An Introduction To International . - The World Economy

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An Introduction to International Economics:New Perspectives on the World EconomyKenneth A. ReinertCambridge University Press 2021Instructor’s Manual forAn Introduction to International Economics:New Perspectives on the World EconomyKenneth A. [email protected] 2021 Cambridge University PressVersion: November 11, 2020

2021 Cambridge University PressContentsNote to the InstructorSuggested Chapter Use by Program1 IntroductionPART I: INTERNATIONAL TRADE2 Absolute Advantage3 Ricardian Model of Comparative Advantage4 Hecksher-Ohlin Model of Comparative Advantage5 Intra-Industry Trade6 The Political Economy of Trade7 Trade Policy Analysis8 The World Trade Organization9 Preferential Trade AgreementsPART II: INTERNATIONAL PRODUCTION10 Multinational Enterprises and Foreign Direct Investment11 Global Value Chains12 Engaging International Production13 MigrationPART III: INTERNATIONAL FINANCE14 Accounting Frameworks15 Global Capital Flows16 Exchange Rates and Purchasing Power Parity17 Flexible Exchange Rates1

2021 Cambridge University Press18 Fixed Exchange Rates19 International Monetary System20 Crises and Responses21 Monetary Unions22. Growth in the Open Economy2

2021 Cambridge University PressNote to the InstructorAn Introduction to International Economics introduces the student or professional readerto the basic concepts of international trade, international production, and internationalfinance. Its only prerequisite is an introductory-level understanding of micro-economics.The book draws upon principles-level concepts such as the circular flow diagram, thesupply and demand model, the production possibilities frontier, and the value chain, eachof which is developed using real-world examples. These basic concepts should be familiarto nearly all readers.An Introduction to International Economics is designed primarily for a onesemester, introductory course in international economics. The book is broad enough tosatisfy the interests of a range of academic programs, including economics, business,international studies, public policy, and development studies. Also, despite itsintroductory-level nature, An Introduction to International Economics covers some oftenneglected, but important topics in international economics. These include intra-industrytrade, intra-firm trade, foreign market entry, global value chains, and migration. The bookalso covers two the major institutions of the world economy in an historical perspective:the World Trade Organization and the International Monetary Fund.This instructor’s manual is designed to help you to teach a one-semester course thatintroduces the student to international economics, including international trade,international production, and international finance. In what follows, we take up each partof the book and each chapter within each of the three parts. We provide chapter objectives,teaching notes, and answers to the review questions.For past users of An Introduction to International Economics, there have beensignificant changes in this second edition in response to numerous referee reports fromboth users and non-users. A few development-related chapters have been removed due toa lack of interest among instructors. The comparative advantage chapter has been split intwo, one on the Ricardian model and a second on the Heckscher-Ohlin model. The chapterson international production have been consolidated into one fewer. A new chapter onglobal capital flows has been included. Overall, the book is more compact and actually lesscostly for your students than the previous edition.3

2021 Cambridge University PressIn teaching a survey course of this kind, there will be a few places where you findyourself outside of your comfort zone. One source that might be helpful to you is ThePrinceton Encyclopedia of the World Economy (Princeton University Press, 2009), a 2volume set that covers a vast array of topics in an accessible manner. Each entry containsan annotated list of references.The book’s web-site is http://iie.gmu.edu. Please contact Kenneth Reinert [email protected] if you have any questions, comments, or ideas concerning the textbookor instructor’s manual. Every effort will be made to address your reactions is subsequenteditions and on the website.4

2021 Cambridge University PressSuggested Chapter Use by ProgramChapterEconomicsBusiness1 IntroductionXPart I International Trade2 Absolute Advantage3 Ricardian Model of ComparativeAdvantage4 Heckscher-Ohlin Model ofComparative Advantage5 Intra-Industry Trade6 The Political Economy of Trade7 Trade Policy Analysis8 The World Trade Organization9 Preferential Trade AgreementsPart II International Production10 Multinational Enterprises andForeign Direct Investment11 Global Value Chains12 Engaging InternationalProduction13 MigrationPart III International Finance14 Accounting Frameworks15 Global Capital Flows16 Exchange Rates and PurchasingPower Parity17 Flexible Exchange Rates18 Fixed Exchange Rates19 The International MonetarySystem20 Crises and Responses21 Monetary Unions22 Growth in the XXXXXXXXXXXXXXXXXXXXX5

2021 Cambridge University PressCHAPTER 1IntroductionChapter ObjectivesMany students will come to your course with a general interest in “globalization” or “theworld economy.” The purpose of Chapter 1 is to build on these interests and tocommunicate some empirical realities for the student to consider. The chapter alsointroduces the student to the three realms of international economics, namely: internationaltrade, international production, international finance, and international development. As aninstructor, you have your own interests, views, and important information concerning thesetopics. I invite you to view Chapter 1 as a complement to your own agenda and encourageyou to bring your own cases, concerns, and anecdotes to the class session related to Chapter1. Students will greatly appreciate this.The chapter also begins to introduce the student to a set of concepts that areimportant to his or her understanding of international economics. These includeinternational trade, trade in services, international production, foreign direct investment,multinational enterprises, international finance, balance of payments, and internationaldevelopment. Each of these will be developed in more detail in subsequent chapters, butan initial introduction to these concepts is helpful.The chapter introduces the student to concerns outside of the typical realms oninternational economics. These include culture, the environment, politics, and technology.They are introduced using the abbreviation CEPT for students to better retain theseconcepts.Finally, the chapter introduces the student to the analytical elements used insubsequent chapters. These include: countries, sectors, tasks, firms, factors of production,currencies and financial assets. They are used in different combinations in subsequentchapters.Because the second edition of the book went into press before the COVID-19pandemic struck. It will be important for you to address this in class and to let the studentsknow that many of the data series presented in Chapter 1 were altered significantly by thepandemic.6

2021 Cambridge University PressChapter OutlineInternational TradeInternational ProductionInternational FinanceImpacts on International DevelopmentLarger RealmsBox: ICT in the World EconomyAnalytical ElementsConclusionTeaching NotesThe chapter tries to arm you with some basic data related to globalization in the areas oftrade, production, and finance. As new data become available, updates will be posted onthe book’s website (iie.gmu.edu). In my experience, the class session devoted to Chapter 1will elicit a number of reactions from the students, including both comments and questions.This is a good time to foreshadow future topics and chapters on your syllabus: “That is anissue we will take up when we discuss .”This is also an important time to orient students towards fundamental concepts ininternational economics. For example, many students cannot distinguish betweeninternational trade and foreign direct investment or between international trade (theexchange of merchandise and services) and international finance (the exchange of assets).It is probably a good idea not to over-estimate your students’ understanding of these keyconcepts. It is not unusual, for example, for students to think that foreign direct investmentis equivalent to international trade.The chapter also stresses the potential for the realms of trade, production, andfinance to be inter-related. Your own personal take on this would be very helpful to yourstudents. While there are a few examples in the chapter, hearing about an additionalexample from you will be very important to the students. This is particularly important inthe areas of culture, the environment, politics, and technology (CEPT) and can be tailoredto your program.Finally, the analytical elements can be a useful tool to orient students to yourcourse. Defining each of these carefully will be beneficial for many of them. For example,a careful definition of an asset is illuminating.Comments on Review Exercises1. Why are you interested in international economics? What is motivating you? How areyour interests, major, or profession affected by the world economy?For smaller classes, this can be used for classroom introductions and discussion. Ifyour class in online, this can be part of an initial discussion board thread.7

2021 Cambridge University Press2. What are the three realms of the world economy addressed in this book? Define eachof them carefully.International trade, international production, and international finance. This seemsperhaps trivial, but many students will benefit from spending time on these distinctions.3. What is the difference between trade in goods and trade in services?Trade in goods involves tangible and storable items (things you can drop on your toe),while trade in service involves intangible and non-storable items (things you cannotdrop on your toe). Note that Chapter 8 goes into specific categories of trade in services.4. What is the difference between international trade and foreign direct investment?International trade involves the cross-border exchange of goods and services, whileFDI consists of the ownership (of over 10 percent) of a foreign firm. FDI can influencetrade substantially but is a separate process. This is a key distinction that is often loston students.5. What is the difference between international trade and international finance?International trade involves the cross-border exchange of goods and services, whileinternational fiancé involves the cross-border exchange of assets. The exchange ofassets is the defining feature of international finance (and the capital account) asopposed to international trade (and the current account).6. Identify one way in which the activities of international trade, finance, and productioncould positively contribute to international development. Identify one way in whichthese activities could negatively contribute to international development. How couldyou demonstrate that the activities have either a positive or negative impact ondevelopment?This question is very open-ended, but important. The question also gets to the issue ofindicators and is worth classroom discussion. FDI that transfers technology couldcontribute to development. Primary product trade in the face of declining commodityprices could have a negative impact on development.7. Take a look at the websites of major venues of the global business/financial press suchas The Economist and the Financial Times. Spend a little time browsing.This is more important than it looks. Having the students understand that there areimportant venues for discussion of economics, financial, and business issues in theworld beyond Google searches is helpful for students.8

2021 Cambridge University PressPart IInternational Trade9

2021 Cambridge University PressCHAPTER 2Absolute AdvantageChapter ObjectivesThe purpose of this chapter is to start the student thinking about international trade withinthe comfort zone of the supply and demand model. The chapter initially defines absoluteadvantage in a way that will help transition to the Ricardian model of comparativeadvantage in Chapter 3. It then considers absolute advantage in the supply and demandmodel. This helps the student to visualize imports as an excess demand (shortage) at worldprices and to visualize exports as an excess supply (surplus) at world prices. It will alsohelp the student to visualize an adjustment of world prices to bring about equilibrium wherethe excess demand (imports) and excess supply (exports) for a particular good are equal.The student will understand the notion of the “gains from trade.” Changes in quantitiessupplied in the movement from autarky to trade are also an opportunity to give an initialsense of the political economy of trade. Throughout, there is an emphasis on trade arisingfrom differences on the supply sides of the countries of the world.Analytical elements for this chapter:Countries, sectors and factors of production.Chapter OutlineDefining Absolute AdvantageBox: Robot Kingdom: Japan’s Advantage in Industrial RobotsAbsolute Advantage in Supply and DemandBox: Rare Earth ElementsGains from TradeLimitationsBox: Illicit TradeConclusionAppendix: Review of Supply and Demand10

2021 Cambridge University PressTeaching NotesAs stated above, the purpose of this chapter is to start the student thinking aboutinternational trade within the comfort zone of the supply and demand model. Two caveatsare in order here, however. First, you should not assume that the students remember thesupply and demand model. A quick review of the model (movement along curves vs. shiftsof the curves) is in order, and the students will be grateful to you if you take the time to dothis. You can point them to the appendix here. Second, it is important to emphasize to thestudents that the absolute advantage model of this chapter describes only a tendency.Actual trade patterns are determined by comparative advantage as discussed in Chapters 3and 4.That said, emphasize to the students that the absolute advantage model is used bytrade policy analysts in anti-dumping and countervailing duty cases (discussed in Chapter7), particularly where the product category involved is narrow. They are learningsomething practical!The absolute advantage model also helps the student to understand the gains fromtrade using consumer surplus and producer surplus. Again, do not assume the studentsremember these concepts. Take a few minutes to review the concepts, and the students willbe appreciative. Be sure to emphasize that the gains from trade are mutual. Students areused to thinking in terms of zero-sum games, and the potential mutual benefits of trademight be new to them. That said, if you are teaching in a developments studies program,mentioning how colonial trading relationships obviated mutual gains from trade might beimportant.This chapter contains a box on “Japan’s Advantage in Industrial Robots.” For yourclassroom preparation, it would be helpful for you to prepare a “box” of your own onabsolute advantage in an area in which you have some knowledge and interest. It wouldalso be useful for you to prompt the students to think of their own examples. The chapteralso contains a box on “Rare Earth Elements,” which have been very newsworthy. Thisexample relates to “realist” trade policies discussed in Chapter 6.There is also a third box on “Illicit Trade.” This is a very active area of researchacross many disciplines, from economics to criminology. This is an opportunity to discussthe presence of illicit activities in the global economy and to note limits to the gains fromtrade concept.To shift the students from a passive to an active mode, have them develop their owndiagrams, like those of this chapter, for two countries and a good for which they have someknowledge. If you want to push them a bit further, have then consider an increase in supplyin the exporting country and explain how this affects the equilibrium world price of thegood.11

2021 Cambridge University PressComments on Review Exercises1. Use Figure 2.5 in the appendix to consider the following changes: a fall in incomes dueto a recession; an increased preference for rice consumption; an increase in input pricesfor rice production; and an improvement in rice production technology. Use diagramsto analyze the effects of these changes on equilibrium price and quantity.The fall in income shifts the demand curve to the left; the increased preference for riceconsumption shifts the demand curve to the right; the increase in input prices for riceproduction shifts the supply curve to the left; and the improvement in rice productiontechnology shifts the supply curve to the right.2. Create an example of an absolute advantage model by choosing two countries and a singleproduct.a. Draw a supply and demand diagram describing autarky and a pattern of absoluteadvantage for your example.b. Show the transition from autarky to trade in your diagram, label the trade flows, anddemonstrate the gains from trade.c. In a new diagram, and starting from a trading equilibrium, show what would happento the world price if income increased by exactly the same, small amount in bothcountries.This question can be done as an in-class exercise to shift the students from passive toactive mode. In “c,” when income increases by exactly the same, small amount in bothcountries, exports in one country will fall, and imports in the other country will rise. Thiswill cause global excess demand, so the world price needs to rise to bring the market backinto equilibrium.3. Can you recall from introductory microeconomics the nations of the price elasticity ofdemand and price elasticity of supply? If so, can you say what would happen to the gainsfrom trade as supply and demand in Vietnam and Japan become more and more inelastic?Inelasticity of the supply and demand curves tends to shrink the gains from trade trianglesB and D in Figure 2.4.12

2021 Cambridge University PressCHAPTER 3The Ricardian Model of Comparative AdvantageChapter ObjectivesThis chapter introduces the student to the concept of comparative advantage using theRicardian model and its linear production possibilities frontier (PPF). The concept isintroduced using the example of trade in rice and motorcycles between Vietnam and Japan.Later in the book (in Part II), the motorcycle example will be extended to foreign marketentry via foreign direct investment. The chapter describes a chain of determination fromsupply-side characteristics, to a pattern of comparative advantage, to a pattern of trade andthe gains from trade. Going through this chapter slowly is very important for your studentsand for your relationship to them. This chapter can be quite challenging to the averagestudent, and they will need your help here. Don’t assume that the students remember thePPF from their introductory microeconomics class. Even if they do, the use of relativeprices in the chapter (covered in the appendix) will probably be new for them.Analytical elements for this chapter:Countries, sectors and factors of production.Chapter OutlineFrom Absolute Advantage to Comparative AdvantageAutarky and Comparative AdvantageBox: Ricardo’s Larger ProjectInternational TradeGains from TradeAppendix: The Production Possibilities FrontierErratumThere is a mistake in Figure 3.5 that has been corrected in the PowerPoint slides oniie.gmu.edu. The correct figure is on the next page.13

2021 Cambridge University PressTeaching NotesIntroducing the student to comparative advantage is not easy. The concept is perhaps themost important thing they will take away from your course, but appreciating it requires adegree of comfort with production possibility frontiers. The appendix will help here, butyou need to emphasize that the linear PPFs in this chapter are a special case of what iscovered in the appendix.To make things easier, this text does not use indifference curves, which some students willnever have seen. Instead, the text utilizes a demand diagonal line. Emphasize two thingshere: 1. the line is not the demand curve (it has the symbol DD and not D and slopes upand not down) and 2. the line is not necessarily a 45 degree line.In the end, the most important insight from this chapter is given in a box:Differences in technology-determined supply conditions among thecountries of the world give rise to complementary patterns of comparativeadvantage. These patterns of comparative advantage, in turn, make possiblecomplementary patterns of international trade.Then, let the student know that, in order to understand supply conditions, she mustunderstand PPFs, a concept they learned in introductory economics. Next, for moststudents, a visit to the appendix under your guidance is in order. It might seem like a wasteof time to you, but they will appreciate your taking the time! A key concept to keepreinforcing is that the slope of a PPF gives the opportunity cost of the good on thehorizontal axis. Relate this opportunity cost to the relative price of the good on thehorizontal axis.14

2021 Cambridge University PressWith the PPF in hand, you can begin to lead them through the body of the chapterusing the Vietnam-Japan example or one of your own choosing. What you arecommunicating to the student is the following:Supply-side technology characteristics Pattern of comparative advantage Pattern of trade Gains from trade.Note, if you feel you are losing your students, acknowledge that they might be outof their comfort zone in this chapter (some students will be). You can encourage them withcomments like, “This is what Ph.D. trade theory students do, and you are doing it!”Don’t get lost in the algebra. Keep coming back to the concept of opportunity costas reflected in the slope of the Ricardian PPF.Comments on Review Questions1. What is the difference between absolute and comparative advantage?Absolute advantage involves only one product and the comparison of only two autarkyprices. Comparative advantage involves two products and, therefore, the comparisonof four autarky prices in the form of relative prices. Comparative advantage is depictedusing production possibilities frontiers, which allow for two goods, rather than supplyand demand diagrams, which only allow for one good.2. Create an example of a comparative advantage model by choosing two countries and twoproducts.a. Draw a diagram describing autarky and a pattern of comparative advantage for yourexample.b. Show the transition from autarky to trade in your diagram, label the trade flows, anddemonstrate the gains from trade.This question can be done as an in-class exercise to shift the students from passive toactive mode. In “b,” students can have a difficult time identifying the trade flows, andoften can mistakenly measure them using the autarky point, which is no longer relevantunder trade. Assistance might be necessary here.3. Think about the movements along the PPFs in Figure 3.4 from points 𝐴 to 𝐵. What isactually happening in these economies to allow these specialization processes to takeplace? Are there any institutional realities that you can think of that would get in the wayof these specialization processes?15

2021 Cambridge University PressParticularly given ongoing concerns about international trade and its impacts ondomestic markets, this is a relevant question. Emphasize that smooth adjustment is notusually possible, and that labor needs to move from one sector to another, losing one joband seeking and hopefully finding another. These issues will be considered again inChapter 6 on the political economy of trade.16

2021 Cambridge University PressCHAPTER 4The Heckscher-Ohlin Model of Comparative AdvantageChapter ObjectivesThis chapter builds on Chapter 3 but shifts the focus from technology in the Ricardianmodel to factors of production in the Heckscher-Ohlin model. It also sets the stage for theuse of the Heckscher-Ohlin model in Chapter 6 on the political economy of trade. It triesto communicate that we should take an eclectic approach to comparative advantage,understanding that it can be based both on technology differences among the countries ofthe world and on factor endowment differences among countries. The commondenominator here is a focus on the supply side of global markets.The chapter also introduces two empirical measures used extensively in trade policyanalysis, revealed comparative advantage (text box) and the gravity model (appendix). Thiswill be relevant for some courses of study.Analytical elements for this chapter:Countries, sectors and factors of production.Chapter OutlineFactors of ProductionFrom Factor of Production to Comparative AdvantageInternational TradeBox: Revealed Comparative AdvantageGains from TradeFDI, Migration and Comparative AdvantageLimitationsBox: Comparative Advantage and the EnvironmentAppendix: The Gravity Model17

2021 Cambridge University PressTeaching NotesHaving taught this material at a much more advanced level than presented in this chapter,I know that even Ph.D. students in Economics sometimes have difficulty conceptuallyseparating out the notions of factor endowments and factor intensities. For this reason, itwill be important for you to emphasize the following visual association for your students:Factor endowments CountriesFactor intensities SectorsWithout this association, sorting out the Heckscher-Ohlin model becomes difficult.Return to this visual as often as necessary.You can then set the stage with the boxes from the end of the chapter. The purposeof the chapter is to understand that there are two sources of comparative advantage:Ricardian model: Differences in technology-determined supply conditionsamong the countries of the world give rise to complementary patterns ofcomparative advantage. These patterns of comparative advantage, in turn,make possible complementary patterns of international trade.Heckscher-Ohlin model: Differences in factor endowments among thecountries of the world give rise to complementary patterns of comparativeadvantage. These patterns of comparative advantage, in turn, make possiblecomplementary patterns of international trade.From here, you can work through the rice-motorcycles example of the chapter orone of your own choice. You will need to emphasize that, in this chapter, the opportunitycosts are increasing rather than constant, and that these increasing opportunity costs arewhat give the PPF its “normal” shape. This property of the PPFs is also what makesspecialization of production incomplete, rather than complete in the Ricardian model.Spending a bit of time on revealed comparative advantage will let the students knowthat trade theory carries over into empirical practice. Mentioning or covering the gravitymodel discussed in the appendix will also help students understand that there are importantempirical aspects to trade theory.Throughout, keep referring Figure 4.3 as yet another visual for what is going on inthis chapter. Figure 4.3 will be taken up again in Chapter 6 on the political economy oftrade where it will be expanded. It is therefore a good touchstone for the students in thispart of the course.18

2021 Cambridge University PressComments on Review Questions1. Create an example of a comparative advantage based on factor endowment bychoosing two countries, two products, and two factors of production. Make one of thefactors labor.a. Draw a diagram describing autarky and a pattern of comparative advantage foryour example.b. Show the transition from autarky to trade in your diagram, label the trade flows,and demonstrate the gains from trade.This question can be done as an in-class exercise to shift the students from passiveto active mode. In “b,” students can have a difficult time identifying the trade flows,and often can mistakenly measure them using the autarky point, which is no longerrelevant under trade. Assistance might be necessary here.2. For your example in Question 1 above, and in words, take yourself through thelogic of Figure 4.3. Do this for both countries, describing endowments, comparativeadvantage, the patterns of trade, and specialization in production.This can continue as a class exercise and helps to develop the intuition of Figure4.3. Having the students translate their graphs into words here will be helpful indeveloping intuition.3. For your example in Questions 1 and 2 above, use the autarky PPF diagrams todescribe how migration from the relatively labor abundant country to the relativelylabor scarce country will impact the PPFs of the two countries and their autarkyprice ratios.This question is an opportunity to give students an understanding of shifts of PPFsresulting from changes in factor endowments. It also gives a sense that factorendowments and, therefore, patterns of comparative advantage are not fixed for alltime but respond to economic changes.19

2021 Cambridge University PressCHAPTER 5Intra-Industry TradeChapter ObjectivesThe purpose of this chapter is to introduce the student to the important difference betweeninter-industry trade and intra-industry trade, a topic neglected in some internationaleconomics textbooks. Motivate your students by letting them know that they are about tounderstand and important topic regarding patterns of trade in the world economy. Alsomotivate them by letting them know that this is a topic considered to be important by “real”trade policy analysts (no exaggeration here). Students like to know they are gettingsomething special.The chapter makes an important distinction between horizontal intra-industry tradeand vertical intra-industry trade. The latter is a l

1 Introduction PART I: INTERNATIONAL TRADE 2 Absolute Advantage 3 Ricardian Model of Comparative Advantage 4 Hecksher-Ohlin Model of Comparative Advantage 5 Intra-Industry Trade 6 The Political Economy of Trade 7 Trade Policy Analysis 8 The World Trade Organization 9 Preferential Trade Agre