Instructor’s Manual

1 Instructor s Manualto accompanyKrugman & ObstfeldInternational Economics:Theory and PolicySixth EditionLinda S. GoldbergFederal Reserve Bank of New YorkMichael W. KleinTufts UniversityThe Fletcher School of Law and DiplomacyJay C. ShambaughDartmouth CollegeThe views presented in this book are those of the authors and need not reflect the views of theFederal Reserve Bank of New York or the Federal Reserve pageContentsiiiChapter 1 Introduction1 Overview of Section I: International Trade Theory3 chapter 2 Labor Productivity and Comparative Advantage: The Ricardian Model 7 chapter 3 Specific Factors and income Distribution13 chapter 4 Resources and Trade: The Heckscher-Ohlin Model21 chapter 5 The Standard Trade Model27 chapter 6 Economies of Scale, Imperfect Competition, and International Trade 35 chapter 7 International Factor Movements41 Overview of Section II.

2 International Trade Policy47 chapter 8 The Instruments of Trade Policy49 chapter 9 The Political Economy of Trade Policy 57 chapter 10 Trade Policy in Developing Countries65 chapter 11 Controversies in Trade Policy71 Overview of Section III: Exchange Rates and Open EconomyMacroeconomics 77 chapter 12 national income accounting and the balance of Payments81 chapter 13 Exchange Rates and the Foreign Exchange Market: 89An Asset ApproachChapter 14 Money, Interest Rates, and Exchange Rates101 chapter 15 Price Levels and the Exchange Rate in the Long Run109 chapter 16 Output and the Exchange Rate in the Short Run119 chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention131 Overview of Section IV: International Macroeconomic Policy 141 chapter 18 The International Monetary System, 1870-1973145 chapter 19 Macroeconomic Policy and Coordination Under 153 Floating Exchange RatesChapter 20 Optimum Currency Areas and the European Experience163 chapter 21 The Global Capital Market: Performance and Policy Problems 171 chapter 22 Developing Countries: Growth, Crisis, and Reform177 Mathematical Postscript1851 chapter 1 INTRODUCTIONC hapter OrganizationWhat is International Economics About?

3 The Gains from TradeThe Pattern of TradeProtectionismThe balance of PaymentsExchange-Rate DeterminationInternational Policy CoordinationThe International Capital MarketInternational Economics: Trade and MoneyCHAPTER OVERVIEWThe intent of this chapter is to provide both an overview of the subject matter of internationaleconomics and to provide a guide to the organization of the text. It is relatively easy for aninstructor to motivate the study of international trade and finance. The front pages ofnewspapers, the covers of magazines, and the lead reports of television news broadcastsherald the interdependence of the economy with the rest of the world. Thisinterdependence may also be recognized by students through their purchases of imports of allsorts of goods, their personal observations of the effects of dislocations due to internationalcompetition, and their experience through travel study of the theory of international economics generates an understanding of many keyevents that shape our domestic and international environment.

4 In recent history, these eventsinclude the causes and consequences of the large current account deficits of the UnitedStates; the dramatic appreciation of the dollar during the first half of the 1980s followed byits rapid depreciation in the second half of the 1980s; the Latin American debt crisis of the1980s and the Mexico crisis in late 1994; and the increased pressures for industry protectionagainst foreign competition broadly voiced in the late 1980s and more vocally espoused inthe first half of the 1990s. Most recently, the financial crisis that began in East Asia in 19972and spread to many countries around the globe and the Economic and Monetary Union inEurope have highlighted the way in which various national economies are linked and howimportant it is for us to understand these connections.

5 At the same time, protests at globaleconomic meetings have highlighted opposition to globalization. The text material willenable students to understand the economic context in which such events 1 of the text presents data demonstrating the growth in trade and increasingimportance of international economics. This chapter also highlights and briefly discussesseven themes which arise throughout the book. These themes include: 1) the gains fromtrade; 2) the pattern of trade; 3) protectionism; 4), the balance of payments ; 5) exchange ratedetermination; 6) international policy coordination; and 7) the international capital will recognize that many of the central policy debates occurring today come underthe rubric of one of these themes. Indeed, it is often a fruitful heuristic to use current eventsto illustrate the force of the key themes and arguments which are presented throughout OF SECTION I: INTERNATIONAL TRADE THEORYS ection I of the text is comprised of six chapters: chapter 2 Labor Productivity and Comparative Advantage: The Ricardian ModelChapter 3 Specific Factors and income DistributionChapter 4 Resources and Trade: The Heckscher-Ohlin ModelChapter 5 The Standard Trade ModelChapter 6 Economies of Scale, Imperfect Competition, and International TradeChapter 7 International Factor MovementsSECTION I OVERVIEWS ection I of the text presents the theory of international trade.

6 The intent of this section is toexplore the motives for and implications of patterns of trade between countries. Thepresentation proceeds by introducing successively more general models of trade, where thegenerality is provided by increasing the number of factors used in production, by increasingthe mobility of factors of production across sectors of the economy, by introducing moregeneral technologies applied to production, and by examining different types of marketstructure. Throughout Section I, policy concerns and current issues are used to emphasize therelevance of the theory of international trade for interpreting and understanding our 2 introduces students to international trade theory through the Ricardian model oftrade. This model shows how trade arises when there are two countries, each with one factorof production which can be applied toward producing each of two goods.

7 Key concepts areintroduced, such as the production possibilities frontier, comparative advantage versusabsolute advantage, gains from trade, relative prices, and relative wages across countries. TheRicardian model is a useful starting point for developing intuition about why countries gainfrom trading with each other. By using even as simple a framework as the Ricardian model,one can begin to debunk some common misconceptions concerning comparative 3 builds upon the insights from chapter 2 by developing trade models which allowcountries to produce goods when production requires more than one factor of important reason for this addition to the model is that this more general frameworkhighlights the effects of trade on income distribution. The first model presented includes4factors of production which are specific to the production of each of two goods.

8 Then, a moregeneral model is introduced, with this latter model allowing for both mobile and specificfactors of production. This extension provides an even richer analysis of the incomedistribution effects of trade. These models set the stage for an initial discussion of thepolitical economy of trade and for justifying economist's support of the principles of freetrade among 4 introduces the classic Heckscher-Ohlin model of trade. The chapter proceeds byfirst presenting a general equilibrium model of an economy with two goods produced by twofactors under the assumption of fixed coefficient production functions. Many of the importantresults of international trade theory are developed. These include: the Rybczynski Theorem,the Stolper-Samuelson Theorem, and the Factor Price Equalization Theorem.

9 Implications ofthe Heckscher-Ohlin model for the pattern of trade among countries are discussed, as are thefailures of empirical evidence to confirm the predictions of the 5 presents a general model of international trade which admits the models of theprevious chapters as special cases. This "standard trade model" is depicted graphically by ageneral equilibrium trade model as applied to a small open economy. Relative demand andrelative supply curves are used to analyze a variety of policy issues, such as the effects ofeconomic growth, the transfer problem, and the effects of trade tariffs and productionsubsidies. The appendix to the chapter develops offer curve an extremely useful tool, the standard model of trade fails to account for someimportant aspects of international trade.

10 Specifically, while the factor proportions Heckscher-Ohlin theories explain some trade flows between countries, recent research in internationaleconomics has placed an increasing emphasis on economies of scale in production andimperfect competition among 6 presents models of international trade that reflect these developments. The chapterbegins by reviewing the concept of monopolistic competition among firms, and then showingthe gains from trade which arise in such imperfectly competitive markets. Next, internal andexternal economies of scale in production and comparative advantage are discussed. Thechapter continues with a discussion of the importance of intra-industry trade, dumping, andexternal economies of production. The subject matter of this chapter is important since itshows how gains from trade arise in ways that are not suggested by the standard, more5traditional models of international trade.