
indirect
European Terms
Bid
Ask
.5072
.5073
:$
$1.4738
$1.4742
.6783
.6785
1.3371
1.3378
0.7475
0.7479
Bank
Quotations
Recall that the reciprocal of

the S(/) bid is the S(/) ask.
5-28
1.3371
1.00
.7479
1.00
Triangular Arbitrage
Bank Quotations
Bid
Ask
Deutsche Bank :$
$1.9712
$1.9717
Credit Lyonnais :$
$1.4738
$1.4742
Credit Agricole :
1.3310
1.3317
No Arbitrage :
1.3371
1.3378
Suppose we observe these banks posting these exchange rates.

As we have calculated the no arbitrage / cross bid and ask
rates, we can see that there is an arbitrage opportunity:
1.00
$1.9712
1
$1.4742 = 1.3371
1.00
5-29
Bank Quotations
Bid
Ask
Deutsche Bank :$
$1.9712
$1.9717
Credit Lyonnais :$
$1.4738
$1.4742
Credit Agricole :
1.3310
1.3317
No Arbitrage :
1.3371
1.3378
By going through Deutsche Bank and Credit Lyonnais, we

can sell pounds for 1.3371.
$1.9712
1.00
= 1.3371
1
1.00
$1.4742
The arbitrage is to buy those pounds
from Credit Agricole for 1.3317
5-30
Bank Quotations
Bid
Ask
Deutsche Bank :$
$1.9712
$1.9717
Credit Lyonnais :$
$1.4738
$1.4742
Credit Agricole :
1.3310
1.3317
Start with 1m: sell to Deutsche Bank for $1,971,200.

$1.9712
10,000,000
= $1,971,200.
1.00
Buy euro from Credit Lyonnais receive 1,337,132
1.00
$1,971,200
= 1,337,132.
$1.4742
Buy from Credit Agricole receive 1,004,078.89
5-31
Spot Foreign Exchange Microstructure

Market Microstructure refers to the mechanics
of how a marketplace operates.
Bid-Ask spreads in the spot FX market:
increase with FX exchange rate volatility and
decrease with dealer competition.
Private information is an important

determinant of spot exchange rates.
5-32
The Forward Market
5-33
Forward Rate Quotations

Long and Short Forward Positions
Forward Cross Exchange Rates
Swap Transactions
Forward Premium
The Forward Market

A forward contract is an agreement to buy or
sell an asset in the future at prices agreed upon
today.
If you have ever had to order an out-of-stock
textbook, then you have entered into a forward
contract.
5-34

The forward market for FX involves agreements
to buy and sell foreign currencies in the future
at prices agreed upon today.
Bank quotes for 1, 3, 6, 9, and 12 month
maturities are readily available for forward
contracts.
Longer-term swaps are available.
5-35

Consider these
Country/currency
in US$ per US$
exchange rates: for
UK pound
1.9717 .5072
British pounds, the spot 1-mos forward
1.9700 .5076
3-most forward
1.9663 .5086
exchange rate is
6-mos forward
1.9593 .5104
$1.9717 = 1.00 while
the 180-day forward
Clearly market participants
rate is $1.9593 = 1.00 expect that the pound will
Whats up with that? be worth less in dollars in
six months.
5-36

Consider the (dollar) holding period return of a
dollar-based investor who buys 1 million at the
spot exchange rate and sells them forward:
gain $1,959,300 $1,971,700 $12,400
$HPR= pain =
= $1,97,1700
$1,971,700
$HPR = 0.00629
Annualized dollar HPR = 1.26% = 0.629% 2
5-37
Forward Premium
The interest rate differential implied by forward
premium or discount.
For example, suppose the is appreciating from
S($/) = 1.55 to F180($/) = 1.60
The 180-day forward premium is given by:
f180,v$
F180($/) S($/) 360

1.60 1.55
=
180 =
2
S($/)
1.55
= 0.0645
or 6.45%
5-38
Long and Short Forward Positions

If you have agreed to sell anything (spot or
forward), you are short.
If you have agreed to buy anything (forward or
spot), you are long.
If you have agreed to sell FX forward, you are
short.
If you have agreed to buy FX forward, you are
long.
5-39
Payoff Profiles
profit
If you agree to sell anything in the

future at a set price and the spot
price later falls then you gain.
S180($/)
0
F180($/) = .009524
If you agree to sell anything in the

future at a set price and the spot
loss price later rises then you lose.
Short position
5-40
Payoff Profiles
profit
short position
0
F180(/$) = 105
-F180(/$)
loss
5-41
Whether the
payoff profile
slopes up or
down depends
S180(/$) upon whether
you use the direct
or indirect quote:
F180(/$) = 105 or
F180($/) = .009524.
Payoff Profiles
profit
short position
S180(/$)
0
F180(/$) = 105
-F180(/$)
loss
5-42
When the short entered into this forward contract,

he agreed to sell in 180 days at F180(/$) = 105
Payoff Profiles
profit
short position
15
S180(/$)
0
F180(/$) = 105
-F180(/$)
loss
5-43
120
If, in 180 days, S180(/$) = 120, the short will make

a profit by buying at S180(/$) = 120 and
delivering at F180(/$) = 105.
Payoff Profiles
profit
F180(/$)
Since this is a zero-sum game, the short position

long position payoff is the
opposite of the short.
S180(/$)
0
F180(/$) = 105
-F180(/$)
loss
5-44
Long position
Payoff Profiles
profit
-F180(/$)
The long in this forward contract agreed to BUY

in 180 days at F180(/$) = 105
If, in 180 days, S180(/$) = 120, the long will
lose by having to buy at S180(/$) = 120 and
delivering at F180(/$) = 105.
S180(/$)
0
120
F180(/$) = 105
15
loss
5-45
Long position
Forward Market Hedge

If you are going to owe foreign currency in the
future, agree to buy the foreign currency now
by entering into long position in a forward
contract.
If you are going to receive foreign currency in
the future, agree to sell the foreign currency
now by entering into short position in a forward
contract.
5-46
Forward Market Hedge: an Example

You are a U.S. importer of British woolens and
have just ordered next years inventory.
Payment of 100M is due in one year.
Question: How can you fix the cash outflow in
dollars?
Answer: One way is to put yourself in a position
that delivers 100M in one yeara long
forward contract on the pound.
5-47
Forward Market Hedge: an Example

0
Step 1
Order Inventory; agree to
pay supplier 100 in 1 year.
Step 2
Take a Long position in
a Forward Contract on
100 million.
1
Step 3
Fulfill your contractual
obligation to forward contract
counterparty and buy 100
million for $195 million.
Step 4
Pay supplier 100 million
(Suppose that the forward rate is $1.95/.)

5-48

Suppose the
forward exchange
rate is $1.95/.
$30m
If he does not
hedge the 100m
$0
payable, in one
year his gain
(loss) on the $30m
unhedged position
is shown in green.
5-49
The importer will be better off if

the pound depreciates: he still
buys 100m but at an exchange
rate of only $1.65/ he saves
$30 million relative to $1.95/
Value of 1 in $
$1.65/ $1.95/ $2.25/
in one year
But he will be worse off if

the pound appreciates.
Unhedged
payable

If he agrees
to buy 100m
in one year at
$30m
$1.95/ his
gain (loss) on
the forward
$0
are shown in
blue.
$30m
5-50
If you agree to buy 100

million at a price of $1.95
per pound, you will make
$30 million if the price of
a pound reaches $2.25.
Long
forward
Value of 1 in $
$1.65/ $1.95/ $2.25/
in one year
If you agree to buy 100 million at a
price of $1.95 per pound, you will lose
$30 million if the price of a pound is
only $1.65.

The red line
shows the
payoff of the
$30 m
hedged
payable. Note
that gains on
$0
one position are
offset by losses
$30 m
on the other
position.
5-51
Long
forward
Hedged payable
Value of 1 in $
$1.65/ $1.95/ $2.25/
in one year
Unhedged
payable
Forward Cross Exchange Rates

Its just an delayed example of the spot cross
rate discussed above.
In generic terms
FN ($ / k )
FN ( j / k ) =
FN ($ / j )
and
FN ($ / j )
FN (k / j ) =
FN ($ / k )
5-52
Notice that the $s cancel.
Forward Cross Rates

January 4, 2008
Currencies
U.S.-dollar foreign-exchange rates in late New York trading.
The 3-month forward /

cross rate is
0.7498
$1.4744 1.00
=
1.00
1.00 $1.9663
5-53
--------Friday------Country/currency
in US$
per US$
Euro area euro
1.4744
.6783
1-mos forward
1.4747
.6781
3-mos forward
1.4744
.6782
6-mos forward
1.4726
.6791
UK pound
1.9717
.5072
1-mos forward
1.9700
.5076
3-mos forward
1.9663
.5086
6-mos forward
1.9593
.5104
Cross-Currency Hedge
Suppose that you are a U.K.based exporter who has sold
1,000,000 order to an Italian
retailer. Payment due in 90
days. Hedge this into pounds.
Sell the euro forward for dollars
Buy the pound forward. If you
had bid-ask spreads, then you
sell the at the bid and buy
at the ask.
5-54
--------Friday------Country/currency
in US$
per US$
Euro area euro
1.4744
.6783
1-mos forward
1.4747
.6781
3-mos forward
1.4744
.6782
6-mos forward
1.4726
.6791
UK pound
1.9717
.5072
1-mos forward
1.9700
.5076
3-mos forward
1.9663
.5086
6-mos forward
1.9593
.5104
$1.4744 1.00
= 749,834.72
1m x
x
1.00 $1.9663
Currency Symbols
In addition to the familiar currency symbols
(e.g. , , , $) there are three-letter codes for
all currencies.
It is a long list, but selected codes include:
CHF Swiss francs
GBP British pound
ZAR South African rand
CAD Canadian dollar
JPY Japanese yen
5-55
SWAPS
A swap is an agreement to provide a
counterparty with something he wants in
exchange for something that you want.
Often on a recurring basise.g. every six months

for five years.
Swap transactions account for approximately 56

percent of interbank FX trading, whereas
outright trades are 11 percent.
Swaps are covered fully in chapter 14.
5-56
Exchange Traded Currency Funds

An ETF where each share represents 100 euros.
Individual shares are denominated in the U.S. dollar and
trade on the New York Stock Exchange.
The price of one share at any point in time will reflect the
spot dollar value of 100 euros plus accumulated interest
minus expenses.
Six additional currency trusts exist on the Australian

dollar, British pound sterling, Canadian dollar, Mexican
peso, Swedish krona, and the Swiss franc.
Currency is now recognized as a distinct asset class, like
stocks and bonds. Currency ETFs facilitate investing in
these currencies.
5-57
Summary
Spot rate quotations
Direct and indirect quotes
Bid and ask prices
Cross Rates
Triangular arbitrage

Forward premium (discount)
Forward points
5-58
End Chapter Five
5-60

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Chapter 1

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Growth in World Production and Trade, 1963-2007 (average annual

Merchandise Exports and Imports by Region, 2007 (billions of dollars)

Top 10 Merchandise Exporters, 2007

Top 10 Merchandise Importers, 2007

Regional Structure of Exports, 2007

Composition of World Merchandise Exports

Value in Share in Share in

Trade and the U.S.

U.S. Merchandise Trade by Area and Country, 2007

Commodity Composition of U.S. Trade, 2007

The Changing Degree on

International Interdependence for Selected Countries and Groups of

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

The Role of Government

The Role of Government

Humes Challenge: the

Limits to Smiths Thinking

Absolute Advantage: The

Limits to Smiths Thinking

A 2-country, 2-commodity world

Mexico (B) 3 hrs/bu

Ricardos argument is that trade

The Production Possibilities

Slope: rise/run = -1000/200 = -5

Slope of the PPF

Classical Model: The

Classical Model: The

The Gains from Trade:

If the U.S. wants to continue to

100 150 200

The Gains from Trade:

The Gains from Trade

100 150 200

The Limits to Mutually

The CPF and Small

The Basis for

The Hecksher-Ohline Theory

Eli Hecksher laid out the basic fundamentals of the

This paper was written in Swedish and was not

An English translation of this paper entitled the Effect

The Hecksher-Ohlin (HO) Theory

Heckshers pupil, Ohlin, elaborated on the ideas

Ohlins book is titled

Ohlin has got the Nobel Price of Economic in

The Hecksher-Ohlin (HO) Theory

L/K in Y = 2 or K/L in Y = 1/2

L/K in Y = 1/4 or K/L in Y = 4

L/K in X = 4 or K/L in X = 1/4 4

Country A (Mexico or China)

L/K in X = 2 or K/L in X = 1/2

The Hecksher-Ohlin (HO)

The Hecksher-Ohlin (HO)

Taking PPF of both Countries into one panel

Tex US Tex Mexico

Relative Factor Intensities,

Capital per employee

Capital per worker

More on Factor Prices

A Review of Trade in the

Autarky in Mexico and the

Autarky in Mexico and the

The Hecksher-Ohlin (HO)