You are on page 1of 66

Notes International Economics


Lecture 1 General introduction on world trade flows (Ch.2)
The Gravity model (Tinbergen) gives an estimation of the size of trade between two countries.
Tij = (Yi)a x (Yj)b / (Dij)c
Tij = vale of trade between country i and j.
Yi = GDP of country i
Yj = GDP of country j
Dij = trade impediments between country i and j.
a,b,c = values that measure importance of size and trade impediments.
ln(Tij) = a x ln(Yi) + b x ln(Yj) c x ln(Dij) + ij
The Gravity model shows that size matters:
1. Larger economies produce more goods and services, so they have more to sell in the
export market.
2. Larger economies generate more income from the goods and services they sell, so they
are able to buy more imports.
Trade impediments
- Distance between markets influences transportation costs and therefore the costs of
import and export.
- Cultural affinity: If countries have cultural ties, it is likely that they also have stronger
economic ties.
- Geography: Ocean harbors, easily navigable rivers, lack of mountain barriers influence
the ease of international transportation.
- Borders: Crossing borders involves formalities that take time and can involve monetary
costs like tariffs. These implicit and explicit costs reduce trade.
Trade agreements increase trade between specific areas.
- The negative effect of distance has becomes smaller over time, but it is still significant.
The world is not flat. A countrys location on the globe is still very relevant for
determining the ease of access to markets.
- Political factors play an important role (wars, free trade negotiations, China opening its
markets etc.)
Changing composition of trade
Today: 55% manufactured goods, 20% services, 18% mineral resources, and 7% agricultural

Past: (VOC/Dutch East-India Company) mostly agricultural and mineral resources.

This change in composition does not only hold for developed, high-income countries. Apart from
some exceptions, middle- and low-income countries also trade mostly manufactured goods.
Important recent developments
1. Trade in intermediate goods, more complex international supply chains increases
countries dependency.
2. Trade in services, more outsourcing because of advanced modern communication
technology. Service outsourcing (or offshoring) occurs when a firm providing services
moves its operations to a foreign location. Service outsourcing can occur for services that
can be performed and transmitted electronically. Trade in services is not a significant part
of the world trade (20%), but its share is increasing. Some services are non-tradable, but
more jobs will become outsourceable.
Increased internationalization of production networks enables countries to specialize and
increases the efficiency of production processes. However, it also increases the vulnerability of
production processes companies diversify their intermediate production to different countries.
- World trade is larger than ever, largest share of trade takes place between developed
nations, but developing world is catching up.
- The gravity model predicts that the volume of trade is directly related to the economic
size of each trading partner and the trade impediments between them.
- Important examples of trade impediments are distance (transport costs), culture,
geography, the existence of borders, free trade agreements.
- Modern transportation and communication have increased trade, but political factors have
historically had a much larger influence on trade.
- Today, most trade is in manufactured goods, while historically agricultural and mineral
products made up most of trade.
- Also, trade in intermediate goods now makes up the largest share of world trade:
- increased complexity of supply chains
- increased international dependency in production
- In the future, trade in services is likely to become a much more important component of
world trade.

Lecture 2 The Ricardian Model (1) (Ch.3)

Theories of trade:
1. Models emphasizing differences between countries as the main driver of trade.
Difference in labor skills, natural resources, physical, and technological create productive
advantages for countries.
2. Models emphasizing economies of scale. No prior differences between countries, but
more efficient if each country specializes in a (few) products only, benefitting from
economies of scale.

To understand the causes and effects of trade its useful to look at models that focus on one
particular motive for trade separately.
Ricardian model
Trade arises because of differences in relative labor productivity between countries.
Opportunity costs: the costs of not being able to produce something because resources have
already been used to produce something else.
Comparative advantage: A country has a comparative advantage in producing a good if the
opportunity cost of producing that good is lower in that country than in other countries.
Gains from trade: More goods and services can be produced and consumed compared to the
situation where each country makes all goods and services itself.
1. Labor is the only factor of production.
2. Labor productivity varies across countries due to differences in technology, but labor
productivity in each country is constant.
3. The supply of labor in each country is constant.
4. Only two goods are important for production and consumption (wine and cheese).
5. Perfect competition between firms, free entry/exit of firms.
6. Perfect labor mobility between sectors.
7. The world consists of two countries: Home and Foreign.
8. No transportation costs.
Production possibilities depend on the amount of labor available and unit labor requirement.
(High unit labor requirement = low productivity).
L = total number of hours worked (constant by assumption)
QC = how many pounds of cheese are produced
QW = how many gallons of wine are produced
aLC = the unit labor requirement for cheese
aLW is the unit labor requirement for wine
Production possibility frontier: aLCQC + aLWQW =< L
In equilibrium: aLCQC + aLWQW = L
The PPF shows the maximum amount of goods that can be produced using a fixed amount of
QW = L/aLW (aLC/aLW) QC
aLC/aLW = opportunity cost of producing and extra unit of cheese in terms of wine. (how
much wine could be produced if one unit less of cheese would be produced?)
wC = PC/aLC
wW = PW/aLW
If wC = PC/aLC > PW/aLW = wW, workers will only make cheese, and vice versa.
Workers are only willing to make both wine and cheese if wC = wW PC/aLC = PW/aLW
Two countries, Home and Foreign
Suppose Home has an absolute advantage: aLC < a*LC and aLW < a*LW

Suppose Home has a comparative advantage in cheese production: aLC/aLW < a*LC/a*LW
lower opportunity cost of producing cheese in terms of wine. (less wine can be produced by
reducing cheese production in home)
Relative price reflects opportunity cost in each country.
If there is no trade: PC/PW = aLC/aLW < a*LC/a*LW = P*C/P*W
It will be profitable to ship cheese from Home to Foreign, and wine from Foreign to Home, this is
an incentive to trade.
World relative supply of cheese = quantity of cheese supplied by all countries relative to
quantity of wine supplied by all countries:
RS = (QC + Q*C)/(QW + Q*W)
1 If the relative price of cheese falls below the opportunity cost of cheese in BOTH countries
[PC /PW < aLC /aLW < a*LC /a*LW]
Nobody produces cheese: both foreign and domestic workers rather produce wine, where wages
are higher.
RS = 0
2 Similarly: if the relative price of cheese rises above the opportunity cost of cheese in BOTH
countries [aLC /aLW < a*LC /a*LW < PC /PW]
Everybody produces cheese: both foreign and domestic workers rather produce cheese, where
wages are higher.
RS = infinite
3 When the relative price of cheese equals the opportunity cost in the home country
[PC /PW = aLC /aLW < a*LC /a*LW]:
Domestic workers are indifferent about producing wine or cheese (wage when producing wine =
wage when producing cheese).
Foreign workers produce only wine.
0 =< RS =< (L / aLC) / (L*/ a*LW)
4 Similarly, when the relative price of cheese equals the opportunity cost in the foreign country
[aLC /aLW < PC /PW = a*LC /a*LW]:
Foreign workers are indifferent about producing wine or cheese (wage when producing wine
same as wage when producing cheese).
Domestic workers produce only cheese.
(L / aLC) / (L*/ a*LW) =< RS =< infinite
5 When the relative price of cheese settles strictly in between the opportunity costs of cheese
[aLC /aLW < PC /PW < a*LC /a*LW]
Domestic workers produce only cheese (where their wages are higher).
Foreign workers still produce only wine (where their wages are higher).
World relative supply of cheese equals Homes maximum cheese production divided by Foreigns
maximum wine production RS = (L / aLC) / (L*/ a*LW)

Relative price
of cheese, PC/PW






L /a LW

Relative quantity
of cheese, QC + Q*C
QW + Q *W

Opening up to trade: PC/PW < PworldC/PworldW < P*C/P*W each country specializes in producing
the good in which they have a comparative advantage.

Lecture 3 The Ricardian Model (2) (CH.3)

Gains from trade?
- Each country specializes in the type of production which uses resources most efficiently.
- Use the income generated from that production to buy the goods and services that it
desires (some of which are produced abroad!)
Domestic workers earn a higher (real) income from specializing in cheese production since the
relative price of cheese increases with trade. They can buy more wine with their cheese.
With trade, they earn w = PworldC / aLC
, this wage buys them:
w/PworldC = 1/aLC cheese, or
w/PworldW = PworldC /PworldW x 1/aLC wine
Before trade, they earned w = PC / aLC
, that wage bought them: w/PC = 1/aLC cheese, or w/PW = PC /PW x 1/aLC wine

Their purchasing power remains the same in cheese and increases in wine (PC /PW <
PworldC /PworldW).
Foreign workers earn a higher (real) income from specializing in wine production since for them
the relative price of wine increases with trade: they can now buy more cheese with their wine.
With trade, they earn w* = PworldW / a*LW
, this wage buys them: w*/PworldW = 1/a*LW wine, or
w*/PworldC = PworldW /PworldC x 1/a*LW cheese
Before trade, they earned w* = P*W / a*LW
, that wage bought them:
w*/P*W = 1/a*LW wine, or
w*/P*C = P*W /P*C x 1/a*LW cheese
Their purchasing power remains the same in wine and increases in cheese (P*C /P*W >
PworldC /PworldW).
Trade expands a countrys consumption possibilities beyond its own production possibilities.
How do wages in the two countries compare when they trade?
Home: wC = PworldC / aLC
Foreign: w*W = PworldW / aLw
Relative wages: WC/W*W = (PworldC/PworldW) x (1/aLC)
WC/W*W < a*LC/aLC
WC/W*W > a*LW/aLW
(a*LW /aLW ) < (wC / w*W) < (a*LC /aLC )
Productivity (technological) differences between countries determine relative wage differences
across countries.
The home wage relative to the foreign wage will settle in between the ratio of how much better
Home is at making cheese and how much better it is at making wine compared to Foreign.
These relationships imply that both countries have a cost advantage in production!
- High wages can be offset by high productivity.
- Low productivity can be offset by low wages.
Comparative advantage with many goods
N goods: i = 1, 2, 3 N
Unit labor requirement: aLi and a*Li
To determine which country has a competitive advantage in which type of production, we need to
know their productivity differences and their wages.
Good i will be produced in the country where total wage payments to produce it are lowest.
If waLi < w*a*Li then only Home will produce good i. Total wage payments = total cost.
Or equivalently, if a*Li/aLi < w/w* if the relative productivity of a country in producing a good
is higher than the relative wage, then the good will be produced in that country.
Relative supply in our model is fixed by the amount of labor in each of the countries: RS = L/L*
Relative demand of domestic labor services falls when w/w* rises.

Why? Two effects

1. As domestic labor services become more expensive relative to foreign labor services,
goods produced in the domestic country become more expensive, and demand for these
goods and the labor services to produce them falls.
2. Fewer goods will be produced in the domestic country (because cheaper to produce
elsewhere), further reducing the demand of domestic labor services.
1. Differences in the productivity across countries generate comparative advantage.
2. A country has a comparative advantage in producing a good when its opportunity cost of
producing that good is lower than in other countries.
3. Countries export goods in which they have a comparative advantage.
- High productivity or low wages give countries a cost advantage.
4. With trade, the relative price settles in between what the relative prices were in each
country before trade.
5. Trade benefits all countries because the relative price of the exported good rises: income
for workers who produce exports rises, and imported goods become less expensive.
6. Empirical evidence supports trade based on comparative advantage, although
transportation costs and other factors prevent complete specialization in production.

Lecture 4 The Specific Factors Model (Ch.4)

International trade has strong effects on the distribution of income within a country:
- Resources cant move immediately or costless from one industry to another.
- Industries differ in the factors of production they demand.
The Ricardian model assumes these two away.
Specific factors model: Countries as a whole benefit from trade, but it may hurt significant
groups within the country.
1. Two goods (cars and food)
2. Three factors of production: labor (L), capital (K), and land (T)
3. Cars are produced using labor and capital
4. Food is produced using labor and land
5. Perfect competition in both markets
6. Labor is a mobile factor: it can move between sectors
7. Land and capital are specific factors: they can only be used in the production of food and
cars respectively.
One country
QC = QC (K, LC)
} Cobb-Douglas functions, diminishing marginal returns. MPL decreases
QF = QF (K, LF)
} with the number of people already employed.
MPL: marginal product of labor; derivative of the production function w.r.t. labor.
Output (Q) = area under the MPL-curve.
L = LC + LF

Production possibilities frontier:

Slope of PPF: opportunity costs of cars in terms of food = - MPLF / MPLC

The opportunity cost rises with the amount of the good already employed: diminishing returns
to labor. With more capital provided the MPL increases -> wages as well.
Prices, wages, and allocation
Labor supply: L
Labor demand: profit-maximizing number of workers.
wC = MPLC x PC
wF = MPLF x PF

If cloth labor is under food labor curve, then workers migrate to food sector. The triangle
from paralel points on both curves + eq point is how much world output increases!
Equilibrium wage and allocation of labour where labor demand functions intersect.
wF = wC MPLF x PF = MPLC x PC - MPLF / MPLC = - PC / PF; otherwise labor moves.
Price change
1. Proportional change in prices. Relative price stays the same. The wage also increases
proportionately. Since the wages and the prices both increase with the same amount, the
real wage stays the same. There is no reallocation of labor and production.
2. A change in relative prices.
Suppose PC increases and PF stays the same PC / PF increases.
- Allocation of labor between sectors changes. (move from f to c production)
- Welfare of workers, capital owners, and land owners changes.
WC increases, this attracts labor, the MPLC will drop because more people now work in the cars
sector. WC = MPLC x PC.
The wage doesnt increase as much as the price does.
Intuition: higher wages attract more workers, but because more people want to work in cars now,
employers can reduce wages a bit and still get enough people to do the job.
The output (QC) will also increase.
Capital owners are better off
1. They earn more: output goes up, and the price of cars rises by 7% whereas wages only
rise by less than 7%.
2. Also: they can buy more food for a given amount of cars they produce (relative price of
cars has risen).
Land owners are worse off
1. They earn less: output goes down, and wages rise by 7% whereas the price of food
remains unchanged.
2. Also: they can buy less cars for a given amount of food they produce (relative price of
cars has risen).
1. Wages go up
2. However, relative wage in terms of cars (PF/PC) falls.
3. However, PF stays the same, so the relative wage in terms of food (PC/PF) rises.
It is ambiguous whether workers are better or worse off, it depends on their preferences for food
and cars.
In the Specific Factors model, a change in relative prices will
- Benefit the owners of the factor specific to the sector whose relative price increases.
- Hurt the owners of the factor specific to the sector whose relative price decreases.
- And, the effect on the mobile factor is ambiguous.
Trade in the Specific Factors Model

Only trade if world relative prices are different from prevailing relative prices without
trade. Trade changes prices, because 1) relative demand changes, because people in other
countries have different preferences. 2) Relative supply changes, firms in other countries can
produce goods at higher or lower costs, because of different technologies and different resources.
Suppose Home can produce more cars relatively cheaper and has more capital / worker available
to produce cars. As a result, the price of cars in Home are relatively low compared to Foreigns
prices. When it opens to trade, other countries will demand cars, which increases the price of
cars. The relative price of cars (PC/PF) has increased.
Labor abundant produces labor intensive good -> after trade relative price will increase in
it. Owners of the other resource are hurt by it.
Gains from trade
With trade, the budget constraint looks like:
PC x DC + PF x DF = PC x QC +PF x QF
(DF - QF) = (PC / PF) x (QC DC)
Imports of food = relative price in terms of cars time exports of cars.

The part of the budget constraint that lies within the blue area, is the part in which the country
is definitely better off. For other parts of the budget constraint, it is possible that the country is

better off, but that depends on the preferences.

Budget constraint intersects the PPF at the chosen production point.
Trade always benefits the country as a whole, because it expands a countrys consumption
Trade strongly influences the income distribution within a country, because it changes the relative
- Benefits the owners of the factor specific to the sector whose relative price increases: the
exporting sector
- Hurts the owners of the factor specific to the sector whose relative price decreases: the
sector that faces toughest competition from imports
- Effect on mobile factors is ambiguous
It is possible to redistribute the income in such a way that the winners compensate the losers,
however, this is very hard to implement.
In the real world this effect of trade may actually be smaller or larger
Why smaller?
- The specific factors cannot move to the other sector (completely immobile)
In the real world this is usually not the case:
- People can acquire new skills, machines can be changed, land can be replanted or used to
build a factory on
=> Heckscher-Ohlin model
Why larger?
- Opening to trade shifts jobs from import-competing to exporting sectors
- In the Specific Factors model, workers move costlessly between sectors
- However, in the real world this may not happen instantaneously
- Finding new jobs in the exporting sector may not be easy
- Opening to trade may lead to an increase in (short-run) unemployment
Summary Trade and the Specific Factors Model
1. International trade often has strong effects on the distribution of income within countries produces losers as well as winners
2. Income distribution effects arise for two reasons:
a. Factors of production cannot move costlessly and quickly from one industry to
b. Changes in an economys output mix have differential effects on the demand for
different factors of production
3. International trade affects the distribution of income in the specific factors model
a. Factors specific to export sectors in each country gain from trade, while factors
specific to import-competing sectors lose.
b. Mobile factors that can work in either sector may either gain or lose
4. Trade nonetheless produces overall gains in the sense that those who gain could in
principle compensate those who lose while still remaining better off than before
5. Most economists would prefer to address the problem of income distribution directly,
rather than by restricting trade

6. Those hurt by trade are often better organized than those who gain, causing trade
restrictions to be adopted that are far from optimal.

Lecture 5 - The Heckscher-Ohlin Model (1) (Ch. 5)

The Heckscher-Ohlin Model focuses only on how differences in resources result in trade
between countries. Each factor of production can be used in each sector. This is more realistic as
most factors of production can be used to produce different goods. Especially in the long run;
people can acquire different skills, machines can be put to a different use, and land can be
1. Two countries: Home and Foreign.
2. Two factors of production: capital (K) and labor (L).
3. Two goods: cars (C) and food (F).
4. Same technology in the two countries.
5. Supply of labor and capital in each country is constant, but varies between countries.
6. Perfect competition in both sectors.
7. In the long run capital and labor can freely move across sectors, but there is no
international mobility of production factors rental rate (r) and wage (w) equalization
between sectors.
8. Cars production is labor-intensive and food production is capital-intensive.
One country
QC = QC(KC, LC) and QF = QF(KF, LF)
Diminishing returns to labor and capital Cobb-Douglas function.
The slope of the PPF = opportunity cost of cars in terms of food. A low MPL high opportunity
Value of production: V = PC x QC + PF x Q=
An isovalue line represents what combination of QC and QF result in the same constant value of
production, V* (given prices for the two goods).
QF = V*/PF (PC/PF) x QC
Slope = - PC/PF
If PC/PF > opportunity cost of cars in terms of food: produce more cars.
If PC/PF < opportunity cost of cars in terms of food: produce less cars.
Given the prices, the economy produces at the point Q that touches the highest possible isovalue
line. At that point, the relative price equals the slope of the PPF, which equals the opportunity
The output does not only depend on prices, but also on the wage (w) and the rental rate (r). If w/r
increases, producers use less labor and more capital in the production of both food and cars.
Cars production is labor-intensive LC/KC > LF/KF at any price level.
PC/PF and w/r are directly related, because prices equal production costs in competitive markets.

Relative goods prices affect relative factor prices. Relative factor prices affect input choices.
Relative goods prices affect input choices.
If PC/PF increases, some firms switch from producing food to producing cars. Food production is
capital-intensive and cars production is labor-intensive. There will be excess supply of capital and
excess demand of labor, therefore w/r will increase. In both sectors, firms use relatively less
labor and more capital than before.

An increase in the relative price of cars, PC /PF, is predicted to:

1. Raise (real) income of workers relative to that of capital owners, w/r (note: they pay the
same prices).
2. Lower the ratio of labor services to capital, L/K, used in both industries.
(But increase the amount of both labor and capital used in car production)
Moreover, it is predicted to:
3. Raise the real income (purchasing power) of workers and lower the real income of capital
w = PC x MPLC
r = PC x MPKC
Since in both sectors, L/K decreases, we know that MPL increases in both sectors and MPK
decreases. Real income of workers goes up and that of capital owners goes down.
Stolper-Samuelson theorem: If the relative price of a good increases, then
- The real wage or rental rate of the factor used intensively in the production of that
good increases.
- The real wage or rental rate of the other factor decreases.
Any change in the relative price alters the distribution of income.

Suppose L increases, but relative prices remain unchanged.

- w/r unchanged
- Input mix in both sectors (LC/KC and LF/KF) unchanged.
(For the derivation see the lecture slides).
LC/KC > LF/KF Capital moves from food to cars production: LC/K increases and KF/K decreases.
Labor also moves to the cars sector. Overall cars output rises and food output falls.
Rybcszynski theorem: If you hold goods prices constant: as the amount of a factor of production
increases, then the supply of the good that uses this factor intensively increases and the supply of
the other good decreases.

Lecture 6 Heckscher-Ohlin Model (2) (Ch.5)

Main results Heckscher-Ohlin model:
1. If a goods relative price goes up (at given factor endowments):
Relative factor price (wage or rent) of the factor used intensively in the production
of that good goes up
Firms in both sectors use relatively less of that factor
Real income of that factor increases, whereas that of the other factor decreases
2. If a factors relative supply increases (at given goods prices):
Output of the good that uses that factor intensively increases
Output of the other good decreases
Trade in the Heckscher-Ohlin Model
A 2 by 2 by 2 model, two countries (Home and Foreign), two products (cars and food), and two
factors of production (capital and labor).
The Heckscher-Ohlin model focuses on differences in resources endowments, assuming
countries are equal in all respects (production technology, consumer preferences).
- Home is labor-abundant (L/K > L*/K*)
- Foreign (*) is capital-abundant (K/L < K*/L*)
Abundance is always measured in relative terms.
Assumption: L/K and L*/K* are not too big or too small: both countries produce both goods.
Initially RD and RS in each country determine how much of each good is produced and at which
RD-curves are equal in both countries. However, RS-curves are NOT the same.
When opening up to trade
- Foreigns food is relatively cheap for Home consumers.
- Homes cars are relatively cheap for Foreign consumers.
Relative prices will converge: PC/PF < PworldC/PworldF < P*C/P*F

Trade makes relative prices converge!

In each country, the relative price of that good rises, that uses a countrys abundant factor
As a result:
1. Home increases its relative supply of cars and exports some of its cars to Foreign.
2. Foreign increases its relative supply of food and exports some of its food to Home.

Heckscher-Ohlin theorem: An economy is predicted to export goods that are intensive in its
abundant factors of production and import goods that are intensive in its scarce factors of
The Heckscher-Ohlin model also predicts:
3. Factor price equalization: opening up to trade causes relative goods prices to converge in the
two countries.
Perfect competition in both sectors implies that goods prices equal production costs.
Given identical technologies production costs are the same in both countries.


Overall gains from trade

No trade: QF = DF and QC = DC
With trade: country can consume more/less than what it produces by importing/exporting from
other countries, but it can only spend what it earns (budget constraint).
(DF QF) = (Pc/Pf) x (QC DC)
Quantity of imports = relative price of exports x quantity of exports
Since the country as a whole always gains from trade, it is possible to make everyone better off.
Without redistribution
Owners of a countrys abundant factor gain from trade: their real income increases.
Owners of a countrys scarce factor are hurt by trade: their real income decreases.
Empirical evidence
1. Pattern on trade. There is no good evidence in the United States, but it explains the pattern of
North-South trade quite well. The trade between developed and developing countries.
2. Factor price equalization. There is no evidence to support this. This is because of the
unrealistic assumptions: equal technologies, both countries produce both goods, no trade costs, all
products are tradable, there is no policy for minimum wages.
3. The effect(s) of trade on income inequality. There is evidence in the Western world to support
this, but there is no evidence for skills-scarce countries.
Skill-biased technological change: technological change that increases skilled labors
productivity more than unskilled labor.

Increase in wages of skilled people more than that of unskilled people. This is contrary to
what is predicted by the Heckscher-Ohlin model.
Firms will hire more skilled workers relative to unskilled workers.
Overall there is no conclusive evidence for neither the Heckscher-Ohlin model nor skills-biased
technological change.
Overall: The evidence to support the predictions made by the Heckscher-Ohlin model is weak.
However, it can explain trade patterns between high income countries and low/middle income
countries. The main explanation for this is that the Heckscher-Ohlin model does consider
technological differences between countries.
When countries do not trade:
Their differences in relative factor abundance, result in different relative goods
prices. Relative price of the good using a countrys abundant factor intensively is
When countries start trading:
Relative prices converge, this has important consequences:
Each country exports the good that uses its abundant factor intensively
Goods price equalization results in factor price equalization across countries
Overall, each country is better off with trade as it expands consumption possibilities
But, specific groups gain while other lose:
Owners of a countrys abundant factor gain
Owners of a countrys scarce factor lose
Winners could compensate losers while still being better off ( in theory)
Empirical evidence supporting HO-model is weak
Main reason for this appears to be that, by focusing only on
differences in resource endowments as a cause of trade it
abstracts from differences in technology (Ricardo)
In the real world:
trade happens BOTH because of differences in resources and differences in

Lecture 7 Standard Trade Model (CH.6)

The Standard Trade Model combines the ideas of the Ricardian, Specific Factors, and
Heckscher-Ohlin Model (all previous models are specials cases of the Standard trade Model).
In the previous models, countries started trading when relative prices differed between countries.
Relative prices differ, because production possibilities differ.
The Standard Trade Model can be used to look at those issues that do not necessarily require us to
make further assumptions on why exactly countries differ in production possibilities.
1. Two goods (cars and food).


Two countries (Home and Foreign).

Home is relatively more efficient in producing cars compared to food.
Foreign is relatively more efficient in producing food compared to cars.
Consumer preferences are the same in both countries.

Production possibilities frontier

Maximize the value of output:
V = PCQC + PFQF QF = (V/PF) (PC/PF) x QC
The relative supply curve can be derived from PPF: if the relative price of a good increases, the
relative supply also increases.
Production choices are determined by the economys PPF and the prices of output.
The value of an economys consumption must equal the value of an economys production.
Demand is determined by the relative prices of goods and consumer preferences (indifference
What if consumption point (RD) is not on the PPF (RS)?

relative price

If there is no trade, relative prices will adjust and will form an equilibrium where RD is tangent to
the PPF.
If there is trade:

World relative prices are determined by:

- World RD (DC + D*C) / (DF + D*F) the same in both countries.
- World RS (QC + Q*C) / (QF + Q*F)
At a given relative price PC/PF: QC/QF > Q*C/Q*F
(For the mathematical derivation, see the lecture slides).
World relative supply of cars > supply of cars in Foreign.
Also: World relative supply of cars < supply of cars in Home.
Trades makes relative world prices converge!
Opening up to trade allows consumers to consume a bundle of goods that could not be consumed
in autarky that lies on a higher indifference curve = gains from trade.
If the relative of price of cars in terms of food increases.
Change of welfare:
1. Income effect: Income goes up, consumers have relatively more to spend so they can in
principle buy more of both goods.
2. Substitution effect: Because PC/PF increases, consumers in Home will buy relatively less
cars than before, because they are more expensive.
Terms of trade and welfare
A countrys Terms of Trade = price of exports / price of imports
A rise in a countrys terms of trade increases its welfare.
A decline in a countrys terms of trade decreases its welfare.
Caveat: A fall in a countrys Terms of trade will never decrease a countrys welfare level below
that in absence of trade.
Economic growth is usually biased: it occurs in one sector more than in others, causing relative
supply to change.
Biased growth changes a countrys PPF. At given prices: biased economic growth increases the
relative supply of the good produced by the sector towards which growth is biased.
No trade
Growth is always good for a country. It expands production = consumption possibilities. It does
not affect other countries growth.
With trade
1. Growth may have an additional effect on the welfare of the country in which the growth
2. BUT it may also have an effect on the welfare of other countries.
Because biased growth changes world relative prices. (prices of the sector decreases)
Biased economic growth changes countries terms of trade (whether it happens at home or

Export-biased growth worsens a countrys terms of trade and welfare.

Import-biased growth improves a countrys terms of trade and welfare.
The overall effect depends on whether growth happens at home or abroad.
If growth happens abroad:
- If export-biased abroad (= import-biased at home): it raises welfare at home.
- If import-biased abroad (= export-biased at home): it reduces welfare at home.
- If unbiased: no effect on welfare at home.
If growth happens at home:
- If export-biased at home: it reduces the positive welfare effect of growth itself.
- If import-biased at home: it raises the positive welfare effect of growth itself.
- If unbiased: only positive effect of growth itself.
Import tariffs and export subsidies
Both import tariffs and export subsidies make domestic prices differ from world prices.
An import tariff of T% increases the domestic price: PD = PWorld (1 + T/100)
An export subsidy of S% also increases the domestic price. PD = Pworld (1+S/100), because
producers should be indifferent about selling at home or trading.
Unless the tariff or subsidy is the same in all sectors, it changes relative prices in the country.
This changes relative supply and relative demand. If the country is large enough, this will also
change world relative supply and demand. Thus it changes world relative prices. Therefore, it
affects a countrys terms of trade.
1 Suppose,
A tariff on food imports in Home PF/PC increases relative demand for food will decrease
relative supply of food will increase. These changes will also be reflected in world relative
demand and supply and thus relative world prices.
The tariff on food imports in Home will decrease the relative world price of food increase the
relative world price of cars. Since Home exports cars, this improves their terms of trade and
lowers Foreigns terms of trade. Therefore, it increases Homes welfare and decreases Foreigns
2 Suppose,
A subsidy on car exports in Home increases the relative price of cars in Home Relative
supply of cars increases and relative demand of cars decreases in Home these changes will be
reflected in world relative demand and supply changes world relative prices.
The subsidy on cars in Home lowers the world relative price of cars worsens in Homes terms
of trade and improves Foreigns terms of trade. As a result, Homes welfare decreases and
Foreigns welfare increases.
The Standard Trade Model predicts that:

An import tariff by the domestic country can increase domestic welfare at the expense of
the foreign country.
An export subsidy by the domestic country reduces domestic welfare to the benefit of the
foreign country.

1. If the country is really small, these effects will also be really small.
2. Tariffs and subsidies do not only change terms of trade, they also distort domestic
production and consumption incentives. This typically lowers welfare.
The overall welfare effect of an import tariff or export subsidy is a combination of this direct
effect and the terms of trade effect:
An export subsidy unambiguously lowers domestic welfare!
An import tariff raises domestic welfare if the terms of trade effect dominates the direct
distortion effect.
The findings that a tariff/subsidy has a different effect for the country which imposes them and
the other country, is based on the assumption that the world consists of two countries. This is not
the case in reality!
Export subsidies on a good decrease the relative world price of that good.
Import tariffs on a good decrease the relative world price of that good.
Export subsidies by foreign countries on goods that
A country imports reduce the price of its imports and increase its terms of trade +
A country also exports reduce the price of its exports and decrease its terms of trade +
Import tariffs by foreign countries on goods that
A country exports reduce the price of its exports and decrease its terms of trade +
A country also imports reduce the price of its imports and increase its terms of trade +
1. The Standard Trade Model captures some essential ideas of the Ricardian, the Specific
Factors, and the Heckscher-Ohlin model.
2. Countries trade because of differences in production possibilities
- When countries do not trade these differences result in different relative goods
- When they open up to trade, these differences in relative goods price mean that
countries have an incentive to actually start trading.
3. To analyze important issues in international economics, not necessary to specify where
these differences exactly come from.
4. Important effect of trade: it changes relative prices.
5. The terms of trade of a country refers to the price of goods the country exports relative to
the price of goods it imports.

6. Export-biased growth reduces a countrys terms of trade, reducing its welfare and
increasing the welfare of foreign countries.
6. Import-biased growth increases a countrys terms of trade, increasing its welfare and
decreasing the welfare of foreign countries.
7. When a country imposes an import tariff, its terms of trade increase and its welfare may
8. When a country imposes an export subsidy, its terms of trade decrease and its welfare

Lecture 8 External Economies of Scale (Ch.7)

Some trade patterns cannot be explained by differences in technologies or resources endowments.
However, increasing returns to scale can explain these patterns:
- IRS provide an incentive for countries to specialize in the production of certain products.
- Therefore, they will import the goods they are not specialized in, but in which another
country is specialized.
- They will export the goods they are specialized in, but in which another country is not
Diminishing returns to scale or diminishing returns to one factor are different!
Diminishing returns to one factor = when only that factor input is increased by x%, output rises
by less than x%.
Diminishing returns to scale = when all factors input is increased by x%, output rises by less
than x%.
If there are no differences in technologies or resource endowments and the production is
characterized by constant returns to scale, the relative prices will be the same in both countries.
Therefore, there is no incentive to trade.
However, increasing returns to scale provide an incentive for trade.
IRS or economies of scale: when all inputs to an industry increase by x%, output increases by
more than x%. A larger scale is more efficient: the cost per unit of output falls as a firm or
industry increases output.
When production is characterized by IRS, it pays to specialize, because using available resources
in one or few sectors makes them more productive than using them in many sectors.
Trade can be mutually beneficent:
- It allows for specialization
- In autarky it is not possible to exploit possible economies of scale.
Economies of scale mean that either larger firms or larger industries are more efficient.
External economies of scale: occurs when the cost per unit of output depends on the size of the
industry (e.g. easy access for suppliers, labor pooling, and knowledge spillovers).
Internal economies of scale: occurs when the cost per unit of output depends on the size of the


An industry with external economies of scale usually consists of many small firms and is
characterized by perfect competition.
An industry with internal economies of scale usually consists of a few large firms and is
characterized by monopoly or oligopoly.
External economies of scale provide an explanation for specialization patterns in various
countries: Concentrating production of an industry in one or a few locations can reduce the
industrys costs, even if the individual firms in the industry remain small.
Reasons why external economies of scale occur
1. Specialized equipment or services (suppliers) may be only supplied by other firms if
the industry is large and concentrated.
2. Labor pooling: Concentrating production of an industry in one or a few locations can
reduce the industrys costs, even if the individual firms in the industry remain small.
3. Knowledge spillovers: workers from different firms can more easily share ideas that
benefit each firm when a large and concentrated industry exists. Also, easier to learn from
nearby concentration of competitors.
Without specifying the drivers of external economies of scale: The larger the industry, the lower
the average costs. Since under perfect competition prices reflect production costs: The larger the
industry, the lower the prices.
The form of the supply curve changes! It is not upward-sloping, but forward-falling. Because
there are always new firms willing to enter the market, offering lower prices.
Without trade: Each country will produce they quantity it demands.
With trade: The country that has the lowest average cost will end up producing everything.
Since the average costs fall, since one country needs to supply for world demand, world prices
fall because of trade!
However, some trade patterns are a result of differences in initial prices. If a country starts
producing first, it will reach a lower AC than a start-up in another country, even though in
the long run the AC of the other country will be lower.
- Historical events
- Chance.
Because of this, a country may have external economies of scale, and will end up producing more
than the other country, because it has an advantage.
1. The wrong location may end up producing it.
2. Lock-in may prevent more efficient producers from emerging. It is more efficient to
produce in the country with the lowest AC, but because of history or chance, the other
country has an advantage and will produce everything, even though this is not the most
efficient choice.
There is no guarantee that the right country will produce goods that are subject to external
economies of scale.

Gains from trade in the presence of external economies of scale

In general: The whole world gains from trade based on external economies of scale, because it
allows countries to specialize, which makes production more efficient, therefore prices are lower.
Welfare increases.
However, some countries do not gain from trade. If a country is more efficient in the production
of a certain good, but another country has external economies of scale due to history or chance,
the price paid in the more efficient country with trade is higher than the price they would pay in
autarky. This is an incentive to protect its own industry, until it is large enough to compete with
the country that now produces the good.
Rapid changes in the location of production are possible, if a country is able to reduce its
production costs (technological innovation, better education population), it may result in rapidly
attracting whole industries. External economies of scale speed up this process.
Dynamic external increasing returns to scale (learning curve): if production costs fall with
cumulative output over time.
This can result in the same effects as static IRS:
- Lock-in of initial advantage
- Rapid changes in the location of production
- Some countries worse off under trade than under autarky.
Theoretically, it can be justified to protect your economy until it gained experience enough to
compete with other countries (infant industry argument), or a large enough cluster is present,
so it can compete on world markets.
In practice:
- Hard to identify which industries to protect, and which industries will never be able to
- Protection may reduce the incentive to innovate and produce efficiently.
External economies of scale are also important for interregional trade.
To what extent external economies of scale can explain differences in regional economies
depends on whether good are tradable or not. Shares of employment in sectors with non-tradable
goods are similar in different regions. However, this is not the case for tradable goods. Here lies a
big role for economies of scale. Production of most tradable goods is to a great extent localized
within a country.
Determinants of regional specialization
- Historical coincidence.
- Geography
1. Trade need not be the result of comparative advantage. Instead, it can result from
increasing returns or economies of scale, that is, from a tendency of unit costs to be lower
with larger output.
2. Economies of scale give countries an incentive to specialize and trade even in the absence
of differences in resources or technology between countries.

3. Economies of scale can be internal (depending on the size of the firm) or external
(depending on the size of the industry).
4. Economies of scale can lead to a breakdown of perfect competition, unless they take the
form of external economies, which occur at the level of the industry instead of the firm.
5. External economies give an important role to history and accident in determining the
pattern of international trade.
- When external economies are important, a country starting with a large advantage
may retain that advantage even if another country could potentially produce the
same goods more cheaply.
6. When external economies are important: the free trade price can fall below the price
before trade in both countries
7. When external economies are important, countries can conceivably lose from trade.
8. Within countries: economies of scale typically even more important to determine
interregional pattern of trade and clustering of tradable goods production.

Lecture 9 The Instruments of Trade Policy (Ch.9)

Total welfare effect of a certain trade policy = terms of trade effect + welfare effect of the policy
distorting production and consumption choices + welfare effect of a change in government
Partial equilibrium framework: We focus on the effects of different trade policies in a single
industry without considering the full effect in the other sectors or countries.
1 Import tariffs
2 types of tariffs:
Specific tariff: a fixed charge for each unit of imported goods.
Ad valorem tariff: a fraction of the value of imported goods.
Effective rate of protection: change in value (measured by goods prices) that firms in an
industry add to the production process, due to a change in trade policy.
Only if the firms makes and sells the good all by itself: effective rate of protection = tariff rate.
(PT P)/P = [(P(1+t) P]/P = t
This is almost never the case, because of the use of intermediate products: effective rate of
protection DOES NOT EQUAL tariff rate.
Value added by firm: P Pintm
After tariff: P(1+t) Pintm
Effective rate of protection: [(P(1+t) Pintm) (P Pintm)] / (P Pintm) = t [P/(P Pintm)] > t
An import tariff on the intermediate product will result in a negative effective rate of protection.
Effective rate of protection = -t[Pintm/(P Pintm)] < 0
Suppose, a tariff affects a single market, cars.
In autarky: PC > P*C

With trade: Foreign exports cars

Home imports cars from Foreign.

Import demand curve (for Home): at each given price: MD = D S

Export supply curve (for Foreign): at each given price: XS* = S* - D*
In equilibrium:
D S = S* - D*
D + D* = S + S*
World demand = world supply
Home imposes an import tariff on Foreigns cars:
Small country (no effect on world relative supply, demand, and prices)
P*C remains the same. P*C = PW
Home: PT = PW + t

As a result of the tariff, imports decline.

Large country (does have an effect on world relative supply, demand, and prices)
Homes prices rise to PW + t. Lowers Homes demand and increases Homes supply. Since Home
is large, this also affects world relative demand and supply. World relative demand decreases and
world relative supply increases. This also changes Foreigns price: Foreigns price decreases.
In the new equilibrium, it has to hold that:
1. Home consumers are indifferent between buying abroad or at home.
2. Foreign producers are indifferent between selling at home or abroad.
PT = P*T + t
PT > PW > P*T


Homes prices rise by less than the import tariff imposed.

Homes car imports fall, due to increased prices.
Foreigns car exports fall, due to fallen prices.

A tariff raises the price in the importing country, and therefore:

Benefits producers (measured in Producer Surplus)
Hurts consumers (measured in Consumer Surplus)
Increasing government revenue.
Consumer surplus measures the amount that consumers gain from purchases by computing the
difference between the price actually paid and the maximum price they would be willing to pay
for each unit consumed. (Area below demand curve, but above price).
Producer surplus measures the amount that producers gain from sales by computing the
difference between the price received and the minimum price at which they would be willing to
sell. (Area above supply curve, but below price).
Consequences of a tariff:
Consumer surplus decreases
Producer surplus increases
Government revenue increases by tQT
Overall effect on welfare = CS + PS + government revenue


Small country: Always a negative welfare effect, since there are no Terms of trade gains, but
only an efficiency loss.
Large country: Possible positive welfare effect if the Terms of Trade effect > efficiency loss.
2 Export subsidy
Ad valorem
In equilibrium firm should be indifferent between exporting and supplying the domestic market:
PS = P*S + s <=>
PS - s = P*S
An export subsidy raises the price of the good in the domestic market.
More focus on export
Less domestic supply Price increases
CS decreases
PS increases
Government revenue decreases by sQS
If a country is large enough: changes in domestic demand (decrease) and domestic supply
(decrease) will also affect world markets. Relative price will go down: Terms of trade
Overall effect on welfare = CS + PS + government revenue
= efficiency loss + Terms of trade loss (this is a welfare gain for Foreign).


3 Import quota
An import quota is a restriction on the quantity of goods that may be imported.
A binding import quota will increases prices of imports (quantity demanded exceeds quantity
supplied at home and abroad).
As a result of an import quota:
Producers benefit
Consumers lose
Government revenue does not change, because there is not import tariff.
Quota license holders get revenue (quota rents) from selling imports at high prices. If the
government is a quota license holder, the quota rents increase government revenue.

A voluntary export restraint (VER) is like an import quota, except it is requested by importing
country, often in return for relaxation of other trade policy. The profits or rents from this policy
are earned by foreign producers. There is a welfare loss for the importing country.


A local content requirement (LCR) is a regulation that requires a specified fraction of a final
good to be produced domestically.
It may be specified in value terms: a minimum share of the value added must represent
value added in home.
Or in physical units.
For domestic producers or intermediates, it protects them in the same way an import quota would.
For firms using intermediates, it does not limit imports, but allows them to import more if they
also produced more Home parts.
However, it does raise the price of intermediates.
A LCR does not provide government revenue nor quota rents and its hard to enforce.
Export credit subsidies
- A subsidized loan to exporters
- U.S. Export-Import Bank subsidizes loans to U.S. exporters
= same effect as export subsidy
Government procurement
- Government agencies are obligated to purchase from home suppliers, even when they
charge higher prices (or have inferior quality) compared to foreign suppliers
= LCR only for government purchases
Bureaucratic regulations
- Safety, health, quality, or customs regulations can act as a form of protection and trade
= same effect as import quota
1. Tariffs drive a wedge between foreign and domestic prices,
- In the small country case, a tariff is fully reflected in domestic prices.
- In the large country case, world price falls and domestic price rises by less than the
2. The costs and benefits of a tariff or other trade policy instruments can be looked at using
the concepts of consumer and producer surplus.
- Domestic producers gain
- Domestic consumers lose
- The government collects tariff revenue (or not)
3. The overall welfare effect of a tariff, quota, or export subsidy can be measured by
- efficiency loss from consumption and production distortions
- terms of trade gain or loss (if country is large)
4. With import quotas, voluntary export restraints, and local content requirements, the
government of the importing country typically receives no revenue.
5. With voluntary export restraints and import quotas, foreigners typically gain by getting
quota rents.

Lecture 10 Trade policy in practice (no) free trade? (Ch. 10, 11, 12)


If countries benefit from trade, why do we observe active trade policies and protests against free
1. Politics:
- Groups that lose from trade, actively lobby to protect their interests.
- Countries retaliate against other countries trade policy.
2. Other gains/disadvantages from trade not taken into account by models:
- Infant industry argument
- Environment
- Labor standards
1 Political economy of trade policy
In democratic societies: politicians have incentives to set policies that gains them the most votes.
But they also need money to campaign for votes.
Models: Politicians care about maximizing their own political success, rather than national
- Median voter theorem: Parties pick policies to court the median voter and attract the
most votes.
- Collective action
1. Two competing politic parties
2. Only one policy
3. Objective is to get majority of votes
4. Parties live up to their promises.
Choice of policy is determined by how many voters will be pleased.
So: no quota, export subsidies, and no import tariffs!
However, trade policy does not follow this principle.
Collective action problem:
- Consumers as a group have an incentive to advocate free trade, but each individual
consumer has no incentive, because his benefit is not large enough to compensate the cost
of advocating free trade.
- Policies that impose large losses for society as a whole, but small losses on each
individual may therefore not face strong opposition.
- For individuals with large individual losses, each individual has a strong incentive to
advocate the policy he desires: tariff, subsidy, or quota. For these individuals, there is no
collective action problem.
Collective action models explain why the median voter theorem does not work for trade policy.
Trade policy in practice
To advocate popular policies, politicians need money to campaign for them. Often, these funds
come from interest groups who do not have a collective action problem, but do have special
interest in a particular policy. Trade restrictions may stay intact, if consumers do not care too
much about them, and the interest groups strongly advocate them.

Trade policies do not only have domestic consequences, but it also affects other countries, who
can retaliate against the restrictions. In an extreme case: trade wars. To prevent trade wars,
international trade agreements are very important.
Even if there is only a threat of restrictions being imposed:
- All countries could enact trade restrictions, even if it is in the interest of all countries to
have free trade
- To avoid this, countries need an agreement that prevents a trade war or eliminates
the existing protection.
Without coordination, countries will choose protectionism, although the best for everyone is free
trade. This explains why international negotiation are very important:
- World Trade Organization
- Bilateral agreements
- Regional Trade Agreements
Free trade, or not?
Models say: trade makes a country as a whole better off, restrictions decrease welfare.
Ricardian, Specific Factors, Heckscher-Ohlin models:
- Free trade expands consumption possibilities, restrictions decrease welfare.
- Losers can always be compensated, since countries as a whole gains from trade.
Increasing returns to scale: Restrictions:
- Limit gains from external economies of scale
- Reduce international competition
- Reduce learning (trade contains knowledge).
Make trade, not war! Trading countries are less likely to go to war.
Political arguments:
- If theres no free trade, policies will be manipulated by political groups welfare
- Rent seeking: people spend time and other resources seeking quota rights and the profit
that they will earn, instead of using them for productive purposes
- Excessive policy making (bananas, cucumbers etc.)
No trade!
Theoretical argument:
A country can gain from imposing import tariffs because of a positive terms of trade effect. Only
if terms of trade effect dominates negative welfare effect and if other countries do not retaliate.
It is very doubtful that this works in practice.
Other arguments:
Domestic market failures
- High underemployment: restrictions on labor mobility, or on wages.
- Private firms can fully profit from technological benefits: lack of innovation.
- Badly functioning capital markets: less firm investment and growth.
- Environmental cost for society because of production, but firms do not fully pay for it: too
much pollution.

In principle, its always the best option to tackle these failure directly, not through trade
restrictions. But sometimes, its hard to directly solve problems.
Suppose that externalities from production are not taken into account by private firms and
investors. With this market failure, marginal social benefit is not accurately calculated by the
producer surplus. Efficiency loss calculations are thus misleading. When a tariff increases
domestic production, the benefit to domestic society can increase by increasing the positive sideeffects of domestic production (more knowledge spillovers)!
This may work, but typically:
- Unclear when a market failure exists and its severity.
- Addressing of market failures by government may be influenced by lobbyists.
- Distortion of incentives to produce or consume may have unintended effects, that
deteriorate the situation.
Infant industry arguments
Only by first protecting own industries, will they ever be able to compete on world-markets.
Import-substitution policies were popular for developing countries in the 80s.
Encourage domestic industries, by protecting them from competing imports
- Extremely high tariffs (even prohibitively high)
- Import quotas
- Local content requirements.
However, countries adopting import-substitution policies grew slower than countries that didnt
adopt these policies.
The infant industry argument was not valid in practice:
- New industries did not become competitive
- Import-substitution industrialization involved costs and promoted wasteful use of
- It involved complex, time-consuming regulations.
- It set high tariff rates for consumers, including firms that needed to buy imported
inputs for their products.
- It promoted inefficiently small industries.
As a result, and because of the rapid growth of East-Asian countries, that did not adopt these
policies, many developing countries started to liberalize trade.
It is difficult to say, but the evidence points out that increasing exports of developing countries
led to growth.
Low wages and poor working conditions in developing countries. Situation is worse than in
developed counties. That is true, but would the country benefit if there was no trade?
On average, workers in developing countries are better off. And anti-globalization movement is
absent in developing countries. On the contrary, people advocate free trade. Furthermore,

developing countries are against labor standards, because they are afraid it will be used as a
protectionism argument by rich countries. Poor conditions are set by the countries itself, not by
trade. However, a change in working conditions is desirable. Improving conditions in exporting
sectors will have a small effect, since most people dont work in exporting sectors, but it can set
an example.
Environmental standards are often opposed to by developing countries, afraid of standards
being used as a protectionism measurement, and afraid for their own development. But the
pollution haven effect is an issue. The solution is to promote sustainable development (this does
not depend on trade). Pollution haven - when economic activity becomes concentrated in one
region because of less strict regulations.
Culture arguments
Trade westernizes other cultures
This argument forgets that:
People, also in developing countries, make their own choices.
People do not have to consume foreign products, if they do, they typically like them.
They define their culture through the choices that they make, not through standards set
by others.
To trade or not to trade?
Overall, gains from trade depend on how you value all its pros and cons
Difficult to put a number on this, but evidence much (much) more towards trade being a good
Just two final thoughts: If trade is really that bad,
1. Why do we see it happening everywhere?
2. Why dont we restrict trade between Rotterdam and Groningen, between New York and
San Francisco, or between Peking and Shanghai?



Lecture 11 Firms in the Global Economy (1) (Ch.8)
The focus will be on firms that do not behave perfectly competitive, the firms that can affect
Trade between similar countries (technologies, relative factor endowments) exchange different
varieties of the same goods.
Intra-industry trade
Grubel-Lloyd index: GLi = 1 - |Xi - Mi| / (Xi + Mi)
i: industry
Xi: value of exports by industry i.
Mi: value of imports by industry i.
GLi = 1 |Xi Mi| = 0: large degree of intra-industry trade. If GLi = 0 Xi > 0 and Mi = 0, or
Xi = 0 and Mi > 0: only in Ricardian or Heckscher-Ohlin trade, only inter-industry trade.
High GL-index: mostly intra-industry trade.
Low GL-index: mostly inter-industry trade.
Trade between identical countries
Largest share of Western European trade is within Western Europe. This is similar with NorthNorth and South-South trade. Only North-South trade can be explained by Ricardian or
Heckscher-Ohlin model.
Summary of stylized facts
Trade in identical goods is important
Trade between identical/similar countries is important
New trade model needed
Notice: Ricardo or HeckscherOhlin trade empirically not dead, but can explain only
trade of different goods between different countries.
New trade model
Monopolistic competition.
Internal economies of scale: Average costs decrease as output increases.
Large firms are more efficient than small ones.
Industries consist of monopoly/few large firms.
Imperfect competitive market structure: excess profits for large firms.
P = MC not possible with IRS: First units of output are sold at P < MC loss at P = MC. In
sectors with IRS (manufacturing) goods are differentiated: firms can set prices, such that P > MC.
Theory of imperfect competition
Firms can influence the price of their product.
Especially relevant when a firm differentiates its good from rivals varieties of the good.
Prices are set such that profit is maximized (monopolist or oligopolists).

Monopolist: MR = MC
Profits: (P AC) x Q
Trade liberalization = increase in market size. Demand curve and MR-curve shift outwards.
Monopolist realizes higher profits (incentive to export).
Assumption: no foreign monopolist exists and trade is costless.
Monopolistic competition: more common than pure monopoly.
1. Single firms differentiate their varieties from their competitors.
2. When setting price, each firm takes prices of competitors as given.
1. Single firm sells more if aggregate demand for class of product increases and if price of
rivals increases.
2. Single firm sells less if number of competitors increases and if own price increases.
Demand function: q = S [1/n b(P P)]
q: a single firms sales
S: total sales of industry
n: number of firms in industry
b: parameter that indicates price sensitivity of sales
P: price charged by firm itself
Pbar: average price in industry
Additional assumption: All firms are symmetric: they have the same demand function, same cost
structure. Therefore, they have the same price.
P = Pbar
q = S/n
Single firm: AC = F/q + c = n x F/S + c
If n increases: AC increases
If S increases: AC decreases
Autarky equilibrium: MR = MC P = c + 1/bn
Assumption: Entry is free, entry occurs until its not profitable anymore.
Equilibrium: p = AC
P = c + 1/bn = nF/s + c = AC
n* = sqrt(S/bF)
Trade increases size AC decreases (market size increases S increases, AC = nF/S + c).
If AC decreases: P decreases, n increases.
Consumers gain since P decreases and n increases (lower prices, more varieties increases
Trade liberalization (integrating markets) has the same impact on P and n as economic growth in
a closed economy.
Undetermined: share of firms in Home and share of firms in Foreign.


Reasons for trade in this setting:

Product differentiation
Internal economies of scale
Significance of intra-trade industry
Intraindustry trade: countries exchange different varieties, produced by the same
Two new channels for gains from trade:
Availability of new varieties
Firms exploit economies of scale (lower average costs, lower price)
Typically: smaller country gains more from liberalization to (intraindustry) trade, as
compared to a larger country.
Roughly 2550% of world trade is intraindustry.
Typically: trade of manufactured goods among developed countries (=majority of world
Due to trade liberalization:
Increased competition
Bad firms are pushed out of the market
Good firms expand.
Net effect of firm selection: intra-industry wide average production increases additional source
for gains of trade.
Firms with marginal costs larger than the intercept (P = 1/bn + P) cannot serve the market
More generally: lower marginal costs lead to higher profits.

Lecture 12 Firms in the Global Economy (2) (Ch.8)

After trade liberalization, the intercept decreases (P = 1/bnautarky + P = 1/bntrade + P)
The least efficient firms exit the market, inefficient firms lose, and the most efficient firms gain
from trade liberalization.


However, only a small share of firms is active on foreign markets. Because of (fixed) export costs
(administrative costs, costs of setting up a production plant abroad). However, the exporting firms
are usually huge.
Fixed export costs
Difficult to estimate, also costly: time needed to export.
Importance of trade costs
They explain why only a subset of firms export.
They explain why exporters are larger and more efficient than non-exporters.

If MC + t > intercept in foreign markets, a firm cannot export profitably.

Charging a lower price for exported goods than for goods sold domestically. It is also an example
of price discrimination. It may only occur if:
Imperfect competition exists: firms can set prices.
Markets are segmented.
Dumping can be a profit-maximizing strategy (jointly maximizing profits over two markets). If
MRH = MC and MRF > MRH, a firm profits from selling abroad.
Generally, dumping is considered to be unfair.


With price dumping: there is a kink in the MR-curve, where it turns in to a horizontal line, at the
point where the domestic MR-curve equals the foreign price. A firm can only attain this kinked
MR-curve if it limits domestic sales to the amount domestic sales, dumping.
From an economic point of view dumping may be good for domestic consumers, since they now
face a lower price.
Claim: anti-dumping tariff is only used as protection of domestic market.
Foreign Direct Investment (FDI): Investment in which a domestic firm controls or owns a
subsidiary abroad. (Only if +10% of voting shares).
Multinational: firm with a FDI.
Greenfield FDI: Company builds a foreign production plant from scratch.
Brownfield FDI: (Mergers & Acquisitions), domestic company buys at least 10% of voting
shares of foreign company.
Greenfield FDI is more stable; mergers and acquisitions occur in surges.
Horizontal FDI: Foreign affiliate replicates production processes of parent company.
Vertical FDI: Buyer-seller relationship between foreign affiliate and parent company; typically:
foreign affiliate produces intermediate goods for parent company.
Horizontal FDI dominates FDI-flows between developed countries. Main reason: locate
production close to large markets to avoid transport costs or tariffs (tariff-jumping FDI).
Vertical FDI dominates FDI-flows between developed and developing countries. This is driven
by production cost differences between countries (Heckscher-Ohlin argument). However, a recent

trend is reshoring foreign production back to the home country (because of poor institutional
Horizontal FDI and proximity-concentration trade-off: (leads to producing good in multiple
High export costs incentive to locate production near customers.
IRS in production incentive to locate production in fewer locations.
FDI activity is concentrated in sectors with high trade costs. Multinationals are usually larger and
more efficient than other firms in the industry (including other exporters).
Additional trade-off:
Horizontal FDI: trade-off between per unit export cost t and fixed cost F for setting up a
production plant abroad.
IF t(Q) > F, the firm has an incentive to engage in horizontal FDI (likely when foreign
sales are large).
Vertical FDI
Trade-off between cost savings due to lower factor prices abroad and fixed cost of setting up a
production plant abroad.
Why not outsourcing or offshoring?
Internalization decision: whether to keep production in-house (vertical FDI) or to outsource it.
Vertical FDI instead of outsourcing:
1. Technology transfer: transfer of knowledge is easier within a company than through
market transactions with separate firms. Patents or property rights may be weak,
knowledge is not easily transferable.
2. Vertical FDI: different stages of production processes in-house. Avoiding hold-up.
However, possible economies of scale when outsourcing).
When do multinationals arise? (OLI)
Ownership advantages: beneficial for domestic firms to own foreign plant due to
patents or trademarks.
Location advantages: low input prices, high transport costs or tariffs.
Internalization advantages: cost-saving to undertake foreign production within the firm.
Zipfs Law: There is a statistical relationship between the size of a city and the geographical
concentration of economic activity. However, there appears to be no theoretical explanation of
this law.

Lecture 13 National income accounting and Balance of Payments (Ch.13)

National income = income earned by a countrys factors of production.
Closed economy: expenditures by buyers = income for sellers = value of production
Gross National Product: value of all final goods and services produced by a countrys factors of
production in a given time period.


GNP consists of:

1. Private consumption (typically dominates)
2. Investment
3. Government consumption
4. Current account balance: exports imports
GNP depreciation + unilateral transfers = national income
Unilateral transfers: payments of expatriate workers to home country, foreign aid, pension
payments to expatriate retirees.
Depreciation and unilateral transfers are mainly exogenous to government policy: GNP and
national income are therefore used interchangeably.
Gross Domestic Product: value of all final goods and services produced within a country in a
given time period.
GDP = GNP payments from foreign countries for domestic factors of production +
payments to foreign for foreign factors of production.
Open economy
Y = Cd + Id + Gd + EX; Y - national income; C - consumption; G - government purchases;
EX: expenditures on domestic production; I - investment
Y = C + I + G + CA
CA = EX IM = Y (C + I + G)
CA > 0: net foreign wealth increases (production > domestic expenditures)
CA < 0: net foreign wealth decreases.
National saving
S = (Y C T) + (T G) = S private + S government
S = Sp + Sg
CA = Y (C + I + G) ---> = Sp+Sg-T
CA = (Y C G) I
CA = S I
CA = net foreign investment
CA = Sp + Sg I
CA = Sp government deficit I (or plus if proficit)
Sg = T G
Balance of payments
Balance of payments records all transactions between domestic and foreign country.
Current account: accounts for flows of goods and services (imports and exports).
Financial account: accounts for flows of financial assets (financial capital).
Capital account: flows of special categories of assets: typically nonmarket, non
produced, or intangible assets like debt forgiveness, copyrights and trademarks.
Current account + Financial account + Capital account = 0

Current account
1. Merchandise
2. Services
3. Income receipts
The world as a whole always has a current account surplus or deficit, even though in theory it
should be equal to zero.
Capital account: records special transfers of assets; usually of minor importance.
Financial account: difference between sales of domestic assets to foreigners and purchases of
foreign assets by domestic citizens.
Financial inflow: foreigners loan to domestic citizens by buying domestic assets; sale of these
assets is a credit (+): domestic economy acquires money.
Financial outflow: domestic citizens loan to foreigners by buying foreign assets; purchase of
these assets is a debit (-): domestic economy gives up money.
We care about national income, GDP, and GNP because they are a way to rank countries.
However, a better measurement is the Human Development Index: 1/3 life expectancy, 1/3
literacy rate, and 1/3 GDP per capita.

Lecture 14 Money, Interest rates, and Exchange rates (1) (Ch.15)

Medium of exchange
Unit of account
Store of value
Liquid asset
Bears little or no interest
Liquid assets: currency in circulation, checking deposits, debit card accounts, savings deposits,
time deposits.
Illiquid assets: bonds (can be traded), loans, deposits of currencies, stocks, real estate, works of
art, etc.
Determinants of individual money demand:
1. Interest rate on non-monetary assets.
2. Risk of unexpected inflation reduces purchasing power of money.
3. Liquidity: need for liquidity increases with price of transactions and with the quantity of
transactions increases.
Determinants of aggregate demand:
1. Interest rate on non-monetary assets.
2. Prices: the higher the price of goods and services, the higher the money demand.
3. Income: higher income implies more demand for goods and services: i.e. more impact on
money demand.

No risk of unexpected inflation: borrowers gain from unexpected inflation, lenders lose overall
no impact on money demand.
Md = P x L(R, Y)
P: price level
Y: real income
R: interest rate on non-monetary assets
L(R, Y): aggregate real money demand
- +
Md/P = L(R, Y)
Interest rates adjust so that money demand equals money supply.
Ms = Md
Ms/P = L(R, Y)
Money supply and the exchange rate in the short run
US: Home country, EU: foreign country
E$/ depends on the return on dollar deposits and the expected return on euro deposits.
E$/ increases: depreciation of the dollar. (you need more dollars to get euros)
Return on deposits ($) are not influenced by E$/. However, return on deposits () decrease when
E$/ increases. Since changes in future E$/ are not related to changes in current E$/, a current
depreciation of the dollar decreases the return on assets (), since the investor has to pay more

Change in domestic money supply

1. MsUS increases R$ decreases.
2. Demand for assets () increase (higher interest rate), demand for assets ($) decreases.
3. US investors supply $ and demand .
4. E$/ increases: depreciation of the dollar. Note: value of other currency doesnt change!
Change in foreign money supply
1. MsEU increases R decreases.

2. Demand for assets () decrease (lower return), demand for assets ($) increases.
3. EU investors supply $ and demand .
4. E$/ decreases: appreciation of the dollar.
Short run: Final goods prices and factor prices are fixed due to menu costs.
Long run: Final goods prices and factors prices are flexible.
Factor prices adjust to clear factor markets.
Real output and income level only depends on a countrys factor endowments and
Real output and income level are independent of money supply.
Interest rate is independent of money supply.
Price level adjusts so that real money supply stays constant.
LM-curve: all combinations of R and Y. Only instrument of central bank is money supply, not
interest rates.
1. An increase in money supply shifts LM-curve to the right interest rate decreases to
reestablish equilibrium on money market domestic demand for investment goods
increases aggregate demand AD increases for a given price level short-run
2. Since increase in money supply is permanent firms adjust their prices price level
increases. This shifts back the LM-curve to its initial position. R, Y and Ms/P are
unchanged long-run equilibrium. (Though price is increased)

Long-run relationship between money supply and price level

P/P = Ms/Ms L(R,Y)/L(R,Y)


Positive (longrun) relationship between money supply and price level especially important for
countries with no simultaneous changes in L!
Economic mechanisms
If Ms increases:
Interest rate R decreases
Lower interest rates imply higher demand for investment goods.
Aggregate demand increases.
Uncertainty of firms: increase in MS temporary or permanent? Firms keep prices fixed
(menu costs) and just increase production (workers work harder and longer).
However, if workers demand wage compensation:
Wages increase
Production costs increase
Prices increase
Real money supply Ms/P decreases
Interest rate R increases
Smaller domestic demand for investment goods.
An increase in the price level exactly compensates the increase in money supply!
Open economy
1. Increase in US money supply decreases R$.
2. Since we now consider the long run, expectations are also important. Investors expect
inflation for the future. Expected euro return-curve shifts right.
3. Demand for assets ($) decreases, demand for assets () increases. Supply of $ and demand
for increases, E$/ increases: depreciation of the dollar.
4. US price level increases in the long run, real money supply in the US decrease, returns on
assets ($) increase.
5. Demand for assets ($) increases, demand for assets () decreases. Supply of and demand
for $ increases, E$/ decreases: appreciation of the dollar.
Notice: new exchange rate is still above initial exchange rate, because the expected euro returncurve shifted to the right.
Exchange rate overshooting (Dornbusch)
Initially a large devaluation/depreciation of the currency, later a slight appreciation of the
Crucial for exchange rate overshooting: sticky prices, i.e. change in nominal money supply has a
shortterm effect on real money supply!

Lecture 15 Price levels and the exchange rate in the long run (1) (Ch.16)
Long-run approach: prices are completely flexible, and goods and money markets are in
equilibrium; changing prices influence interest rate and exchange rate in the long-run.


Law of One Price (LOP): If free trade is costless and if competition is perfect, the same good is
sold at the same price in all trading countries. Hardly holds in reality.
Reasons for violation of LOP:
Different taxes across countries.
Transportation costs and different production costs under multinational activity.
Transportation costs and different forms of competition.
Purchasing Power Parity (PPP): Application of LOP for all goods and services (or a
representative basket of goods and services) across countries.
PNL = PCH x E/CHF (how many e it costs to get 1 frank)
PNL = Aggregate/average price level in the Netherlands
PCH = Aggregate/average price level in Switzerland

Ratio of average prices determines exchange rates.

PPP implies that households have the same purchasing power in all countries.

Absolute PPP: Holds if exchange rates equal level of average prices across countries:
Relative PPP: Holds if the change in exchange rates equals the change in relative prices.
NL, t CH, t = (E/CHF, t - E/CHF, t-1) / E/CHF, t-1 with t = inflation rate from t-1 to t.
If absolute PPP holds, relative PPP holds as well. NOT vice versa!
Absolute LOP for individual goods absolute PPP
Relative LOP for individual goods relative PPP
Monetary approach to exchange rates
Long run: prices are flexible prices always adjust so that absolute PPP holds.
If absolute PPP holds, the equilibrium exchange rate is determined by Ms, R, and Y of both
Ms increases:
Proportional increase in PEU.
Proportional depreciation of relative to $, since PPP holds.
Comparable prediction as previous long-run model without PPP.
REU increases:
L(REU, YEU) decreases
PEU increase to maintain equilibrium on European money market.

Proportional depreciation of relative to $, since PPP holds.

Different outcome than previous model!

YEU increases:
L(REU, YEU) increases
PEU decreases to maintain equilibrium on money market.
Proportional appreciation of relative to $, since PPP holds.
Causal relationships:
Exogenous change (Ms, R, Y):
Prices adjust to maintain equilibrium on money market.
This leads to an adjustment of the exchange rate, since PPP holds.
Fisher effect
Relationship between nominal interest rates and inflation.
Interest parity condition: REU RUS = (Ee/$ - E/$) / E/$ <- Fisher equation
When the equation holds, there is no incentive for investors to relocate their investments, if they
expect the higher interested to be outweighed by a depreciation of the currency.
If relative PPP holds, changes in relative aggregate prices equal relative change in exchange rates.
REU RUS =eEU, t eUS, t
Fisher effect: An increase in the expected domestic inflation rate ceteris paribus leads to an equal
increase in the interest rate on domestic assets.
An increase in RUS decreases real money demand: PUS has to increase for an equilibrium on the
US money market. Due to PPP, the increase in the PUS leads to a depreciation of $.
Reasons for failure of PPP
Trade barriers and non-traded goods:
Transportation costs and trade restrictions imply that some goods are not traded.
Services are often non-tradable.
Even if good is traded, due to transportation costs: prices differ between countries.
Imperfect competition:
Pricing to market: same good is sold at different prices in different markets, depending
on market structure.

Lecture 16 Price levels and exchange rates in the long run (2) (Ch.16)
Real exchange rate approach: Composition of basket of goods is allowed to differ between
countries; households also demand non-tradable goods, goods which are uniquely supplied to one
Real exchange rate: Rate of exchange for goods and services across countries. Relative price of
goods and services across countries.

q$/ = E$// x PEU / PUS

Real depreciation of the dollar: US basket of goods becomes less valuable relative to EU
basket. More of the US basket of goods has to be spent to obtain one EU basket of goods.
When absolute PPP holds, q = 1
Determinants of the real exchange rate
1. Nominal exchange rate
2. World relative demand for US goods: increase in relative demand for US goods increases
relative price of US goods. PUS / (PEU x E$/) increases increase of the value of US
goods relative to EU goods, real appreciation of the dollar.
3. Relative supply of US goods: Increase in relative supply of US goods decreases relative
price of US goods: PUS / (PEU x E$/) decreases decrease of the value of US goods
relative to EU goods, real depreciation of the dollar.
Vertical RS-curve: In the long run, total productivity only depends on factor endowments and
Upward-sloping RD-curve: increase in q$/ = E$// x PEU / PUS implies that US goods become
cheaper relative to EU goods demand for US goods increases relative to demand for EU
Preferences for US goods increase
1. RD for US goods increases
2. RD-curve shifts to the right
3. Price of US goods relative to the price of EU goods increases
4. Real exchange rate decreases.
Technological progress in Europe
1. RS of EU goods increases
2. RS-curve shifts to the left
3. Price of EU goods relative to the price of US goods decreases
4. Real exchange rate decreases.
Increase in US money supply
1. Proportional increase of the price of US goods in the long run
2. No real consequences
3. No change of the real exchange rate.
Nominal exchange rate: E$/ = q$/ x PUS / PEU
1. Increase of money supply changes price levels. Nominal exchange rate changes
proportionally no change of the real exchange rate.
2. Increase in US inflation: increase in US nominal interest rate, a decrease in US real
money demand, an increase in US prices. Nominal exchange rate changes proportionally
no change of the real exchange rate.
3. Increase in relative demand for domestic (US) goods (tradable and non-tradable). Increase
in relative demand for US goods does not necessarily imply a proportional decrease in
relative demand for EU goods PUS increases. However, foreign exchange market is

only partially influenced by changes in relative demand. Still, real exchange rate
decreases, since the price level in US relative to the price level in EU increases.
The effect of an increase in relative demand for domestic goods has an ambiguous effect
on the nominal exchange rate.
4. Increase in relative supply of domestic (US) products. (1) Price level in US decreases and
(2) income in US increases. (1) Has a negative effect on the nominal exchange rate, since
EU demand for tradable US goods increases. (2) Has a positive or negative effect on the
nominal exchange rate, since US demand for tradable EU goods increases PEU
increases. Real exchange rate increases a real depreciation of the dollar, US goods
become relatively cheaper.
Crucial for real exchange rate approach: Real changes (demand/output) do not translate 1:1 into
foreign exchange market since part of the goods is non-traded.
Determinants of nominal exchange rate:
Changes in monetary factors: no changes of real exchange rate.
Changes in relative demand/supply for/of domestic goods:
Changes of the real exchange rate
Increase in RD for domestic goods decrease real exchange rate, nominal exchange
rate changes as well.
Increase in RS of domestic goods: ambiguous effect on nominal exchange rate.
Monetary factors do not change the real value of goods, only the nominal exchange rate.
Real factors change the real value of goods, also the real exchange rate.
Interest rate differences
Fisher effect is too simplistic, since relative PPP does not hold.
q$/ = E$/ x PEU / PUS
(qe$/ - q$/) / q$/ = (Ee$/ - E$/) / E$/ - (eUS eEU)
Expected change in real exchange rate = expected change in nominal exchange rate + expected
Combining with interest parity condition (RUS REU = (Ee$/ - E$/) / E$/
RUS REU = (qe$/ - q$/) / q$/ + (eUS eEU)
Nominal interest rate differences = real depreciation of domestic currency + expected inflation
rate differences between countries.
Differences in real interest rates
re R e
r: real interest rate
R: nominal interest rate
e: expected inflation rate
Correct expression: (1+R) / (1+) = 1+r (1+R) / (1+) - 1 = r
For derivation: see slides.

When R and are small, expressions are similar.

Approximation reUS reEU = (RUS eUS) (REU eEU)
Combining with: RUS REU = (qe$/ - q$/) / q$/ + (eUS eEU)
Leads to: reUS - reEU = (qe$/ - q$/) / q$/

Lecture 17 Exchange rates and open economy macroeconomics (Ch.17)

Determinants of aggregate demand
Real exchange rate q
Increase in real exchange rates increases price of foreign goods relative to price of domestic
1. Volume of exports increases
2. Volume of imports decreases
3. Value of imports in terms of domestic currency increases.
Assumption: Volume effect dominates value effect: increase in real exchange rate overall
decreases value of imports.
+ + + +
Y = Y (q, (Y-T), I, G)
An increase in net income (Y-T) has a positive effect on YD because of the assumption of home
bias: positive effect on an increase in (Y-T) dominates the negative effect of imports.
+ + + +
Short run: prices are fixed: Y = Y = Y (q, (Y-T), I, G)
Aggregate demand = Aggregate output: D = Y
There is always an adjustment of production, no adjustment of prices due to short-run analysis.
The slope of the AD-curve is smaller than 1, since there are savings.
An increase in the nominal exchange rate, ceteris paribus, makes domestic goods cheaper relative
to foreign goods. AD increases with nominal exchange rate. Aggregate output Y will increase as
The relationship between exchange rate and AD is illustrated by a move along the DD-curve.
Increase in G: AD increases for a given exchange rate DD-curve shifts right.
Decrease in T: AD increases for a given exchange rate DD-curve shifts right.
Increase in I: AD increases for a given exchange rate DD-curve shifts right.
Decrease of P relative to P*: AD increases for a given exchange rate DD-curve shifts right.
Increase in home bias: AD increases for a given exchange rate DD-curve shifts right.
Increase of preferences for today: consumption increases and savings/investments decline.
Assumption: investments are partially financed by credits DD-curve shifts right.


Due to international capital mobility, interest parity condition must hold: RUS REU = (Ee$/ - E$/) /
Money market equilibrium: M/P = L(R, Y)
Short-run equilibrium on money market
Increase in real income Y
1. Real money demand increases (MD-curve shifts downwards)
2. Interest rate R increases
3. Nominal exchange rate E decreases (interest parity condition).
Negative relationship between Y and E in order to keep domestic money market and foreign
exchange market in equilibrium.
AA-curve: all combinations of output and nominal exchange rate.
Increase in money supply
1. R decreases
2. Depreciation of domestic currency (E increases)
3. AA-curve shifts upwards.
Increase in price level
1. Real money supply decreases
2. R increases for equilibrium on money market
3. Appreciation of domestic currency (E decreases)
4. AA-curve shifts downwards.
Decrease in preference for liquidity
1. Real money demand decreases
2. R decreases
3. Depreciation of domestic currency (E increases)
4. AA-curve shifts upwards.
Increase in R*
1. Demand for foreign assets increases
2. Demand for foreign currency increases
3. Depreciation of domestic currency (E increases)
4. AA-curve shifts upwards.
Increase in Ee
1. Investors expect domestic currency to depreciate in the future
2. Demand for foreign deposits increases
3. Depreciation of domestic currency (E increases)
4. AA-curve shifts upwards.
Equilibrium values for nominal exchange rate and aggregate supply imply:
Equilibrium on goods market (YS = YD)
Equilibrium on money market (M/P = L(R, Y))

Simultaneous equilibrium on goods market and money market (DD-curve and AA-curve
Above DD-curve: excess demand since nominal exchange rate is too high.
Above AA-curve: either (1) nominal exchange rate too high for equilibrium on foreign exchange
market, or (2) Y too high for equilibrium on money market.
Adjustment of nominal exchange rate: equilibrium on foreign exchange market and money
market, but there is still excess demand for domestic goods.
Appreciation of domestic currency and increase in output: demand for domestic goods decreases
and supply of domestic goods increases until equilibrium is realized.

Temporary changes in monetary and fiscal policy

Crucial: policy measures are temporary and do not influence expectations about the future.
Monetary policy: Central bank changes money supply.
Fiscal policy: Government changes government expenditures and taxes.
MoFleFi: Monetary policy with Flexible exchange rates works Fine (fiscal policy doesnt).
Temporary increase in money supply
Money market: decrease in R
Foreign exchange market: decrease in R decreases demand for domestic deposits and domestic
currency. The domestic currency depreciates: E increases for given Y.
AA-curve shifts upwards
Goods market: increases in E makes domestic goods relatively cheaper, demand for domestic
goods and production increase.
Move on DD-curve to the right/upwards (No shift of DD-curve since positive relationship
between E and Y is already represented by the positive slope of the DD-curve).
Increase in government expenditures
Goods market: demand and production of domestic goods increases.
DD-curve shifts to the right
Money market: real money demand increases due to increase in Y. R increases for equilibrium on
the money market.

Foreign exchange market: The increase in nominal interest rate R increases demand for domestic
deposits and currency domestic currency appreciates (E decreases).
Move on the AA-curve to the right/downwards (No shift on AA-curve since negative
relationship between E and Y is already represented by the negative slope of the AA-curve).
A decrease in taxes T, which increases consumption, has the same qualitative effect.
Policies to maintain full employment
Assumption: There is initially no involuntary unemployment and output is at its natural level.
There may be unemployment, but that is completely voluntary.
Exogenous shock: temporary shift of world preferences against domestic goods.
1. Decrease in demand for domestic goods DD-curve shifts to the left.
Potential stabilization policies:
2. Increase in money supply: domestic currency depreciates and income Y increases.
3. Increase in government spending: leads to initial equilibrium

Exogenous shock: Increase in money demand (preference for liquidity increases)

1. Increase in domestic money demand increases domestic interest rate increase in
demand for domestic deposits and currency domestic currency appreciates (E
decreases) AA-curve shifts downwards.
Potential stabilization policies:
2. Increase in money supply: Domestic interest rate increases domestic currency
depreciates (E increases)
3. Increase in government spending: DD-curve shifts to the right Y increases R
increases E decreases


Problems with stabilization policies

1. Households reacts to policy measures: High employment is ensured unions demand
higher wages firms increases prices workers demand further wage increase firms
increase prices again. Inflationary bias.
2. Interpreting data by policy makers: which policy measures are necessary in order to reach
full employment again?
3. Implementation lag: Time difference between decision to implement and actual
implementation. Anti-cyclical policy may become a pro-cyclical policy.
4. Governmental interventions lead to rent-seeking behavior (spending wealth on political
lobbying to increase one's share of existing wealth without creating wealth).
Permanent changes in monetary and fiscal policy
Crucial: policy measures are permanent and influence expectations about the future exchange
Permanent increase in money supply
1. R decreases
2. Demand for domestic deposits and domestic currency decreases
3. Depreciation of the domestic currency (E increases)
Qualitatively the same results.
However, quantitatively different results:
1. People now expect future depreciation of domestic currency
2. Demand for domestic deposits and thus for domestic currency decreases further
3. Further depreciation of domestic currency (E increases even more)
AA-curve shifts further upwards because of expected further depreciation (expected further
increase in E).
Larger decrease in demand for domestic deposits
Larger decrease in demand for domestic currency
Larger depreciation of domestic currency (larger increase in E): self-fulfilling prophecy.
Long-run adjustment to permanent increase in money supply
Permanent overtime: wages increase
Demand increases permanently and production costs increase permanently, firms increase
their prices.
Demand for domestic goods decreases at given exchange rate: DD-curve shifts to the left.
Increase in prices real money supply decreases real interest rate increases for
equilibrium on money market demand for domestic deposits and currency increases
appreciation of domestic currency (E decreases) AA-curve shifts downwards.


In the long run, output returns to its initial level (only determined by factor endowments and
technology, nominal changes do not affect real output).
Permanent increase in G (or permanent decrease in T)
Increase in public demand Y increases
Money market: Real money demand increases interest rate increases appreciation of
domestic currency (E decreases, move on AA-curve) and expected further appreciation of
domestic currency (Ee decreases, since increase in G is permanent, AA-curve shifts downwards).
Net effect on Y: No changes, since output is only determined by factor endowments and
technology. The positive and negative effect on Y compensate each other.
Increase in public demand decreases private demand for domestic goods!

Current account
A large current account deficit is not desirable, since future generation has to save more.
All combination of nominal exchange rate E and income Y which lead to the desired level of the
current account:
CA (E x P*/P, Y T) = X
Positive effect of E x P*/P: higher foreign price leads to more foreign demand for domestic
goods: more exports CA increases
Negative effect of Y T: More demand more imports CA decreases
XX-curve: All combinations of E and Y that lead to the desired level of the current account.
The slope of the XX-curve is flatter than the slope of the DD-curve.

Increase in money supply

1. AA-curve shifts upwards
2. New temporary equilibrium (AA and DD) above XX-curve: positive effect on the current
Increase in G (decrease in T)
1. DD-curve shifts to the right
2. New temporary equilibrium (AA and DD) below XX-curve: negative effect on the current
In the short run, a depreciation of the domestic currency leaves import and export volumes
constant. The value effect dominates. However, in the long run, imports gradually decrease and
exports gradually increase, the volume effect starts to dominate the value effect. The adjustment
path has a shape that somewhat looks like a J.

Lecture 18 Fixed exchange rates and foreign exchange intervention (Ch.18)

Types of exchange rate regimes
Fixed exchange rate (to peg exchange rate): Central bank determines exchange rate.
Managed floating exchange rate: Exchange rate is in principal determined by supply
and demand. However, the central bank can intervene if the exchange rate leaves the
band, when it exceeds the lower or upper bound.
Flexible exchange rate: Only supply and demand determine the exchange rate.
Central bank intervention and money supply
Balance sheet
Foreign assets
Deposits held by private banks
Domestic assets
Currency in circulation
Assets: Foreign government bonds, gold, foreign exchange reserves, domestic government bonds,
loans to domestic bonds, etc.
Liabilities: Deposits of private banks, domestic currency in circulation.
Any central bank purchase of assets automatically results in an increase in the domestic money
supply, while any central bank sale of assets automatically results the domestic money supply to
An increase or decrease in the liabilities of the central bank often leads simultaneously to an
increase or decrease of amount of foreign currencies supplied to the foreign exchange markets.
Fixing exchange rates
Central bank: selling foreign currency and buying domestic currency appreciation of domestic
currency relative to foreign currency.


Foreign exchange markets in equilibrium when R R* = (Ee E) / E

Fixed exchange rate: Ee = E (Ee E) / E = 0 equilibrium when R = R*
Equilibrium on money market: M/P = L(R, Y)
Increase in Y
1. R increases for equilibrium on money market
2. Demand for domestic (foreign) currency increases (decreases).
3. Domestic currency appreciates (E decreases).
However, if the central bank increases domestic money supply after an increase in Y, domestic
interest rate remains constant and E remains constant.

Monetary policy with fixed exchange rates

In the short run, goods prices are fixed: instrument of monetary policy is quasi non-existent under
fixed exchange rates. Changes in supply of domestic currency, ceteris paribus, change the
exchange rate. The central bank has to compensate increase in domestic money supply by
decreasing domestic money supply.
Alternative 1
Shortcut: concentration only on the foreign exchange market:
1. Increase of supply of domestic currency and decrease of supply of foreign currency on the
foreign exchange market:
2. Decreases value of domestic currency relative to value of foreign currency
Without intervention of the central bank:
Depreciation of domestic currency, AAcurve shifts upwards.
With central bank intervention:
Central bank buys domestic currency in exchange for foreign currency:
1. Decrease of supply of domestic currency and increase of supply of foreign currency

2. Appreciation of domestic currency, AAcurve shifts downwards to initial position.

Alternative 2
Considering domestic money market and foreign exchange market:
1. Domestic money market: increase of supply of domestic currency decreases domestic
interest rate (R decreases) for equilibrium on domestic money market.
2. Decrease in R decreases demand for domestic deposits and for domestic currency.
Without intervention of the central bank:
Depreciation of domestic currency, AAcurve shifts upwards.
With central bank intervention:
Central bank decreases supply of domestic currency (e.g., buying domestic currency in exchange
for foreign currency);
1. Domestic interest rate increases (R increases), which increases demand for domestic
deposits and for domestic currency.
2. Appreciation of domestic currency, AAcurve shifts downwards.
Fiscal policy with fixed exchange rates
Short run: fiscal policy is more effective: due to fixed exchange rates, there is no crowding out of
private demand due to an increase in public demand.
FiFiFi: Fiscal policy with Fixed exchange rates works Fine (monetary policy doesnt).
Increase in G
Goods market: Demand for domestic goods increases at given E, production of domestic goods
increases as well DD-curve shifts to the right.
Money market: Real money demand increases due to increase in Y R increases for equilibrium
on the money market.
Foreign exchange market: Increase in R increases demand for domestic deposits and domestic
Without central bank intervention: Domestic currency appreciates (E decreases).
With central bank intervention: Increase in real money demand is compensated by an increase in
domestic money supply AA-curve shifts upwards no increase in R and demand for
domestic currency relative to foreign currency. E remains unchanged.
Long run: when an increase in G is permanent: inflationary bias.
1. Goods prices increase, which decrease demand for domestic goods.
2. DD-curve shifts to the left due to the increase in prices.
However, the long-run level of output is only determined by a countrys factor endowments and
technologies DD-curve shifts back to its initial position.
On the money market, in the long run, when prices increase and output decreases:
Real money supply decreases and real money demand decreases.
Short run:
Long run: additionally

Increase in G Increase in money supply

Increase in prices and decrease in output.

E is constant, but the real exchange rate decreases: q$/ = E$/ x PEU/PUS
Depreciation/appreciation: value of currency changes due to market forces. This happens under
flexible exchange rates.
Devaluation/revaluation: value of currency changes due to central bank intervention on the
foreign exchange market. This happens under fixed exchange rates.
Devaluation: Higher fixed E
Revaluation: Lower fixed E
Currency devaluation
1. E increase and Ms increases
2. Increase in E increases demand for domestic goods: output Y increases.
3. Increase in money demand without increase in money supply.
4. R increases E decrease
However, increase in money supply decreases R and leaves R* unchanged: R decreases E
increases to a higher level.
Financial crises and capital flight
Demand for domestic currency decreases central bank constantly buys domestic currency in
exchange for foreign currency to fix the exchange rate. When reserves are used up, the domestic
currency devaluates. Investors may expect further devaluation: investors sell domestic assets
and buy foreign assets demand for domestic currency decreases this accelerates the
decrease of foreign exchange reserves of the central bank domestic currency devaluates.
Capital flight: Financial capital moves out of the country Investments and demand for
domestic goods decreases.
A higher domestic R is needed:
1. Central bank reduced domestic money supply further
2. Higher interest rate reduces demand for domestic goods domestic output and
employment decrease.


Expectations of foreign investors decrease demand for domestic assets and crucially contribute to
financial crises.
Investors expectations are influenced by:
1. Expectations about the central banks foreign currency reserves.
2. Expectations about development of demand for domestic goods (Decrease in Yd
increase in E).
Speculative attack: speculators expect that central banks foreign currency reserves are scarce.
Speculators exchange domestic currency into foreign currency at favorable exchange rate.
When central banks reserves are used up, domestic currency is devalued.
Investors change foreign currency back into domestic currency, again at a favorable
exchange rate.
Real wealth increases if prices are fixed in the short run.
Currency crisis
Investors lose confidence in an economy:
Investors sell domestic assets
Excess supply and devaluation of domestic currency
With a fixed exchange rate regime, monetary policy is not independent anymore, monetary policy
cannot be used to keep interest rates low or to fight inflation. R R* = (Ee E) / E, there is a
direct relationship between interest rates and exchange rate. Policies which influence domestic
money market (change in R) influence foreign exchange market, i.e. monetary policy is not
independent with fixed E.
Imperfect asset substitutability

Bonds which are denominated in different currencies imply different risk levels (higher risk
investors demand a higher return).
Types of risk
1. Default risk, the risk that the loan will not be paid back and investors lose their money.
2. Exchange rate risk, a depreciation of a currency lowers (expected) returns from
investments into that currency.
Adjusted interest parity condition: R R* = (Ee - E) / E +
: risk premium for investing in domestic assets (increase in increases R).
An increase in shifts interest parity condition to the right depreciation of domestic currency
due to lower demand for domestic assets.
Alternatively, central bank changes money supply and adjusts to keep E constant
Ms increases R decreases E increases
Central bank simultaneously decreases risk of investing in domestic assets () interest parity
condition curve shifts to the left E decreases.
Net effect: E remains constant, since there is a fixed exchange rate.
How can the central bank or government influence the risk premium ?
depends on investment alternatives, differences between:
Returns on regular stocks and on government bonds
Returns on government bonds of different countries.
Risk premium of regular stocks: securing trade credits, expropriation, war.
Risk premium on government bonds: reducing government debt, controlling exchange rate.

Lecture 19 International Monetary System (Ch.18, 19)

Fixed exchange rate systems
1. Reserve currency system: fixed exchange rate between domestic currency and foreign
reserve currency.
2. Gold Standard: value of currency is linked to value of gold (implied fixed exchange rate).
Changes in exchange rate system can be explained by the trilemma of objectives
1. Monetary policy independence adjusting monetary policy to economic conditions.
2. Fixed exchange rate more transparency in international transactions.
3. International capital mobility allows to invest into the internationally most profitable
Countries can only reach two out of these three objectives.
Adjusted interest parity condition: R R* = (Ee E) / E + transaction costs.
If international capital mobility holds: transactions costs = 0.
Objective of government: macroeconomic equilibrium
Domestic equilibrium: output level which results at natural rate of unemployment.
External equilibrium: combination of output Y and exchange rate E which leads to a
current account equilibrium.

Domestic equilibrium
+ - ++ +
Y = Y(C, T, I, G, E)
Y-axis: E
X-axis: G, T
Downward-sloping line that reflects domestic equilibrium.
Above curve: higher inflation / overemployment.
Below curve: unemployment.
Negative slope, because a decrease in E (less private demand for domestic goods) has to be
compensated by increase in G to keep employment/inflation constant.
External equilibrium
+ - +
CA = CA(G, T, E)
Y-axis: E
X-axis: G, T
Upward-sloping line that reflects external equilibrium.
Above curve: CA surplus
Below curve: CA deficit.
Positive slope, because increase in E (more private demand for domestic goods) has to be
compensated by increase in G (Y, which increases private demand for foreign goods) to keep
trade balanced.
G0 / E0 leads to internal and external equilibrium.

Fixed exchange rate: adjustment problems, macroeconomic equilibrium is not reachable if E is

not equal to E0. Increase (decrease) of G can reduce unemployment (current account deficit).
Either internal or external equilibrium is reachable, not both. Only one instrument (G) only
one objective achievable.
Tinbergen Rule: A government can only achieve any number of policy objectives if it has at
least the same number of independent policy instruments available.


However, there are also problems with flexible exchange rate into which direction should the
government start.
An economy can only achieve both equilibria if the government first realizes domestic
equilibrium and then external equilibrium. The other way around does not work.
Gold Standard (1870-1914)
(Implied) fixed exchange rate regime.
Currencies valued in terms of gold.
Reality: exchange rates fluctuated in narrow margins: shipping costs of gold.
1. Discoveries of new gold sources: Ms increases inflation
2. Growing economies require increase in central banks gold reserves, otherwise deflation
and unemployment.
3. Countries with large gold reserves can influence worldwide inflation.
4. No monetary policy available to fight unemployment.
World wars and recession (1914-1945)
Countries printed more money to finance the war no convertibility into gold anymore.
Great Depression 1929 devaluations and capital controls in order to support domestic economy.
Consequences: aggravation of crisis, unemployment, outbreak of World War II.
Bretton Woods Era (1945-1971)
Establishment of International Monetary Fund (IMF) and World Bank
New system of international economic order:
Free trade
No beggar-thy-neighbor policies
Stable international monetary system to encourage free trade.
US dollar as international reserve currency (value fixed to gold price).
Other currencies pegged their currency to the USD with 1% margin, expect China
and Eastern Block.
Change of margin only with IMF-approval.
The n-1 problem
The USD was the anchor currency: all countries pegged their currency to USD.
US had complete monetary policy independence.
High inflation in the US other countries had to buy USD.
Enormous USD reserves of other countries, breakdown of Bretton Woods system.
Speculation against USD by German central bank.
Consequence: other currencies had to be revalued with approval of IMF break down of the
Bretton Woods system.
Floating exchange rates (1971-now)
Exchange rates are not freely determined by market forces.
No separate legal tender (formal dollarization or euroization).

Currency board arrangements: commitment to change domestic currency for specific

foreign currency at fixed exchange rate, domestic currency issued only for foreign
exchange at fixed exchange rate.
Conventional fixed-peg arrangements.
Pegged exchange rates within horizontal bands
Crawling peg: fixed exchange rate is adjusted periodically.
Crawling band: central exchange rate or margins of band are adjusted periodically.
Managed floating: central bank influences exchange rate without commitment to a
specific exchange rate.
Independently floating: exchange rates determined by market forces.

Lecture 20 International Financial Institutions (Ch.21)

European Monetary System was originally a system of fixed exchange rates implemented in
1979. The EMS transformed into the European Monetary Union (EMU). Membership of EMU
implies exchange rate fixed within specific bands restrained fiscal and monetary policies
Euro replaces domestic currency.
Potential benefits of the Euro
Greater market integration (economic growth) due to common currency.
More uniform political interests.
German influence moderated under European System of Central Banks (ESCB).
No devaluations/revaluations, capital flights, and speculation with common currency.
Exchange Rate Mechanism (ERM): currencies allowed to fluctuate 2.25% around target
exchange rates. Exceptions: Portugal, Spain, Britain, and Italy, whose currencies were allowed to
fluctuate 6% around target exchange rates.
Greater flexibility with monetary policy
Preventing speculation.
Credit system to help out countries that need assets and currencies to intervene in foreign
exchange market.
Due to strict German fiscal and monetary policies, there were some problems with the British
pound, so Great Britain had to leave the EMS. The ERM was redefined at a margin of 15%.
EMS member states adopted fiscal and monetary policies as Germany inflation rates in the
EMS converged.
Maastricht Treaty (1991, implemented in 1992)
Free movement of capital
Coordination of policies
Establishment of EMI/ECB
Stability & growth pact criteria for being allowed to participate in monetary union.
Convergence criteria


1. Inflation: less than 1.5 percentage points higher than average of three lowest
inflation rates among EU member states.
2. Interest rate: less than 2 percentage points higher than long-term interest rate in
average of three low-inflation countries.
3. EMS membership: no devaluation in the two years before entry into EMU.
4. Budget deficit: (new debt) less than 3% of GDP.
5. Public debt: (accumulated debt) less than 60% of GDP.
1. ECB + national central banks of EMU member states (Euro system).
2. National central banks of non-member states.
The goal is to keep inflation below 2% per year.
Theory of optimum currency areas
Advantage of monetary union in general: currency crisis can be avoided.
Suppose the following situation:
Positive demand shock in the Netherlands. Negative demand shock in France.
Demand and employment increase (decrease) in the Netherlands (France).
In a monetary union, E is fixed. Therefore, real exchange rate q has to be changed via changes in
goods prices PNL and PFR. However, the goods prices depend on wages wNL and wFR. A problem
arises, because wages are inflexible in the Netherlands and France.
1st alternative adjustment mechanism: unemployment in France, overemployment in the
Netherlands workers could migrate from France to the Netherlands. However, labor mobility
within Europe is small.
2nd alternative adjustment mechanism: transfer of additional tax revenues in the Netherlands to
France, used for unemployment benefits in France. However, only feasible is EU budget were
large and there would be a sufficient degree of solidarity.
Whether an adjustment is really necessary, depends on:
Size of shock
The less diversified the economy, the more serious the effect of the shock.
European countries are highly diversified (real) exchange rate adjustment is less necessary.
In case of symmetric shock: identical reaction by both countries only in case of homogeneous
EMU optimum currency area, if EU had
Wage flexibility (goods prices can adjust to the shock)
Labor mobility (migration can cushion the shock)
Large budget (monetary transfers can cushion the shock)
Solidarity between countries (monetary transfers can cushion the shock)
Diversified production structure (shock less severe)
Homogeneous preferences (identical reaction to a shock).

However, a monetary union evolves over time, so EMY can still become an optimum currency
Benefits of common currency
Elimination of transaction costs
Price transparency: better arbitrage opportunities, more competition
Less uncertainty with respect to foreign prices
Less uncertainty with respect to future prices
International currency: common currency can be reserve currency of other countries.
Seigniorage gains (difference between value of money and costs of issuing money) by
central bank of currency union.
Costs of common currency
Loss of monetary policy independence for stabilizing output.
No reaction of exchange rates to changes in aggregate demand.
However, costs depend on degree of market integration.
Simple decision rule: A country should join currency area if benefits exceed costs of joining.
Most EMU countries benefit from common currency. There is at least a high degree of economic
Large intra-EU trade.
Large amount of foreign financial and direct investment.
However, there is no empirical research on benefits of Euro.
However, arguments in favor of Euro:
Euro leads to more trade (less transaction costs) and more trade leads to more growth
Appreciation of domestic currency increases price of domestic goods on world markets
less exports.
Monetary integration leads to political integration.
Size of intra-EU trade hasnt increased relative to extra-EU trade.
Importance of transaction costs is unclear.
Before the introduction of the Euro, there already was a fixed exchange rate regime.
Appreciation of domestic currency makes imports cheaper and forces domestic firms to
become more productive.
Costs of having the Euro
Exchange rates not determined by market forces, fixed at level of 1.
Who pays for having artificially low/high exchange rate? Consumers (imports overly
expensive) and workers (low real wages); weak countries would benefit from flexible
exchange rates.
EU countries outside EMU have not performed worse in last decade.
Higher inflation: real value of debt in debtor countries decreases, but real wealth in
creditor countries decreases.