second edition

elonornic^ROBERT C. FEENSTRA ALAN M.TAYLORUniversity of California, Davis University of California, Davis

WORTH PUBLISHERS

L

Contents

Preface xxix

CHAPTER 1 Trade in the Global Economy 1 PART 1

1 International Trade 3 Introduction toThe Basics of World Trade 3 J n ^ n a t o n a l TradeA P P L I C A T I O N Is Trade Today Different from the Past? 4

H E A D L I N E S An iPod Has Global Value. Ask the (Many)Countries That Make It 5

Map of World Trade 7Trade Compared with GDP 10"Barriers to Trade 11"First Golden Age" of Trade 12"Second Golden Age" of Trade 13

H E A D L I N E S A Sea Change in Shipping 50 Years Ago 15The Financial Crisis 15

2 Migration and Foreign Direct Investment 17Map of Migration 17Map of Foreign Direct Investment 20

3 Conclusions 23Key Points, Key Terms, and Problems

CHAPTER 2 Trade and Technology: The Ricardian Model 27 PART 2

1 Reasons for Trade 29 P a t t e r n s o f

Proximity 29Resources 29Absolute Advantage 30

S I D E B A R Can Comparative Advantage Be Created? The Caseof "Icewine" 31

Comparative Advantage 31

S I D E B A R David Ricardo and Mercantilism 32

2 Ricardian Model 33The Home Country 33The Foreign Country 37

XII CONTENTS

A P P L I C A T I O N Comparative Advantage in Apparel, Textiles, andWheat 39

3 Determining the Pattern of International Trade 40International Trade Equilibrium 40Solving for Wages across Countries 44A P P L I C A T I O N Labor Productivity and Wages 46

4 Solving for International Prices 48Home Export Supply Curve 48Foreign Import Demand Curve 50International Trade Equilibrium 51

A P P L I C A T I O N The Terms of Trade for Primary Commodities 52

5 Conclusions 54Key Points, Key Terms, and Problems

CHAPTER 3 Gains and Losses from Trade in the Specific-FactorsModel 59

1 Specific-Factors Model 61The Home Country 61The Foreign Country 64Overall Gains from Trade 64

A P P L I C A T I O N How Large Are the Gains from Trade? 65

2 Earnings of Labor 66Determination of Wages 66Change in Relative Price of Manufactures 67

A P P L I C A T I O N Manufacturing and Services in the United States:Employment and Wages across Sectors 70

A P P L I C A T I O N Trade Adjustment Assistance Programs: Financing theAdjustment Costs of Trade 73

3 Earnings of Capital and Land 74Determining the Payments to Capital and Land 74

H E A D L I N E S Services Workers Are Now Eligible for TradeAdjustment Assistance 75

Numerical Example 77What It All Means 80

. A P P L I C A T I O N Prices in Agriculture 80

H E A D L I N E S Rise in Coffee Prices—Great for Farmers, Tough onCo-ops 82

4 Conclusions 83Key Points, Key Terms, and Problems

CONTENTS XIII

CHAPTER 4 Trade and Resources: The Heckscher-OhlinModel 87

1 Heckscher-Ohlin Model 88Assumptions of the Heckscher-Ohlin Model 89

A P P L I C A T I O N Are Factor Intensities the Same across Countries? 91No-Trade Equilibrium 92Free-Trade Equilibrium 94

2 Testing the Heckscher-Ohlin Model 98Leontief's Paradox 99Factor Endowments in the New Millenium 100Differing Productivities across Countries 102

H E A D L I N E S China Drawing High-Tech Research from U.S. 105Leontief's Paradox Once Again 106

3 Effects of Trade on Factor Prices 109Effect of Trade on the Wage and Rental of Home 110Determination of the Real Wage and Real Rental 113Changes in the Real Wage and Rental: A Numerical Example 114A P P L I C A T I O N Opinions toward Free Trade 117

4 Conclusions 119Key Points, Key Terms, and Problems

Appendix to Chapter 4 124

CHAPTER 5 Movement of Labor and Capital between Countries127

1 Movement of Labor between Countries: Migration 129Effects of Immigration in the Short Run: Specific-Factors

Model 129

A P P L I C A T I O N Immigration to the New World 132

A P P L I C A T I O N Immigration to the United States and EuropeToday 133

H E A D L I N E S Europe Sours on Labor Migration 134Other Effects of Immigration in the Short Run 136Effects of Immigration in the Long Run 137Rybczynski Theorem 142Factor Price Insensitivity 143

A P P L I c A T I o N The Effects of the Mariel Boat Lift on IndustryOutput in Miami 143

A P P L I C A T I O N Immigration and U.S. Wages, 1990-2004 145

XIV CONTENTS

2 Movement of Capital between Countries: Foreign DirectInvestment 146Greenfield Investment 146FDI in the Short Run: Specific-Factors Model 147FDI in the Long Run 149

A P P L I C A T I O N The Effect of FDI on Rentals and Wages in Singapore150

3 Gains from Labor and Capital Flows 153

H E A D L I N E S The Myth of Asia's Miracle 153

Gains from Immigration 154

S I D E B A R Immigrants and Their Remittances 157

A P P L I C A T I O N Gains from Migration 158

Gains from Foreign Direct Investment 160

4 Conclusions 161 -Key Points, Key Terms, and Problems

PART 3 CHAPTER 6 Increasing Returns to Scale and MonopolisticNew Explanations Competition 167for International 1 Bas jcs o f ^ C o m p e t i t i o n 1 7 0

.?. Monopoly Equilibrium 170Demand with Duopoly 171

2 Trade under Monopolistic Competition 172Equilibrium without Trade 174Equilibrium with Free Trade 176

3 The North American Free Trade Agreement 180Gains and Adjustment Costs for Canada under NAFTA 180

H E A D L I N E S What Happened When Two Countries LiberalizedTrade? Pain, Then Gain 181

Gains and Adjustment Costs for Mexico under NAFTA 181

H E A D L I N E S NAFTA Turns 15, Bravo! 184Gains and Adjustment Costs for the United States under NAFTA 185

4 Intra-lndustry Trade and the Gravity Equation 189Index of Intra-lndustry Trade 189The Gravity Equation 190

. A P P L I C A T I O N The Gravity Equation for Canada and the United, States 192

5 Conclusions 195Key Points, Key Terms, and Problems

CONTENTS XV

CHAPTER 7 Offshoring of Goods and Services 199S I D E B A R "Foreign Outsourcing" versus "Offshoring" 201

1 A Model of Offshoring 201Value Chain of Activities 202Changing the Costs of Trade 205

A P P L I C A T I O N Change in Relative Wages across Countries 207Change in Relative Wages in the United States 208Change in Relative Wages in Mexico 213

2 The Gains from Offshoring 214Simplified Offshoring Model 215Production in the Absence of Offshoring 215Terms of Trade 218

S I D E B A R Offshoring Microsoft Windows 221A P P L I C A T I O N U.S. Terms of Trade and Service Exports 222

3 The Politics and Future of Offshoring 225

H E A D L I N E S How to Destroy American Jobs 226The Future of U.S. Comparative Advantage 227

H E A D L I N E S Caterpillar Joins "Onshoring" Trend 227

4 Conclusions 229Key Points, Key Terms, and Problems

CHAPTER 8 Import Tariffs and Quotas under Perfect PART 4Competition 237 International Trade

1 A Brief History of the World Trade Organization 239 F.9!!?.'.?.?.

2 The Gains from Trade 240Consumer and Producer Surplus 240

S I D E B A R Key Provisions of the GATT 241Home Welfare 243Home Import Demand Curve 245

3 Import Tariffs for a Small Country 246Free Trade for a Small Country 246Effect of the Tariff 246

Why and How Are Tariffs Applied? 250

S I D E B A R Safeguard Tariffs 251

A P P L I C A T I O N U.S. Tariffs on Steel and Tires 252

4 Import Tariffs for a Large Country 256Foreign Export Supply 257

XVI CONTENTS

Effect of the Tariff 258

A P P L I C A T I O N U.S. Tariffs on Steel Once Again 262

5 Import Quotas 263

H E A D L I N E S Banana Wars 264

H E A D L I N E S Sweet Opportunity 265

Import Quota in a Small Country 265

A P P L I C A T I O N China and the Multifibre Arrangement 269

6 Conclusions 272Key Points, Key Terms, and Problems

CHAPTER 9 Import Tariffs and Quotas under ImperfectCompetition 279

1 Tariffs and Quotas with Home Monopoly 281No-Trade Equilibrium 282Free-Trade Equilibrium 283Effect of a Home Tariff 284Effect of a Home Quota 286

A P P L I C A T I O N U.S. Imports of Japanese Automobiles 288

2 Tariffs with Foreign Monopoly 291Foreign Monopoly 291

A P P L I C A T I O N Import Tariffs on Japanese Trucks 293

H E A D L I N E S The Chickens Have Come Home to Roost 295

3 Dumping 296Numerical Example of Dumping 298

4 Policy Response to Dumping 298Antidumping Duties 299

H E A D L I N E S China Escalates Trade Fight Over European ShoeTariff 300

A P P L I C A T I O N Antidumping Duties Versus Safeguard Tariffs 302

5 Infant Industry Protection 304Free-Trade Equilibrium 305Tariff Equilibrium 306

A P P L I C A T I O N Examples of Infant Industry Protection 307U.S. Tariff on Heavyweight Motorcycles 308Computers in Brazil 311

Protecting the Automobile Industry in China 313

H E A D L I N E S Shanghai Tie-Up Drives Profits for GM 316

H E A D L I N E S Thanks to Detroit, China Is Poised to Lead 317

CONTENTS XVII

6 Conclusions 318Key Points, Key Terms, and Problems

CHAPTER 10 Export Subsidies in Agriculture and High-Technology Industries 325

1 WTO Goals on Agricultural Export Subsidies 326Agricultural Export Subsidies 327Other Matters from the Hong Kong WTO Meeting 328

H E A D L I N E S Developing Countries Split over WTO FarmProtection 329

2 Agricultural Export Subsidies in a Small Home Country 330Impact of an Export Subsidy 330

3 Agricultural Export Subsidies in a Large Home Country 333Effect of the Subsidy 334

A P P L I C A T I O N Who Gains^and Who Loses? 335

H E A D L I N E S G8 Shifts Focus from Food Aid to Farming 338

4 Agricultural Production Subsidies 338

H E A D L I N E S Hunger and Food Security Back on PoliticalAgenda 339

Effect of a Production Subsidy in a Small Home Country 339Effect of the Production Subsidy in a Large Home Country 341

5 High-Technology Export Subsidies 342"Strategic" Use of High-Tech Export Subsidies 342Effect of a Subsidy to Airbus 345Subsidy with Cost Advantage for Boeing 347Best Strategy for Boeing 348

A P P L I C A T I O N Subsidies to Commercial Aircraft 349

H E A D L I N E S WTO Says Aid,to Airbus for A380 Was Illegal 351

6 Conclusions 352

H E A D L I N E S Dreamliner Production Gets Closer Monitoring353

Key Points, Key Terms, and Problems

CHAPTER 11 International Agreements: Trade, Labor, and theEnvironment 359

1 International Trade Agreements 361The Logic of Multilateral Trade Agreements 362Regional Trade Agreements 365

XVIII CONTENTS

Trade Creation and Trade Diversion 367

H E A D L I N E S China-ASEAN Treaty Threatens Indian Exporters367

Numerical Example of Trade Creation and Diversion 368Trade Diversion in a Graph 369

A P P L I C A T I O N Trade Creation and Diversion for Canada 372

2 International Agreements on Labor Issues 372Labor Side Agreement under NAFTA 373Other Labor Agreements 374

H E A D L I N E S Wal-Mart Orders Chinese Suppliers to LiftStandards 376

3 International Agreements on the Environment 377Environmental Issues in the GATT and WTO 377Does Trade Help or Harm the Environment? 381

H E A D L I N E S The Power of Big Corn 382The.Tragedy of the Commons 383

H E A D L I N E S Europe Leans Toward Bluefin Trade Ban 386International Agreements on Pollution 386A P P L I C A T I O N The Kyoto Protocol and the Copenhagen Accord 388

H E A D L I N E S Dismal Outcome at Copenhagen Fiasco 390

4 Conclusions 391Key Points, Key Terms, and Problems

PART 5Introduction toInternationalMacroeconomics

CHAPTER 12 The Global Macroeconomy 397

1 Foreign Exchange: Currencies and Crises 398How Exchange Rates Behave 399Why Exchange Rates Matter 400When Exchange Rates Misbehave 401Summary and Plan of Study 402

H E A D L I N E S Economic Crisis in Argentina 403

2 Globalization of Finance: Debts and Deficits 404Deficits and Surpluses: The Balance of Payments 404Debtors and Creditors: External Wealth 407Darlings and Deadbeats: Defaults and Other Risks 408Summary and Plan of Study 409

3 Government and Institutions: Policies and Performance 410Integration and Capital Controls: The Regulation of InternationalFinance 410Independence and Monetary Policy: The Choice of Exchange RateRegimes 412

CONTENTS XIX

Institutions and Economic Performance: The Quality of Governance 413

H E A D L I N E S The Wealth of Nations 414Summary and Plan of Study 416

4 Conclusions 417Key Points, Key Terms, and Problems

CHAPTER 13 Introduction to Exchange Rates and the Foreign PART 6Exchange Market 421 Exchange Rates

1 Exchange Rate Essentials 422Defining the Exchange Rate 422Appreciations and Depreciations 424Multilateral Exchange Rates 426Example: Using Exchange Rates to Compare Prices in a CommonCurrency 427

2 Exchange Rates in Practice 429Exchange Rate Regimes: Fixed Versus Floating 429

A P P L I C A T I O N Recent Exchange Rate Experiences 430

3 The Market for Foreign Exchange 435The Spot Contract 435Transaction Costs 436Derivatives 436

A P P L I C A T I O N Foreign Exchange Derivatives 437Private Actors 438Government Actions 438

4 Arbitrage and Spot Exchange Rates 439Arbitrage with Two Currencies 440Arbitrage with Three Currencies 441Cross Rates and Vehicle Currencies 4,42

5 Arbitrage and Interest Rates 443Riskless Arbitrage: Covered Interest Parity 443A P P L I C A T I O N Evidence on Covered Interest Parity 445Risky Arbitrage: Uncovered Interest Parity 447

S I D E B A R Assets and Their Attributes 447A P P L I C A T I O N Evidence on Uncovered Interest Parity 450Uncovered Interest Parity: A Useful Approximation 451Summary 452 •

6 Conclusions 453Key Points, Key Terms, and Problems

XX CONTENTS

CHAPTER 1 4 Exchange Rates I: The Monetary Approach in theLong Run 459

1 Exchange Rates and Prices in the Long Run: Purchasing PowerParity and Goods Market Equilibrium 460The Law of One Price 461Purchasing Power Parity 462The Real Exchange Rate 463Absolute PPP and the Real Exchange Rate 463Absolute PPP, Prices, and the Nominal Exchange Rate 464Relative PPP, Inflation, and Exchange Rate Depreciation 464Summary 466

A P P L I C A T I O N Evidence for PPP in the Long Run and Short Run 466How Slow Is Convergence to PPP? 467What Explains Deviations from PPP? 468

S I D E B A R Forecasting When the Real Exchange Rate Is.„ Undervalued or Overvalued 469

H E A D L I N E S The Big Mac Index 470

2 Money, Prices, and Exchange Rates in the Long Run: MoneyMarket Equilibrium in a Simple Model 472What Is Money 472The Measurement of Money 472The Supply of Money 473The Demand for Money: A Simple Model 474Equilibrium in the Money Market 475A Simple Monetary Model of Prices 475A Simple Monetary, Model of the Exchange Rate 476Money Growth, Inflation, and Depreciation 477

3 The Monetary Approach: Implications and Evidence 478Exchange Rate Forecasts Using the Simple Model 478

A P P L I C A T I O N Evidence for the Monetary Approach 481

A P P L I C A T I O N Hyperinflations of the Twentieth Century 482

H E A D L I N E S The First Hyperinflation of the Twenty-FirstCentury 485

S I D E B A R Currency Reform 486

4 Money, Interest Rates, and Prices in the Long Run:, A General Model 486The Demand for Money: The General Model 487Long-Run Equilibrium in the Money Market 488Inflation and Interest Rates in the Long Run 488

-The Fisher Effect 489(Real Interest Parity 490

CONTENTS XXI

A P P L I C A T I O N Evidence on the Fisher Effect 491The Fundamental Equation under the General Model 492Exchange Rate Forecasts Using the General Model 493

5 Monetary Regimes and Exchange Rate Regimes 495The Long Run: The Nominal Anchor 496

A P P L I C A T I O N Nominal Anchors in Theory and Practice 498

6 Conclusions 500Key Points, Key Terms, and Problems

CHAPTER 15 Exchange Rates II: The Asset Approach in theShort Run 507

1 Exchange Rates and Interest Rates in the Short Run:UIP and FX Market Equilibrium 508Risky Arbitrage 508Equilibrium in the FX Market: An Example 510Adjustment to FX Market Equilibrium 511Changes in Domestic and Fbreign Returns and FX Market Equilibrium 512Summary 514

2 Interest Rates in the Short Run: Money Market Equilibrium 514Money Market Equilibrium in the Short Run: How Nominal Interest RatesAre Determined 514Money Market Equilibrium in the Short Run: Graphical Solution 516Adjustment to Money Market Equilibrium in the Short Run 516Another Building Block: Short-Run Money Market Equilibrium 517Changes in Money Supply and the Nominal Interest Rate 517

A P P L I C A T I O N Can Central Banks Always Control the Interest Rate?A Lesson from the Crisis of 2008-2009 519

Changes in Real Income and the Nominal Interest Rate 520The Monetary Model: The Short Run versus the Long Run 520

3 The Asset Approach: Applications and Evidence 521The Asset Approach to Exchange Rates: Graphical Solution 521Short-Run Policy Analysis 523

A P P L I C A T I O N The Rise and Fall of the Dollar, 1999-2004 526

4 A Complete Theory: Unifying the Monetary andAsset Approaches 527 ;Long-Run Policy Analysis 528

S I D E B A R Confessions of a Forex Trader 530Overshooting 534

S I D E B A R Overshooting in Practice 536

XXII CONTENTS

5 Fixed Exchange Rates and the Trilemma 537What Is a Fixed Exchange Rate Regime? 537Pegging Sacrifices Monetary Policy Autonomy in the Short Run:Example 537Pegging Sacrifices Monetary Policy Autonomy in the Long Run:Example 539The Trilemma 540

S I D E B A R Intermediate Regimes 542

A P P L I C A T I O N The Trilemma in Europe 543

6 Conclusions 544

A P P L I C A T I O N News and the Foreign Exchange Market in Wartime 544Key Points, Key Terms, and Problems

PART 7 CHAPTER 16 National and International Accounts: Income,The Balance of Wealth, and the Balance of Payments 553

1 Measuring Macroeconomic Activity: An Overview 554The Flow of Payments in a Closed Economy: Introducing the NationalIncome and Product Accounts 554The Flow of Payments in an Open Economy: Incorporating the Balance ofPayments Accounts 556

2 Income, Product, and Expenditure 558Three Approaches to Measuring Economic Activity 559From GNE to GDP: Accounting for Trade in Goods and Services 559From GDP to GNI: Accounting for Trade in Factor Services 560

A P P L I C A T I O N Celtic Tiger or Tortoise? 561From GNI to GNDI: Accounting for Transfers of Income 563What the National Economic Aggregates Tell Us 564

H E A D L I N E S Are Rich Countries "Stingy" with Foreign Aid? 565Understanding the Data for the National Economic Aggregates 566What the Current Account Tells Us 568A P P L I C A T I O N Global Imbalances 569

3 The Balance of Payments 574Accounting for Asset Transactions: the Financial Account 574Accounting for Asset Transactions: the Capital Account 574Accounting for Home and Foreign Assets 575How the Balance of Payments Accounts Work: A Macroeconomic View 576How the Balance of Payments Accounts Work: A Microeconomic View 576

S I D E B A R The Double-Entry Principle in the Balance ofPayments 578

Understanding the Data for the Balance of Payments Account 578What the Balance of Payments Account Tells Us 582

CONTENTS XXIII

4 External Wealth 582The Level of External Wealth 583Changes in External Wealth 583Understanding the Data on External Wealth 584What External Wealth Tells Us 586

5 Conclusions 587

S I D E B A R Beware of Greeks Bearing Statistics 587Key Points, Key Terms, and Problems

Appendix to Chapter 16 593

CHAPTER 17 Balance of Payments I: The Gains from FinancialGlobalization 595

1 The Limits on How Much a Country Can Borrow: The Long-RunBudget Constraint 597How The Long-Run Budget Constraint Is Determined 598The Budget Constraint in a Two-Period Example 599A Long-Run Example: The Perpetual Loan 601Implications of the LRBC for Gross National Expenditure and GrossDomestic Product 602Summary 603

A P P L I C A T I O N The Favorable Situation of the United States 603

A P P L I C A T I O N The Difficult Situation of the Emerging Markets 606

2 Gains from Consumption Smoothing 608The Basic Model 608Consumption Smoothing: A Numerical Example and Generalization 609

Summary: Save for a Rainy Day 613

S I D E B A R Wars and the Current Account 613

A P P L I C A T I O N Consumption Volatility and Financial Openness 614A P P L I C A T I O N Precautionary Saving, Reserves, and Sovereign Wealth

Funds 615

3 Gains from Efficient Investment 616

H E A D L I N E S Copper-Bottomed Insurance 617The Basic Model 618Efficient Investment: A Numerical Example and Generalization 618Summary: Make Hay While the Sun Shines 621A P P L I C A T I O N Delinking Saving from Investment 621Can Poor Countries Gain from Financial Globalization? 623A P P L I C A T I O N A versus k 627

S I D E B A R What Does the World Bank Do? 631H E A D L I N E S A Brief History of Foreign Aid 631

XXIV CONTENTS

4 Gains from Diversification of Risk 633Diversification: A Numerical Example and Generalization 633A P P L I C A T I O N The Home Bias Puzzle 638Summary: Don't Put All Your Eggs in One Basket 640

5 Conclusions 641Key Points, Key Terms, and Problems

Appendix to Chapter 17 647

CHAPTER 18 Balance of Payments II: Output, Exchange Rates,and Macroeconomic Policies in the Short Run 649

1 Demand in the Open Economy 650Preliminaries and Assumptions 650 »Consumption 651'Investment 652The'Govemment 652The Trade Balance 653

H E A D L I N E S Expenditure Switching and the DollarDevaluation 655

H E A D L I N E S The Curry Trade 656

A P P L I C A T I O N The Trade Balance and the Real Exchange Rate 657Exogenous Changes in Demand 658

S I D E B A R Barriers to Expenditure Switching: Pass-Through andthe J Curve 659

2 Goods Market Equilibrium: The Keynesian Cross 662Supply and Demand 662

Determinants of Demand 662Factors That Shift the Demand Curve 664Summary 665

3 Goods and Forex Market Equilibria: Deriving the IS Curve 665Equilibrium in Two Markets 666Forex Market Recap 666Deriving the IS Curve 668Factors That Shift the IS Curve 669Summing Up the IS Curve 671

4 Money Market Equilibrium: Deriving the LM Curve 671'Money Market Recap 672Deriving the LM Curve 673Factors That Shift the LM Curve 673Summing Up the LM Curve 674

CONTENTS XXV

5 The Short-Run IS-LM-FX Model of an Open Economy 675Macroeconomic Policies in the Short Run 676Monetary Policy under Floating Exchange Rates 677Monetary Policy under Fixed Exchange Rates 678Fiscal Policy under Floating Exchange Rates 679Fiscal Policy under Fixed Exchange Rates 680Summary 682

6 Stabilization Policy 683

A P P L I C A T I O N Australia, New Zealand, and the Asian Crisis of 1997 683

Problems in Policy Design and Implementation 686

A P P L I C A T I O N Macroeconomic Policies in the Liquidity Trap 687

7 Conclusions 691

Key Points, Key Terms, and Problems

Appendix 1 to Chapter 18 696

Appendix 2 to Chapter 18 698

CHAPTER 19 Fixed versus Floating: International Monetary PART 8Experience 699 Applications and

1 Exchange Rate Regime Choice: Key Issues 701 .f.9!If^X.J.??.H^A P P L I C A T I O N Britain and Europe: The Big Issues 701Key Factors in Exchange Rate Regime Choice: Integration and Similarity 706Economic Integration and the Gains in Efficiency 706Economic Similarity and the Costs of Asymmetric Shocks 707Simple Criteria for a Fixed Exchange Rate 708

A P P L I C A T I O N Do Fixed Exchange Rates Promote Trade? 709

A P P L I C A T I O N Do Fixed Exchange Rates Diminish MonetaryAutonomy and Stability? 711

2 Other Benefits of Fixing 714Fiscal Discipline, Seigniorage, and Inflation 714

S I D E B A R The Inflation Tax 715Liability Dollarization, National Wealth, and ContractionaryDepreciations 717Summary 723

3 Fixed Exchange Rate Systems 724Cooperative and Noncooperative Adjustments to Interest Rates 724Cooperative and Noncooperative Adjustments to Exchange Rates 727A P P L I C A T I O N The Gold Standard 729

XXVI CONTENTS

4 International Monetary Experience 731The Rise and Fall of the Gold Standard 731Bretton Woods to the Present 734

5 Conclusions 737Key Points, Key Terms, and Problems

CHAPTER 20 Exchange Rate Crises: How Pegs Work and How TheyBreak 741

1 Facts about Exchange Rate Crises 742What Is an Exchange Rate Crises? 742How Costly Are Exchange Rate Crises? 742

S I D E B A R The Political Costs of Crises 745Summary 746

2 How Pegs Work: The Mechanics of a Fixed Exchange Rate 747Preliminaries and Assumptions 747The Central Bank Balance Sheet 748Fixing, Floating, and the Role of Reserves 750How Reserves Adjust to Maintain the Peg 750Graphical Analysis of the Central Bank Balance Sheet 751Defending the Peg I: Changes in the Level of Money Demand 752

A P P L I C A T I O N Risk Premiums in Advanced and Emerging Markets 755

A P P L I C A T I O N The Argentine Convertibility Plan Before the TequilaCrisis 758

Defending the Peg II: Changes in the Composition of Money Supply 760A P P L I C A T I O N The Argentine Convertibility Plan After the Tequila Crisis 766The Central Bank Balance Sheet and the Financial System 767Summary 769

S I D E B A R The Great Reserve Accumulation in Emerging Markets 770

3 How Pegs Break I: Inconsistent Fiscal Policies 772The Basic Problem: Fiscal Dominance 773A Simple Model 773

A P P L I C A T I O N The Peruvian Crisis of 1986 777Summary 780

4 How Pegs Break II: Contingent Monetary Policies 780The Basic Problem: Contingent Commitment 781A Simple Model 782

A P P L I C A T I O N The Man Who Broke the Bank of England 787Summary 788

CONTENTS XXVII

5 Conclusions 788Can We Prevent Crises? 788

Key Points, Key Terms, and Problems

CHAPTER 2 1 The Euro 795

1 The Economics of the Euro 798The Theory of Optimum Currency Areas 798Simple Optimum Currency Area Criteria 799What's the Difference between a Fix and a Currency Union? 800Other Optimum Currency Area Criteria 801

A P P L I C A T I O N Optimum Currency Areas: Europe versus theUnited States 803

Are the OCA Criteria Self-Fulfilling? 806Summary 808

H E A D L I N E S Currency Unions and Trade 809

2 The History and Politics of the Euro 810A Brief History of Europe 810Summary 817

3 Eurozone Tensions in Tranquil Times, 1999-2007 817The European Central Bank 818The Rules of the Club 821Sticking to the Rules 825

4 The Eurozone in Crisis, 2008-2010 827

H E A D L I N E S Can the Euro Survive? 830

5 Conclusions: Assessing the Euro 831Key Points, Key Terms, and Problems

CHAPTER 22 Topics in International Macroeconomics 837

1 Exchange Rates in the Long Run: Deviations from Purchasing PowerParity 838

Limits to Arbitrage 838

A P P L I C A T I O N It's Not Just the Burgers That Are Cheap 841Nontraded Goods and the Balassa-Samuelson Model 843Overvaluations, Undervaluations, and the Productivity Growth: ForecastingImplications for Real and Nominal Exchange Rates 845

A P P L I C A T I O N Real Exchange Rates in Emerging Markets 847Conclusion 849

XXVIII CONTENTS

2 Exchange Rates in the Short Run: Deviations from Uncovered InterestParity 849

H E A D L I N E S Eastern Europe and the Euro 850A P P L I C A T I O N The Carry Trade 850

H E A D L I N E S Mrs. Watanabe's Hedge Fund 854A P P L I C A T I O N Peso Problems 855The Efficient Markets Hypothesis 857Limits to Arbitrage 860Conclusion 863

3 Debt and Default 863A Few Peculiar Facts about Sovereign Debt 865A Model of Default, Part One: The Probability of Default 866A P P L I C A T I O N Is There Profit in Lending to Developing Countries? 871A Model of Default, Part Two: Loan Supply and Demand 872A P P L I C A T I O N The Costs of Default 875Conclusion 878

I?

A P P L I C A T I O N The Argentina Crisis of 2001-2002 879

4 The Global Macroeconomy and the 2007-2009 Crisis 882H E A D L I N E S Is the IMF "Pathetic"? 883

Backdrop to the Crisis 883Panic and the Great Recession 890Conclusion: Lessons for Macroeconomics 900Key Points, Key Terms, and Problems

Index 1-1