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CHAPTER

Introduction to The World Economy: Open-Economy Macroeconomics and Finance

C HAPTER K EY P OINTS
1. The introduction asks you to think about what it means to assert that theres a world economy. International economic interdependence is difficult to define or quantify. We can quantify some symptoms, such as the extent of trade, relatively easily. Others, including political and distributional issues, are more difficult. Its important to understand from the very beginning the gains and losses associated with the trend toward increasing international interdependence, as well as the differing degrees to which various countries are involved. Despite the growing internationalization of world markets, economic policy making is still viewed largely as a matter of national sovereignty. Even so, most international economic policies have important domestic distributional consequences. The World Economy: Open-Economy Macroeconomics and Finance emphasizes this issue. Why are trade-related distributional issues typically presented as the United States versus China rather than as U.S. consumers versus U.S. producers? And why are the distributional effects of macroeconomic policies and exchange rate changes ignored by so many commentators? In addition to introducing some of the basic issues of international economics, the first chapter establishes a pattern followed throughout the book of drawing connections between abstract concepts (for example, interdependence, international organizations, international crises) and their more concrete counterparts (for example, the volume of trade, cross-border security transactions, synchronization of business cycles, the International Monetary Fund, the Argentinean debt and banking crisis). Mastering these connections is essential if the course is to enhance your understanding of the world economy. During the course, be sure to practice reading accounts of current events and international macroeconomic policy making; and think about how the models and tools from The World Economy apply to those events. We use the term economic significance of political boundaries to draw attention to the differences between domestic and international economic activity. When you read about current events, practice thinking about how their international character affects the issues, controversies, and outcomes. The conceptual distinction between positive and normative analysis is helpful in analyzing abstractly the efficiency and distributional effects of economic policies. Although the distinction obviously is somewhat artificial and frequently overdrawn in debates, the centrality of the tension between concerns of efficiency and distribution in international economic policy justifies the attempted distinction.

2.

3.

4.

5.

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Q UICK Q UIZ
1. Since World War II, the volume of international trade (a) has declined because of the spread of protectionist policies. (b) has declined because of rising transportation costs. (c) has stayed approximately constant. (d) has risen at about the same rate as the growth of production. (e) has risen, but not as fast as production. (f) has risen more rapidly than production. 2. Positive analysis refers to (a) situations in which a change in policy makes everyone better off. (b) situations in which the net effect of a policy is determined to be positive. (c) situations in which the analyst is positive that he or she is correct in the analysis. (d) relatively value-free analysis of the way the world works, as opposed to value-based analysis of the way the world should be. (e) value-based analysis of the way the world should be, as opposed to relatively value-free analysis of the way the world works. (f) analysis of positive-sum games. 3. Examples of international economic interdependence include (a) the effects of OPEC oil-price policies on developed and developing countries. (b) the international relocation of industries such as autos in response to trade barriers. (c) the integration of financial markets in bonds, stocks, and currencies. (d) the tendency of economies to experience common economic booms and recessions. (e) all of the above. (f) (c) and (d), but not (a) or (b). 4. A product is American if it (a) is produced in the United States. (b) is produced in the United States using no imported inputs. (c) is produced by American workers. (d) is produced by a firm all of whose stock is owned by American citizens. (e) is produced by a firm whose corporate headquarters is located in the United States. (f) none of the above; there is no single necessary and sufficient condition to make a product American. 5. Political boundaries have economic significance because (a) countries use different currencies. (b) countries follow different economic policies. (c) countries have different legal, political, and economic systems. (d) policy makers often weight a policys effect on domestic residents more heavily that its effect on foreigners. 2 SOUTH-WESTERN

(e) all of the above. (f) (a) and (d), but not (b) or (c).

ANSWERS TO QUICK QUIZ

1. f. 2. d. 3. e. 4. f. 5. e.

M ATCHING
Match each key term with the appropriate definition.

D EFINITIONS
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. A country that doesnt participate in international trade has a(n) ___. A country that participates in international trade has a(n) ___. Economic policies and legal, language, and currency barriers create a(n) ___. Models that attempt to describe how the world economy works use ___. Models that attempt to prescribe how the world economy should be use ___. The macroeconomic analysis of international economics is called ___. When events in one economy affect conditions in another, and vice versa, the two exhibit ___. Prices of one currency in terms of other currencies are ___. If savers in one country lend funds to borrowers in another country, the process is ___. Economists call the degree to which markets for goods, services, labor, and capital operate freely across national boundaries ____.

K EY T ERMS
A. international interdependence B. international economic integration C. international investment D. economic significance of political boundaries E. open-economy macroeconomics F. exchange rates G. open economy H. closed economy I. positive analysis J. normative analysis

A NSWERS
1. H. 2. G.

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3. D. 4. I. 5. J. 6. E. 7. A. 8. F. 9. C. 10. B

P ROBLEMS
1.

AND

Q UESTIONS

FOR

R EVIEW

What are some of the symptoms of international interdependence? Can you think of possible measures of interdependence beyond those mentioned in the chapter?

ANSWER Symptoms of international interdependence include the growing volume of trade, both in absolute terms and as a share of total world production, and the synchronization of economic activity across countries. Additional measures of interdependence might include: (a) the quantity of resources spent by countries in influencing the policy decisions of other countries or in supporting international agencies such as the World Bank, the International Monetary Fund, or the World Trade Organization, (b) the degree to which countries output prices, factor prices, and interest rates converge, and (c) the extent of foreign investment.

2.

What are the major questions addressed by international microeconomics? What are some current international events or policy debates that might be related to the tools of microeconomics? ANSWER International microeconomics studies countries production, consumption, and trade decisions; how relative prices are determined in world markets; and the effects of international trade on the distribution of income. Current policy issues in the international microeconomics area include the trade disputes over market access between the United States and Europe (for example, in the case of agricultural export subsidies), the debate over the desirability of trade retaliation against other countries policies (for example, between the United States and Cuba over human rights), the debate over the effects of the North American Free-Trade Agreement (NAFTA), and discussions concerning how the transitional economies of Eastern Europe can be integrated into the international trade system.

3.

What are the major questions addressed by open-economy macroeconomics? What are some current international events or policy debates that might be related to the tools of macroeconomics? ANSWER The major questions addressed by open-economy macroeconomics include the determination of the levels of output, employment, prices, interest rates, and the exchange rate in an open economy, as well as the efficacy of various types of macroeconomic policies. The large swings in the value of the dollar relative to other currencies (particularly the yen and euro), U.S. pressure on Japan to pursue expansionary policies, and the Asian, Turkish, and Argentinean financial crises impacts on economies around the globe are central openeconomy macroeconomic policy debates.

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4. What is the difference between positive and normative analysis? Why is the distinction important? ANSWER Positive analysis attempts to understand the way the world works. Normative analysis incorporates value judgments about the desirability of various outcomes. For example, we might agree based on positive analysis that unrestricted trade in automobiles would decrease employment in the U.S. automobile industry, but disagree based on normative analysis about the desirability of unrestricted trade in automobiles. The distinction is important because it helps to pinpoint the source of disagreements. Do the two sides of an argument disagree about the likely effects of a certain policy? Or do they disagree about the desirability of those effects? 5. All economic issues contain both positive and normative elements. Nonetheless, some statements are primarily positive and others primarily normative. Classify each of the following statements: (a) Obviously, the U.S. government has allowed the dollar to lose too much value; imports have become too expensive. ANSWER (a) normative [note the judgment about the desirability of the policy] (b) If the money stock continues to expand rapidly, other things being equal, there will be inflation. ANSWER positive (c) Governments should try to limit international interdependence in order to maintain domestic control over the policy-making process. ANSWER normative [note the use of the word should].

6.

Figure 5 in the text indicates that the United States, compared with many other economies, engages in relatively little international trade. Give two possible reasons for this observation. [Hint: Both reasons are related to the size of the U.S. economy.] ANSWER Large, economically diverse countriessuch as the United Statestend to trade less internationally, relative to the size of their economies, than do smaller, more homogeneous countries because the former have such extensive opportunities to trade within the country (e.g., exchanging Alaskan oil for Florida citrus fruit, or Californian computer software for carpets from Georgia). Also, U.S. exports and imports represent relatively small shares of the countrys GDP, in part, simply because GDP is so large.

A NSWERS
1. 2. 3. 4. 5. 6. H. G. D. I. J. E.

TO

M ATCHING

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7. A. 8. F. 9. C. 10. B.

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