International Economics

ARGUMENTS FOR
PROTECTION
Dr Lidia Mesjasz
Cracow University of Economics
Outline
 Introduction
 Traditional arguments for protection:
 Domestic market failure argument
 Terms of trade argument
 Infant industry argument
 Tariff to increase aggregate employment
 Tariff to increase employment in a particular industry
 Tariff to offset foreign dumping
 Tariff to offset a foreign subsidy
 Tariff to benefit a scarce factor of production
 National defense argument
 Tariff to improve the balance of trade
 New arguments for activist trade policy
2
TRADITIONAL ARGUMENTS
FOR PROTECTION
3
Introduction: what does economic theory say
about free trade and protectionism?
 Economic theory does not provide a
dogmatic defense of free trade, something
that it is often accused of doing.
 Economic theory says that governments

should use as much free trade as possible
and as little protectionism as necessary
 The degree of free trade or protectionism

depends on the state of an individual
economy
4
Domestic market failure argument (1)
 Market does not function effectively (e.g. labor
market is not clearing, capital market is not
allocating resources efficiently, etc.)
 Trade policy can offset domestic market failures
Counterarguments:
 Domestic market failure should be corrected by

domestic policies aimed directly at the problem’s
sources. Trade policy is „second-best” solution, but
never the most efficient response to domestic
market failure.
 Market failures are difficult to diagnose precisely =>
difficult to prescribe appropriate policy response.
5
Example: aim is to save jobs in the US car industry
 Cut wages: 1.„first best solution”
US labor market is inflexible, so this may not resolve the problem.
 A domestic subsidy to car producers: 2.„first best

solution”
 A subsidy can create massive political opposition because it
would increase government budget deficit or require a tax
increase
 General public may not support a subsidy as autoworkers are
among the highest-paid workers in the manufacturing sector
 An import quota on cars: „second best solution”

6
 Yet an import quota would be even more expensive
than production subsidy, because while bringing
about the same increase in employment, it would
also distort consumer choice.
 However, the cost of an import quota is less visible

taking the form of higher car prices rather than direct
government outlays.
Most trade policy instruments are adopted

not because their benefits exceed their costs but
because the public fails to understand their true costs.
7`
The terms of trade argument
 A restrictive trade policy can lead to an improvement
of a country’s terms of trade, and as a result the
national welfare can be enhanced.
 A large country may be able to gain from an import

tariff if it reduces the world price of the imported
good.
 A large country may also be able to gain from an

export tariff due to its positive impact on the export
price.
E.g. Saudi Arabia as an oil exporter can increse its

TOT and welfare by imposing an export tariff on oil.
8
The terms of trade counterarguments:
 Small countries have no ability to affect

world prices => trade policy instruments will
always reduce their welfare.
 Terms of trade argument is a beggar-my-

neighbor argument because welfare and TOT
of the trading partner falls.
 If the partner country retaliates with a tariff,

both countries will end up with reduced
welfare; if continual retaliation occurs, trade
may shrink dramatically.
9
The infant industry argument
 A new domestic industry (or firm) that has a potential comparative
advantage should be given a temporary protection against low-cost
imports.
Validity of the argument:

 Uncertainty whether the protected industry will be able to develop
its comparative advantage without facing competition
 Difficult to identify industries that are truly infant and likely to

develop economies of scale and become low-cost producers
 What is a proper form of protection? (production subsidy vs. tariff)
 Why cannot a firm expand on its own by borrowing funds from

capital market?
10
 Net effect of protection vs. welfare costs of protection.
Tariff to increase aggregate employment
 A tariff will result in a shift in domestic demand from foreign
goods to home-produced goods => the import-substitute
industries will expand their output and employment, and through
multiplier effects other home industries will expand too and add
new jobs.
 It is uncertain if aggregate employment will increase as

the home country may lose jobs in the export industries if:
 Retaliatory tariffs are imposed by trading partners.
 Trading partners reduce their imports from the home country (as
their exports and national income have fallen).
 Home currency appreciates (foreign currency depreciates due to

less demand for imports) => lower exports and higher imports
 Expansionary monetary and fiscal policy might accomplish the

same goal more directly and with more certainty than a tariff.
11
Tariff to increase employment in a particular
industry
 If protection is granted to a given industry, demand
shifts from the import to the home product because the
last one is cheaper. Higher demand for the home good,
raises its price, and induces domestic producers to
produce more and employ more labor.
Validity of this argument:

 An increase in employment in a protected industry may
be done at the expense of employment in other
industries
 A tariff is not the best method of increasing

employment. A subsidy to production or employment
is a less costly way to attain the same goal. 12
Tariff to offset foreign dumping
 Dumping by foreign firms into the home country is unfair
and constitutes a threat to domestic producers because
of the lower import price.
 An antidumping duty can offset the foreign firm’s unfair

price advantage.
Validity:
 Protection is valid with predatory dumping that causes

domestic factors of production move in and out of the
industry because of fluctuating import prices.
 In practice it’s difficult to identify the immediate

motivation behind dumping.
13
Tariff to offset a foreign subsidy
 A foreign government subsidy awarded to a foreign
import supplier constitutes unfair trade with the
home country.
 A countervailing duty (CVD) should be imposed to

restore equal footing to the home and foreign
industry.
Validity:
 If a subsidy allows the firm to export the good in

which it does not have a comparative advantage,
then the subsidy generates a distortion from free-
trade allocation of resources and world welfare is
reduced. CVD by offsetting this distortion may help
to restore a more efficient trade pattern.
14
Tariff to benefit a scarce factor of
production
 A tariff benefits a scarce factor of production by
redistributing income from the abundant factor to
the scarce factor (recall HO model)
Validity:
 Although the scare factor gains from a tariff, the

country as a whole loses welfare
 A direct transfer of income by taxing the abundant

factor and awarding the tax revenue to the scarce
factor would be less costly for the economy.
15
National defense argument for a tariff
 An industry that is vital to national security should
be protected to expand its domestic production and
makes the country independent of foreign supplies
in times of world conflicts or national emergency.
Validity:
 It’s not easy to identify which industries are vital to

national defense
 Other instruments of protection are superior to

tariffs (a good may be stockpiled, a production
subsidy)
 Full self-sufficiency might not be rational provided

that a country has diversified its supply sources and
signed defense alliances with other countries 16
Tariff to improve a trade balance (1)
 An import tariff will reduce imports and trade balance
will improve.
=> A tariff may not imporove the balance of trade, IF:

 trading partners retaliate
 trading partners reduce their imports from the home
country
 a tariff has reduced imports of inputs used by the home
country’s export industries => exports may fall
 home currency appreciates, reducing its exports and
increasing imports
 an inflationary pressure appears in the home country,
reducing its exports and increasing imports
17
Tariff to improve a trade balance (2)
 Trade deficit is a macroeconomic problem:
Y = C + I + G + (X−M)
Y – (C + I + G) = X–M
Trade deficit (X < M) occurs when Y < (C + I + G)
 Solution: increase income and/or cut spending
 Devaluation (or depreciation) of the home currency

is less costly (then a tariff) policy of eliminating or
reducing trade deficit.
18
NEW ARGUMENTS
FOR ACTIVIST TRADE POLICY
19
New arguments for protection
 Emerged in the 1980s in advanced economies and
focused on high-technology industries.
 Two kinds of market failures in advanced countries:
 inabilityof firms in high-technology industries to

capture all the benefits of the knowledge they
create (technological spillover argument)
 presence of monopoly profits in highly

concentrated oligopolistic industries (imperfect
competition argument)
 Government intervention in trade to overcome the

market failures.
20
1. Technological spillover argument
 Firms that invest in new technologies

generate knowledge that can also be used by
other firms without paying for it (externalities
or marginal social benefits of the knowledge).
 Due to technological spillover, incentives to

innovate are weak.
 There is a good reason to subsidize high-

tech industries.
21
Technological spillover argument (2)
 But some questions arise:
 Isthe government policy able to target

precisely this activity that generates
knowledge?
 How much subsidy is justified? (externalities

don’t have a market price)
 Some externalities may spill over to other

countries.
22
2. Imperfect competition argument
 Due to imperfect competition in oligopolistic
industries, huge profits can be generated.
 An international competition over who gets these

profits
 By subsidizing domestic firms the government may

try to shift these high profits from foreign to
domestic firms.
 If a domestic subsidy deters foreign competitors,

profits of domestic firms can rise by more than the
amount of the subsidy => the subsidy increases the
national welfare at the expense of other countries’
welfare.
23
Brander-Spencer analysis
Assumptions:
 Two companies compete in a market of aircrafts
(Airbus from Europe and Boeing from the USA).
 Market size for aircrafts is limited to allow both firms

for efficient production.
 Due to high cost on R&D, only a large scale of
production is efficient.
 Each firm’s decision whether to produce a new

aircraft is based on the expected profits and other
firm’s decision:
 If both companies produce, each will make a loss.
 If only one company produces, it will make a huge
profit.
24
Scenario A: without subsidy
Airbus
Boeing Produce Don’t produce
-5 00
Produce -5 100
100
100
100 0
Don’t produce 0 0
• In a simultaneous game theoretic set-up: Two Nash-equilibria

• In reality: Game is not a simultaneous game but a sequential game
• Which company will receive the profits? => The company which is
first!
• First mover advantage! => Boeing produces and Airbus does not so!
25
Scenario A: Europe pays a subsidy of 25
to Airbus
Airbus
20 0
Produce -5 100
125 0
Don’t produce 0 0
• One Nash-equilibrium: Airbus serves market as a

monopolist
• Boeing is deterred from entering
• Profit for Airbus is higher than subsidy => Europe’s
welfare increases at the expense of the US welfare
26
Scenario B:
 Suppose, instead of symmetric pay-offs (scenario A)

there are asymmetric pay-offs (scenario B)
 Suppose, Boeing has some underlying advantage of

25 mill (due to better technology)
In the result:
 Boeing can produce profitably even if Airbus enters
 Airbus cannot produce profitably if Boeing enters
27
Scenario B: without subsidy
Airbus
-20 00
Produce 5 125
125
100 0
Don’t produce 0 0
• If Boeing has an underlying advantage, only Being produces and

Airbus does not produce.
• One Nash-equilibrium: Boeing serves market as a monopolist

28
Scenario B: Europe pays a subsidy of
25 to Airbus
Airbus
5 5 0
Produce 55 125
125 0
Don’t produce 0 0
• One Nash-equilibrium: Both companies produce
• Airbus receives a subsidy of 25 but gains only a profit of 5

• Subsidy did not allow Airbus to raise profits as much as in scenario A
because it failed to deter Boeing’s entry
29
Concerns about strategic trade policy
 Do governments have enough information to use
strategic trade policy effectively?
 In scenario A: a subsidy allows to improve national
welfare
 In scenario B: a subsidy allows only to compensate
for losses
 If one industry is granted strategic advantage, other

industries face strategic disadvantage.
 Strategic trade policy is a kind of beggar-thy-neighbor

policy (national welfare increases at the expense of
other countries welfare), and thus faces a risk of
foreign retaliation or even a trade war that would leave
everyone worse off.
30
THE CLASSICAL THEORIES
OF INTERNATIONAL TRADE
Dr Lidia Mesjasz
mesjaszl@uek.krakow.pl
Basic questions of international
trade theories:
◼ What is the basis for trade?
◼ What does determine the pattern of trade?
◼ What does determine the volume of trade?
◼ What does determine the prices in international
trade?
◼ What are the gains from trade and how are they
distributed among the trading nations?
◼ What is the effect of trade on the earnings of factors
of production?
◼ How can governments regulate the volume of
international trade and what might be the effects of
such regulation? 2
1. Early Trade Theories
◼ Mercantilism
◼ The challenge to mercantilism by early
classical writers
◼ Price-specie-flow mechanism
◼ Absolute advantage
3
Mercantilism and the Mercantilist
Economic System: 1500-1750
◼ Mercantilism: a collection of economic thoughts in

1500-1750 that had huge impact on government policy
◼ View 1.: A nation can increase its wealth by exporting

more than importing (wealth = money)
◼ Exports are good and imports are bad.
◼ A trade surplus country gains from trade at the

expense of a trade deficit country that looses from
trade (trade is a zero-sum game).
4
Mercantilism and government policy (1)
◼ View 2.: Government should regulate economic
activity, both domestic and foreign.
◼ Exports were subsidized and imports were limited by

high tariffs and quotas.
◼ Trade monopolies were granted exclusive trading

rights.
◼ Use and exchange of precious metals were strictly

controlled by the government (exports of gold and
silver by individuals were prohibited).
5
Mercantilism and government policy (2)
◼ View 3: Labor theory of value: economic value of a
good is determined by the total amount of labor
necessary to produce it.
 labour should be of good quality

 wages were kept low
to allow high competitiveness of domestic exports
PARADOX
◼ Rich nations in the Mercantalists sense comprised of
large numbers of very poor people.
◼ Specie (wealth) was accumulated at the expense of

current consumption.
6
The challenge to mercantilism by early classical
writers
David Hume (1752): Political Discourses
Price-specie-flow mechanism: a nation cannot continue

to accumulate specie without negative repercussions to
its international competitive position
Italy (trade surplus) vis-à-vis Spain (trade deficit)

Exports > Imports Exports < Imports
Net inflow of specie <=> Net outflow of specie
Money supply ↑ Money supply ↓
Prices↑ & wages Prices↓ & wages
Imports↑ & exports↓ Imports ↓ & exports ↑
UNTIL UNTIL
Exports = Imports <=> Exports = Imports
7
The challenge to mercantilism by early classical
writers (2)
Adam Smith (1776): The Wealth of Nations
◼ Smith perceived a nation’s wealth not in its holdings

of precious metals, but in enlarging its productive
capacity.
◼ Countries should specialize and export those

commodities in which they have an absolute
advantage while import those commodities in which
the trading partner has an absolute advantage.
◼ Source of absolute advantage as the unique set of

natural resources (including climate).
8
Adam Smith (1776): The Wealth of Nations
◼ Trade is a positive-sum game ( it is beneficial

for all trading countries).
◼ Free market, free competition, free

international trade – allow world resources to
be utilised most efficiently and maximize
world welfare.
◼ Little need for government to control

economy (laissez faire).
9
Numerical example: Adam Smith’s concept of
absolute advantage
Poland France
Agriculture 5 hr/unit 9 hr/unit
Industry 8 hr/unit 6 hr/unit
◼ Poland has an absolute advantage in Agriculture

◼ France has an absolute advantage in Industry
◼ Poland should specialize in Agriculture, and France
in Industry.
10
Gains from specialization
Suppose: each country produces 1 more unit of its

absolute advantage good
Changes in Agriculture Industry

production
Poland + 1 unit
France + 1 unit
Total gains
11
Suppose: each country produces 1 more unit of its

absolute advantage good

production
Poland + 1 unit -5/8 unit
France -6/9 unit + 1 unit
Total gains +1/3 unit +3/8 unit
12
Autarky vs. trade
Assumption:
Each country has 2000 units of labor and this is

initially split 50:50 among both sectors.
Production &
consumption in Agriculture Industry
autarky
Poland
France
World
13
Autarky vs. trade
Assumption:
Each country has 2000 units of labor and this is

initially split 50:50 among both sectors.
Production &
autarky
Poland 200 units 125 units
France 111,1 units 166,7 units
World 311,1 units 291,7 units
14
Gains from trade: production
Assumption:
Full specialization
Production after
Agriculture Industry
specialization
Poland
France
World
15
Gains from trade: production
Assumption:
Full specialization
Production after
specialization
Poland 400 units 0
France 0 333,3 units
World 400 units 333,3 units
16
Gains from trade: consumption
Suppose:
Rate of exchange: 1:1
Poland exports 100 units of Agriculture, and
France exports 100 units of Industry
Consumption after
trade 1 A/ 1 I
Poland
France
World
17
Gains from trade: consumption
Assumptions:
Rate of exchange: 1 unit A/ 1 unit I
Poland exports 100 units of Agriculture, France
exports 100 units of Industry
Consumption after
trade 1 A/ 1 I
Poland 300 units 100 units
France 100 units 233,3 units
World 400 units 333,3 units
18
From Adam Smith to David Ricardo
◼ Adam Smith’s finding that trade can be

mutually beneficial was a powerful argument
for reducing trade barriers that characterized
the Mercantilist period.
◼ David Ricardo expanded upon Smith’s

concept of absolute advantage and
demonstrated that potential gains from trade
were far greater than those promised by the
concept of AA.
19
2. David Ricardo concept
of comparative advantage
◼ Difference between absolute and

comparative advantage
◼ Numerical examples
◼ Terms of trade
◼ Distribution of the gains from trade (law of
reciprocal demand)
◼ Monetarized Ricardo model
◼ Ricardo model in graphical terms
◼ Limitations of the classical model
20
David Ricardo
„The Principles of Political Economy and
Taxation”, 1817
◼ Gains from international trade are not limited

to absolute advantage.
◼ Even if one country has an absolute

disadvantage in both sectors, international
trade can still be advantageous as long as
comparative advantage exist.
21
Assumptions of the Basic Ricardian Model
1. Countries have fixed endowment of resources.
2. Factors of production are homogeneous.
3. Goods are valued in terms of the relative labor

content emobodied in them (labour theory of value).
4. Per unit production costs are constant (labour hours

per unit of output do not change with the quantity
produced => supply curve is horizontal).
5. Labor is completely mobile between the two sectors

(=> wages are the same within the country).
22
Assumptions of the Basic Ricardian Model (2)
6. Labor is completely immobile internationally (=>
wages differ between countries).
7. Technology is fixed and differs between countries.
8. Full employment.
9. Perfect competition.
10. Free market: no government-imposed barriers to

economic activity.
11. Transportation costs (internal and external) are

zero.
23
Ricardian Comparative Advantage
Absolute advantage:
◼ Unit labor requirements in one good is lower in one
country compared to the other country
(e.g. in Agriculture: 5h in Poland and 9h in France).
Comparative advantage:
◼ Relative labor requirements of the two goods is lower
in one country compared to the other country
(Agriculture/Industry: 5/8 in Poland and 9/6 in France).
24
Numerical example: Ricardian comparative
advantage
Opportunity cost Opportunity
of Agriculture cost of Industry
Poland 9 hr/unit 10 hr/unit 9/10 10/9
France 8 hr/unit 6 hr/unit 8/6 6/8
◼ Poland has an absolute disadvantage in both goods.

◼ France has an absolute advantage in both goods.
◼ Poland has a comparative advantage in Agriculture (lower
opportunity cost of Agriculture).
◼ France has a comparative advantage in Industry (lower
opportunity cost of Industry).
25
Suppose: each country produces 1 more unit of

its comparative advantage good

production
Poland + 1 unit
France + 1 unit
Total gains
26
Suppose: each country produces 1 more unit of

its comparative advantage good

production
Poland + 1 unit -9/10 unit
France -6/8 unit + 1 unit
Total gains +1/4 unit +1/10 unit
27
Autarky (pre-trade) price ratios
◼ In a perfectly competitive economy, relative
commodity prices reflect the opportunity costs of
their production.
◼ Relative price of Agriculture in terms of Industry:

in Poland: (PA/PI)PL = 9/10
in France: (PA/PI)FR = 8/6
◼ Pre-trade differences in relative commodity prices

reflect comparative advantage and provide the basis
for mutually beneficial trade.
28
International price ratio
◼ (PA/PI)PL ↑
◼ (PA/PI)FR ↓
◼ In free trade equilibrium: (PA/PI)PL = (PA/PI)FR
„law of one price”: if there are no barriers to trade, and

goods are homogenous, then eventually prices for the
same product should be the same.
◼ What will be an international equilibrium price (terms

of trade, TOT)?
9/10 < TOT < 8/6
29
Numerical example:
Gains from trade
Assumptions: Production &
Each country
produces 1000
autarky
units of each Poland 1000 1000
good in France 1000 1000
autarky. World 2000 2000
After
specialization Production after
each country specialization
produces 1500 Poland 1500
units of its CA
good. France 1500
World
30
Gains from trade
Production &
Assumptions:
Each country autarky
produces Poland 1000 1000
1000 units of France 1000 1000
each good in
autarky. World 2000 2000
After Production after

specialization Agriculture Industry
each country specialization
produces Poland 1500 550
1500 units of
its CA good.
France 625 1500
World 2125 2050
31
Gains from trade
Assumption: Terms of trade = 1
Poland exports 460 units of Agriculture, France exports
460 units of Industry
Consumption after
trade 1 A/ 1 I
Poland 1040
France 1040
World
If international terms of trade lies within the autarky price

ratios, both countries can gain from trade.
32
Gains from trade
Assumptions: Terms of trade = 1
Poland exports 460 units of Agriculture, France exports
460 units of Industry
Consumption after
trade 1 A/ 1 I
Poland 1040 1010
France 1085 1040
World 2125 2050
If international terms of trade lies within the autarky

price ratios, both countries can gain from trade.
33
Suppose: TOT = 8/6
◼ Autarky prices:(PA/PI)PL = 9/10 & (PA/PI)FR = 8/6
◼ TOT: (PA/PI)INT = 8/6
◼ Gains for France: 8/6 – 8/6 = zero

◼ Gains for Poland: 8/6 - 9/10= 0.43 units
◼ The closer the world price (TOT) is to

one country’s autarky relative price, the
greater the gains for the other country.
34
Distributions of gains from trade
◼ Each country can benefit from free trade, but

the benefits are not necessarily equal.
◼ Benefits of trade are determined by:
➢ international relative price (TOT)

➢ size and elasticity of demand
➢ size of the economy (GDP)
35
Distributions of gains from trade (1)
◼ John Stuart Mill, 1848 – the law of reciprocal
demand:
➢ The equilibrium terms of trade reflects the

size and elasticity of demand of each
country for the goods of the other country.
➢ The higher demand for imports => the

higher TOT => the lower the gains from
trade
36
Distributions of gains from trade (2)
◼ Larger countries => with higher GDP and
higher demand for imports => pay higher
relative price of imports (TOT) => lower gains
from trade.
◼ Smaller countries => with lower GDP and
lower demand for imports => pay lower
relative price of imports (TOT) => higher
gains from trade.
◼ When small countries trade with large

countries, the small ones are likely to enjoy
most of the gains from trade (the importance
of being unimportant). 37
Ricardian model in money terms
◼ Includes: wages and exchange rates
◼ Wages and exchange rate affect goods

prices
◼ Can countries with higher wages compete in

international market with low-wage countries
and benefit from international trade?
38
Ricardian model in money terms (cont.)
◼ Suppose:
 wage rate in Poland: WP (in PLN)

 wage rate in France: WF (in EUR)
 exchange rate: E = no. of PLN per 1 EUR
 wage rate in France in terms of PLN: WF x E
◼ Assume that the exchange rate is fixed.
39
Domestic production costs
◼ Domestic production costs of each good = number
of hours per unit of output times the wage rate:
Domestic production costs of agricultural goods:

 in Poland: 9 x WP
 in France: 8 x WF x E
Domestic productions costs of industrial goods:

 in Poland: 10 x WP
 in France: 6 x WF x E
! Note: multiplying labour hours by the wage rates

does not change the internal price ratios since wages
are the same in both sectors within the country.
40
Export conditions and wage ratios
◼ Export conditions: countries export goods they
produce relatively cheaper than the other country
PL: 9 x WP < 8 x WF x E
FR: 6 x WF x E < 10 x WP
◼ WP < 8/9 x WF x E / WF  E
◼ WP > 6/10 x WF x E / WF  E
◼ WP/ WFE < 8/9
◼ WP/ WFE > 6/10
◼ Wage ratios: 6/10 < WP/ WFE < 8/9
or 9/8 < WFE / WP < 10/6

41
Relative wages’ limits
9/8 < WF E / WP < 10/6
Relative labour productivity Relative labour productivity

in Agriculture in Industry
◼ Relative wages should be related to relative labour

productivity in the two countries.
◼ Wage differential between countries should not exceed

the maximum labour productivity differential or else a
country may lose its comparative advantage.
◼ Wages in France should not be more than 10/6 (1.67)

times greater than wages in Poland.
42
KEY FINDINGS OF THE RICARDO MODEL:
◼ Comparative advantage is important not absolute.
◼ Countries should specialize in the sector where they have a

comparative advantage.
◼ With full specialization, both countries will gain from trade

even if one country has an absolute disadvantage in both
sectors.
◼ Small countries gain more than large countries.
◼ If a country is so large that it determines the TOT, this

country will not benefit from trade.
◼ The ability to export depends not only on relative labor

efficiency, but also relative wages and the exchange rate. 43
Ricardo Model in graphical terms
◼ Basis for trade and gains from trade can be

illustrated with PPF concept.
◼ Production-possibilities frontier (PPF) – all

combinations of two goods that a nation can
produce by fully utilizing its resources and
technology available to it.
◼ PPF is a straight line reflecting the assumption of

constant-opportunity costs.
44
Ricardian PPF in autarky
Production
Poland France
during 1 hour
Agriculture 1/9 unit 1/8 unit
Industry 1/10 unit 1/6 unit
Production
Poland France
during 1 hour
Agriculture 400 units 450 units
Industry 360 units 600 units
Numbers from the first table have been multiplied by

3600 to obtain larger numbers of units.
45
Ricardian PPF in autarky (2)
Production in
Poland France
autarky
Agriculture 400 units 450 units
Industry 360 units 600 units
Industry 600
B |Slope PPFF|= 600/450=8/6= PA/PI

360
|Slope PPFPL|= 360/400=9/10= PA/PI
400 450 Agriculture
46
Ricardian PPF in autarky (3)
Slopeof PPF = Opportunity cost and relative price of a good
on the horizontal axis
• |Slope PPF PL| = (PA /PI) PL = 9/10

• |Slope PPFFR| = (PA /PI) FR = 8/6
• Poland has a lower slope of its PPF => lower opportunity

cost in A => lower relative price in A => CA in Agriculture.
• France has a steeper slope of its PPF => lower opportunity

cost in I => lower relative price in I => CA in Industry.
• Points A and B: production and consumption points in

autarky are the same => PPF = CPF
47
Ricardian PPFs and CPFs with trade
◼ (PA/PI)PL ↑ => slope PPFPL ↑
◼ (PA/PI)FR↓ => slope PPFFR ↓
◼ (PA /PI)PL= (PA /PI)FR => slope PPFPL = slope PPFFR =

international relative price (PA /PI)INT = TOT
9/10 < TOT < 8/6 e.g. TOT = 1
◼ Changes in relative prices => changes in the level of

production
◼ Countries specialize completely in their CA goods
producing at A’ and B’
◼ Countries consume on their new CPFs (outside their
autarkic PPFs) whose slopes are equal to TOT.
◼ The further the new CPFs lie outside the autarky
PPFs the larger the potential gains from trade.
48
Maximum gains from trade
through full specialization
Industry
600
B’
400
B Slope TOT = 1 = slope CPF
360
A’400 450 600 Agriculture
49
Limitations of the classical model
◼ Labor theory of value (only one production

factor)
◼ Constant opportunity costs
◼ No explanation for the differences in labor

productivity between countries.
50
Multilateral
Trading System
GATT/WTO
Lidia Mesjasz, PhD

Lidia Mesjasz, CUE 1
Outline
◼ Costs of protectionist trade policy
◼ Advantages of international trade
negotiations
◼ Evolution of international trade policy
◼ Purposes and principles of the world trading
system GATTT/WTO
◼ GATT/WTO major achievements in trade
liberalization
◼ Recent trends in world trade policy

Costs of Protectionist Trade Policy
◼ Less efficient allocation of production

◼ Decreased competition
◼ Higher overall retail prices for consumers
◼ Less trade flows => fewer goods and less
variety of goods for consumers
◼ Reduced national and world welfare
◼ Encourage retaliations and lead to a trade war
=> (everyone would be worse off)

Advantage of international trade negotiations:
avoid a trade war
Japan Free trade Protection

U.S.
Free trade 10 10 20
-10
Protection -10 --55 -- 55
20
• Each government acting individually (making the best

decision for itself), will chose to protect => a trade war
that leaves everyone worse off. (=> Nash equilibrium)
• Both governments would be better off if both refrain
from protection and choose free trade (=> Pareto
equilibrium)
Evolution of international trade policy
◼ Before World War II: bilateral negotiations; an item-by-item
approach to tariffs reduction
◼ Bretton Woods conference (1944) - failed to deliver any results
◼ United Nations Conference on Trade and Employment -
Havana 1947 (Charter of International Trade Organization,
never ratified)
◼ Trade negotiations in Geneva (23 countries): General
Agreement on Tariffs and Trade (GATT) – 1947: multilateral
negotiations, across-the-board approach to tariffs reduction
◼ World Trade Organization (WTO) - Marrakesh 1994.
Purposes of world trading system
◼ set the rules of conduct of international trade
◼ provide a forum for multilateral negotiations

aimed at lowering trade barriers
◼ serve as an arena for hearings to resolve

international trade disputes

Principles of world trading system
◼ Non-discrimination (treating others equally):
➢ Most-favoured nation (MFN) - any special tariff cuts offered

by one country to another would automatically be extended to
all other WTO members.
➢ National treatment – imported goods should be treated no

less favourable than the domestic goods.
❖ MFN Exceptions:
➢ Article XXIV GATT: Regional Trade Arrangements (RTAs)
➢ General System of Preferences (GSP) for developing
countries
➢ Anti-dumping actions and countervailing (anti-subsidy)
measures.
7 Lidia Mesjasz, CUE
Principles of world trading system (cont.)
◼ Reciprocity of concessions (exception: GSP)
◼ Tariff binding - tariffs that have been cut in

international negotiations are bound and cannot be
unilaterally raised
◼ Trade disputes – should be settled by

consulatations (WTO is an important arbiter of
trade disputes)
◼ Other prinicples:
➢ Interdiction of quantitative restrictions
➢ Interdiction of damping and subsidies
GATT
Lidia Mesjasz, CUE
• an agreement and not organization (without structure)

• „contracting parties” and not members
• negotiations occured in „rounds”
9
The Uruguay Round (1986-1994)
◼ Final agreement: in Marrakesh, Marocco, April 1994 by
123 countries
◼ World Trade Organization set up (164 members in
2022).
◼ A significant progress was made in:
➢ liberalizing trade in services and agriculture (The
General Agreement on Trade in Services, GATS):
national treatment and MFN treatment in services.
➢ expanding protection of intellectual property rights
(Trade-related intellectual property rights,TRIPs):
minimum standards for trademarks, patents and
copyrights.
➢ improving the procedures of dispute settlements
mechanism
10
➢ reducing non-tariff trade barriers Lidia Mesjasz, CUE
The Uruguay Round major achivements:
◼ Developed nations agreed to cut over a six-year period:

➢ export subsidies on agricultural goods by 36
percent
➢ domestic support for agriculture by 20 percent
➢ average tariffs on agricultural goods by 36 percent
◼ NTBs on argicultural products have been replace with

tariffs and tariffs have been gradually reduced
◼ Quotas on textiles, clothing, agricultural goods have
agreed to be gradually eliminated until 2005.
◼ Quotas and export subsidies on manufactured products
have been banned completely.
Lidia Mesjasz, CUE
WTO: juridical structure
12
13 Lidia M
Ngozi Okonjo-Iweala of Nigeria –
Director General of the WTO (1March 2021-31August 2025)
15
Differences between GATT and WTO
◼ GATT was a provisional agreement, while the WTO is
a full-fledged international organization.
◼ GATT agreement applied to trade in goods; WTO

agreements cover goods, services and intellectual
property rights.
◼ Most agreements signed within the WTO framework

are obligatory for all members without exceptions
whereas under GATT countries could pick and
choose agreements they wanted to sign.
◼ Dispute settlement procedures in the WTO has been

strengthened by making them quicker, automatic and
binding for members.
WTO Ministerial Conferences
◼ Singapore, 9-13 December 1996
◼ Geneva, 18-20 May 1998
◼ Seattle, November 30 – December 3, 1999
◼ Doha, 9-13 November 2001: Doha Development Round
◼ Cancún, 10-14 September 2003
◼ Hong Kong, 13-18 December 2005
◼ Geneva, 30 November - 2 December 2009
◼ Geneva, 15-17 December 2011
◼ Bali, 3-6 December 2013
◼ Nairobi, 15-19 December 2015
◼ Buenos Aires, 10-13 December 2017
◼ Nur-Sultan, Kazakhstan, 8-11 June 2020 (postponed)
◼ Geneva, 12-16 June 2022 Lidia Mesjasz, CUE
Doha Development Agenda (2001…….)
◼ 21 subjects are being negotiated (agriculture,
services, intellectual property rights, and many
others)
◼ „Single undertaking” rule: nothing is agreed until

everything is agreed
◼ To close the Doha Round a single package must be

signed by all WTO members without any option to
pick and choose.
◼ The deadline for ending the Doha Round (2005) has

been missed. Lidia Mesjasz, CUE 18
Doha Round: major achievements
◼ Ministerial Conference in Hong Kong (2005)
➢ Developed nations pledged to cut production
subsidies and eliminate export subsidies on
agricultural goods and cotton (but refused to do so in
Potsdam in 2007)
➢ Developed nations agreed to give duty-free and
quota-free (DFQF) access for cotton exports from
least-developed countries (LDCs)
◼ Ministerial Conference in Geneva (2011)
➢ DFQF access for LDCs goods
➢ Preferential treatment in services for developing
countries
Doha Round (cont)
◼ Ministerial Conference in Bali (2013)
➢ Simplifed customs procedures to facilitate trade
➢ DFQF access for LDCs goods
◼ Ministerial Conference in Nairobi (2015):

➢ Commitment to abolish export subsidies on
agriculture and cotton
➢ DFQF access for developing countries’ cotton
producers
➢ Special safeguard mechanism (SSM) for developing
countries’ agricultural producers
➢ Preferential treatment for LDCs’ service suppliers
➢ Elimination of tariffs on information technology products
by 2019. Lidia Mesjasz, CUE 20
Tariff restrictiveness by region

Tariff restrictiveness by product

Tariff free trade

Non-tariff measures by types and
sectors

Border NTMs by countries
25 LIDIA MESJASZ, PhD

Trade defence measures

Trade defence measures by initiating country

THE HECKSCHER-OHLIN
MODEL
dr Lidia Mesjasz
mesjaszl@uek.krakow.pl
Agenda
◼ Assumptions of the H-O theory
◼ Heckscher-Ohlin theorem
◼ Factor price equalization theorem
◼ Stolper-Samuelson theorem
◼ Rybczynski theorem
◼ Practical application of the H-O theory
◼ HO model and imperfect competition
◼ Theoretical restrictions to HO model
2
H
Heckscher and Ohlin
3
Motivation
• The model is based on Heckscher’s (1919) article The
Effect of Foreign Trade on the Distribution of Income
(published in Swedish in Ekonomisk Tidskrift) and
was further developed in Ohlin’s (1933) book
Interregional and International Trade.
• The H-O Model applies tools of neoclassical theory to

international trade.
• By relaxing some of the strict assumptions of the

classical model, the H-O model provides one
possible explanation for a comparative advantage:
different relative factor availabilities in the two
countries.
4
Assumptions:
1. Two countries (A, B), two homogeneous goods (X, Y)
and two homogeneous factors of production (labor L,
capital K) => „2x2x2 model”
2. Factors of production are fixed and relatively different

in each country: (K/L)A ≠ (K/L)B.
3. Goods have different factor intensities (K/L)X ≠ (K/L)Y,

and this difference holds for all possible factor price
ratios (r/w) in both countries.
4. Technology is identical in both countries.
5
Assumptions (2):
5. Production is characterized by increasing

costs (or decreasing returns to scale)
6. Factors are perfectly mobile within each
country but not mobile between countries
7. Tastes and preferences are the same in
both countries
8. Perfect competition
9. No transportation costs
10. No restrictions to trade.
6
Countries: relative factor abundance
(physical definition)
◼ Relative amount of factors is critical, not absolute
Suppose: KA=100 & LA=100 KB=1000 & LB=2000
(K/L)A > (K/L)B because 1>1/2
(L/K)B > (L/K)A because 2> 1
Country A is relatively capital abundant although it is

endowed with fewer capital units in absolute terms.
Country B is relatively labor abundant.

7
Countries: relative factor abundance
(price definition)
◼ The greater the relative abundance of a factor, the
lower its relative price.
Country A: (K/L)A > (K/L)B => (r/w)A < (r/w)B

Country B: (K/L)B < (K/L)A => (r/w)B > (r/w)A
◼ The link between relative factor abundance and

relative factor prices is true due to the assumptions
of identical technology and identical tastes in both
countries.
◼ If technologies and tastes differed between

countries, this link would not be true (see: demand
reversal, factor intensity reversal).
8
Relative factor endowments in selected
countries in 1992
Labor/Land
Capital/Labor Capital/Land
Country (worker/sq.
($/worker) ($/sq. kilometer)
kilometer)
Australia 38,729 40,162 1
Germany 41,115 4,491,403 109
Hong Kong 14,039 42,117,000 3,000
UK 22,509 2,572,554 114
US 35,993 476,187 13
Australia has an abundant supply of agricultural land but a

scanty population. Land is cheap and wages are high in
comparison with most other countries. Therefore,
production of goods that require vast areas of land but little
labor is cheap.
9
Goods: factor intensities
◼ Goods have different relative factor intensities at
common factor prices, and this difference holds for
all possible factor price ratios.
Suppose: (K/L)X > (K/L)Y or (L/K)X < (L/K)Y
good X is relatively capital intensive

good Y is relatively labor intensive
◼ Counter example: factor intensity reversal.
10
PPF with increasing opportunity costs
Good Y
|Slope| of PPF = opportunity
cost of X = PX/PY
(PX/PY)3 > (PX/PY)1

C
(PX/PY)1
E (PX/PY)2
(PX/PY)3
Good X
+1 +1 13
Determinants of PPFs
◼ The shape and position of the PPF are

determined by:
 relative factor abundance of a country

 relative factor intensities of goods
Relatively capital abundant country should be able

to produce relatively more of capital intensive
goods.
Relatively labour abundant country should be able

to produce relatively more of labour intensive
goods. 14
PPFs in the autarky scenario
Good Y
Country B
Country A
Good X
15
How can we find optimal production points
in autarky?
Good Y
(PX/PY)B
Country B
PB
Country A
PA
(PX/PY)A
Good X
16
Conclusions from the diagram:
◼ Country A has a lower relative price of good X than

country B: (PX/PY)A < (PX/PY)B
◼ Country A has a lower opportunity cost in producing
good X than country B
◼ Country A has a comparative advantage in good X,
and country B has a comparative advantage in Y.
=> Differences between countries in autarky relative

prices are the basis for mutually beneficial trade.
17
How can we find an autarky equilibrium?
Good Y
Tastes in country A
and B are the same:
Country B => CICA =CICB
B F
Country A
C
A
E
Good X
18
Autarky equilibrium
Good Y
(PX/PY)B Tastes in country A

and B are the same
=> CICA =CICB
Country B CICA=CICB
EB
Country A
EA
(PX/PY)A
Good X
19
Autarky equilibrium
◼ Countries A and B have a common CIC due to the
assumption of identical demand in both countries.
◼ An autarky equilibrium is located at the tangency of

the PPF and the highest attainable community
indifference curve CIC (EA and EB).
◼ The slope of the PPF is equal to the slope of the CIC.
◼ The slope of the PPF reflects the opportunity cost

and the relative price of good X while the slope of
CIC reflects the marginal rate of substitution (MRS).
20
Free trade
◼ In country A: (PX)A↑ (PY)A ↓=> (PX/PY)A ↑ => slope of
the PPFA ↑
◼ In country B: (PX)B ↓ (PY)B ↑ => (PX/PY)B↓ => slope of
the PPFB ↓
◼ Changes in relative prices lead to changes in

production of both goods in both countries.
◼ As production expands in HO model, its opportunity

cost increases.
◼ Production will continue to expand so long as its

opportunity cost is no more than the international
relative price (QA and QB in the diagram).
21
Free trade (2)
◼ Countries produce at points of partial specialization
(QA and QB) where the slope of the PPF = slope of
international relative price (PX/PY)int
◼ Countries consume at CA and CB that lie on CIC1

tangent to (PX/PY)int
◼ Country A specializes in good X, exports X and

imports good Y.
◼ Country B specializes in good Y, export Y and
imports good X.
◼ Trade triangles are congruent (exports of one country
= imports of the other).
22
Gains from free trade in HO model
CIC1
CIC0
QB
EB
CA= CB
EA
QA
(PX/PY) Int
X
23
1. The H-O Theorem
Heckscher-Ohlin Theorem
A country will export the commodity that uses
relatively intensively its relatively abundant factor
of production, and it will import the good that uses
relatively intensively its relatively scarce factor of
production.
24
2. Does international trade affect
factor prices?
Autarky:
relative factor abundance  relative factor prices
Country A:
(K/L)A > (K/L)B =>(r/w)A< (r/w)B & (PX/PY)A< (PX/PY)B
or (w/r)A >(w/r)B & (PY/PX)A> (PY/PX)B
Country B:
(L/K)B > (L/K)A => (w/r)B< (w/r)A & (PY/PX)B <(PY/PX)A
or (r/w)B> (r/w)A & (PX/PY)B> (PX/PY)A
25
Relative factor prices and relative good prices
under autarky
(w/r)A > (w/r)B and (PY/PX)A > (PY/PX)B
(PY/PX)
(PY/PX)A
(PY/PX)B
w/r
(w/r)B (w/r)A
26
From autarky to trade:
adjustment of factor prices
With international trade:
Country A:
◼ (PX/PY)A ↑ production of X ↑ demand for capital ↑ r ↑
◼ (PY/PX)A ↓ production of Y ↓ demand for labor ↓ w ↓
◼ (r/w)A ↑ (w/r)A ↓
Country B
◼ (PX/PY)B ↓ production of X ↓ demand for capital ↓ r ↓
◼ (PY/PX)B ↑ production of Y ↑ demand for labor ↑ w ↑
◼ (r/w)B ↓ (w/r)B ↑
27
Relative good prices and relative factor
prices converge with trade
(PY/PX)
(PY/PX)A
(PY/PX)Int
(PY/PX)B
w/r
(w/r)B (w/r)Int (w/r)A
28
Factor price equalization theorem
Factor Price Equalization Theorem
Paul A. Samuelson, 1949

If all assumptions of the H-O model are
satisfied, then free international trade will
lead to equalization of absolute and relative
factor prices between the trading nations.
rA = rB and wA = wB
(r/w)A= (r/w)B and (w/r)A = (w/r)B
29
Mobility of goods vs. mobility of factors
of production
◼ Samuelson (1949): international free trade
leads to equalization of factor prices among
the trading nations.
◼ Robert Mundell (1957): the same result can be

obtain if factors of production were mobile
between countries (abundant factors would
move from the low price countries to high
price countries until factor prices (and
commodity prices) were equalized.
◼ Goods movements and factors movements

are substitutes for each other in terms of their
impact on factor prices. 30
3. Does international trade affect income
distribution within a country?
◼ In realtively capital abundant country A:
r A↑ wA↓
◼ Nominal income of Capital owners (r · K) ↑

◼ Nominal income of Labor owners (w · L) ↓
◼ In relatively labour abundant country B:
wB↑ rB↓
◼ Nominal income of Labor owners (w · L) ↑

◼ Nominal income of Capital owners (r · K) ↓
31
Impact of international trade
on income distribution
◼ Free international trade affects not only nominal

but also real incomes of factors’ owners.
◼ Under perfect competition the price of a good

must equal its marginal cost:
PX = MCX = aKX· r + aLX · w

PY = MCY = aKY · r + aLY· w
where:
aK – number of additional units of capital
aL - number of additional units of labor
32
on income distribution (2)
◼ With trade, in country A:
PX ↑ = aKX · r ↑ + aLX · w ↓
◼ Price of good X rises less than the rental rate of capital

(r) as the wage rate (w) falls => real income of capital
owners rises (r/PX) ↑
PY ↓ = aKY · r ↑ + aLY · w ↓
◼ Price of good Y falls less than the wage rate (w) as the
rental rate of capital (r) rises => real income of workers
falls (w/PY) ↓
33
on income distribution (3)
◼ Magnification effect: factor price changes
relatively more than the price of the good
intensive in that factor.
(r/PX)↑ (w/PY) ↓
Conclusion:
◼ Incomes (nominal and real) of the owners of
the abundant factor increase with free trade.
◼ Incomes (nominal and real) of the owners of

the scarce factor decrease with free trade.
34
Stolper-Samuelson Theorem
Wolfgang Stolper, Paul Samuelson, 1941

With full employment both before and after trade
takes place, the increase in the price of the abundant
factor and the fall in the price of the scarce factor
imply that the owners of the abundant factor will find
their real incomes rising and the owners of the scarce
factor will find their real incomes falling.
Owners of the relatively abundant factor favor free trade

policy, whereas owners of the relatively scarce factor
favour protectionist trade policy.
35
4. How can economic growth affect
production possibilities and trade pattern?
◼ So far, we have assumed that factor

endowments are constant.
◼ In the real world, economic growth implies

that factor endowments change.
◼ Suppose, labour force in the capital-

abundant country A grows.
36
Rybczynski effect
Good Y
Shock: Labor force
Z1 increases in country A
Y1
(PX/PY)0
(PX/PY)0
Z0
Y0
X0
Good X
X1 37
Rybczynski Theorem
Rybczynski Theorem, 1955

If terms of trade are constant and both countries
produce both goods, an increase in one factor will
result in an increase in the output of the good using
that factor intensively, and a decrease in the output
of the good using that factor extensively.
38
Why do we study the Heckscher-Ohlin
model of trade?
◼ It allows to assess benefits and costs of preferential
trade arrangements (PTAs), such as free trade areas
or customs unions.
Example: NAFTA, capita/labor ($/worker) in 1992:
Canada 44.970
USA 35.993
Mexico 13.687
1. What does the H-O theorem predict with respect to

NAFTA countries?
39
H-O model predictions with respect to
NAFTA countries
2. What does the factor-price equalization theorem
predict?
3. What does the Stolper-Samuelson theorem predict?
4. What does the HO model predict with respect to

unemployment?
5. What does Rybczynski theorem predict? (Suppose,

capital stock increases in Canada)
6. Who is likely to be FOR and AGAINST NAFTA

creation? (consider factors of production, industries,
political parties, social groups, trade unions, etc.)
40
Imperfect competition: traditional
domestic monopoly
◼ The assumption of perfect competition in the H-O
model guarantees the equalization of product prices
and factor prices with free trade.
◼ Suppose: traditional domestic monopoly
◼ Autarky: A domestic monopolist serves home country

consumers
◼ International trade: a domestic monopolist still serves
domestic consumers alone (no imports or re-imports) but
exports goods to foreign countries
◼ In both autarky & trade a monopolist maximizes profit
◼ In the domestic market: a monopolist is a price setter
◼ In the world markets: a monopolist is a price taker
49
Domestic monopoly
Domestic monopoly andand exports:
exports
Scenario 2: “Free” Trade
Price
P1
PAUT
MC
Pint P int = MR int
MR D
Q1 QAUT Qint Output
50
Domestic monopoly and exports:
Conclusion
◼ Under imperfect competition international

trade does not lead to a convergence of
commodity prices between the domestic and
foreign markets, but commodity prices
diverge even further.
51
Imperfect competition: a single world
supplier
Suppose:
◼ A single world supplier who is a profit

maximizer
◼ National markets can be kept separated
◼ International arbitrage cannot take place
◼ Elasticities of demand differ between

national markets
52
Price discrimination in international trade
Country 1 Country 2
P P
P1
P2
MC
MR1 D1 MR2 D2
Q Q
Q1 Q2
Less elastic demand More elastic demand
53
Price discrimination in international trade:
Conclusion
◼ Price discrimination leads to charging different

goods prices in different countries: a higher price in
the market with less elastic demand, and lower price
in the market with more elastic demand.
◼ So long as markets can be kept separated and

arbitrage is impossible: differences in goods prices
will exist.
◼ Since there is no equalization in goods prices,

factor price equalization will not take place either.
54
Introduction to
International Economics
Dr Lidia Mesjasz
1
Basic measurements of socio-
economic activity:
 Size of the economy
 Standard of living
 Economic growth
 Participation in international trade

Size of the economy:
 Gross domestic product (GDP) -
the market value of all newly produced,
final goods and services, produced
within the country.
 Gross national product (GNP) –

the market value of all newly produced
final goods and services, produced by
the country’s resources, no matter
where they are located geographically.
3
Standard of living:
 GDP/GNP per capita => an average income in

a country (GDP/POP or GNP/POP)
 GINI coefficient => a distribution of income
in a society (0-1, where 0 = perfect equality, 1
= perfect inequality)
 Human Development Index (HDI)=> a
measure of human development (GDP per capita
at PPP exchange rate, life expectancy at birth,
adult literacy rate)
➢ 0.0-0.500 – low level of human development,
➢ 0.501- 0.799 – medium level of human
development
➢ 0.800-1.0 – high level of human development 4
Standard of living (2):
 Human Poverty Index (HPI) => a measure of
human poverty
◼ for developing countries - HPI 1 (probability at
birth of not surviving to age 40, adult illiteracy
rate, population without sustainable access to an
improved water source and children underweight
for their age)
◼ for developed countries - HPI 2 (probability at
birth of not surviving to age 60, adults lacking
functional literacy skills, population below income
poverty line, rate of long-term unemployment).
5
Standard of living (3):
 Multidimensional Povery Index (MPI)
measures social exclusion in three key dimensions:
◼ Education (child school attendance, years of

schooling by household members)
◼ Health (child mortality, nutrition)
◼ Living standard (access to: electricity, drinking
water, sanitation, solid fuel for cooking and heating,
a finished floor, has assets that: a) allow access to
information, b) support mobility, c) support
livelihood (e.g. own agricultural land, own livestock).
6
Economic growth:
 percentage change in GDP/GNP
 percentage change in per capita

GDP/GNP (GDP2/POP2: GDP1/POP1)
Important to distiguish between:

 nominal GDP vs. real GDP
 GDP at market exchange rate vs. GDP at
PPP exchange rate
7
Participation
in international trade
 Indexes of oppeness:
◼ Ratio of exports/GDP or GNP
◼ Ratio of exports and imports/GDP or GNP
8
Topics for individual studies:
https://e-uczelnia.uek.krakow.pl/mod/page/view.php?id=4111
•Characteristics of National Economies:
- Economic Growth
- International Trade
- Direction of International Trade
- Structure of International Trade
- Index of Openness
- Human Development Index (HDI)
- Human Poverty Index (HPI)
- Multidimensional Poverty Index (MPI)
- Gini Coefficient (Gini Index)
9
Compulsory Readings:
•International Trade Statistics by WTO:

https://www.wto.org/english/res_e/statis_e/statis_e.htm
•UN Human Development Reports: http://hdr.undp.org/en
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•UNDP Statistical Data: http://hdr.undp.org/en/data
A New Human Development Deal:
http://hdr.undp.org/en/reports/global/hdr2010/platform 10
NEW THEORIES OF
INTERNATIONAL
TRADE
dr Lidia Mesjasz
Outline
 Introduction
 Intra-industry trade
 Economies of scale
 International trade with economies of scale
 Imitation lag hypothesis
 Product cycle theory
 Linder theory
2
Introduction: trade pattern of the United
States with Mexico
 Contrary to popular belief, the top U.S. imports from

Mexico are not fruits and vegetables – these
represented only 8% of the U.S. imports in 2017.
 The top US imports were: vehicles (27%), electrical

machinery (20%), and machinery (17%).
 The same categories constituted top three American

exports to Mexico: machinery 18%, electrical
machinery 17%, vehicles 8,6%.
3
Intra vs. inter-industry trade
 Intra-Industry Trade (IIT): a country both exports
and imports goods in the same product
classification category.
 IIT impossible to explain by Ricardo or HO models:

a country cannot have a comparative advantage and
a comparative disadvantage in the same good at the
same time.
 Inter-Industry Trade: a country’s exports and

imports are in different product classification
categories (trade based on different factor
endowments).
4
Reasons for intra-industry trade
 Product differentiation
 Transport costs
 Degree of product aggregation
 Differing income distributions within
countries
 Economies of scale
5
Reasons for IIT: Product differentiation
 producers differentiate their products to

create a sense of brand loyalty among their
consumers
 consumers want a broad range of

characteristics in a product to choose from.
 E.g. a BMW and a Ford are both motor cars. A

Budweiser and a Heineken are both beers. But
are they really the same products?
6
Reasons for IIT: Transport costs
- a physically large country

- a product has a large bulk relative to its value
The U.S. is both importing and exporting the same good.
Seller
Buyer
7
Reasons for IIT: Degree of product
aggregation
 IIT might be a statistical fiction or artifact

caused by using aggregative goods
classification categories.
 A widely used classification system is

Standard International Trade Classification
(SITC) of the United Nations.
 The broder product category is used, the

larger intra-industry trade.
8
Reasons for IIT: Degree of product
aggregation (2)
 Suppose, a country exports beverages and

imports tobacco.
 The broad category of “beverages and

tobacco” would show IIT,
 but the narrower categories of “beverages”

alone or “tobacco” alone, would not show
IIT.
9
Reasons for IIT: Differing income distributions
(H. Grubel, 1970)
 Even if two countries have similar per capita incomes, differing
distributions of total income can lead to intra-industry trade
Number of
households
Country I Country I: heavy
Country II concentration of
housholds with lower
incomes
Country II: more normal

income distribution
y1 y5 y3 y2 y6 y4 Household income
10
Reasons for IIT: Economies of scale
 Traditional theories were based on constant ruturns
to scale (Ricardo model) or decreasing returns to
scale (HO model).
 Modern trade theories are based on increasing

returns to scale (decreasing costs) or economies of
scale.
 Types of economies of scale:

 internal economies of scale (IES) occur when the
firm’s average costs fall as the firm’s output rises,
 external economies of scale (EES) occur when the
firm’s average costs fall as the whole industry’s
output rises. 11
Internal vs. external economies of scale
 Sources of internal economies of scale: large

fixed costs
 Sources of external economies of scale: the

industry growth
 EES helps to explain the phenomenon of

industrial agglomeration (geographical
concentration of production) e.g. „Silicon
Valley”.
12
Dynamic economies of scale
 Suppose, coutries A and B have been
producing different versions of the same
good over a long run.
 By acquiring production experience (learning

by doing) in a particular version of the good,
they were able to achieve dynamic
economies of scale.
 The intra-industry trade was intensified.

13
Economies of scale and market structure
 Both EES and IES are important reasons for
intra-industry trade.
 But they have different implications for market

structure.
 EES: all firms in a particular industry enjoy per

unit cost reductions; perfect competition
between the firms.
 IES: large firms have cost advantage over

small firms; imperfect competition.
14
Kemp model (1964): EES and international
trade
 Two industries (X, Y); both experience external
economies of scale => production possibility frontier
is convex.
 An autarky equilibrium is located in point E:

PX/PY = MCX/MCY
 With a convex PPF equilibrium is unstable =>

departure from point E decreases marginal costs of
production and allows for realization of economies of
scale.
 Economy tends to move to the points of complete

specialization (N or M).
15
A convex production possibility frontier
Good Y
PY/PX > MCY/MCX
M
H
PX/PY = MCX/MCY
PX/PY > MCX/MCY
0 N Good X
16
Implications of economies of scale on
international trade?
 With economies of scale the pattern of specialization

will depend on TOT to which the country is exposed:
- if TOT1 => full specialization in X (N)

- if TOT2 => fully specialization in Y (M)
- if TOT3 => full (N, M) or partial specialization (F)
 Economies of scale generate uncertainty with respect

to specialization and trade pattern.
17
The convex PPF and gains from trade
Good Y
M
TOT2
TOT3
TOT1
F TOT3
TOT3
N
0 Good X
PX/PY
18
Trade based solely on economies of scale
Good Y TOT = (PX/PY )aut
E CIC2
CIC1
0 N Good X
19
Kemp model - conclusions
 Economies of scale provide a basis for
specialization and trade between countries
with identical production possibilities and
tastes.
 To take advantage of economies of scale,

each country must concentrate on producing
a limited number of goods and produce them
in large quantities.
 With economies-of-scale it is difficult to

predict trade pattern.
20
Krugman model (1979): IES and
international trade
Assumptions:
 Internal economies of scale

 Monopolistic competition
 Products are differentiated

 Each firm maximizes profits as a monopolist by
producing where MC=MR
 Many firms in the industry, easy entry and exit
 Demand curve is downward sloping and less elastic
(as products are not perfect substitutes)
 MR is less than price
 MC is constant
21
Short-run profit maximization for the firm in
monopolistic competition
Price, Economic profit [Q1 x (P1 - AC1]

Cost draws new firms into the industry
P1 F
AC1 B
AC
MC
MR D
Q1
Output
22
Long-run profit maximization for the firm in
monopolistic competition
Number of firms increases

Price,
 D curve shifs down
Cost
 MR shifts down
 Price decreases
P1  P = AC = equilibrium E
F  Production decreases
P2=AC2 E  AC is higher
B  Profit is zero
AC1
AC
MC
MR2 MR1 D2 D1
Q2 Q1 Output
23
Monopolistic competition and trade
Domestic firms can export and foreign
firms enter domestic market
Price,  Demand curve is more elastic
Cost
 Firm’s output increases
 AC decreases
P1  P decreases
 P = AC = equilibrium G
P2=AC2 E
G
P3=AC3 AC
MC D3
MR2 D2 MR3
Q2 Q3 Output
24
Krugman model: conclusion
 International trade allows for:
- realization of economies of scale

(expansion of production and reduction
per unit cost)
- greater variety of goods for consumers
25
Economies of Scale and Comparative Advantage
 Two countries (Home and Foreign)

 Two factors of production (Capital and Labor)
 Home is capital-abundant country
 Two industries: cloth and food, with cloth the more
capital-intensive industry
Two Scenarios:
1. Perfect competition in the cloth sector, homogenous
goods; no economies of scale.
2. Monopolistic competition in the cloth sector,

differentiated goods; economies of scale exist.
26
Trade in a World Without Increasing Returns
27
Trade with increasing returns and monopolistic
competition
28
Inter- and intra-industry trade: conclusions
 Inter-industry trade (cloth for food) is driven
by comparative advantage, whereas intra-
industry trade (cloth for cloth) is driven by
economies of scale
 The pattern of intra-industry trade itself is

unpredictable
 Trade based on economies of scale creates

extra gains over the gains from CA:
 reduction in average per unit costs
 a wide range of choice for consumers 29
Inter- and intra-industry trade (2)
 The relative importance of intra-industry trade
depends on how similar countries are.
 IIT plays a large role in trade of manufactured

goods among advanced industrial countries.
 If IIT is a dominant part of trade, everyone can

gain from trade (negative income distribution
effect of inter-industry trade is small).
30
The level of a country’s IIT
 | Xi / X  Mi / M |
I  1
 Xi / X  Mi / M
 I index of intra-industry trade

 i commodity categories
 Xi (Mi) exports (imports) in category i
 X (M) total exports (imports)
Numerator: Absolute difference between the share of

exports and imports over all commodity categories
Denominator: Sum of the share of exports and

imports over all commodity categories 32
The level of a country’s IIT
Good Value of Exports Value of Imports
W 500 200
X 200 400
Y 100 400
Total 800 1000
| 500 / 800  200 / 1000 |  | 200 / 800  400 / 1000 | 100 / 800  400 / 1000 |
I  1
( 500 / 800  200 / 1000 )  ( 200 / 800  400 / 1000 )  ( 100 / 800  400 / 1000 )
| 0.625  0.200 |  | 0.250  0.400 |  | 0.125  0.400 |

I  1  0.575
( 0.625  0.200 )  ( 0.250  0.400 )  ( 0.125  0.400 )
IIT < 0,1 > if IIT=1 => total intra-industry trade

if IIT= 0 => total inter-industry trade 33
Indexes of Intra-industry Trade for U.S. Industries, 1993
Inorganic chemicals 0.99
Power-generating machinery 0.97
Electrical machinery 0.96
Organic chemicals 0.91
Medical and pharmaceutical 0.86
Office machinery 0.81
Telecommunications equipment 0.69
Road vehicles 0.65
Iron and steel 0.43
Clothing and apparel 0.27
Footwear 0.00 34
The imitation lag hypothesis (M.V. Posner, 1961)
Assumptions:
 Technology differs between countries

 There is a delay in transmission and diffusion of
technology
Consider two countries:
 Country I (an innovator)

 Country II (an imitator)
 A new product appears in country I due to success

in R&D.
35
The imitation lag hypothesis (2)
 Imitation lag: the length of time that elapses
between the product’s introduction in country
I and the appearance of its version produced
by firms in country II.
 Demand lag: length of time between the

product’s appearance in country I and its
acceptance by consumers in country II. It may
be due to:
 delay in information flow
 loyalty to the existing consumption bundle
 Net lag: difference between imitation and

demand lags: country I has monopoly on
exports of the new product to country II. 36
The imitation lag hypothesis (3)
 Months 1–4: demand lag
 Months 1–15: imitation lag
 Net lag: 11 months
 During 11 months Country I has a monopoly

on exports a new manufactured product to
Country II (trade is based on differences in
technologies).
 A country may become a successful exporter

by continually innovating. 37
Product life cycle theory (PCT)
(R. Vernon, 1966)
 Trade pattern may be affected by a life cycle

of a new manufactured product
Suppose
 A new product (e.g. microwave oven) is

developed in the United States, and has two
features:
 it is addressed to high-income demands
 its technology is labor-saving
38
Product life cycle theory (2)
 A new product goes through 3 stages in its
productive life:
- New product stage
- Maturing product stage
- Standardized product stage
1. New product stage:
 Limited amount of production, high costs, high price
of a new product
 A new good is produced and sold only in the U.S.
 Production process changes a lot in response to
consumers’ reaction to the new product.
39
2. Maturing product stage
 Standardization of production process and mass
production techniques => economies of scale.
 US export its new product to other developed

countries.
 US may re-alocate production abroad via FDI (if the

cost picture is favourable) => US production and US
exports will decrease.
 !!! PCT assumes that capital and management are

mobile internationally!
40
2. Maturing product stage (2)
 Lots of FDI flew from the US to Western Europe in
1960. and 1970. and later on from Japan to Asian
countries.
 As labor is less mobile than capital, goods prices are

heavily influenced by labor costs.
 If labor costs in Western Europe are lower than in

the US (which was the case in 1966!) trade flows
might be reversed: the US imports a new product
from Western Europe.
 !!! PCT does not ignore factor endowments and

factor prices in determining trade flows.
41
3. Standardized product stage
 Characteristics of the product and the

production process are well known, and
 labor costs play a major role in the overall

production costs,
 production may shift to developing countries,

and the US and other developed countries
import the „new” product from developing
countries (trade pattern shifts).
42
The trade pattern of the US in the product cycle theory
Production,
Consumption U.S. consumption
of product Exports
Imports
U.S.
production
Time
t0 t1 t2
New-product Maturing-product Standardized-
stage stage product stage 43
Empirical verification of PCT
 Export-displacement feature of PCT (e.g.
television receivers, automobiles, textile and
apparel).
 FDI feature of PCT e.g. American MNCs

established their subsidiaries worldwide and
re-alocated production of a new product
outside the United States.
 Growing share of US exports come from

overseas production of American MNCs. 44
The Linder theory (S. Linder, 1961)
 Linder explains trade in manufactured goods (the HO
theory explains trade in primary products)
 Linder theory is demand oriented (the HO theory was

supply-oriented)
Linder assumed that:
 Per capita income determines demand pattern
 Demand pattern determines the production pattern
 Production pattern determines the exports pattern

45
Overlapping demand (Linder, 1961)
 Country I: Demand for goods A, B, C, D, E
 Country II: Demand for goods C, D, E, F, G
 Country III: Demand for goods E, F, G, H, J
 Trade will occur in goods that have overlapping

demand
 Goods C, D, E will be traded between I and II
 Goods E, F, G will be traded between II and III
 Only good E will be traded between I and III
 International trade in manufactured goods is more

intense between countries with similar per capita
income than dissimilar per capita income.
46
PREFERENTIAL
(REGIONAL) TRADE
ARRANGEMETNS
Dr Lidia Mesjasz
Outline
◼ PTA vs. GATT/WTO trading system

◼ Free trade area vs. customs union
◼ Welfare effects of a PTA
 trade creation
 trade diversion
2
PTA versus GATT/WTO
◼ International trade agreements, such as the
GATT/WTO involve A NONDISCRIMINATORY
CLAUSE
◼ Nondiscriminatory treatment is granted by MFN

clause
◼ All countries granted an MFN status pay the same

tariff rates.
◼ Tariff reductions must apply to ALL TRADING

PARTNERS
… with one important exception

3
Important exception…
◼ It is against the rules if country A has a lower tariff rate
on imports from country B than those from country C…
◼ … but it is acceptable if countries A and B agree to have

zero tariffs on each others’ products.
Free trade by two different agreements:
◼ Free trade area (FTA): products can be shipped freely

within the FTA but each country has an individual tariff
policy against third countries.
◼ Customs union (CU): free trade among the CU members
and a joined tariff policy against third countries.
4
Free trade area vs. customs union
“The difference between a free trade area and a
customs union is, in brief, that the first is politically
straightforward but an administrative headache
while the second is just the opposite.”
Customs union (e.g. EU):

◼ Tariff administration is relatively easy due to a
common external tariff (CET): the same tariff is
payed at the CU border, but from then on the
imported goods are shipped freely.
◼ By having CET countries agree to cede part of their

sovereignty to a supernational entity. 5
Free trade area (e.g. NAFTA, USMCA)
◼ Member countries may have different tariffs

on imports from nonmembers => risk of
transshippment to avoid higher external
tariffs.
◼ Customs inspections at the internal borders:

determine whether a good originate in a
trading area and hence qualify for crossing
the internal borders duty free.
◼ Rules of Origin: criteria that determine the

origin of the good.
6
Transshippment problem in FTA
Mexico T= 0 % USA
T= 10%
T = 2%
T-shirt from
Bangladesh
7
Welfare effects of a PTA
◼ Nondiscriminatory tariff reduction is a good

thing because it raises economic efficiency
and welfare (at least in a small country).
◼ Is a PTA also good? Perhaps not as good as

a nondiscriminatory tariff reduction but
better than none?
◼ Is it possible for a country to make itself

worse off by joining a PTA?
8
Can joining a FTA be harmful?
◼ Slovakia price: $4
◼ Czech price: $6
◼ Poland price: $8
Scenario A:
Poland imposes a uniform tariff of $5
◼ Poland does not import from neither Slovakia nor Czech Rep.
◼ Consumers pay $8 = Poland’s cost of production $8
Poland signs a FTA with Czech Republic:
◼ Imports from Czech Rep. will replace Polish production

◼ Consumers pay $6 = Czech’s cost of production $6
=> Poland gains from joining a FTA 9

Can joining a FTA be harmful? (2)
◼ Slovakia price: $4
◼ Czech price: $6
◼ Poland price: $8
Scenario B:
Poland imposes a uniform tariff of $3
◼ Poland imports from Slovakia

◼ Consumers pay $7 => real cost for PL= Slovakia’s cost $4
Poland signs a FTA with Czech Republic:
◼ Imports from Czech Rep. will replace imports from Slovakia

◼ Consumers pay $6 => real cost for PL = Czech’s cost $6
=> Poland loses from joining a FTA 10

Conclusion: Can joining FTA be harmful?
◼ Poland gains if FTA replaces the higher-cost

domestic production by a lower-cost imports
from a member country (scenario A).
◼ Poland loses if FTA replaces the lower-cost

production of a nonmember country by a
higher-cost production of a member country
(scenario B).
11
Example: Welfare effects of a PTA (1)
P SPL
PPL
PSL < PCZ => PSL + T < PCZ + T
PSL+T
PCZ T PCZ < PSL + T
PSL
DPL
Q1 Q5 Q3 Q4 Q6 Q2
12
Example: welfare effects of a PTA (2)
Free trade situation:
◼ Poland buys from Slovakia at price = PSL

◼ Domestic production = Q1
◼ Domestic consumption = Q2
◼ Imports from Slovakia = Q2 – Q1
A uniform tariff of $T on both Czech and Slovakian goods
◼ PSL < PCZ = > PSL + T < PCZ + T

◼ Poland buys from Slovakia at price = PSL+T
◼ Imports from Slovakia = Q4 – Q3
◼ Tariff revenue = (Q4 – Q3) x T
13
Example: welfare effects of a PTA (3)
PTA between Poland and the Czech Republic
◼ PCZ < PSL + T

◼ Poland imports from the Czech Republic at PCZ
◼ Imports from Czech Republic = Q6 – Q5
◼ Tariff revenue = zero
14
Welfare effects: a uniform tariff vs. PTA (4)
PSL+T
PCZ
PSL
A uniform tariff A PTA 15

Example: Net effect of a PTA (5)
Consumer gain – producer loss – government revenue = Net effect
a+b+c+d –a –c–e = b+d–e
P SPL
PPL
PSL+T
PCZ a b c d T
PSL e
DPL
Q1 Q5 Q3 Q4 Q6 Q2
16
Net effect of a PTA: conclusion:
◼ Net impact of a PTA can be positive or negative

depending on the relative sizes of trade creation
(b+d) and trade diversion (e)
◼ If trade creation (b + d) exceeds trade diversion (e), a

PTA increases member countries’ welfare
◼ If trade diversion (e) dominates trade creation (b +

d), welfare falls => in that case a PTA is worse than a
uniform tariff
◼ If trade diversion equals trade creation => the net

effect of a PTA in neutral
17
Extremum: Only trade creation
Poland creates a PTA with Slovakia: net benefit = (b + g + f) + (d + h + i)
P SPL
PSL+T
PCZ a b c d T
PSL g f e h i
DPL
Q1 Q5 Q3 Q4 Q6 Q2
18
Static effects of a PTA (Jacob Viner, 1950)
◼ Trade creation: increases welfare: a PTA

allows to replace high-cost domestic
production with lower-costs member
production, leading to a greater specialization
in production based on CA; as a result new
trade flows are created between member
countries.
◼ Trade diversion: reduces welfare: a PTA shifts
production from more efficient nonmember
producers to less efficient member producers,
i.e. away from comparative advantage.
19
TARIFFS AND
NTBs
Dr Lidia Mesjasz
Outline
1. Introduction
2. Instruments of trade policy
3. Tariff: The small country case
4. Tariff: The large country case
5. Import quota
6. Production subsidy
7. Export subsidy: The small country case
8. Export subsidy: The large country case
9. Dumping
2
Introduction
Trade theory
◼ Why do nations trade?

◼ What are the causes and consequences of
international trade?
Trade policy
◼ What should a nation’s trade policy be?

◼ Why do governments put restrictions on trade?
◼ Who will benefit and who will lose from trade
restrictions?
◼ What will be the net impact of trade restrictions on
the national welfare?
3
Trade Policy: actions taken by a government to
influence the pattern of trade
TRADE
POLICY
Opportunity Relative
costs prices
Comparative
advantage
TRADE VOLUME
& NATIONAL WELFARE 4
Instruments of trade policy
◼ Tariffs
◼ Non-tariff barriers (NTBs):

➢ quotas
➢ subsidies
➢ dumping
➢ government procurement
➢ administrative barriers
5
Basic tariff analysis
◼ A tariff is a tax levied on imports (mainly) or

exports (rarely)
◼ Ad valorem tariff – a given percentage of the

price of the imported good (10%, 25%...)
◼ Specific tariff – a fixed amount of money per

unit of goods imported ($3 per barrel, 2 cents
per pound)
◼ Compound tariff is a combination of a

specific and ad valorem tariff
6
Basic tariff analysis (2)
◼ Two objectives of a tariff:
➢ Protectdomestic industry against foreign

competition
➢ Fiscal(generate revenues for the

government)
◼ A purely revenue tariff
◼ A purely protective tariff (e.g. prohibitive tariff)

7
Basic tariff analysis (3)
Typical import duties in a tariff schedule:
◼ General rates of duty (MFN rates)- apply to goods

from countries that have been granted most-favored-
nation status (WTO members)
◼ Non-MFN rates
◼ Preferential duties apply to:

➢ preferential trade agreements (PTAs) e.g. FTA, CU
➢ special tariffs programs granted to developing
countries (e.g. Generalized System of Preferences,
Caribbean Basin Initiative)
➢ countries with historical and economic ties (e.g. the
British Commonwealth) 8
Non-tariff measures (NTMs)
◼ Import quotas: specific quantitative restrictions

put on the physical amount of imported goods
◼ Subsidies: financial assistance paid by the

government to domestic producers for exported
(or produced) units or value
◼ Dumping: a sale of a good in a foreign market at a

price below the price for which the same good
sells in the domestic market or below its
production cost. 9
NTMs (continued)
◼ Government procurement: government agencies are obligated to
purchase from domestic suppliers, even when they charge higher prices
(or have inferior quality) compared to foreign suppliers.
◼ Administrative measures:
➢ border measures: lengthy and complicated bureaucratic

procedures being undertaken on borders (inspection, certification
requirements, quarantines and other border formalities) that
generate costs at entry.
➢ health, safety and environmental standards: regulations placed

on the imported goods that must be satisfied to enter the domestic
market
➢ embargo: a complete ban on imports, usually put in place as a

form of political punishment (is rare; economic sanctions are more
common). 10
ANALYSIS OF A TARIFF
11
Nominal versus effective tariff rates
◼ How much protection is given to domestic
producers by an import tariff?
◼ Example: Production of television sets in an

economically small country
◼ Free-trade:
➢ Price of a domestic TV set = $500
➢ Price of an imported TV set = $500
➢ Value of imported inputs = $300
➢ Domestic value-added (V0)= ?
➢ V0 = $500-$300= $200
12
• 10% nominal tariff on imported TV
sets:
➢ Value of imported inputs = $300
➢ Domestic value-added (V1)=$550-$300=
$250
➢ Effective rate of protection (ERP): % change
in domestic value added: (V1–V0)/V0 = (250 -
200)/200 = 0.25 (25%)
13
• 10% nominal tariff on imported TV sets
plus 5% nominal tariff on imported
inputs

➢ Price of imported inputs = $315
➢ Domestic value-added (V1) = $550-$315=
$235
➢ ERP = (235 - 200)/200 = 0.175 or 17.5%
14
Nominal vs. effective tariff rates
◼ Nominal tariff rate reflects how much the

price of a final good can increase as a result
of a tariff.
◼ Effective tariff rate shows how much value

added in the domestic import-competing
industry can change by the tariff structure of
the country.
15
Formulas for calculating ERP
ERP = (V1 – V0)/ V0
◼ V0 - domestic value-added under free trade

◼ V1 - domestic value-added with a tariff on imports
tf - ati
ERP =
1− a
◼ tf - tariff rate on the final good

◼ ti – tariff rate on inputs
◼ a - free trade value of input i as a percentage of the
free trade value of the final good f
16
NRP vs. ERP: general rules
◼ If tf > ti , ERP > tf
◼ If tf = ti , ERP = tf
◼ If tf < ti , ERP < tf
◼ Escalated („cascading”) tariff structure:

nominal tariff rates on imports of
manufacturing products are higher than
those on raw materials and intermediate
goods.
◼ „Cascading” tariff structure guarantees
positive ERPs throughout all sectors of the
economy.
17
Highest nominal and effective tariff rates in the USA
Nominal rate (%) Effective rate (%)
Wearing apparel 27.8 50.6
Textiles 14.4 28.3
Glass and glass products 10.7 16.9
Nonmetallic mineral 9.1 15.9
products
Footwear 8.8 13.1
Furniture and fixtures 8.1 12.3
Miscellaneous manufactures 7.8 11.1
Metal products 7.5 12.7

Electrical machinery 6.6 9.4
Food, beverages and tobacco 6.3 13.4
22-industy average 5.2 8.1 18

Economic effect of a tariff
Assumptions:
◼ A partial equilibrium analysis: focuses on the good

market where a tariff is imposed, ignoring the tariff’s
impact on the rest of the economy.
◼ Domestic and foreign goods are homogenous.
◼ Tariff scenario serves as a benchmark: other

instruments of trade policy will be evaluated in
comparison to a tariff.
19
Impact of an import tariff in a small country
A domestic market for a specific product

Price
Domestic supply
PA
PT
T = PT –PFT
PFT
Domestic demand
Q1 Q3 Q4 Q2 Quantity
20
Equilibrium in autarky, free trade and with a tariff
Autarky equilibrium:
◼ Price = PA
◼ domestic consumption =domestic production
◼ no imports
Free trade equilibrium:

◼ Price = PFT
◼ Q1 – domestic production
◼ Q2 – domestic consumption
◼ Q2 – Q1 = imports
Equilibrium with a tariff:

◼ Price = PT
◼ Q3 – domestic production
◼ Q4 – domestic consumption
◼ Q4 – Q3 = imports
21
Consumer surplus and producer surplus
Price Price
S
P1
P2
P* P*
P2
D P1
1 2 3 4 Q 1 2 3 4 Q
Consumer surplus: the area Producer surplus: the area

bounded by the demand curve bounded on top by the
on top and the market price market price and below by
below. the supply curve 22
Welfare effects of a tariff in a small country
CS: in free trade: AFC, with the tariff: AEB
=> CS ↓ by EBCF ( - a - b - c - d)
PS: in free trade: FGK, with the tariff: EHK
Price => PS↑ by EHGF ( a)
TR: in free trade = 0, with tariff: T (Q4 – Q3) = HBJI (c)
Net effect: - (GHI + BCJ) = - b - d
A
S
PA
E H B
PT
a b c d C
F G I PFT
J D
K
Q1 Q3 Q4 Q2 Quantity
23
Welfare effects of a tariff in a small country
Producer gain + government revenue - consumer loss
+a +c - (a+ b +c+ d)
◼ Net effect of a tariff (deadweight loss, DWL) = – b – d
◼ DWL: a cost to society created by economic

inefficiency.
◼ Production DWL (triangle b) ➔ a tariff allows to

expand inefficient, higher cost domestic production.
◼ Consumption DWL (triangle d) ➔ a tariff lowers

domestic consumption due to a price increase.
◼ A tariff in a small country reduces national welfare. 24

Welfare effects of a tariff in a large country
Net effect of a tariff: - b - d + e
Price consumers loss + producers gain + gov. revenues
- a- b–c-d a c+e
$108 PT
a b c d PFT PT –PFT<T
T=$10 $100
e
$98 PT -T
D
Q1 Q3 Q4 Q2 Q
25
Welfare effects of a tariff in a large country
◼ Tariff raises the price for consumers in the
importing country by less than the full
amount of the tariff (PT –PFT<T)
◼ Tariff lowers the price of imports and thus

improves terms of trade (TOT) of the large
importing country
◼ Terms of trade gain = e

◼ Production DWL = b
◼ Consumer DWL = d
26
Welfare effects of a tariff in a large country (2)
◼ Net effect of a tariff in a large country: – b – d + e
if b + d = e => a tariff does not change national welfare

if (b+d) > e => a tariff decreases national welfare
if e > (b+d) => a tariff increases national welfare
◼ Net effect depends on the ability of a large country to

„force” foreign producers to lower their prices by
imposing an optimal tariff.
◼ Optimal tariff: the level of a tariff that maximizes a large

country’s welfare by trading off the volume of sales and
price of the imported goods. 27
Import quota
Producer gain – quota rent – consumer loss
+a -c - (a + b + c + d)
P Net effect of an import quota: = – b – c – d
S
Pq
a b c d
PFT
Q1 Q2 Q
Q3 quota Q4
28
Import quota (2)
◼ Import quota: Direct restriction on the quantity of
imported goods
◼ The restriction is usually enforced by issuing import

licenses to some group of individuals, firms or
governments of exporting countries.
◼ Import quota always raises the domestic price of the

imported good, which allows the licence holders to
make a profit = a quota rent (c)
29
Import quota (3)
◼ Domestic government receives no revenue,

which makes an import quota more costly
compared to an equivalent tariff.
◼ Only if government auctions off the rights to

import, welfare effects of a quota will be the
same as in the tariff scenario.
30
Import tariffs vs. import quotas
◼ From the perspectives of:
➢ Domestic producers
➢ Foreign producers
➢ Domestic welfare (does it matter if a country is
small or large?)
◼ Why quotas are used if they hurt domestic market

more than tariffs?
◼ Quotas on most manufactured products have long

been prohibited by GATT/WTO. Under the Uruguay
Round agreement (1994) countries agreed to
eliminate quotas on agricultural goods and textiles by
31
2005.
Choosing the policy of protection
◼ Government should consider:
➢ what is the goal of trade policy (to raise

government revenue or to protect
domestic industry)
➢ which policy instrument will achieve this

goal with the lowest welfare cost for the
country (a tariff or perhaps a production
subsidy)
32
Production subsidy
◼ Suppose, the government wants to
increase domestic production of
energy sources (e.g. oil, gas, coal).
◼ Production subsidy: a government

gives domestic oil producers some
money per unit of the good they
produce.
33
The impact of a production subsidy on
domestic producers
P Subsidy:
S €50 per unit of
production
S’
130
€Sub
100 130 - € Sub
100 - € Sub
100 150 Q
34
The effects of a production subsidy
Net effect of a subsidy: a – (a + b) = - b

Domestic producer gain (a) – subsidy payment (a+b)
P
subsidy: €50
per unit of
production
€S S-Sub
€250 = PFT+ Sub PFT + T

a b d T=S
€200 = PFT
F
€150=PFT - S D
Q1 Q3 Q4 Q2
Q
35
The effects of a subsidy to home producers
Equilibrium with free trade:
◼ Prices of domestic and imported goods = PFT
◼ CS = EJK
◼ PS = KLM
◼ Production = Q1, Consumption = Q2, Imports = Q2 - Q1
Equilibrium with a subsidy:

◼ Price = PFT
◼ F = equilibrium point with subsidy
◼ Production ↑ = Q3, Consumption = Q2, Imports ↓= Q2 - Q3
◼ CS didn’t changed
◼ PS ↑ by area a
◼ Subsidy payment = Sub x Q3 = - (a + b)
Producer gain – subsidy payment = Net effect of a subsidy

a - (a+b) = -b
36
Production subsidy vs. tariff
◼ To increase domestic production from Q1 to Q3, the
government can choose between a tariff and a
production subsidy
 Price with a tariff = PFT + T

 Price with a subsidy = PFT
 Government revenue with a tariff = c

 Government payment with a subsidy = - (a + b)
 DWL with a tariff = b + d

 DWL with a subsidy = b
◼ A tariff is more harmful for domestic economy than a

production subsidy. 37
Export subsidy
◼ An export subsidy: money paid by the
government to domestic producers for each
unit of the exported good.
Goals of export subsidy:
◼ boost domestic production and employment

◼ increase international competitiveness of
domestic firms
◼ reduce trade deficit
38
Export subsidy in a small country: free
trade situation
P
S
Exports = Q2 - Q1
PFT
D
Q1 Q2 Q
39
The effects of an export subsidy in a small country
Net effect of an export subsidy = – b – d
producer gain – consumer loss – subsidy payment
P a+b+c –a–b –b–c–d
PFT +Sub
a b c d
PFT
D
Q3 Q1 Q2 Q4 Q
40
Export subsidy in a large country: free trade
situation
Country A Country B
P SA P
DB SB
PFT PFT
DA
Q Q
Q1 Q2 Q1 Q2
imports exports
41
The effects of an export subsidy in a large country
Country A Country B
P SA P
Amount of the
export subsidy
DB SB
PS
PFT
PS *
DA
Q3 Q1 Q2 Q4 Q Q3 Q1 Q2 Q4 Q
imp1 exp1
imp0 exp0 42
Welfare effects for the importing country A
Net effect of an export subsidy = consumers gain – producers loss
b+c+d = a+b+c+d -a
P SA P
SA
PFT
a b c d
PS*
DA
DA
Q1 Q2 Q Q3 Q1 Q2 Q4 Q
imports imports 43
Welfare effects for the exporting country B
Net effect of = producer gain - consumer loss – subsidy payment
an export subsidy a + b + c -a-b - b – c – d – e – f -g = – b – d – e – f – g
P P
SB SB
PS
a b c d
PFT Sub
e f g
PS*
DB DB
Q1 Q2 Q3 Q1 Q2 Q4 Q
Q
exports exports
44
Export subsidy and CVD
◼ Export subsidy decreases welfare in both small and
large exporting countries
◼ A large country is additionally (above the usual

DWL) hurt by the deterioration of its terms of trade
(e + f + g)
◼ Export subsidy brings a net welfare gain for the

importing country
◼ Producers in an importing country who were hurt by

export subsidy, may petition for protection that takes
a form of a countervailing duty (CVD) => an extra
duty that raises the price of the imported good to its
fair market value.
45
Dumping
Two definitions:
◼ „price-based”: dumping is a sale of a good in a
foreign market at a price below the price for which
the same good sells in the domestic market.
◼ „cost-based”: dumping is a sale of a good in a
foreign market at a price below its production cost.
Types of dumping:
◼ persistent
◼ sporadic
◼ predatory
46
Persistent dumping (international
price discrimination)
◼ Persistent dumping – the good is continually
sold in international markets at a lower price
than in the home country in order to
maximize total profits in the long run.
Conditions for persistent dumping to occur:
◼ A domestic firm must have some degree of market

power
◼ Price elasticity of demand for its products must be
different in domestic and foreign markets
◼ The domestic and foreign markets must be perfectly
separated to prevent a good arbitrage.
47
Intermittent dumping:
◼ Sporadic dumping – a foreign producer (or

government) occasionally exports excess
surplus of a good at a lower price.
◼ Predatory dumping – a foreign firm sales a

good at a lower price on the importing
country market until producers in that
country are driven out of the market, and
then the firm exploit its monopoly power by
raising prices.
48
Predatory dumping
Dumping at price P1:
P CS ↑ by a + b + c + d
S
PS ↓ by –a
DWC ↑ by + b + c + d
Dumping at price P2
PFT is predatory:
a b c d
P1 Domestic
D producers have
P2 been driven out of
the market
Q3 Q1 Q2 Q4 Q
A domestic market of the importing country for a specific product

49
Antidumping duty
◼ An antidumping duty is a special tariff (in

addition to any normal duty) imposed on
foreign goods that were dumped in the
domestic market to offset the price
differentials (dumping margin).
◼ Dumping and injury to domestic producers in

the importing country must be proved (an
injury test).
50
Trade defence measures
◼ Goal: protect domestic producers against unfair

foreign competition:
 Anti-dumping measures (antidumping duties)
 Anti-subsidy measures (countervailing duties)
 Safeguard measures (permit to restrict imports if

they cause injury to domestic industry):
◼ Provisional duties
◼ Quantitative restrictions
◼ Other measures (suspension or withdrawal of any
earlier consession)
51
ECONOMIC GROWTH
AND INTERNATIONAL
TRADE
Dr Lidia Mesjasz
1. Sources of economic growth
◼ Economic growth: a quantitative change in
the level of production that allows the
country to reach a higher level of real
income and presumably a higher level of
well-being.
◼ Economic growth can be a result of:
 an increase in productive resources (labor,
capital, land, natural resources)
 technological change => greater productivity
of labour and/or capital => fewer inputs or
greater amount of output
2
2. Effects of factors growth on the PPF
Car Car Car
Cloth Cloth Cloth
(a) Both factors grow at (b) Only capital grows (c) Only labor grows
the same rate (factor-
K/L increases K/L decreases
neutral growth)
K/L constant
Cars: K-intensive Clothes: L-intensive
3
3. Types of a new technology
◼ factor-neutral – a proportionate reduction in

the use of capital and labor per unit of output
(K/L constant)
◼ capital-saving – a more than proportionate
reduction of capital than labor per unit of
output (K/L falls)
◼ labor-saving – a more than proportionate
reduction of labor than capital per unit of
output (L/K falls)
4
4. Effects of a new technology on the PPF
Cars Cars
b)
c)
Clothes Clothes
(a) Factor-neutral technology (b) Factor-neutral technology only in car

in both industries production (or capital-saving
technology)
c) Factor-neutral technology only in
clothes production (or labour-saving
technology) 5
5. Factor growth, trade and welfare –
A small country case
General assumptions:
◼ Two factors of production: labor, capital (fully

employed)
◼ Two goods: cars (K-intensive), clothes (L-
intensive)
◼ The economy is relatively labor abundant
◼ PPF with increasing costs
◼ The economy is small
◼ Free trade policy
6
5.1 Labor and capital grow at the same rates
Cars C
K/L constant
C2
P
C1
B P2
A P1
0 Clothes
NEUTRAL ECONOMIC GROWTH: a proportionate increase in both
factors of production leads to the proportional expansion in the
output of exportables and importables, and proportional expansion
of trade. 7
5.2 Supply of labor increases more than capital
Cars C
L/K increases
C2
P
C1
B
P2
A
P1
0 Clothes
PROTRADE BIASED GROWTH: a relative increase in the supply of

the factor used intensively in the production of exportables results
in the expansion of trade that exceeds the expansion of GDP.
8
5.3 Supply of capital increases more than labor
Cars C
K/L increases
C2
P2 P
C1 B
A
P1
0 Clothes
ANTITRADE BIASED GROWTH: a relative expansion in the supply

of the factor used intensively in the production of importables
results in the reduction of trade relative to GDP growth.
9
6. Factor growth, trade and welfare –
A large country case
6.1. Growth decreasing welfare
Assumptions:
◼ The economy is a large world supplier of cocoa
◼ Two goods: cocoa (L-intensive), machines (K-intensive)
◼ The economy is relatively labor abundant
employed)
◼ The country faces neutral or protrade biased growth
10
Immiserizing growth, J. Bhagwati, 1958
C
Machines
C2 C1
P2
P1
TOT2
TOT1
Cocoa
In a large country growth in its exportables leads to a

deterioriation in its terms of trade and welfare. 11
Immiserizing growth (2)
◼ Conditions for immiserizing growth to occur:
 country must have a significant market

power in a certain product in the world
markets
 world demand for this product must be
relatively inelastic
 economic growth should be neutral or
concentrated in an export sector
12
6.2 Growth increasing welfare
Assumptions:
◼ The economy is a large world importer of oil

◼ Two goods: oil (L-intensive), machines (K-
intensive)
employed)
◼ The economy is relatively capital abundant
◼ Growth is concentrated in the import sector
13
Growth increasing economic welfare (2)
C
Oil
C2
CIC2
C1 P2
B P
CIC1
A
P1 TOT2
TOT1
O Machines
In a large country growth in its importables leads to

an improvement in its terms of trade and welfare. 14
7. Economic growth, trade, welfare:
Conclusions
◼ Economic growth in a small country

participating in international trade always
leads to an increases in its welfare.
◼ Economic growth in a large country

participating in international trade may
increase its welfare (antitrade biased growth)
or decrease its welfare (neutral or protrade
biased growth).
15
Balance of Payments
and
National Income Accounting
Dr Lidia Mesjasz
Lecture outline
• Balance of payments definition and accounts
• A double-entry bookkeeping rule
• Examples of paired transactions
• Fundamental balance of payments identity
• External wealth (international investment
position)
• Balance of payments accounts and national
income and product accounts
• Absorption approach to the BOP
• Fiscal approach to the BOP 2
Balance of Payments Definition
• a summary statement in which all economic
transactions between residents of the reporting
country and residents of the rest of the world
(ROW) are recorded during a given time period,
usually a calendar year.
• Residents are economic agents (such as

households, firms, or governments) who
normally reside in a country, even if they are
temporarily abroad (such as tourists, diplomats,
military personnel, migrant workers, or
students).
• Entries in the BoP accounts represent economic

flows rather than stocks.
3
BALANCE OF PAYMENTS ACCOUNTS:
• Current Account (CA)

• Capital Account (KA)
• Financial Account (FA)
– Nonreserve Financial Account (NFA)
– Official Reserve Settlements Account
(ORS)
4
CURRENT ACCOUNT (CA)
• Goods: Export (X) and Import (IM): Balance
- general goods on
- goods for processing goods
and
• Services: Transportation, Travel and Other: communication, services
construction, insurance, financial, computer and information services) (N)
• Primary Income (formerly Investment Income)

Net
- Compensation of employees (wages and salaries, employers’ social investment
contributions) income
- Investment income (dividends, interests, rents, reinvested earnings) (NINV)
• Secondary income (formerly Unilateral transfers): Net

unilateral
- General government (food aid, social benefits, retirement pensions,
transfers
annual government’s contributions to international organizations) (NUT)
- Other sectors (workers’ remittances, private gifts, subscriptions,
5
grants, donations, membership fees, and other).
CAPITAL ACCOUNT (KA)
• Capital transfers: debt forgiveness, bail-outs,
investment grants
• Purchase and sale of nonproduced, nonfinancial

assets (patents, trademarks, copyrights, natural
resources, etc.)
6
FINANCIAL ACCOUNT (FA)
• Nonreserve Financial Account (NFA):
✓Direct investment (investment in a foreign company
designed to acquire a controlling interest in it)
✓Portfolio investment (purchase shares, bonds or other
financial assets with the aim of gaining a return and/or
diversifying investment risk)
✓Financial derivatives (financial instruments linked to a
specific financial instrument or indicator or
commodity, used for risk management, hedging,
arbitrage and speculation).
✓Other investment (credits, loans, deposits, certificate
of deposits, commercial papers, etc.) 7
FINANCIAL ACCOUNT (FA) cont.
• Official Reserve Settlements Account (ORS):

changes in the official reserves held by the
central bank (such as, foreign governments’
securities, world currencies, monetary gold,
reserve position in the IMF and Special
Drawing Rights).
8
A DOUBLE-ENTRY BOOKKEEPING RULE
• Each transaction enters the balance of payments
twice: as a credit (+) and as a debit (-) => sum of
credits and debits on all BOP accounts should
equal zero.
• A CREDIT - any transaction resulting in a receipt of

currency from foreigners (e.g. exports of goods, assets).
• A DEBIT - any transaction resulting in a payment to

foreigners (e.g. imports of goods, assets).
9
STATISTICAL DISCREPANCIES
• Reasons for existence of statistical
discrepancies (errors and omissions):
– Not always both sides of a transaction are
registered simultaneously
– Some transactions enter the balance of
payments as estimates
– Some transactions are not registered at all
10
EXAMPLES OF PAIRED TRANSACTIONS in Polish BOP
1. A Polish petroleum company imports oil from Saudi Arabia and
makes payment from its bank account in Poland.
– imports of oil (- CA, goods)
– exports of Polish assets (+ FA, other investment)
2. A Mexican tourist buys a meal at the Cracow restaurant and pays
with his VISA credit card.
– exports of travel services (+CA, services)
– imports of foreign (Mexican) assets (- FA, other investment)
3. The EU grants Poland funds to build a new electricity plant
– capital transfer received (+KA)
– imports of foreign (EU) assets (- FA, other investment)
4. A Polish bank pays off the loan with interest to a British bank
– interest paid (- CA, primary income), loan paid (- FA, other
investment)
– exports of Polish assets to a British bank: (+ FA, other investment)
11
FORMAL EQUALITY OF THE BOP
• Due to the double entry of each transaction:
CA + KA + NFA + ORS + SD = 0
• Fundamental balance of payments identity:
CA + KA + NFA + SD = − ORS
– If CA + KA + NFA + SD > 0 => ORS must be negative

value to ensure an overall balance, so CB imports net
financial claims from ROW and official reserves
increase.
– If CA + KA + NFA + SD < 0 => ORS must be positive
value to ensure an overall balance, so CB exports net
financial claims to ROW and official reserves fall.
12
RELATIONSHIP BETWEEN
CURRENT AND FINANCIAL ACCOUNTS
• Suppose, KA and SD are zero, then surpluses in CA must
be offset by deficits in FA, and deficits in CA must be offset
by surpluses in FA
CA = - FA
CA = - (NFA + ORS)
• If debits > credits on CA => CA deficit => FA surplus =>

country borrows from ROW and accumulates net financial
liabilities to ROW => its external wealth falls.
• If credits > debits on CA => CA surplus => FA deficit =>

country lends to ROW and accumulates net financial
claims (assets) on ROW => its external wealth increases.
13
EXTERNAL WEALTH = NET INTERNATIONAL
INVESTMENT POSITION
• External wealth (W) or international investment
position (IIP) = total external assets (A) – total
external liabilities (L)
- If W > 0, a country is a net creditor to ROW
- If W < 0, a country is a net debtor to ROW
• How can a country increase its external wealth?

- running a CA surplus (through its own thrift)
- running a KA surplus (by receiving gifts of wealth)
- enjoying positive capital gains (thanks to changes in
assets prices or exchange rate)
14
BOP and NATIONAL INCOME/PRODUCT
ACCOUNTS
In a closed economy:
• GDP = C + I + G
• I = GDP – C – G
• S = GDP – C – G
• S = I (domestic saving = domestic investment)
In an open-economy:
• GDP = [(C + I + G) - IM] + X, or equivalently
• GDP = (C + I + G) + (X - IM)
• GDP = A + N
A (domestic absorption) = C + I + G
N (net exports) = X - IM
15
GDP vs. GNP
• Gross domestic product (GDP) is the total market
value of all final goods and services produced in the
domestic economy during a given period.
• Gross national product is GDP plus net

investment income as some of the domestic GDP is
produced by foreign capital and some foreign GDP is
produced by domestic capital:
GNP = GDP + NINV

GNP = (C + I + G) + (N + NINV)
Adding net unilateral transfers (NUT) to GNP:
GNP + NUT = (C + I + G) + (N + NINV + NUT)

= (C + I + G) + CA 16
Absorption approach to the BOP
If: GNP = (C + I + G) + CA
Then, CA = GNP – A
absorption approach to the balance of payments:

the current account can only be improved if domestic
absorption declined relative to GNP.
17
Savings and Current Account
• In a closed-economy, domestic saving:
S = GDP – C – G
I = GDP – C – G
I=S
• In an open economy, national saving:
S = GNP – C – G
since GNP = (C + I + G) + CA, then
S = I + CA I = S - CA
where:
I = domestic investment, + CA = net foreign investment
- CA = net foreign borrowing
18
Is a current account deficit bad?
It depends:
• If CA deficit reflects higher current consumption,

then repaying the accumulated debt will require
lower future consumption.
• If CA deficit reflects an increase in investment with

yields exceeding the cost of external borrowing, it
may lead to higher future consumption.
19
Private and Government Saving
• Private saving: SP = GNP – C – NT
NT = net taxes paid by the private sector to the government
• Government saving: SG = NT – G
• Total national saving: SP + SG = GNP - C – G

S = I + CA
SP + SG = I + CA, then SP = I + CA – SG = I + CA – (NT-G)
SP = I + CA + (G – NT)
CA = (SP - I) + (NT - G)
(SP - I) = net private saving
(NT – G) = net government saving (fiscal surplus or deficit)
20
Fiscal approach to the balance of payments
• CA = (SP - I) + (NT - G)
• CA deficit may be a result of: net private saving
deficit OR net government saving deficit (fiscal
deficit)
• Fiscal deficit is often accussed of being the primary

cause of the CA deficit („twin deficit”).
• Twin deficit reflects correlation between CA nad

fiscal deficits, but does not imply causation.
21
US CA deficit and fiscal surplus
22
ECONOMICS
OF EXCHANGE RATES
Lidia Mesjasz, PhD

Lecture Outline
• Definition of an exchange rate
• Exchange rates and international transactions
• Exchange rates arrangements
• Major factors influencing exchange rates
• Theory of Purchasing Power Parity (PPP)
• Theory of Interest Parity (IP)
• International Fisher equation: the link
between PPP and IP
2
What is an exchange rate?
• Exchange rate: the value of one currency in
terms of another currency
• Currency - official legal tender of the country.
• Exchange rates can be quoted in two ways:
- value of the domestic currency per unit of a foreign
currency (0.85 GBP/1 EUR where: EUR – a base
currency; GBP is a quoted currency) OR
- value of the foreign currency per unit of a domestic
currency (e.g. 1.1765 EUR/1 GBP where GBP is a
base currency; euro is a quoted currency)
3
Exchange rates and international transactions
How many dollars would it cost to buy a British sweater costing
£50 ?
• At $1.50/ £ , the sweater would cost: (1.50$/£) x £50 = $ 75
• At $1.25/ £, the sweater would cost: (1.25$/£) x £50 = $ 62.50
(pound depreciated)
• At $1.75/ £, the sweater would cost: (1.75$/£) x £50 = $ 87.50
(pound appreciated)
How many British pounds would it cost to buy a pair of American
jeans costing $45?
• at $1.50/ £ , the jeans would cost: ($45)/ (1.50$/£) = £ 30
• at $1.25/ £, the jeans would cost: ($45)/ (1.25$/£) = £ 36
(dollar appreciated)
• at $1.75/ £, the jeans would cost: ($45)/ (1.75$/£) = £ 25.7
(dollar depreciated) 5
Exchange rates and international
transactions: general conclusion
• All else equal, a depreciation of a country’s
currency makes its domestic goods (exports)
cheaper for foreigners, and foreign goods (imports)
more expensive for domestic consumers.
• All else equal, an appreciation of a country’s

currency makes its domestic goods (exports) more
expensive for foreigners, and foreign goods
(imports) cheaper for domestic consumers.
6
Annual Report on Exchange Arrangements and Exchange Restrictions 2021, IMF 2022.
7
Exchange rate arrangements in 2021
(percent of IMF members)
Hard pegs 13.0
• no seperate legal tender 7.3
• currency board 5.7
Soft pegs 47.7
• conventional peg 20.7
• crawl-like arrangement 12.4
• stabilized arrangement 12.4
• crawling peg 1.6
• pegged within horizontal bands 0.5
Floating 33.2
• managed 16.6
• free floating 16.6
8
Annual Report on Exchange Arrangements and Exchange Restrictions, IMF 2022.
Fixed exchange rate
▪ definition: a value of the currency is fixed (pegged)
by the monetary authorities to the value of:
➢ another single currency (e.g. USD, euro)
➢ the average value of the basket of currencies or
➢ gold (in gold-standard system 1870-1914)
▪ it is maintained by government/central bank
intervention in the foreign exchange market
▪ two key terms used only when referring to a fixed
exchange rate :
➢ revaluation of the currency (if the value of the
currency is raised)
➢ devaluation of the currency (if the value of the
currency is lowered) 9
No seperate legal tender
▪ the currency of another country circulates
as the sole legal tender
➢ formal dollarization (e.g. Panama,
Ecuador, El Salvador)
➢ formal euroization (e.g. Kosovo,
Montenegro)
▪ the country completely surrenders its
control over the domestic monetary policy
10
Currency board
• an explicit legislative commitment to exchange
domestic currency for a foreign currency at a
fixed exchange rate
• domestic currency is fully backed by foreign
assets
➢ central bank has little scope for discretionary
monetary policy
➢ credibility of the government’s commitment to
maintain the fixed exchange rate is greater than
under any other fixed exchange rate systems
• E.g. Hong Kong, Bosnia and Herzegovina, Bulgaria

Conventional peg or
stabilized arrangement
• the country formally pegs its currency at a
fixed rate to another currency or basket of
currencies and maintain the fixed parity
through foreign exchange intervention
• in reality, the exchange rate may fluctuate

within narrow margins of less than ±1%
around a central rate (conventional peg) or
must remain within a margin of 2% relative to
a statistically identified trend for six months
or more (stabilized arrangement).
12
Conventional peg/stabilized arrangement
Exchange
rate
Peg/parity
Time
13
Crawling peg or
crawl-like arrangement
• the central rate is gradually adjusted in small
amounts at a fixed rate or in response to
changes in selected quantitative indicators,
such as past inflation differentials vis-à-vis
major trading partners
• the goal of a crawling peg arrangement is to

prevent a real appreciation of the domestic
currency that would occur in case of higher
domestic inflation and would be harmful to
domestic exporters. 14
Crawling peg
Exchange
rate
Peg/parity
Time
15
Pegged within horizontal bands
• the central bank establishes certain margins of
fluctuations of at least +/-1% around a fixed central
rate within which it allows the currency to float
• CB intervenes in the forex market only when the

value of the currency exceeds the upper or lower
margins
• E.g. Exchange Rate Mechanism (ERM) of the

European Monetary System in 1979 (+/-2.25%
around ECU), replaced by ERM II in 1999 (+/-15%
around euro).
16
Pegged within horizontal bands
Exchange
rate
upper limit
Peg/parity
lower limit
Time
17
Floating exchange rate
• definition: the value of the currency is
determined solely by the demand for, and
supply of, the currency on the foreign
exchange market
• there is no government intervention to
influence the value of the currency
• two key terms used only when referring to a floating

exchange rate :
➢ appreciation of the currency (if the value of the
currency rises)
➢ depreciation of the currency (if the value falls) 18
Floating exchange rate (2)
• Free floating
➢central bank interventions in the forex
market occurs only exceptionally to address
disorderly market conditions
• Managed floating
➢central bank occasionally intervenes in the
forex market to moderate or prevent undue
fluctuations that may be harmful for the
economy, but without targeting a specific
level of the exchange rate.
19
Factors influencing exchange rates
• Goods prices (inflation rates) – PPP theory
• Interest rates – interest parity theory
• Economic growth:
– current account channel: higher GDP => higher
imports => depreciation of the domestic currency
– financial account channel: higher GDP => higher
investment inflow => appreciation of the domestic
currency
• Economic policy (exchange rate policy, monetary policy,

fiscal policy, trade policy) 20
Factors influencing exchange rates (2)
• Consumers’ and businesses’ confidence
• Political events and political stability
• Expectations and beliefs
• News (good or bad)
• „Shocks” (natural disasters, pandemics, sudden

reduction in oil supply, technological innovation, etc.) 21
Inflation and exchange rate
• What does inflation mean?
– the purchasing value of the currency falls

with regard to:
• goods it can buy
• currencies it can buy
=> the currency depreciates.
22
Purchasing Power Parity Theory
• Prices of an identical goods in any two countries
should be the same as measured in the same
currency.
• Absolute PPP theory: P = S x P*

where: P - domestic price, P* - foreign price, S - spot
exchange rate (value of a domestic currency
measured in the foreign currency)
• PPP exchange rate: S = P/ P*

23
Example: Absolute PPP
• Suppose, identical goods (a MC burger) cost:
– in Poland: P = 20 PLN
– in Germany P* = 5 Euro
S = P/P* = 20/5 = 4 zł/1 euro
• If inflation in Poland rises:
– Poland: P= 25 PLN
– German: P* = 5 Euro
– S = 25/5 = 5 zł/1 euro
➢ Zloty depreciated (and euro appreciated) to

keep the real purchasing value of the
currencies stable. 24
Absolute PPP fails to hold in reality:
• Assumptions of the PPP theory are not
satisfied in a real world (transportation costs,
trade restrictions, tax differentials).
• Consumer Price Indices (CPI) are country

specific and incomparable.
• Many goods and services included in a CPI

(e.g. housing and medical care) are not traded
internationally (so prices will not equalize).
Limited use of absolute PPP
➢ Absolute PPP cannot be used to predict
exchange rate movements (It is highly unlikely
that exchange rates would move to the rates
that equalize prices of identical baskets of
goods in any two countries).
➢ Absolute PPP is used to estimate how much

currencies deviate from their PPP level => „Big
Mac index”.
26
Big Mac Index: under /overvaluation
• Big Mac price (in January 2018):
- in China: 20.40 CNY
- in USA: 5.28 USD
• PPP exchange rate: 20.40/5.28 = 3.86 CNY/1 USD
• Actual exchange rate = 6.43 CNY/1 USD
• USD was overvalued by 66%

[(6.43-3.86/3.86)] x 100 = 66.58%
• CNY was undervalued by 40%
[(1/6.43-1/3.86) : 1/3.86] x 100 = 39.98%
27
28
29
Relative PPP
• Relative PPP addresses price changes as
opposed to absolute price levels:
%  in S = %  in P - %  in P*
%  in S =  -  *
 – domestic inflation rate
* – foreign inflation rate
• Suppose, inflation in Poland: 10%, in the EU: 4%
• Euro should appreciate and Polish zloty depreciate
by about 6% to keep the real purchasing value of the
currencies stable.
30
Empirical Evidence on PPP
• Actual exchange rates diverge considerably from the PPP
rates, although they do have a tendency to go back towards
the PPP rates in the long run.
• Actual exchange rates are much more volatile than the
national price levels (capital flows determine exchange rates
movements much more than trade flows).
• PPP holds better for traded than non-traded goods.
• PPP is less likely to hold if one uses consumer price indices
(CPI), which include both traded- and non-traded goods, than
wholesale price indices (WPI), which are dominated by traded
goods.
• PPP holds better for high inflation countries (changes in
overall prices outweigh changes in relative prices).
31
Interest Parity Theory
(interest rate and exchange rate)
• Demand for financial assets (currency deposits)
depends on:
➢ expected rate of return, which depends on:

– interest rate the currency will earn
– value of the currency in future (expected
appreciation or depreciation)
➢ liquidity
➢ risk level
32
Interest Parity : Example (1)
• Suppose, a business person from India having 1 million
INR considers 2 investment options with similar risk
(government bonds) and similar liquidity (maturity of 1
year):
– Indian bonds (in INR): 10%
– Australian bonds (in AUD): 8%
• A spot exchange rate today S = 50 INR/1 AUD

• An expected exchange rate in 1 year Se+1 = 52 INR/1
AUD
33
IP: Example (2)
• How many rupees will an Indian investor end up with at
the end of the year by investing 1 million rupees in India
or in Australia?
An expected rate of return from an Indian bond:

• 1 mill INR x 1.1 = 1,100,000 INR
An expected rate of return from an Australian bond:
• 1 mill INR/50 = 20,000 AUD
• 20,000 AUD will yield after one year 21,600 AUD (20,000
x 1.08).
• 21,600 AUD are expected to be worth in one year 21,600
AUD x 52 INR/AUD = 1,123,200 INR. 34
IP: Example (3)
• Formula for the expected rate of return from an
Australian investment:
RAUD + (Se INR/AUD – SINR/AUD)/SINR/AUD
– interest rate on Australian bonds: RAUD = 8%

– expected rate of appreciation of AUD:
(Se INR/AUD – SINR/AUD)/SINR/AUD = 52 -50 /50 = 4%
35
IP: Example (4)
• Because the anticipated return on Australian bonds
(12%) is higher than on Indian bonds (10%):
RAUD + (Se INR/AUD – SINR/AUD)/SINR/AUD > RINR
=> it is more profitable to invest in Australia
• Interest arbitrage will take place and ultimately

remove the above difference:
RAUD + (Se INR/AUD – SINR/AUD)/SINR/AUD = RINR
36
Interest Arbitrage (1)
Spot forex market for Australian dollar => SAUD↑
S S1
S0
D1
D0
Q of AUD
37
Loanable funds market in India => RINR ↑
RINR S1
S0
D0
Q1 Q0 Q
38
Loanable funds market in Australia => RAUD↓
RAUD S0
S1
D0
Q0 Q1 Q
39
Future spot forex market for Australian dollar =>
Se+1↓
S e+1
S0
S1
D0
Q of AUD
40
Result of Interest Arbitrage
• Interest arbitrage removed the difference in the
expected returns from Australian and Indian
investments:
RINR = RAUD + (Se INR/AUD – SINR/AUD)/SINR/AUD
41
Generalization of the example
• R - nominal interest rate in a domestic country (expressed as a
decimal fraction)
• 1 + R - rate of return on 1 unit of a domestic currency
• R* - nominal interest rate in a foreign country
• 1 + R* - rate of return on 1 unit of a foreign currency
• S – today’s spot exchange rate (the number of a domestic
currency per 1 unit of a foreign currency)
• Se+1 – expected exchange rate at the end of the year (defined
as above)
• (1 + R*)/S – rate of return on 1 unit of a foreign currency
measured in the foreign currency
• (1+ R*) Se+1/S – expected rate of return on 1 unit of a foreign
currency measured in the domestic currency
42
Interest parity (IP)
• Interest parity holds if investments in all currencies
offer the same expected rates of return:
(1+ R) = (1+ R*) Se+1/S
• IP implies that:
– all currencies are equally desirable assets
– interest arbitrage is not needed
– forex market is in equilibrium
• If interest parity doesn’t hold, then interest arbitrage

will take place and remove the difference in the
expected rates of return on domestic and foreign
currencies. 43
Interest parity in a (more) formal version :
1+ R Se + 1
=
1+ R * S
1 + R 1 + R * Se + 1 S Simplified IP condition:
− = −
1+ R * 1+ R * S S
(1 + R ) − (1 + R*) Se + 1 − S
=
1+ R * S
R - R * Se + 1 − S
=
1+ R * S
44
UNCOVERED INTEREST PARITY (UIP)
Interest rates differential between domestic and foreign

financial instruments should approximately be equal to
the expected depreciation or appreciation of the foreign
currency.
• Uncovered IP implies that there is a foreign exchange

risk in purchasing a foreign financial instrument
because a future spot exchange rate is unknown.
45
UNCOVERED INTEREST PARITY (2)
• An Indian investor faces a foreign exchange risk since:
− actual exchange rate of AUD in a year (S+1) could differ

from the expected exchange rate (Se+1)
− effective return (1+ R*)S+1/S≠expected return (1+ R*)Se+1/S
• To cover the exchange rate risk, an Indian investor can use

a forward contract:
− selling his return in AUD (1 + R*)/S for rupees at a given
forward exchange rate (F), with a delivery of rupees in a
year.
46
COVERED INTEREST PARITY
• A forward contract eliminates foreign exchange risk by:
– replacing expected exchange rate (Se+1) with the
given forward exchange rate (F), and
– replacing expected return: (1+ R*) Se+1/S
with the guaranteed return: (1 + R*)F/S.
• Covered interest parity (CIP):
F -S
R - R* =
S
Interest rates differential between domestic and foreign
financial assets should approximately be equal to the
forward premium or discount of the foreign currency. 47
Inflation rates- Exchange rates – Interest rates
• Relative PPP:
% in S =  - *
S+1 – S/S =  - *
• Expected relative PPP:

Se+1 – S/S = e - e*
• UIP: Se+1 – S/S = R - R*

48
International Fisher Equation
By combining the expected version of relative PPP and
UIP, we obtain international Fisher equation:
UIP PPP
R- R*= Se+1– S/S = e- e*
international Fisher equation

interest rate differentials between countries are
approximately equal to expected inflation rates
differentials 49
International Fisher Equation (2)
• Suppose, domestic inflation is expected to rise by
2%.
• What does international Fisher equation imply

(holdings all other things constant)?
– nominal interest rate on domestic currency
deposits will rise by 2% so as the real interest
rate (r = R – πe) stayed constant
– domestic currency will depreciate by about 2% to
keep the real purchasing value of the domestic
currency stable.
50
FOREIGN EXCHANGE MARKET
and
Central Bank Policy
Lidia Mesjasz, PhD

Lecture Objectives:
• Identify major factors influencing short-term
fluctuations of currencies
• Explain how a central bank monetary policy

can influence a forex market and the entire
economy
• Define the concept of inconsistency trinity

and discuss its possible solutions
2
Lecture Agenda:
1. Foreign exchange market:
– characteristic features
– major participants
2. A simple model of a forex market
– demand and supply of foreign exchange
– short-term currency fluctuations
3. Central bank monetary policy under flexible
and fixed exchange rates
4. Policy trilemma
– defining the problem
– real life examples 3
Foreign exchange (forex) market
• A global, decentralized, over-the counter (off-
exchange) market where different currencies are
traded 24 hours a day.
• Daily turnover in the global forex market: 6.6 trillion

USD in 2019 (25 times of daily global GDP).
• Geographically dispersed market with 5 major

locations (80% of global FX trading)
• „Interbank market”: bulk of currency transactions in

the wholesale market by bank dealers
4
Forex market (2)
• Currency transactions via telephone and computer
networks by debating and crediting banks’ accounts
(no physical transfer of currencies across countries’
borders).
• Majority of currency trading in USD (88%).
• Contracts for immediate delivery of currencies are

carried out in the spot markets (at spot rates).
• Contracts for future delivery of currencies are

carried out in forward and futures markets (at
forward rates).
5
7
Forex market participants
1. Commercial banks and other depository institutions:
buy/sell deposits in different currencies for
investment purposes.
2. Non-bank financial institutions (mutual funds, hedge

funds, pension funds, insurance companies): buy/sell
foreign assets for investment purposes.
3. Commercial companies: buy/sell foreign currencies to

pay for goods or services.
4. Official sector institutions: central banks (to control

money supply, inflation, interest rates or to stabilize
the value of domestic currency); governments 8
Forex market participants
9
Forex market for PLN
No of No of
euros per euros per Supply
1 PLN 1 PLN (of zlotys from Poland)
A
1/4 € 1/4 €
B
B 1/5 €
1/5 €
A
Demand for
ZL from EU
Q of ZL Quantity of ZL
Demand for zlotys Supply of zlotys

from EU from Poland
11
Equilibrium in the forex market
S’
Value
of zł S S
¼€
D’
D D
Q zł Q zł
Forex market for zloty Forex market for złoty
12
Relationship between forex market for zloty
and forex market for euro
No of €
Supply No of zł Supply
(of zl from PL) per 1€ (of euros from EU)
per 1 zł
S2
1/E*
E*
(0.25 (4 zł
EUR per
EUR)
per zł) Demand D2 Demand
(for zl from EU) (for euro from PL)
Q of zlotys Q of euros
Forex market for zloty Forex market for euro
D for zloty <=> S of euros

13
Short-term (daily) volatility of currencies
14
Short term vs. long term
fluctuations of currencies
• It is important to distinguish between:
- short-term vs. long-term fluctuations of
currencies
- different types of flows:
➢ trade flows (in Current Account)
➢ private capital flows (in Non-reserve Financial
Account)
➢ official capital flows (in Official Reserve
Settlements Account)
15
Reasons for short-term fluctuations
of currencies
• Expected profitability of investment depends

on:
- State of the economy (changes in GDP,

interest rates, trade deficit, etc.)
- Political situation (election, stability of

government, wars, military conflicts, etc.)
16
GDP impact on a forex market (1)
Suppose, there are indications that the Swiss economy is improving?
What will happen to CHF?
Forex market for Swiss Franc (CHF)

Value
of S1
CHF S0
B
appreciation
A
D1
D0
Q of CHF
17
GDP impact on a forex market (2)
Suppose, the latest figures indicate that Great Britain may
be moving into recession. What will happen to the GBP?
Forex market for GBP

Value
of S0
GBP S1
A
„Herd
Depreciation behaviour”
B
D0
D1
Q of GBP
18
Interest rate impact on a forex market
• Rate of interest (ROI) influences the rate of

return from investment in bonds:
– if ROI goes up
 profitability of bonds goes up
 capital inflows
– if ROI goes down
 profitability of bonds goes down
 capital outflows
19
Suppose, the ECB raises its interest rates.
What will happen to euro?
Forex market for euro

Value of S1
Euro S0
B
Appreciation
A
D1
D0
Q of EUR
20
Suppose, the US FED raises its interest rates.
What will happen to euro?
Value of
EUR S0
S1 If USD RoI
A
rises =>
depreciation relative
B eurozone
ROI falls
D0
D1
Q of
21 EUR
Suppose, people expect that the US Fed will raise
its interest rates. What will happen to euro?

Value
of EUR S0
S1
A
depreciation
B
D0
D1
Q of EUR
22
Suppose, we expect euro-zone interest rates to go up,
but the value of the euro goes down (holding all other
things constant). How can we explain this result?
• Last week investors believed that today the euro-

zone interest rates were going to go up by 0.5%
points
▪ They bought 10 million euros => euro appreciated
• Today investors believe that the euro-zone interest
rates are going to increase by only 0.25% points
▪ They sell 2 million euros => euro depreciates
=> Need to compare investors’ expectations over time!

23
Interest rates’ impact on the forex market:
a general rule
• Usually, holding all other things constant, if

actual, relative and expected interest rates go
up, the value of the currency goes up and the
other way round.
24
How do investors create their expectations
about interest rates?
• Short-term interest rates are controlled by central
banks
• Central banks use interest rates to achieve domestic

macroeconomic goals:
– fight inflation (ROI ↑)
– stimulate economic growth (ROI ↓)
• Investors need to look at the state of the economy.

25
What is a problem:
inflation or weak economy?
• Evidence that inflation may be a problem:
– inflation: high, increasing or more than expected
– GDP growth: strong
– consumers’/businesses’ confidence: high
– unemployment: low or decreasing
• Evidence that weak economy may be a problem:

– inflation: low or decreasing
– GDP growth: weak
– consumers’/businesses’ confidence: low
– unemployment: high or increasing
26
Monetary policy of the central bank
Prices (A): high inflation => ROI ↑

contractionary monetary
AS policy
A
(B): weak economy: ROI ↓
B
expansionary monetary
AD1 policy
AD0
Real GDP
By changing an interest rate CB conducts counter-cyclical

policy to minimise peaks and troughs of the business cycle
27
Suppose, the ECB is following traditional domestic
macroeconomic goals of fighting inflation or reducing
unemployment. A new government report is released that
shows that the consumer price index is higher than expected.
What will be the likely short-term effect of this news on the
forex market for the euro?
Vale of S1
the euro S0
B
D1
D0
Q of EUR
28
Suppose, the ECB is following traditional domestic
macroeconomic goals. European Commission releases a new
report that shows that unemployment in the euro-zone is
increasing. Explain the likely effect on the forex market for the
euro. Then suppose, a few days later the ECB announces that it
will not lower the interest rate.
Value of
EUR S0
S1
A
2 1
B
D0
D1
Q of EUR
29
How can a central bank keep
a fixed exchange rate ?
• By exchange control (not allowing domestic
currency to be freely traded eg. North Korea,
Myanmar, Vietnam)
• By capital control (putting restrictions on

currency trading in international capital
transactions)
• By foreign exchange intervention (when

domestic currency is freely traded) 30
Foreign exchange intervention
• Direct intervention: central bank buys or sells the
domestic currency in the forex market:
➢ to lower the exchange rate: CB sells the domestic
currency and buys foreign currencies
➢ to raise the exchange rate: CB buys the domestic
currency and sells foreign assets
• Indirect intervention: central bank „manipulates”
private investors’ behaviour by changing a domestic
interest rate:
➢ to lower the exchange rate => CB lowers ROI
➢ to raise the exchange rate => CB raises ROI
31
Direct foreign exchange intervention
changes money supply
S0
S1
ROI MS2 MS0 MS1
i*
CB sells its own currency
MD0
D1 Q
D0 Money market
CB buys its own currency

32
Conflict in goals
• Foreign exchange intervention affects the
domestic money supply => entire economy
(output, employment).
• This may lead to conflict in goals between:

➢ exchange rate stability
➢ monetary policy autonomy
(when capital moves freely across national
borders)
33
Conflict in goals: example
Suppose: no capital control, fixed exchange rate, economy in recession
Value ROI MS1 MS0

of
currency S0
S1
i*
D0
MD0
D1
Forex market Q Money market Q
With free movement of capital, the CB cannot use the interest rate to
both combat recession and stabilize the exchange rate.
34
Policy trilemma (inconsistency trinity)
• It’s impossible to achieve three goals
simultaneously:
– Fixed exchange rate

– Monetary independence
– Free movement of international capital
• One of the goals has to be given up.
35
Inconsistency trinity
Full capital control
2. Independent 1. Fixed
Rise in
monetary policy exchange rate
capital
mobility
Floating Currency
exchange 3. Full capital union
rate markets
integration
Solutions to monetary trilemma:
• Forego independent monetary policy (e.g.

gold standard 1875-1913, euro-zone)
• Impose capital control (e.g. Bretton Woods

system 1944-1971)
• Float the exchange rate (e.g. developed

countries in the current multicurrency
monetary system)
37
Is it possible to avoid policy trilemma?
„Sterilized” foreign exchange intervention: forex market
intervention + open market operation
ROI MS1 MS0
D1
D0 MD0
Q
Forex market Money market
CB buys its own currency to CB buys domestic government bonds
stop its depreciation to increase money supply
38
South East Asian currency crisis of 1997:
policy trilemma in practice
• Countries most hit by the crisis: Thailand, Indonesia,
Malaysia, South Korea, Philippines
• A huge capital inflow in the early 1990s:

– high economic growth, good economic
fundamentals
– fixed exchange rates
– no capital controls
• July 1997: a huge capital outflow from Thailand

triggered by:
– large and fast growing short-term foreign debt
– bad news: CB foreign exchange reserves lower than
oficially claimed. 39
Currency crisis in Thailand, July 1997
Investors’ panic => capital outflows => sharp drop in Thai baht
=> massive speculation against baht => a far deeper plunge =>
FX interventions => high interest rate led to economic slowdown
(policy trilemma !) => loss of CB foreign reserves => baht
delaved and floated.
Value S0
of THB S1
in USD A
e
D0
D1
Q
40
Currency contagion
and policy trilemma resolution
• Contagion played a major role in crisis transmission:
Indonesia, Malaysia, South Korea, Philippines, Brazil,
Argentina, Russia, Turkey
• Policy trilemma was resolved:

– by floating exchange rates (Thailand, South Korea,
Indonesia, Philippines)
– by returning to capital control (Malaysia)
• East-Asian crisis revealed that:

With one policy tool (interest rate), it’s not possible
to hit two different goals: domestic (inflation, growth)
and international (fixed exchange rate) if capital can
move freely in and out of a country. 41
Currency crisis
in the Exchange Rate Mechanism, 1992/93
ERM – a „horizontal band” system of exchange rates among the
currencies of the European Monetary System (EMS) set up in
1979 .
Value of GBP S0
in ECU
If exchange rate
changes within
2.25%
the band,
peg CB does not
intervene
- 2.25%
D0
Q of GBP
Forex market for GBP
42
Background of the ERM crisis
• German reunification on July 1, 1990 => increase in
government spending on restructuring the former
GDR => budget deficit increases => inflationary
pressure
• Bundesbank raises interest rate => foreign capital

inflows => appreciation of DM.
• Capital outflows from other EMS countries =>

depreciation of their currencies => CBs
interventions on FX market => higher ROIs cooled
their economies (policy trilemma !).
43
British pound crisis, September 1992
• Speculative attack on the pound => Bank of England FX
intervention and policy trilemma:
– defending the pound => ROI rises => risk of prolonging or
deepening the existing recession
– Bank of England interventions => sells DM and buys GBP =>
inflation in Germany grow => risk of spreading inflation to
other EMS countries
• Crisis resolution:
– devaluation and floatation of the pound => quitted the ERM
– other currencies were devalued and stayed in the ERM
– the UE Commission widened the ERM fluctuation band to +/-
15% (August 2, 1993) => ERM II.
• ERM crisis has shown the same policy trilemma as the East Asian
crisis.
44
FINANCIAL CRISES
Lidia Mesjasz, PhD

Lecture Outline
• Common features of and factors driving
financial crises
• Major types of financial crises
• currency crises
• capital account crises
• debt crises
• banking crises
• Causes of financial crises
• Symptoms of financial crises
• Implications of financial crises
• Predicting financial crises
2
Common elements of financial crises
• substantial changes in credit volume and asset

prices;
• large scale balance sheet problems (of firms,
households, financial intermediaries and/or
sovereigns);
• severe disruptions in financial intermediation and
the supply of external financing;
• large scale government support (liquidity support,
recapitalization).
3
Factors driving financial crises
• fundamenal factors (macroeconomic imbalances,
internal or external shocks)
• ”irrational” factors:
✓runs on banks (a large number of depositors
simultaneously withdraw their money from
banks)
✓contagion and spillovers among financial markets
✓assets busts (a rapid drop in assets prices)
✓credit crunches (a sudden reduction in the
availability of credit or tightening the conditions
to obtain a credit)
✓fire-sales (selling assets at a very low price to
obtain cash to pay off the debts)
4
Types of financial crises
• currency crises
• sudden stops (capital account crises
or balance of payments crises)
• debt crises
• banking crises
7
A currency crisis - definition
a speculative attack of foreign capital on the

domestic currency resulting in:
• a devaluation (or sharp depreciation), and
• CB interventions on the forex market by:
• selling large amount of international
reserves, or
• sharply raising interest rates, or
• imposing capital controls.
8
First generation models of currency crises
• Krugman (1979), Flood and Garber (1984) => “KFG”
models.
• Examples: Latin America 1980s, Argentina 2001,
Ireland 2007
• A fundamental inconsistency in domestic policies:
expansionary fiscal policy and a fixed exchange rate.
• Expansionary fiscal policy => fiscal deficit =>
inflation => domestic currency depreciates =>
outflow of foreingn capital => CB foreign exchange
interventions => loss in foreign reserves =>
speculative attack => accelerates and deepens the
currency collapse.
• Crisis is inevitable!
9
Second generation models of currency crises
• Obstfeld and Rogoff, 1986
• Examples: ERM 1992/93, Hong Kong 1998
• Crisis is not inevitable!
• Currency crisis is a result of a speculative attack that depends
on investors' expectations as to whether the government will
be willing to defend or give up the fixed exchange rate:
✓A good equilibrium: investors believe that the government
will keep the fixed exchange rate (benefits > costs) => no
speculative attack => no crisis.
✓A bad equilibrium: investors believe the government will
give up the fixed exchange rate (costs of defending the peg
harmful for the economy) => speculative attack =>
government fulfills investors' expectations by abandoning
the peg => a self-fulfilling crisis.
10
Third generation models of currency crises
• Examples: East-Asia 1997, Mexico 1994, Russia

1998, South America 1999-2001, Turkey 2001
• Eclectic and heterogeneous nature of the crises
• Multiple causes of crises:

➢institutional and structural weaknesses
➢information asymmetry and its consequences
➢balance-sheet mismatches in the private sector
➢psychology of investors’ behavior
11
Institutional and structural weaknesses
• premature and/or poorly sequenced financial

liberalization
• weak (or lack of) government safeguards
• ineffective banking supervision
• formal or informal government guarantees to
cover private sector losses („too big to fail”
problem)
• crony capitalism
• lack of bankruptcy law
12
Information asymmetry
and market inefficiency
• Adverse selection: when information

asymmetry exists, banks make an inefficient
allocation of credit in the economy.
• Moral hazard: taking excessive risks on behalf

of someone else (e.g. under actual or
potential government guarantees).
13
Balance sheet mismatches
• Currency mismatches => exchange rate risk

➢banks/companies borrow in foreign
currencies and lend/earn in domestic
currency
• Maturity mismatches => liquidity risk

➢companies finance long-term projects with
short-term loans
➢banks take short-term deposits (liabilities)
and grant long-term credits (assets)
14
Psychological causes of currency crisis
• Panic
• Mood swings (market sentiment: bullish,
bearish)
• Contagion, domino effect: transmission of
crises across financial markets (due to panic,
loss in confidence, risk aversion, etc.)
• Herd behavior: mechanically imitating the
behavior of other investors to avoid losses
that would be inevitable if they acted
„against the market”.
15
Symptoms of Currency Crises
• An exchange rate depreciation is more than 15
percent per year (Rogoff, Reinhart)
• An exchange rate depreciation is of at least 25
percent cumulative over a 12-month period, and
at least 10 percentage points greater than in the
preceding 12 months (Frankel, Rose)
• Speculative pressure index (a weighted average of
changes in the nominal exchange rate,
international reserves and interest rate) exceeds
the standard deviation by 1.5 times of its overall
mean (Eichengreen, Rose, Wyplosz)
16
A sudden stop = capital account
crisis = balance of payments crisis
• a large (and often unexpected) fall in

international capital inflows
or
• a sharp reversal in capital flows to a country
(and a sharp rise in the country’s credit
spreads).
17
Causes of Sudden Stops
• Usually caused by international factors (e.g.
changes in international interest rates or
spreads on risky assets).
• more likely to happen in countries with:

• large cross-border financial linkages
• large foreign exchange liabilities
• large balance sheet mismatches
• relatively small tradable sectors relative to
domestic absorption
• may have adverse implications for a real

economy (a fall in credit => output contraction).
18
Symptoms of Sudden Stops
• One or more year-on-year fall in capital flows are
at least two standard deviations below its mean.
• Crisis starts (ends) when the annual change in

capital flows falls (exceeds) one standard
deviation below (above) its mean.
• Systemic sudden stop: large reversals in capital

flows coincide with output collapses.
19
A debt crisis - definitions
• A foreign debt crisis: a country stops
servicing its foreign debt obligations (public
or private or both).
• A domestic public debt crisis: a government

does not honor its domestic fiscal obligations
in real terms, either by:
• defaulting explicitly
• inflating or otherwise debasing its
currency
• employing some other forms of financial
repression. 20
Domestic public debt crisis
•Currency debasement: lowering the actual (real)
value of domestic currency by:
• reducing the metal content of coins or switching to
another metal
• printing additional paper money or creating
electronic money
=> INFLATION: reduces the real value of government debt
•Financial repression: policy that results in savers

earning returns below the rate of inflation
21
Types of Foreign Debt Crises
• Illiquidity crises (short-term)
• Insolvency crises (long-term)
Causes of illiquidity crises:
• maturity or currency balance sheet mismatches
• increase in international interest rates
• deterioration in terms of trade
• decline in world demand for the debtor’s country
exports
• appreciation of a foreign currency in which debt
is denominated
• sudden stops in capital flows or capital flight
22
Causes of insolvency debt crisis
• Inefficient use of foreign credits:

✓imports of consumption or military
goods
✓non-industrial or inefficient
investment
• embezzlement of foreign credits by

despotic regimes (illegitimate or
odious debt)
23
Foreign Debt Crises: Solutions (1)
• Solutions to illiquidity crises:
• debt standstill or moratorium
• debt rollover
• debt rescheduling
• liquidity financing
• Solutions to insolvency crises:

• debt repudiation
• debt forgiveness
• debt or debt-service reduction
24
• Debt standstill or debt moratorium: a temporary
suspension of debt service payments falling due within
a given period.
• Debt rollover: extension of credit: upon repayment

funds are relent to the same borrower for similar
purposes.
• Debt rescheduling: a change of the terms and

conditions of the existing debt contract, including:
• extending repayment periods,
• extending grace periods for the repayment of
principal,
• fixing the exchange rate at favourable level for
foreign currency debt,
• rescheduling the payment of arrears,
• reductions in the contractual interest rate. 25
• Debt repudiation: a sovereign refuses to
honor its debt obligations (e.g. Mexico in
1861, the Soviet Union in 1918, Argentina in
2001).
• Possible creditors’ reaction to repudiation:
- cutting off access to capital markets
(including trade credits)
- trade sanctions (on imports from the
debtor country)
- seizure of the debtors’ assets abroad
26
• Debt restructuring: a settlement between a
debtor and its creditors that alters the
terms of servicing an existing debt and
provides some relief in repayment. It takes
the forms of:
• debt rescheduling
• debt refinancing
• debt forgiveness (reduction)
• debt conversion
• new lending
27
• Debt refinancing: replacement of an existing debt
instrument, including arrears, with a new debt
instrument.
• Debt forgiveness: the voluntary cancellation of all or
part of a debt obligation within a contractual
arrangement between a creditor and a debtor.
• Debt conversion (swaps) are exchanges of the existing
debt for:
• a new debt (debt-to-debt swaps)
• equity (debt-for-equity swaps)
• exports (debt-for-exports swaps)
• domestic currency (to be used for development
projects in the debtor country).
=> Debt conversion results in debt reduction or debt-

service reduction.
28
Symptoms of Sovereign Debt Crises
• Debt crisis starts with:
• default on payments
• increase in sovereign bonds’ spreads
(indicates probability of default)
• Debt crisis is over when a country:

• regains access to private capital markets
• regains a certain credit rating
29
A banking crisis - definition
• actual or potential bank runs that force
banks to suspend repayment of their
liabilities (illiquidity or insolvency), or
• compel the government to intervene to

prevent this to happen by extending
liquidity and capital assistance on a large
scale.
30
Causes of Banking Crises
• Banking crises occur due to:
• bank runs or banking panics

• moral hazard (caused by government’s
bailout guarantees)
• poor regulation and supervision
• ‛connected lending’
• a sharp increase in non-performing loans
• a sharp decrease in bank’s asset value
31
Symptoms of Banking Crises
• A combination of events:
• runs on several banks
• forced closures, mergers, or government

takeover of many financial institutions
• government support to one or more

financial institutions
32
Implication of Financial Crises
• Financial:
✓a sharp decline in assets prices
✓a sharp drop in supply of credit
• Real:
✓large output losses and significant
declines in consumption, investment,
employment, exports and imports, etc.
✓recessions worse than “normal” business
cycle recessions
✓high fiscal costs of resolving banking
crises
✓an increase in public debt 33
Early Warning Indicators of Financial Crises:
• rapid growth in credit and assets prices
• a rise in the money (M2) multiplier
• a high ratio of broad money (M2) to international
reserves
• substantial short-term debt coming due
• rapid real exchange rate appreciation
• a large current-account deficit relative to GDP and
investment
• a high ratio of short-term capital flows to GDP
• deterioration in the terms of trade
• shocks to world interest rates and commodity prices 34
Open Economy
Macroeconomic Policy
(IS-LM-BP Analysis)
Lidia Mesjasz, PhD

OUTLINE
• Goals of economic policy (internal and

external)
• Deriving IS, LM and BP curves
• Macroeconomic equilibrium
• Role of capital mobility
• Economic policy with fixed exchange rates
• Economic policy with floating exchange rates
2
Macroeconomic equilibrium
• Equilibrium in goods market (IS curve)
• Equilibrium in money market (LM curve)
• Equilibrium in balance of payments (BP
curve)
=> IS-LM-BP analysis (Mundell-Fleming model)
3
IS curve is downward sloping
Suppose, ROI ↑ => I ↓, Y ↓
R
IS
4
Factors that determine the position of
IS curve
Suppose, consumers’ confidence falls => C↓, Y↓
R
B A
IS
IS’
Y
5
IS curve (cont.)
• Suppose, domestic prices fall compared to foreign
prices => M↓, X↑, Y↑
R
A B
IS’
IS
Y
6
LM curve is upward sloping
Suppose, Y↑ => MD↑ => ROI ↑
ROI MS
ROI
LM
I2 B I2 B
A
I1 I1
A MD’
MD
Money market Y
Y1 Y2
7
LM curve
Suppose MS↑ => RoI↓ => LM curve increases
ROI MS MS1
ROI
LM
LM1
A
A
B
MD B
Money market Y
Y1
8
BP curve
• Balance of payments is in equilibrium when:

– CA deficit = KA surplus, or
– CA surplus = KA deficit, and
– OSB = zero
In other words,
- CA deficit + KA surplus = zero, or
- CA surplus + KA deficit = zero, and
- OSB = zero
9
BP curve is upward sloping
Suppose, Y↑ => M↑ => CA deficit↑ or CA surplus↓
=> ROI↑
R
BP
I1
C
A
I0 B
Y
Y0 Y1
10
BP curve At point B:
- KA not changed
What can we say about BP at points B and C? - CA deficit ↑ or
- CA surplus ↓
- CA deficit + KA surplus
R
BP is a negative number or
Surplus - CA surplus + KA deficit
I1
C
is a negative number
- BP deficit
I0 A B Deficit At point C:
- CA not changed
- KA surplus ↑or KA
deficit ↓
-CA deficit + KA surplus
is a positive number or
Y - CA surplus + KA deficit
is a positive number
Y0 Y1
- BP surplus
11
Capital mobility and BP curve
Low capital mobility High capital mobility

R R
BP
C
BP
C
A B A B
I1 I1
Y1 Y2 Y Y
Y1 Y2
12
Perfect capital mobility and BP curve
BP
13
Macroeconomic equilibrium
R BP R LM
LM
BP
A
A
IS IS
Y Y
Low capital mobility High capital mobility
14
Economic Policy
under Fixed Exchange Rates
1. Perfect capital mobility
Fixed exchange rate
Monetary policy - expansionary
R
LM 1
LM 2
A
R1 BP
IS
Y1 16
2. Low capital mobility
Fixed exchange rate
R BP
LM 1
A
R1 LM 2
B
R2
IS
Y1 Y2 17
Fixed exchange rate
Fiscal policy - expansionary
R
LM 1
LM 2
A
C
R1 BP
IS 2
IS1
Y1 Y2 18
4. Very low capital mobility
Fixed exchange rate
R BP
LM 2
C
LM 1
A B
R1
IS2
IS1
Y1 Y2 19
Economic Policy
under Floating Exchange Rates
R LM 1
LM 2
A C
R1 BP
IS2
IS 1
Y1 Y2 21
R BP1
BP2
LM 1
A
R1 LM 2
C
B
IS 2
IS1
Y
22
R
LM 1
A
R1 BP
IS 2
IS1
Y 23
R BP1
BP2
LM 1
C
A B
R1
IS3
IS 2
IS1
Y 24
5. High capital mobility
R LM1
B BP2
C BP1
A
R1
IS 2
IS3
IS1
Y 25
Real-income effects of economic policies
• With fixed exchange rates:
– Monetary policy doesn’t work
– Fiscal policy always work (but it works best when
capital mobility is high)
• With flexible exchange rates:

– Monetary policy always works
– Fiscal policy works or not depending on the
degree of capital mobility.
26

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ARGUMENTS FOR

 Economic theory says that governments

 The degree of free trade or protectionism

 Trade policy can offset domestic market failures

 Domestic market failure should be corrected by

 Cut wages: 1.„first best solution”

US labor market is inflexible, so this may not resolve the problem.

 A domestic subsidy to car producers: 2.„first best

 An import quota on cars: „second best solution”

 However, the cost of an import quota is less visible

Most trade policy instruments are adopted

 A large country may be able to gain from an import

 A large country may also be able to gain from an

E.g. Saudi Arabia as an oil exporter can increse its

 Small countries have no ability to affect

 Terms of trade argument is a beggar-my-

 If the partner country retaliates with a tariff,

Validity of the argument:

 Difficult to identify industries that are truly infant and likely to

 What is a proper form of protection? (production subsidy vs. tariff)

 Why cannot a firm expand on its own by borrowing funds from

 It is uncertain if aggregate employment will increase as

 Retaliatory tariffs are imposed by trading partners.

 Home currency appreciates (foreign currency depreciates due to

 Expansionary monetary and fiscal policy might accomplish the

Validity of this argument:

 A tariff is not the best method of increasing

 An antidumping duty can offset the foreign firm’s unfair

 Protection is valid with predatory dumping that causes

 In practice it’s difficult to identify the immediate

 A countervailing duty (CVD) should be imposed to

 If a subsidy allows the firm to export the good in

 Although the scare factor gains from a tariff, the

 A direct transfer of income by taxing the abundant

 It’s not easy to identify which industries are vital to

 Other instruments of protection are superior to

 Full self-sufficiency might not be rational provided

=> A tariff may not imporove the balance of trade, IF:

Trade deficit (X < M) occurs when Y < (C + I + G)

 Solution: increase income and/or cut spending

 Devaluation (or depreciation) of the home currency

 Two kinds of market failures in advanced countries:

 inabilityof firms in high-technology industries to

 presence of monopoly profits in highly

 Government intervention in trade to overcome the

 Firms that invest in new technologies

 Due to technological spillover, incentives to

 There is a good reason to subsidize high-

 Isthe government policy able to target

 How much subsidy is justified? (externalities

 Some externalities may spill over to other

 An international competition over who gets these

 By subsidizing domestic firms the government may

 If a domestic subsidy deters foreign competitors,

 Market size for aircrafts is limited to allow both firms

 Each firm’s decision whether to produce a new

• In a simultaneous game theoretic set-up: Two Nash-equilibria

• One Nash-equilibrium: Airbus serves market as a

 Suppose, instead of symmetric pay-offs (scenario A)