INTERNATIONAL ECONOMICS Francisco L. Rivera-Batiz BAU International University Section 6. The National Income Accounts March 7, 2018 @ Francisco Rivera-Batiz 2018. All rights reserved * Graded Midterms Exams returned today. No class next week (Spring Break). * Readings for this section: Rivera-Batiz and Rivera-Batiz, International Finance and Open Economy Macroeconomics, chapter 11. Andrea Pescatori, Damiano Sandri and John Simon, “No Magic Threshold,” Finance & Development, June 2014, 39-42. Thomas Herndon, Michael Ash and Robert Pollin, “Does High Public Debt Consistently Stifle Economic Growth?: A Critique of Reinhart and Rogoff,” Working Paper, Department of Economics, University of Massachusetts at Amherst, April 2013. Dennis Tao Yang, “Aggregate Savings and External Imbalances in China,” Journal of Economic Perspectives, Vol. 26, No. 4, Fall 2012, 125-146. Carmen M. Reinhart and Kenneth S. Rogoff. 2010. "Growth in a Time of Debt" American Economic Review, Vol. 100, No. 2, May 2010, 573-577. * The last section examined the concept of a current account balance deficit from the point of view of the balance of payments accounts. In this section, we will adopt a different point of view on the U.S. current account balance deficit. We will focus on the national income and product accounts, which describe the various production and spending outcomes of an economy over a certain period of time (say, a year). * Income is mostly obtained from production, so we will focus on studying national production. The main concept used to measure national production is Gross National Product, GNP. What is GNP? * GNP = The value of all (final) goods and services produced by a country’s residents in a given time period (YN ). GNP = GDP + R where GDP = Value of (final) goods and services produced domestically (YD ) and Where R = Net factor income from abroad = Goods and services produced by domestic residents abroad minus goods and services produced by foreign residents (including multinational corporations) in the domestic economy. * Gross Domestic Product = The value of all (final) goods and services produced domestically in a given time period (YD ). This output can be purchased by two groups: (1) Purchases of domestic goods and services by foreign residents (domestic exports, X ), (2) Purchases of domestic goods and services by domestic residents. Let us look at this last component in more detail. * Purchases or expenditures of domestic residents on domestic goods and services = Total purchases or expenditures of domestic residents (called domestic absorption, A) Minus Total purchases or expenditures of domestic residents on foreign goods and services (domestic imports, M ) * So, with these definitions: Output of Spending of Spending of Domestic = Domestic Residents + Foreign Residents Goods and on Domestic Goods on Domestic Goods Services (YD) and .

1. INTERNATIONAL ECONOMICS
Francisco L. Rivera-Batiz
BAU International University
Section 6. The National Income Accounts
March 7, 2018
@ Francisco Rivera-Batiz 2018. All rights reserved
*
Graded Midterms Exams returned today.
No class next week (Spring Break).
*
Readings for this section:

2. Rivera-Batiz and Rivera-Batiz, International Finance and Open
Economy Macroeconomics, chapter 11.
Andrea Pescatori, Damiano Sandri and John Simon, “No Magic
Threshold,” Finance & Development, June 2014, 39-42.
Thomas Herndon, Michael Ash and Robert Pollin, “Does High
Public Debt Consistently Stifle Economic Growth?: A Critique
of Reinhart and Rogoff,” Working Paper, Department of
Economics, University of Massachusetts at Amherst, April
2013.
Dennis Tao Yang, “Aggregate Savings and External Imbalances
in China,” Journal of Economic Perspectives, Vol. 26, No. 4,
Fall 2012, 125-146.
Carmen M. Reinhart and Kenneth S. Rogoff. 2010. "Growth in a
Time of Debt" American Economic Review, Vol. 100, No. 2,
May 2010, 573-577.
*
The last section examined the concept of a current account
balance deficit from the point of view of the balance of
payments accounts.
In this section, we will adopt a different point of view on the
U.S. current account balance deficit.
We will focus on the national income and product accounts,
which describe the various production and spending outcomes
of an economy over a certain period of time (say, a year).
*

3. Income is mostly obtained from production, so we will
focus on studying national production.
The main concept used to measure national production is
Gross National Product, GNP.
What is GNP?
*
GNP = The value of all (final) goods and services produced by a
country’s residents in a given time period (YN ).
GNP = GDP + R
where GDP = Value of (final) goods and services produced
domestically (YD ) and
Where R = Net factor income from abroad = Goods and services
produced by domestic residents abroad minus goods and
services produced by foreign residents (including multinational
corporations) in the domestic economy.
*
Gross Domestic Product = The value of all (final) goods and

4. services produced domestically in a given time period (YD ).
This output can be purchased by two groups:
(1) Purchases of domestic goods and services by foreign
residents (domestic exports, X ),
(2) Purchases of domestic goods and services by domestic
residents. Let us look at this last component in more detail.
*
Purchases or expenditures of domestic residents on
domestic goods and services
=
Total purchases or expenditures of domestic residents
(called domestic absorption, A)
Minus
Total purchases or expenditures of domestic residents on
foreign goods and services (domestic imports, M )
*
So, with these definitions:

5. Output of Spending of Spending of
Domestic = Domestic Residents + Foreign Residents
Goods and on Domestic Goods on Domestic
Goods
Services (YD) and Services and services (X)
↓
Total spending Spending of
of Domestic - Domestic Residents
Residents on Foreign Goods and
(A) Services (M)
Therefore:
YD = A - M + X
= A + X - M
*
So: YD = A + X - M
But YD is GDP. We want GNP, YN .
GNP = GDP + R
Or:
YN = YD + R:
Therefore:
YN = A + X - M + R

6. But by the definition of the current account balance (excluding
unilateral transfers):
CAB = X - M + R
So: YN = A + CAB
*
So: YN = A + CAB
Or: CAB = YN - A
This states that a current account balance deficit (CAB <
0) means that a country’s residents are spending more than they
have available as income ( A > YN ).
On the other hand, a current account balance surplus
means that a country’s residents are spending less than they
have available as income ( A < YN ).
Why? Let us look at it from the perspective of a
household.

7. Just as we did before, consider a household as if it were a
country and let us look at its “international” transactions.
*
Household X “International Transactions,” 2016
Salary for job (exports of services) $20,000
Yard sale (exports of goods) 1,000
Purchases of food (Imports of goods) -15,000
Maid hired (imports of services) -10,000
Home mortgage interest payments -10,000
(foreign investment interest payment)
--------------
Current Account Balance $-14,000
*
Household X “International Transactions,” 2016

8. Salary for job (exports of services) $20,000 income
Yard sale (exports of goods) 1,000 income
Purchases of food (Imports of goods) -15,000 Spending
Maid hired (imports of services) -10,000 Spending
Home mortgage interest payments -10,000 Spending
(foreign investment interest payment)
-------------- --------------
Current Account Balance $-14,000 $-14,000
*
The U.S. current account balance deficit means that the U.S. is
spending in excess of its income.
This “excess” spending surfaces as an “excess” of the value of
imports of goods and services relative to American exports.
This excess spending relative to income could also be seen as a
failure of Americans to save a high enough fraction of their
income.
Let me show you this.
*
We have already established this relationship:

9. YN = A + CAB
↓
Income of Total Spending Current
Domestic = of Domestic + Account
Residents Residents Balance
(called absorption)
Let us talk a little bit more about the total spending of
domestic residents, or absorption, which we symbolize by A.
What are the major categories of spending?
*
Total spending of domestic residents (A )
=
Private Consumption spending (C )
+
Private Investment spending (I )
+
Government spending (G )
*

10. So: YN = A + CAB
= C + I + G + CAB
Let us look at the case of the United States.
Which one do you think is the most important factor
determining GNP in the United States (consumption, C,
investment, I, government spending, G, or net exports to the
rest of the world, as represented by the current account balance,
CAB (excluding unilateral transfers)?
*
United States National Income Accounting, 2016, in Billions of
US$
Gross National Product 18,751
Private Consumption 12,758Private Investment
3,036Government Spending 3,277Current
Account Balance -320
(excluding unilateral transfers)
*

11. Getting back to the GNP (national income) identity:
YN = A + CAB
= C + I + G + CAB
Let us now also decompose government spending into its
consumption and investment components:
G = CG + IG
Where CG is equal to government consumption spending
(spending on health, defense, etc.) and
IG is equal to government investment spending (spending on
roads, equipment, physical plant, etc.)
*
For the United States, how much does the government invest
relative to what it consumes?
*
U.S. Consumption and Investment Expenditures, 2016
______________________________________
Category Consumption Investment
______________________________________
Total 15,413 3,899

12. Private 12,758 3,277
Government 2,655 622
______________________________________
Source: Bureau of Economic Analysis, U.S. National and
Income Accounts, 2016.
*
So, let us now change our GNP identity to decompose
government spending into its consumption and investment
components:
G = CG + IG
From before, remember that:
YN = C + I + G + CAB
= C + I + CG + IG + CAB
= C + CG + I + IG + CAB
Or: CAB = YN - ( C + CG ) – (I + IG )
↓ ↓
CAB = National Savings – National Investment
*

13. CAB = National Savings – National Investment
A Current Account Balance deficit (CAB<0) means that
national savings are less than national investment.
The country is consuming too much (saving too little)
relative to its income. As a result, domestic investment
expenditures exceed the domestic funding available through
savings.
Let us look at the data for the U.S.
*
In presenting the statistics, let us divide both sides by national
income (or GNP) in order to adjust for the growing size of the
American economy:
CAB = National Savings – National Investment
CAB/GNP = (National Savings/GNP)
– (National Investment/GNP)
*

14. Explaining the U.S. Current Account Balance Deficit, 1991-
2016
_____________________________________________________
__
Year CAB/GNP National Savings/GNP Natl.
Investment/GNP
_____________________________________________________
___
1991 0.000 = 0.171 - 0.171
1999 -0.025 = 0.181 - 0.206
-0.037 = 0.141 - 0.178
-0.020 = 0.139 - 0.159
2016 -0.017 = 0.178 - 0.195
_____________________________________________________
___
Source: National Income and Product Accounts of the US, 2017.
Note: The CAB (current account balance) in this table excludes
unilateral transfers.
*
In the 1990s, the US current account balance deteriorated
largely because of rising investment.
In the 2000s, the US current account balance deteriorated

15. because of declining savings.
But why was there a decline in the savings rate of the U.S. in
the 2000s?
*
Returning to our national accounting identity before,
remember that the current account balance is equal to the excess
of the income over spending of domestic residents:
CAB = YN - ( C + I + G )
Let us modify this relationship by adding and subtracting
this term: (TR – TX), where TR represents transfer and other
payments from the government to the private sector and TX are
the tax revenues of the government.
CAB = YN + (TR – TX) - ( C + I + G ) - (TR – TX)
*
Reproducing the equation here:
CAB = YN + (TR – TX) - ( C + I + G ) - (TR – TX)
Or:
CAB = (YN + TR – TX - C) - I + ( TX - G - TR )

16. ↓ ↓ ↓
Private Savings Private Government
Investment Budget Balance, B
CAB = (Private Savings - Private Investment) + B
If the government has a budget deficit, then this will tend
to have a negative impact on the current account balance.
If the government has a budget surplus, this will tend to
reduce the current account balance deficit.
*
Does the U.S. has a government budget deficit?
How much is it?
*
The U.S. Government Budget Deficit, 2016
In Billions of US$
_______________________________________________
2016
_______________________________________________
Government Revenues, TX, 5,346
Government Expenditures, G +TR, 6,278
Government Consumption 2,655
Government Investment 622

17. Government Transfer Payments 3,001
and Other Expenses
Government Budget Balance, B, -932
_______________________________________________
Source: National Income and Product Accounts, 2017.
*
What has happened in the U.S. in terms of explaining the
Current
Account Balance Deficit using the new relationship we derived
above?
CAB = (Private Savings - Private Investment) + B
Let us adjust the equation on both sides, as we did before, by
dividing
by GNP:
CAB/GNP = (Private Savings/GNP - Private Investment/GNP)
+ B/GNP
What are the data for the US?
*

18. The U.S. Twin Deficit Disorder Syndrome, 1991 to 2017
_____________________________________________________
__
Year CAB/GNP B/GNP (Private S-I)/GNP
_____________________________________________________
___
1991 0.000 -0.050 0.050
1999 -0.025 0.007 -0.032
2007 -0.042 -0.029 -0.013
-0.037 -0.063 0.026
-0.020 -0.085 0.065
2016 -0.017 -0.050 0.033
_____________________________________________________
___
Source: National Income and Product Accounts of the US, 2017.
*
In the 1990s, the US increased its current account deficit
mostly because the private sector was carrying out huge
amounts of spending in the form of investment.
During this time period, the government stopped over-spending
and eventually generated a budget surplus.

19. *
But in the 2000s, the US increased its current account deficit
mostly because the public sector began to over-spend.
During this time period, the private sector initially also had an
excess of spending (private investment exceeds private savings)
but this was sharply reversed as the economy entered into crisis,
with private investment declining below private savings.
It is the government that is over-spending over the last few
years.
*
Government Budget deficit/GNP, 1991 to 2016
_______________________________________________
Year B/GNP
_______________________________________________
1991 -0.050
1994 -0.037
2000 0.015
2002 -0.040
2004 -0.045
2008 -0.063
2011 -0.096
2012 -0.085
2016 -0.050
_______________________________________________
Source: National Income and Product Accounts of the US, 2017.

20. *
Are the U.S. current account balance deficits a problem?
We talked about this before, but let us revisit it now with
the new perspectives.
*
There are several possible problems with current account
balance deficits:
First, they need to be financed, as we have shown before.
The excess purchases from the rest of the world need to be
paid for.
*
As debt accumulates, the risk attached to domestic
investments rises and foreign capital may suddenly stop,

21. creating a stressful domestic financial situation (in the form of
rising interest rates, declining economic activity, etc.), which
could emerge into a full-blown crisis.
*
In the case of the U.S., the growth of debt has been fueled by
government, sovereign debt since the early 2000s.
Is there a level of government debt that burdens a country in
such a way that it cannot grow, recuperate from the
indebtedness trap?
Is it 50% of GDP or 100% of GDP or 150% of GDP or what?
In their book: This Time is Different: Eight Centuries of
Financial Folly, Princeton University Press, 2009, economists
Carmen Reinhart and Kenneth Rogoff examine this issue.
So, Reinhart and Rogoff conclude that when high-income
countries reach public debt of about 90% of GDP, then this
would have a negative –not positive– effect on economic
growth.
What is the situation in the US?

22. *
*
U.S. Government Debt as a % of GDP
But more recently,
a study
has argued that
Reinhart and Rogoff
are wrong.
Why?
Effects of Higher Debt on GDP Growth Rates
________________________________________
Debt/GDP Mean GDP Mean GDP
(%) Growth (R-R) Growth (H-A-P)
________________________________________0-30%
4.1% 4.2%30-60% 2.8 3.160-90%
2.8 3.2Above 90% -0.1
2.2
________________________________________
Sources: R-R (2010), H-A-P (2013).

23. This is also the result that is obtained by the more recent paper
by Andrea Pescatori and co-authors in the journal Finance and
Development in your readings:
“No Magic Threshold,” Finance & Development, June 2014.
The other question about the macroeconomic impact of growing
debt to GDP ratios is that, in contrast to Reinhart and Rogoff’s
initial (and incorrect) conclusion, some countries have managed
very high debt to GDP ratios without rising interest rates,
inflation, or a collapse of their economies.
In fact, they have managed to grow moderately even with sky
high debt to GDP ratios.
Which major country has been able to sustain huge debt to GDP
ratios and still grow in recent years, even though moderately?
Japan, Government Debt as a % of GDP
Japan, GDP per-capita (adjusted for inflation, in US$)
Some also believe that the U.S. is
a special case.
President Obama said a couple of

24. years ago: “I believe in American
exceptionalism with every fiber of
my being.”
He was not really referring to
economic exceptionalism, and his
view –very popular among American
foreign policymakers-- was widely
criticized.
But is the U.S. a special country in the
economic arena, a uniqueness which
may also allow the government to
sustain high levels of debt for a much
longer period of time than say Greece
or Argentina?
What makes the U.S. exceptional?
Because the dollar is by far the most popular reserve currency
in the world, foreigners, including foreign central banks, have
been willing to continuously increase their holdings of U.S.
assets, including government debt, virtually without any
additional risk premia.
But the demand for international reserves by foreign central
banks could eventually dry out.
*
*

25. So, the question is how far can the U.S. sustain its borrowing
spree.
Can this continue or is there a crisis in the future?
And the answer to this question is:
*
*
We don’t know!
*
INTERNATIONAL ECONOMICS
SECTION 8. THE EXPANSION OF WORLD TRADE
By
Francisco L. Rivera-Batiz
BAU International University
April 4, 2018
@ 2018 Francisco Rivera-Batiz, All Rights Reserved

26. *
Assignment #3 is due now!!!
Assignment #4 will be distributed next week.
Note that the final exam is on Wednesday, April 25th, from 6 to
9 PM. I will give you sample questions for the exam next week.
Because we need to make up the class we missed last week, we
will be extending the class for 15 minutes each day, so we will
end at 9:15 PM tonight and for the following weeks.
Section 8. The Expansion of World Trade: Multilateral and
Regional Policies, Technology and Geography
Multilateral and regional trade agreements, the World Trade
Organization (WTO), non-tariff barriers to trade, protectionism
in high-income and developing countries, customs unions, trade
creation versus trade diversion.
Readings: Krugman, Obstfeld and Melitz, chapter 2.
Michele Ruta and Mika Saito, “Chained Value,” Finance &
Development, March 2014, 1-4.
Jagdish N. Bhagwati, “Dawn of a New System,” Finance &
Development, December 2013.
Hans Peter Lankes, “Market Access for Developing Countries,”
Finance and Development, Vol. 39, No. 3, September 2002.

27. By any measure, the last 20 years have seen a historic rise of
international trade in goods and services almost anywhere in the
world.
We talked a little bit about this at the beginning of this course.
Why has there been such a rise of international trade?
*
Barriers to International trade:
Transportation costs Information and marketing costs Barriers
created by the public sector:
Tariffs
Non-tariff barriers (quotas,
licensing requirements, etc.)
*
The major reason why international trade has risen over the last
40 years has been the reduction in government barriers to
international trade.
There are tariff and non-tariff barriers to trade.
Let us look first at tariff barriers.

28. *
Tariff Rate, t
Cost of Import Duties
t = --------------------------------------------------
Total value of Imports
*
Which country in the world has the highest average tariff
rate on imports?
Which one has the lowest?
*
Countries with Lowest and highest
Average Tariff Rates on Imports, 2015
__________________________________________________
Lowest Tariff Highest Tariff
__________________________________________________
Switzerland 0.0% The Bahamas 27.6%
Singapore 0.0 Iran 18.7

29. Hong Kong 0.0 Bermuda 16.9
Georgia 0.2 Sudan 15.8
Iceland 0.3 Laos 14.3
Chile 0.6 Gabon 14.0
Mauritius 0.9 Central Af. Rep. 13.8
United States 1.7 Togo 13.7
European Union 1.8 Bangladesh 13.3
__________________________________________________
Weighted average, includes only manufactured products.
Source: United Nations, United Nations Conference on Trade
and Development Handbook of Statistics, 2017.
*
But even countries with
high tariff rates today
have had a process of
tariff reductions
over time.
*
Average Tariff Rate, 1990-2015
________________________________________________
Country 1990 2015
________________________________________________
Bangladesh 106.6% 13.3%

30. Pakistan 50.9 11.5
Brazil 38.0 10.3
China 36.5 4.1
USA 4.1 1.7
European Union 5.8 1.8
Switzerland 0.0 0.0
Singapore 0.6 0.0
Hong Kong, China 0.0 0.0
________________________________________________
Weighted average; includes only manufactured products.
Source, UNCTAD, 2017.
*
Tariffs are just one type of barrier imposed by governments on
international trade.
Non-tariff barriers to trade can be as effective in restricting
trade.
Import quotas, strict sanitary requirements, subsidies given to
domestic producers, import license requirements, all create
barriers to trade.
*
To assess more carefully the extent of
liberalization of international trade over time,

31. to incorporate both tariff and non-tariff
barriers to trade, economist Jeffrey Sachs
–a colleague at Columbia-- joined
economist Andrew Warner in proposing
the following set of guidelines
in order to consider whether an economy
was open or closed.
*
They defined an economy to be open to international trade
if:
Average tariff rates are less than 40 percent
Non-tariff barriers cover less than 40 percent of trade
Any black market premium on the exchange rate is less than
20%
4. Government has no monopoly of major exports.
*
Sachs and Warner then proceeded to compute whether various
economies in the world were open or not in the period of 1970
to 1990.
At the time they compiled data for 93 countries.
*

32. In a more recent and comprehensive paper, Stanford
University economists, Romain Wacziarg and Karen Horn
extended the series up to 1998 and added countries excluded by
Sachs and Warner in their original paper, expanding the sample
to 141 countries.
(Romain Wacziarg and Karen Horn Welch, “Trade
Liberalization and Growth: New Evidence,” World Bank
Economic Review, Vol. 22, No. 2, June 2008, 187-231).
*
*
So, clearly, globalization has increased over time, but the
process seems to have accelerated since 1985.
Before that date, most economies were closed to trade.
What happened in 1985 or 1986 that led to an acceleration of
trade liberalization?

33. *
In 1986, the Uruguay Round of the General Agreement on
Tariffs and Trade (GATT) started.
This round started a process of global trade liberalization that is
behind the globalization we have seen in recent decades.
*
Reductions in barriers to trade have occurred mostly
through trade agreements among countries.
There are three types of trade agreements:
Multilateral Trade Agreements, which have occurred
through the General Agreement on Tariffs and Trade (GATT)
and the World Trade Organization.
Regional or Bilateral Accords, such as Free Trade Zones
(NAFTA, etc.) or Customs Unions (such as the European Union)
or Free Trade Agreements between two or more countries.
*
The GATT was created in 1947, as an institutional means
to foster international trade after the end of the Second World.

34. From 1947 to 1994, GATT functioned through rounds of
negotiations which, over the years, led to multilateral
agreements to reduce trade barriers among many countries.
*
The so-called Uruguay Round of multilateral trade talks
began in 1986 and ended in 1994.
It was one of the most productive in terms of reductions in
trade barriers and it established the basis for the acceleration of
globalization over the last 20 years.
The GATT ended in 1994 and was replaced by the World
Trade Organization (WTO) in 1995, which supervises the GATT
agreements.
*
The WTO is constituted as an organization of over 150
member countries.
The most important decisions are adopted at the so-called
Ministerial Conferences, in which WTO representatives from
member countries meet to ratify agreements and to agree on new
initiatives.

35. *
But the WTO has become the focus of criticism by many in poor
countries, and has become a focus of attack from activist
groups.
*
One of the major problems faced by the WTO is that many in
developing countries see the process of trade liberalization
generated by the WTO as having provided great benefits to rich
countries not to poor countries.
Why?
*
The WTO sharply reduced barriers to the trade
of manufactured products, but the Agricultural Trade
Agreement reached by GATT was very weak and left
most protectionist measures in place.

36. *
¿And why is this unequal?
The problem is that rich countries use their economic
policies to strongly support their agricultural sectors.
So, agricultural producers in low and middle-income
countries cannot compete effectively in international markets
with the heavily-subsidized producers in the rich countries,
which can sell their products at lower prices.
*
Expenditures on Subsidies and Other Programs Protecting the
Agricultural Sector, 2015
_______________________________________________
Millions of US Dollars
_______________________________________________
Japan 50,395
USA 90,849
European Union 111,591
Republic of Korea 22,930
______________________________________________
Source: OECD, Agricultural Policies in OECD Countries,

37. 2017.
*
Professor Xavier
Sala-i-Martin has calculated
that the subsidies given by the European Union to cattle farmers
add up to almost $6,000 per year per cow.
Given that a lot of these subsidies are not in the form of
tariffs, the tariff rates discussed above do not reflect them.
It looks like the markets of rich countries are wide open to
the products of developing countries.
But they are not.
*
So, the data suggests that high-income countries do have major
policies that prevent agricultural producers in developing
countries from competing in those markets.
But some economists object to the view that there is unequal
trade in agricultural products.

38. *
On the one hand, high-income countries do have significant
non-tariff barriers to agricultural imports from developing
countries.
On the other hand, low-income countries also have their own
barriers to agricultural imports from other countries, often at
higher levels than those in high-income countries.
*
Tariff rates on agricultural imports
2010/2011
______________________________________________
Country Average Tariff rate
______________________________________________
Egypt 66.3
Tunisia 65.1
Morocco 42.9
India 38.5
Brazil 37.2
Iran 28.9
Algeria 23.3
______________________________________________
Source: UNCTAD, 2013.
*

39. And many developing countries also protect heavily their
agricultural sectors through subsidies and other means.
*
Protectionism in the Agricultural Sector, Developing Countries,
2014-2016
_____________________________________________________
____________
Colombia Indonesia Turkey
_____________________________________________________
___________
Tariff rate on imports (%) 12.0% 4.2%
42.2%
Weighted average, 2014
Milk Products tariff, 2014 (%) 43.5% 5.5%
129.6%
Subsidies to the agricultural 3,400 36,000
18,000
Sector (millions of $)
2016
Subsidies in 2016 13.7% 29.1% 29.2%
As a % of the value
of agricultural production)
_____________________________________________________
_____________
Sources: OECD (2017) and WTO (2016)

40. *
The WTO has tried in the
last fifteen years to reduce
protectionism in the
agricultural sector of
high-income countries.
Just after the September 11
World Trade center attacks
In 2001, the WTO held a
ministerial conference in
Qatar.
*
This Conference led to the start of an initiative to use trade
concessions from rich countries as a means for economic
development of poor countries.
This was called the “Doha Road to Development.”
*
In the last WTO ministerial conference in Kenya, which

41. ended in December 2015, there was an agreement that will
reduce some export subsidies made to the agricultural sector in
both high-income and low-income countries.
But the Doha negotiations did not lead to a comprehensive
reduction of tariffs, import quotas and most other barriers to
agricultural trade.
*
Despite the failure of multilateral trade negotiations in recent
years, movements towards freer trade have continued in recent
years through Regional and Bilateral Accords, such as Free
Trade Zones (North American Free Trade Zone, etc.) or
Customs Unions (such as the European Union or Mercosur).
*
In 1990 there were just 50 of these two types of trade
agreements in the world.
But by the end of 2015 there were more than 325 such
agreements.
China has 23 regional or bilateral free trade agreements,
Japan has 24 and India has 28.
*

42. There is only one country in the world that did not have any
major unilateral or regional trade agreement with other
countries until recently.
Which country is this?
*
Mongolia is a member of the World Trade Organization,
but until 2014 it did not have any major bilateral or regional
trade agreement with any other country.
In July 2014, a bilateral trade agreement was signed by
Mongolia with Japan.
*
Anyway, some economists are highly critical of regional free
trade agreements.
They point out that these agreements are actually very
dangerous.
Instead, they argue, trade liberalization should occur through
multilateral agreements, as sponsored by the WTO.
*

43. So, what is the problem with regional trade agreements, or even
with bilateral trade agreements?
*
Economist Jacob Viner, born
In 1892, was a professor of
Economics at Princeton
University in the U.S.
He was concerned about the
effects of customs unions on
International trade.
*
The problem he saw with customs unions –and other
regional or bilateral trade agreements– is that they do not
necessarily increase trade at a global level, they only promote
trade among member countries.
In many cases, customs unions actually create barriers to –
and reduce– trade with non-member countries.
Professor Viner concluded that customs unions have:

44. Trade creation effects with member countries
Trade diversion effects with non-member countries.
*
Let me give you an example
from Latin America.
The Andean Group
was created in 1969 and is
currently a customs union
between Bolivia,
Colombia, Peru, and
Ecuador.
*
An example of trade diversion is the impact that the creation of
the Grupo Andino had in 1969 on international trade between
Peru and Argentina (to the benefit of Colombia).
This case study is taken from research by:
A. Gupta and Maurice Schiff, Regional Integration and
Agricultural Trade, Policy Research Working Paper No. 1805,
The World Bank, Washington, D.C., 1997.
*

45. Exports of cattle to Peru
Millions of US$
________________________________________
Argentina Colombia
________________________________________
1966-1968 10.4 2.4
1970-1972 0.4 13.0
________________________________________
Gupta and Schiff (1997).
*
This issue of trade creation and diversion is very relevant
to one of the major recent developments in international
trade: Brexit, the decision by the United Kingdom to
leave the European Union.
Most observers argue that Brexit will have a strong negative
effect on the international trade of the United Kingdom.
But Prof. Viner would argue instead that it may not be so bad
for the United Kingdom.
He would argue that membership in the EU has created trade
with the EU but reduced trade with other trading partners.

46. Exports of the United Kingdom,
Top Five Countries in 2014
__________________________________________________
% of Total U.K. Exports
of goods and services
__________________________________________________
World 100%
European Union 53.4%
United States 12.6
Switzerland 6.9
China 5.1
Hong Kong 2.4
__________________________________________________
Source: United Nations, World Integrated Trade System, 2016.
*
Imports of the United Kingdom,
Top Five Countries in 2014
__________________________________________________
% of Total U.K. Imports
of gods and services
__________________________________________________
World 100%
European Union 52.7%
China 9.2
United States 8.4
Canada 2.0

47. Japan 1.5
__________________________________________________
Source: United Nations, World Integrated Trade System,
2016.
*
Brexit might lead to lower trade with the EU but greater trade
with other trading partners, including the United States, Canada,
China and Japan.
Overall, the international trade of the U.K. with the rest of the
world may not be affected that much in the long-run.
So, we have seen how international trade has grown
dramatically since the 1980s.
Part of this growth of trade was due to the reduction or
elimination of tariff and non-tariff barriers to trade imposed by
governments.
This was done mainly through multilateral trade agreements
forming part of the GATT and the WTO.
But there have been other forces in the growth of trade.
Technological changes in global production have given a sharp
boost to global trade.
What are these technological changes in production?

48. Beginning in the eighties, world production has been
revolutionized by the computer and information technology
revolutions that have made possible a growing fragmentation or
unbundling of production.
In manufacturing industries --such as the automobile,
electronics, airline, and clothing industries, among many
others– there is a rising tendency to subdivide the production of
final goods into separate components –or activities– that can
then be produced in various countries, with the final assembly
also occurring in a different country.
The Boeing 787 airliners are assembled in the U.S. but the parts
and components are produced mainly outside the United States.
The center fuselage is made by Alenia (a company in Italy); the
flight deck seats by Ipeco (United Kingdom); the tires by
Bridgestone (Japan); the landing gear by Messier-Bugatti-
Dowty (France); and the cargo doors by Saab (Sweden).
This is one example of what economists call global value chains
(GVCs) or multi-country manufacturing.
All over the world, final products—from automobiles and cell
phones to pharmaceuticals and medical devices—are produced
in one country using inputs from many others, organized mostly
by large multinational companies.
According to UN-WTO data, close to 80 percent of global
exports of goods and services now occur through global value
chains.

49. The third major factor behind the growth of global trade has
been the sharp drop in transportation and communications costs
seen in the last few decades.
High transportation costs have been a deterrent for the growth
of international trade.
It was Professor
Jeffrey Sachs, who
first examined in
detail the claims that
geography has an
important negative
effect on trade and,
therefore, on economic
development.
He finds that access to
coasts and navigable
rivers reduces transport
costs and raises
trade.
*
XXXXXXXXXXXX
XXXXXXXXXXXX
*

50. But the information technology revolution has made the costs of
transportation much lower in some sectors of the economy,
specially in services.
The supply of some medical services, such as diagnostic
radiology, for example, can be made over the internet, with
patients or technicians sending X-rays, laboratory results, etc.
over the internet, for the evaluation of doctors located far away.
American radiology units, for example, can send to India
(Mumbai or Bangalore) their images, for a careful analysis by
an Indian radiologist.
The cost of transmission is small and the analysis by the Indian
radiologists can cost one-tenth of the cost of a radiologist in the
United States.
Indeed, radiology companies in India do this now not only in
the US but also in the United Kingdom, Singapore and other
countries.
Trade in Services, as a % of Gross Domestic Product
__________________________________________________
Trade in Services(as a % of GDP), 2015
__________________________________________________
World Average 13%
Singapore 97%
Honk Kong, China 58%
Switzerland 30%
Panama 30%
United Kingdom 19%

51. India 14%
__________________________________________________
Source: World Bank, World Development Indicators, 2017.
*
INTERNATIONAL ECONOMICS
SECTION 9. THE DETERMINANTS OF AND THE
GAINS/LOSSES FROM INTERNATIONAL TRADE
By
Francisco L. Rivera-Batiz
BAU International University
April 4, 2018
@ 2018 Francisco Rivera-Batiz, All Rights Reserved
*
9. The Theory of the Determinants and Gains/Losses from Trade
Ricardian and Hecksher-Ohlin theories of comparative
advantage, the potential gains and losses from trade, the
sectoral effects of trade liberalization, the effects on wages and

52. income distribution, the Stolper-Samuelson theorem, intra-
industry trade, dynamic comparative advantage.
Readings:
Krugman, Obstfeld and Melitz, chapter 11.
Giorgio Barba Navaretti and Paolo Epifani, “Trade Policy
Principles,” training module of the World Bank Course on
“Trade Policy and WTO Accession for Economic Development:
Application to Russia and the CIS,” Moscow, Russia, July 2004.
So, what are the determinants of international trade, and what
are the consequences of trade?
We will examine first the theory and then the evidence on this
topic.
*
We use a simple market analysis that focuses on the demand for
and supply of a product in a market.
We shall look at the market for the product –let us say, sugar–
before and after the economy opens to international trade (or
before it eliminates barriers to trade).
*

53. The theoretical framework
that we use is the one
that most economists
adopt and it is part
of the discussion in
the classical
textbook on this topic,
written by Paul Krugman, professor of economics
at NYU, and Maurice
Obstfeld, who is a professor at the University
of California at Berkeley
but also is currently
research director at the IMF.
*
We start by analyzing a market that is not initially involved in
any international trade (we call it autarky).
We will then analyze what happens to this market if it allows
(opens up) to international trade.
Let us assume that the country (or nation) is Puerto Rico and
the market is the market for sugar.
*

54. As you know, a market consists of two sides: demand and
supply.
Let us look first at the demand for sugar in Puerto Rico.
*
What determines the demand for sugar
in Puerto Rico or any other place. That is,
what factors influence the demand for sugar?
Consumers in Puerto Rico buy sugar based on their tastes but of
course limited by the budget (income) that they have available
and the price of sugar.
Usually, as the price of a product rises, the quantity demanded
for that product declines.
So, as the price of sugar rises, the quantity demanded of sugar
drops.
Demand for Sugar
in Puerto Rico
p
QD
Price of

55. a pound
of sugar
in dollars
In Puerto
Rico
Quantity demanded of sugar in Puerto Rico
during a week, in thousands of tons of sugar
*
2. Supply of Sugar in Puerto Rico.
What are the factors that determine the supply of sugar in
Puerto Rico (remember the economy is under autarky)?
*
Agricultural producers in Puerto Rico produce sugar by using
inputs or factors of production, such as workers (laborers), land,
fertilizers, machinery, etc.
They determine how much sugar they are going to produce with
the objective of maximizing profits.
If the price of sugar in Puerto Rico rises, suppliers have an
incentive to increase production, so that they can make more

56. profits.
The positive relationship between price and quantity produced
in the market is represented diagrammatically by the supply
curve.
*
Supply curve of sugar in Puerto Rico
p
QS
Quantity of sugar produced in Puerto Rico,
in thousands of tons a week.
Price of
sugar in
Puerto
Rico
*
The price and quantity sold in a market is established through
the interaction of demand and supply.
The market is in equilibrium when demand and supply are equal
to each other.
If the market is not in equilibrium, then prices will change,
moving demand supply towards their equilibrium value.
*

57. Domestic Market Equilibrium
p
QD,QS
Q*
.
.
.
.
.
- - - - - - - - - - - - -
P*
Thousands of tons of sugar sold in Puerto Rico in a week
E
Domestic Supply Curve
Domestic Demand curve
*
So far, we have carried out our analysis within the context of an
economy that is closed to international trade, that is under
autarky.
*
What happens to this analysis when

58. there is international trade?
The most important change is that, once the product is available
from world markets, domestic or internal prices must adjust to
international market prices.
If the price of sugar is higher in world markets than it is
initially in Puerto Rico, then it must rise to match the world
market price of sugar.
No producer of sugar in Puerto Rico would be willing to sell
their sugar below the world market price, since they can always
ship the product abroad and obtain the world market price
(minus the transportation costs, which are very small).
*
If the price of sugar is lower in world markets than in Puerto
Rico initially, then the price of sugar in Puerto Rico will go
down to match world market prices.
No buyer of sugar in Puerto Rico will pay more than the global
market price since he or she can always import the product more
cheaply from abroad (plus some minor transportation costs).
Let us examine the changes diagrammatically.
We first choose the case when the price of sugar in world
markets is below the price of sugar in Puerto Rico under
autarky.
The domestic (internal) price of sugar in Puerto Rico under

59. autarky was P*, as a previous diagram showed.
Let us assume that the world market price is PFT .
Let us therefore look at the changes in the sugar market in
Puerto Rico, as the market opens up to international trade.
*
Market Equilibrium under Free Trade
p
QD,QS
Q*
- - - - - - - - - - - - -
P*
E (equilbrium under autarky)
Domestic Supply Curve
Domestic demand curve
PFT
A
B
Qc
Qp
0
*

60. In this case, the local price of sugar in Puerto Rico goes down,
which raises the quantity consumed but reduces the quantity
produced.
The market for sugar becomes an import market, where sugar is
imported.
The result is that different groups in the economy are affected
differently.
*
The impact on consumers is positive: they can consume more
sugar at a lower price.
But the impact on producers is negative: they have to sell at a
lower price, which reduces their profits and may force them to
cut production or even close down.
So we have seen what happens when a market opens up to
international trade when there is an import market.
What happens when the local market becomes an export market?
In an export market, the price of the product in world markets is
higher tan the initial domestic price.
*

61. Market Equilibrium under International Trade:
An Export Market
p
QD,QS
Q*
- - - - - - - - - - - - -
P*
E (equilibrium under autarky)
Domestic Supply Curve
Domestic Demand Curve
PLC
A
B
Qp
Qc
0
*
In this case, domestic producers gain since they can now sell
their product at higher prices.
But consumers in this export market are actually hurt because
they have now to pay more for sugar.
Sometimes it is said that consumers always benefit from free
trade. It is not true.
In fact, this is exactly the case in some countries where

62. international trade bring higher prices of agricultural products,
which hurts consumers, especially the poor.
*
As a conclusion, then, the impact of trade on production
depends on whether the sector is an export or import sector.
The producers of export products gain because their prices are
higher in world markets.
But the producers of import products lose because the prices at
which they can sell their products go down.
*
But which industries grow and which disappear? That is, which
industries become export industries and which become import
industries?
In other words, what determines the competitiveness of
domestic industries (whether they can sell at a price below or
above the world market price) and, therefore, whether they
become export or import industries?
The British economist
David Ricardo (1772-1823)
was the first to seriously
examine this issue.

63. Ricardo argued that the most important factor in determining
what products a country should export and import is based on
the comparative or relative productivity of different firms or
industries in the country.
In other words, if the country can produce computer chips or
software at a lower cost relative to producing steel or
aluminum, then it should be exporting computer chips and
software and importing steel and aluminum.
This was called the theory of comparative advantage because it
says that a country will export products in which it has a
comparative –or relative– advantage in producing.
Note that it does not say that countries will export products in
which they are more productive relative to other countries.
It says that countries will export those products in which they
are more productive relative to other products that can be
manufactured within the country.
This is important because there is the fear that, if some
countries are more productive than others in producing
everything (they can produce computers more cheaply, or
produce clothing more cheaply, or anything else), then they will
export everything, and countries that are not as productive will
end-up importing everything from the most productive
countries.
This type of viewpoint, which Ricardo argues is fallacious,
leads policymakers in some countries to impose tariffs on
imports from countries that are highly productive or have lower
costs of production.
But Ricardo argued that, for international trade, countries that
are the most productive in everything compared to other

64. countries, will not find it profitable to export everything but
instead, they will profit by specializing in what they themselves
do best, that is, those sectors in which they have the greatest
productivity.
The reason is because they can compete more effectively and
profit more by focusing on producing those products that they
themselves can produce at the lowest cost.
If they focus instead on producing everything, there will be
many firms that will be producing and exporting products that
generate much lower profits than those of the sectors in which
the economy is the most productive.
Note that this is a concept that applies to many other fields and
to life itself.
It is best understood by using a life-example.
Even if, as a person, you are more talented than others in every
field , you should focus your career in the field in which you
are the most talented and relatively more productive (can derive
the most profit).
For example, suppose you are very talented with your hands. No
one else in your university and even in the country has the hand
skills you have and so you could be a great medical surgeon.
But you are also very fast at typing, among the best in your
school and maybe top-twenty in the country.
Should you follow both careers: surgery and secretarial
assistant? Maybe spend half a week as a surgeon and half a
week as secretarial assistant?
So, Ricardo argued that countries will export goods that they

65. have a comparative advantage in producing, that is industries in
which they can produce relatively more efficiently or at
relatively low cost.
But what Ricardo did not discuss that much was what are the
factors that make a country most productive in some sectors of
production relative to others.
One could argue that the United States is more productive in
producing high-tech products, such as Intel chips, and less
productive in producing steel and aluminum.
So, according to the theory of comparative advantage, the US
should export high-tech products and import steel and aluminum
from other countries.
But what makes the US relatively more productive in producing
computer chips relative to steel or aluminum?
This is the issue that two Swedish economists,
Eli Hecksher and Bertil Ohlin, decided to examine.
We will discuss their contribution in the next class.
INTERNATIONAL ECONOMICS
Francisco L. Rivera-Batiz
BAU International University

66. Section 6. The National Income Accounts, Conclusion
March 28, 2018
@ Francisco Rivera-Batiz 2018. All rights reserved
*
Assignment #3 will be distributed today.
It is due before class next week.
Hard copy only please!
We also need to make up the class we missed last week.
So we will extend the class for 15 minutes each day, beginning
next week, so that we finish at 9:15 PM instead of 9:00 PM.
Readings for this section:
Rivera-Batiz and Rivera-Batiz, International Finance and Open
Economy Macroeconomics, chapter 11.
Andrea Pescatori, Damiano Sandri and John Simon, “No Magic
Threshold,” Finance & Development, June 2014, 39-42.
Thomas Herndon, Michael Ash and Robert Pollin, “Does High
Public Debt Consistently Stifle Economic Growth?: A Critique
of Reinhart and Rogoff,” Working Paper, Department of
Economics, University of Massachusetts at Amherst, April

67. 2013.
Dennis Tao Yang, “Aggregate Savings and External Imbalances
in China,” Journal of Economic Perspectives, Vol. 26, No. 4,
Fall 2012, 125-146.
Carmen M. Reinhart and Kenneth S. Rogoff. 2010. "Growth in a
Time of Debt" American Economic Review, Vol. 100, No. 2,
May 2010, 573-577.
*
A previous section examined the concept of a current account
balance deficit –or trade deficit-- from the point of view of the
balance of payments accounts.
In this section, as discussed last time, we adopted a different
point of view on the U.S. current account balance deficit.
We focused on the national income and product accounts, which
describe the various production and spending outcomes of an
economy over a certain period of time (say, a year).
*
As we have discussed in the last class, current account balance
deficits represent an excess of the imports and goods and
services over exports and goods and services.
This excess of purchases of imports from foreign residents over
sales of exports to foreigners must be paid-for or financed.

68. *
So, current account balance deficits, if they accumulate over
time, are either financed from the country’s official foreign
exchange reserves (cash) or by borrowing, that is, by
accumulating debt.
Neither of these is a good choice.
So, as we saw in the last class, the U.S. has a substantial,
persistent current account deficit.
Let me refresh your memory.
The U.S. Current Account Balance Deficit, 1991-2016
_____________________________________________________
__
Year CAB/GNP
_____________________________________________________
___
1991 0.0
1999 -2.5%
-3.7%
-2.0%
2016 -1.7%
_____________________________________________________
___

69. Source: National Income and Product Accounts of the US, 2017.
Note: The CAB (current account balance) in this table excludes
unilateral transfers.
*
This current account balancer deficits corresponds to a trade
balance deficit and it is the basis for the policies President
Trump has been engaging lately.
He argues the current account balance and trade deficit of the
United States is because unfair trade practices of other
countries.
This is not correct.
But this is not the problem just of the United States.
Many other countries also have significant and systematic
current account balance (CAB) deficits.
Which country has CAB deficits, a country important for BAU?
TURKEY: CAB/GDP, expressed as a %
In the case of the United States, the current account deficits
have been financed by borrowing.
But excess borrowing is generally to be avoided, even in the
U.S.
So, what are some possible ways through which the U.S. could
reduce its current account balance and trade deficits

70. According to the national income accounts perspective, a
current account balance deficit means that a country is spending
too much (consuming too much) and this is what generates the
imports that causes the trade deficits.
There are two sources of spending in a country: the private
sector and the government.
Form this perspective, what are the solutions for the trade
deficit in the U.S.?
*
(1) Reduce budget deficits. The twin deficits disorder syndrome
means that, holding other things constant, a reduction of the
U.S. budget deficit will result in a reduction of the current
account balance deficit, foreign borrowing, etc.
(2) Provide incentives for private savings. If private savings
were to increase, this would also act to reduce the current
account balance deficit, with a resulting decline of borrowing
from the rest of the world.
In the 1990s, the US economy increased both its savings
and investment.
And the increased investments did pay off substantially as
they were in a number of areas (information sector, electronics,
biotechnology, construction, infrastructure) that increased

71. American productivity and were associated with strong
economic growth.
*
(3) Promote supply-side and market-creating policies that
increase U.S. production through technical change, innovation,
and worldwide economic expansion. These policies will
increase income while at the same time generating export niches
for the American economy. Seeking closer economic ties and
ventures with East Asia (including China), Africa and other
parts of the world may be part of such a strategy.
These constitute more sustainable policies than seeking to
switch exports from China or other countries to the U.S.
through exchange rate or trade policies.
*
INTERNATIONAL ECONOMICS
Francisco L. Rivera-Batiz
BAU International University
Section 7
The Effects of Macroeconomic Policies
In an Open Economy

72. March 28,2018
@All rights reserved Francisco Rivera-Batiz 2018
*
The basic reference for this discussion is Rivera-Batiz and
Rivera-Batiz, chapter 13.
Please check out also the other readings:
*
Nouriel Roubini, “America’s Bad Border Tax,” Project
Syndicate, March 3, 2017.
The Economist, “Big Currency Devaluations are Not Boosting
Exports as Much as they Used to,” The Economist Print Edition,
January 9, 2016.
International Monetary Fund, “Exchange Rates still Matter for
Trade,” IMF Survey, World Economic Outlook Analysis,
September 2015.
Jose Antonio Ocampo, “The Federal Reserve and the Currency
Wars,” Project Syndicate, October 20, 2012.
Martin Feldstein, “Resolving the Global Imbalance: The Dollar
and the U.S. Savings Rate,” Journal of Economic Perspectives,
Vol. 22, No. 3, summer 2008,113-125.

73. Christine Ebrahim-Zadeh, “Dutch Disease: Too Much Wealth
Managed Unwisely,” Finance and Development, March 2003.
*
In order to introduce our next topic today –macroeconomic
analysis-- let me first talk to you about a paradox in economics.
What we are going to try to do today –among other things– is to
explain this paradox.
It shows very well how macroeconomic analysis can explain
what, at first glance, appears unexplainable.
*
There is a perception that countries without natural
resources have a much more difficult growth experience than
those with natural resources.
That the best that can happen to the citizens of a country is
to have the discovery of oil, minerals or other natural resources.
*

74. Indeed, for most people, the discovery of valuable natural
resources in an economy is a matter for celebration.
*
But the reality is very different.
As we will see, the evidence shows that resource-rich
countries do not grow faster than other countries and may
actually grow at a slower rate.
*
A simple look at the richest countries in the world does not
find many natural-resource rich countries.
Suppose, for example, that we divide the endowment of
natural resources (say, barrels of crude oil reserves) by the
population in a country.
Which country has the highest value?
*

75. Do Rich Countries Have Greater Crude Oil Reserves?
_____________________________________________________
___________
País GDP Crude oil reserves,
per-capita(2012) thousand barrels
(2012) per person
_____________________________________________________
________
Singapore $51,709 0.0
Kuwait 51,497 101,500.0
United States 49,965 26,800.0
Japan 46,720 0.0
Finland 46,178 0.0
Austria 47,226 0.0
Belgium 43,412 0.0
United Arab Emirates 39,057 136,700.0
Saudi Arabia 25,136 265,400.0
South Korea 22,590 0.0
Russia 14,037 74,200.0
Venezuela 12,728 296,500.0
Angola 5,484 13,500.0
Nigeria 1,555 37,000.0
_____________________________________________________
____________
Sources: World Bank, US Department of Energy, 2014.
*
*

76. Consider the case of Nigeria, one of the largest oil exporters in
the world today.
Oil reserves were discovered in Nigeria in 1965.
The sum of oil revenues over the period of 1965-2000 was equal
to about $500 billion (in today’s prices).
Did Nigeria become richer as a result of its natural resources?
*
Nigeria’s Economic Development Experience
______________________________________________
1970 2000
______________________________________________
GDP Per-Capita $1,113 $1,084
(PPP-inflation-
adjusted)
Poverty rate 36% 70%
People living 19 million 90 million
Under poverty
______________________________________________
*

77. But, of course, this is just one case.
Can we draw a similar conclusion from an analysis of other
countries, using
statistical analysis, such as linear regression?
*
In the 1990s,
Jeffrey Sachs,
then at Harvard
now at Columbia UNiversity,
examined the issue
empirically and
found no positive
relationship between
a country’s natural
resources and greater
economic growth.
*
The reference is:
J. Sachs and A. Warner, “Natural Resource Abundance and
Economic Growth,” NBER Working Paper, December 1995.

78. *
*
Growth of GDP Per-Capita and Natural Resource Exports
Source: Jeffrey Frankel, Resource Abundance: Pitfalls and
Prescriptions,
Harvard University (2013).
*
The fact that most natural-resource-rich countries appear
to be growing slower than other economies has led some to refer
to the presence of a “Natural Resource Curse.”
*
What explains the negative empirical connection between

79. endowments of natural resources and growth?
*
One common hypothesis is that the presence of large rents
(profits) connected to the natural resources industry leads to
corruption and poor public sector governance that destroy the
rest of the economy.
*
This is the point made by the Spanish economist
Xavier Sala-i-Martin, and his co-author, Arvind Subramanian,
In their paper: “Addressing the Natural Resource Curse:
An Illustration from Nigeria.”
“Stunted institutional development –including corruption, weak
governance, rent-seeking, plunder, etc.– is a problem intrinsic
to most countries that own certain natural resources, such as oil
or minerals.”
Sala-i-Martin and Subramanian, IMF Working Paper.
*

80. It is a problem that is
not limited to Nigeria
but affects many
countries that have
natural resources.
The human behavior
underlying the discovery
of natural resources
serves as the basis for the
movie The Treasure
of Sierra Madre.
But although this explanation helps in explaining some specific
cases, there must be other causes at work in explaining why the
exploitation of natural resources has failed to lift standards of
living in so many countries.
*
For example, the Netherlands discovered the presence of rich
natural gas deposits a few decades ago.
They have excellent governance in their country, yet they also
had difficulties experiencing growth when they started
exploiting natural gas.
*

81. In fact, their situation was documented in an article by the
magazine The Economist entitled: The Dutch Disease.
This is how this paradoxical situation has become known
in the economics literature.
We will try to provide an explanation.
*
The analytical framework I am going to talk about today is
inherited from the work of John Maynard Keynes, published in
his 1936 masterpiece, The General Theory of Employment,
Interest and Money.
It was later extended to better incorporate international issues
by two economists Robert Mundell (a Columbia University
economist) and Marcus Fleming (a Canadian economist working
at the IMF at the time).
It is now known as the Mundell-Fleming model.
*
The Mundell-Fleming framework focuses on how international
forces affect the impact of government policies or other
economic changes in an economy.
It argues that the effects of government policies and other

82. economic changes vary enormously when you consider their
international implications.
*
Let us consider monetary policy.
We already talked about the difficulties encountered by
countries under fixed exchange rates in managing monetary
policy.
So, let us consider the effects of monetary policy under flexible
exchange rates.
*
Suppose the Federal Reserve decides the expand the
monetary base, and therefore the money supply in the United
States.
How does the increased money supply affect the economy?
What is its most immediate effect?
*
An increase of the money supply increases the liquidity
available in the economy and the financial system and tends to

83. lower interest rates.
Banks tend to have lots of money to lend and because of this
they offer lower interest rates to their customers.
*
The lower interest rates tend to raise private sector investment
and this raises, output, income and employment. Remember
that, from the national income accounts:
YN = C + I + G + CAB
Where YN is GNP, C is private consumption, I is private
investment, G is government spending and CAB is the current
account balance.
So, domestically, the expansionary monetary policy lowers
interest rates, raises investment and leads to increased
employment and output.
But, there is an additional impact of expansionary
monetary policy.
This impact occurs through the international effects of
monetary policy.
Remember again, that, from the national income
accounts:
YN = C + I + G + CAB

84. The international effects of monetary policy enter through
its impact on CAB, the current account balance.
*
To examine, how monetary policy affects the current
account balance, let us ask first: what impact do lower U.S.
interest rates have on the value of the dollar?
To think about this problem, first ask what effect would
lower interest rates have on the flow of capital to the United
States.
Would it increase or decrease?
If interest rates in the rest of the world are constant, then
lower U.S. interest rates will lead to capital outflows, as
investors will seek higher returns in the rest of the world.
But what would capital outflows do to the value of the
dollar?
*

85. In order to purchase foreign assets, U.S. residents would
need to buy foreign currencies.
So, the demand for foreign currencies rises and the supply
of dollars (to buy the foreign currencies) would rise in foreign
exchange markets.
But what happens when there is an increase in the supply
of dollars for sale in foreign exchange markets?
*
There is a reduction in the price of a dollar in terms of
foreign currencies, or what is the same, there is a depreciation
in the value of the dollar.
But what would a depreciation of the dollar do to U.S.
exports and imports and, therefore, to the current account
balance?
It is not as simple as it seems.
*
Let me remind you that the current account balance is equal to
the balance of exports and imports of goods and services plus
net factor income from abroad plus net unilateral transfers.
But in the case of the U.S., the current account balance is

86. determined essentially by the net balance of exports, X, and
imports of goods, M, so that ignoring everything else:
CAB = X – MWhat factors influence exports and imports?
*
There are four main sets of factors affecting the current
account balance:
1. Domestic income, Y. As domestic income rises, domestic
residents spend more. Some of this falls on imported goods and
services. So, the domestic demand for imports increases.
2. Foreign income, Y*. As foreign income rises, foreign
residents spend more. Some of this falls on the goods and
services that we (the domestic economy) exports. As a result,
domestic exports increase.
3. The exchange rate (to be discussed next)
4. Other factors, such as politics, the weather, earthquakes, oil
discoveries, etc.
*
Remember that the real exchange rate is defined as:

87. eP* e ($ per Yuan) P* (Price of Chinese goods in
Yuan)
q = ------ = -----------------------------------------------------------
--------
P P (Price of US goods in dollars)
Price of foreign goods in domestic currency
q = -------------------------------------------------------------------
Price of domestic goods in domestic currency
*
Since the real exchange rate is:
q = eP*/P
As the real exchange rate increases, foreign goods and
services become relatively more expensive.
This causes imports to decrease and exports to increase.
*
So, holding prices constant (P and P*), an increase in the

88. exchange rate, e (a domestic currency depreciation) causes the
real exchange rate to increase and it would tend to increase
exports and reduce imports.
But the impact of an increase in the exchange rate on the
current account balance is not necessarily positive!
*
CAB = Value of Exports – Value of Imports
= P EX - e P* IM
P = Price of exports (domestic goods exported)
EX = Quantity of Exports
e = exchange rate (dollars per yuan)
P* = Price of Imports (price of foreign, say, Chinese goods)
IM = quantity of imports (say, imports from China)
So, what happens when the exchange rate increases?
*
Let us assume that prices, P and P*, are fixed in the short-run
(which is what we do observe happens).
Suppose e goes up (the dollar depreciates in value)

89. CAB = Value of Exports – Value of Imports
↑ ↑ ↓
= P EX - e P* IM
Note that the dollar depreciation, the increase in e, tends to
improve the current account balance because it tends to reduce
the quantity of imports, IM, and increase the quantity of
exports, EX.
But it also tends to worsen the current account balance because
it raises the cost of imports, and therefore, the value of those
imports.
*
Whether the current account balance improves or not
depends on whether the dollar depreciation leads to a large
enough reduction in the quantity of imports and a large enough
increase in the quantity of exports to offset the rise in the value
of imports.
Economists refer to this condition as the Marshall-Lerner
condition, for the economists who established the exact
mathematical condition for a currency depreciation to have a
positive impact on the trade balance.
*

90. The empirical evidence on this issue shows that currency
devaluations have very little impact on the current account
balance in the short-run.
If anything, the impact can be negative in the short-run, because
the quantities exported and imported do not change much over a
short period of time (weeks or even months)
The impact is more positive over longer periods of time, as the
currency depreciation leads to a reduction in the quantity of
imports and to greater exports as well.
*
CAB
Time
↑
Currency
Depreciation
J-Curve effect of a currency depreciation on
The Current Account Balance (CAB)
*

91. But some have questioned recently whether currency
depreciations exert any significant influence on exports even in
the long-run.
One of your readings, from The Economist, appears to suggest
the relationship has weakened.
What is the recent evidence on how currency value changes
affect trade in the long-run?
A recent study by Daniel Leigh, Weicheng Lian, Marcos
Poplawski-Ribeiro, and Viktor Tsyrennikov published as part of
the 2015 World Economic Outlook –published by the IMF--
examined this issue.
You have a summary of this article as part of your readings.
*
*
Leigh et. al. define the long-run effects of a real effective
currency depreciation, which takes place after one year.
They look at case studies of 60 countries in the period of 1980
to 2014.
What do they conclude?
*

92. “The results suggest that a 10 percent real effective depreciation
in an economy’s currency is associated with a rise in real net
exports of, on average, 1.5 percent of GDP, with substantial
cross-country variation around this average.” (p. 111)
“Similarly, the estimates indicate that the Marshall-Lerner
condition holds, so that a currency depreciation [in the long-
run] improves the trade balance” (page 111)
*
*
So, the impact of currency devaluation is positive in the long-
run, but not necessarily in the short-run.
American policymakers who think that a revaluation of the yuan
(a depreciation of the dollar relative to the yuan) is going to
reduce the U.S. trade deficit with China will be disappointed
since this may not happen until several years in the future.
Similarly, those who expect that if Greece abandons the euro
and re-creates its own currency, the drachma, a depreciation of
the drachma will improve Greece’s trade balance may be
disappointed in the short-run.
*
So, let us assume that a dollar depreciation does improve the
current account balance by raising exports and reducing
imports.
Let us summarize the chain of events regarding expansionary
monetary policy:

93. *
An increase of the money supply leads to:Reduction of interest
rates, which causes:Capital outflows, which causes: A
depreciation of the domestic currency, which leads to: An
improvement of the current account balance, by raising exports
and reducing imports (assuming the Marshall-Lerner condition
is satisfied).
But what does this do to output, and therefore income,
employment, etc.?
The impact on output can be determined from the national
accounts equation, we derived earlier, for GNP:
YN = C + I + G + CAB
Where YN is GNP, C is private consumption, I is private
investment, G is government spending and CAB is the current
account balance.
So, if CAB rises, then output, income, employment, etc.
increase.
So, monetary policy is highly effective in stimulating
economic growth in an economy under flexible exchange rates
because of two reasons:

94. First, domestically, the effect is to lower interest rates,
which stimulates private domestic investment spending (I
above), which raises production and employment.
Second. There is an indirect effect through international
trade: the lower interest rates generate capital outflows that
cause a depreciation of the domestic currency, which –over
time--stimulates exports and also raises production and
employment (raising CAB above).
*
*
The U.S. has flexible
Exchange rates.
So, Ben Bernanke, the
Chairman of the Fed
In the U.S., was
right in seeking to
counteract the
Great Recession with
massive, expansionary
monetary policy.
*
However, although the objective of the Federal Reserve’s
expansionary monetary policy was to support the banking
system and stimulate the economy by raising credit, consumer
spending, etc., the expansionary policy had also other
consequences.

95. As we just explained, an increase in the money supply of a
country causes that country’s currency to depreciate in value.
So, the expansionary monetary policy in the U.S. led to a
depreciation of the dollar, which was then reflected in an
appreciation of other currencies.
But these exchange rate changes then had consequences on the
international competitiveness of American versus the products
of other countries.
The depreciation of the dollar caused U.S. export products to
become relatively more competitive relative to the exports of
other countries. Other countries, therefore, lost competitiveness
and their exports dropped.
A currency depreciation is therefore what economists call a
beggar-thy-neighbor policy.
It helps the domestic economy grow at the expense of other
countries.
Of course, other countries will react to such policies.
The reaction, in Brazil, Colombia and many other developing
countries, in 2011 and 2012, was to intervene in foreign

96. exchange markets by buying dollar reserves in order to reduce
the supply of dollars and cause an appreciation of the dollar and
a depreciation of their own currencies.
Other countries also adopted policies to depreciate their
currencies, including Japan, to counteract the dollar
depreciation.
This currency war has subsided but remains a threat in world
economic affairs.
Let us now go back to the issue of how the exploitation of
natural resources affects an economy.
So, let us examine the effects of an increase in the export
of natural resources, obtained as a result of the discovery and
exploitation of those resources, say crude oil.
What would be the impact of such an expansion using the
Mundell-Fleming theoretical framework? How does it affect
output and employment?
*
*

97. The impact on output can be determined from the national
accounts equation, we derived earlier, showing the demand
determinants of GNP:
YN = C + I + G + CAB
Where YN is GNP, C is private consumption, I is private
investment, G is government spending and CAB is the current
account balance.
So, what happens if crude oil exports increase?
The direct effect of the increased oil exports is to increase the
current account balance, thus raising output and employment.
But this is not the end of the story. We have to look also at the
international repercussions of the increased exports and
production.
To understand the repercussions of the oil expansion, you
must understand that the expansion of production is based on
greater needs for capital in the oil industry.
The increased demand for capital, however, will tend to
cause an increase in domestic interest rates.
This has significant repercussions.
If interest rates in the rest of the world are constant, then

98. higher domestic interest rates will lead to capital inflows, as
investors will seek the higher returns offered by the booming
oil-based economy.
But what would capital inflows do to the value of the
domestic currency?
*
In order to invest in domestic assets, foreign residents
would need to buy the domestic currency.
So, the demand for domestic currency would rise in
foreign exchange markets.
But what happens when there is an increase in the demand
for domestic currency in foreign exchange markets?
*
There is a increase in the price of the domestic currency in
terms of foreign currencies, or what is the same, there is an
appreciation in the value of the domestic currency.
But what would an appreciation of the domestic currency
do to domestic exports and, therefore, to the current account
balance?

99. *
A domestic currency appreciation will tend to hurt domestic
competitiveness, which will reduce domestic exports of non-oil
products.
So, although exports of oil rise, the exports of everything else
declines.
And this phenomenon is what economists call “Dutch disease.”
The conclusion is that, although an increase in the
exploitation and export of natural resources may have a positive
initial impact on the economy, this is reversed by the negative
impact on other sectors of the economy.
Overall, then the exploitation of natural resources, may not
have such a beneficial effect on a country.
*
*
SEQ CHAPTER h r 1International Economics

100. Prof. Rivera-Batiz
BAU International University
Spring 2018
Assignment #3
Please answer all of the sections of following four questions.
Please provide explanations for your answers, including any
calculations you have carried out. The problem set is due on
April 4th (before class). Note that this problem set is to be
answered individually, although small groups can work on it
together. The answers must be submitted as a hard copy. Please
provide comprehensive answers, showing where your results
come from and supporting your answers with data and/or any
references to academic studies.
1. The following table shows the National Income and Product
Account of the United States and the Consolidated Government
Account one decade ago, in 2007.
U.S. National Income Account and Consolidated Government
Account, 2007
(In billions of dollars)
_____________________________________________________
_________________________

101. 2007
_____________________________________________________
_________________________
Summary National Income and Product Accounts
Gross National Product (GNP)
13,937
Private Consumption
9,734
Private Investment

102. 2,125
Government Spending
2,689
Govt. consumption
2,221
Govt. investment
468
Current Account Balance (excludes unilateral transfers)
-611
Government Consolidated Budget
Government Revenues
4,213
Government Outlays (includes govt. spending plus
4,633
transfer payments and other expenditures
_____________________________________________________

103. _________________________
Source: U.S. Department of Commerce.
(A) How much was U.S. absorption in 2007? As a proportion of
GNP, was absorption in 2007 greater or lower than in 2016
(using the data presented in class)? Please explain your
calculations.
(B) As a fraction of GNP, how does the current account balance
(excluding unilateral transfers) in 2007 compare with that in
2016 (as presented in class)? What are the economic
implications of this change?
(C) How much, as a fraction of GNP, was the budget balance in
2007? Did the budget balance deteriorate or improve between
2007 and 2016 (using the data presented in class), as a fraction
of GNP? By how much? Explain.
(D) Break down the current account balance (as a fraction of
GNP) into its national savings and investment components (as a
fraction of GNP). What were the changes between 2007 and
2016 (as presented in class)? What accounts for the changes in
the current account balance: changes in savings or changes in
investment or both? Explain.
2. Shinzo Abe is the current Prime Minister of Japan. He has
advocated a number of significant economic reforms since he
became Prime Minister in 2012. One of these reforms involves
the use of expansionary monetary policy, which the central bank
of Japan has actively followed. The U.S. Treasury, however, has
criticized so-called Abenomics, arguing that its monetary policy
constitutes a “beggar-thy-neighbor” policy and that it unfairly
discriminates economically against the United States. Do you
agree or disagree with the U.S. Department of Treasury and
why?
3. Some economists have recently argued that currency
devaluations or depreciations have lost their ability to improve
the current account balance or trade balance of the

104. industrialized economies. The magazine The Economist, for
example, observes that “devaluations do not seem to have
provided quite the same boost [to exports] recently.” What is
the evidence available on the effects of currency depreciation
on the current account balance or the trade balance? Is the
Economist correct? Please explain.
4. Due to the discoveries of vast deposits of copper, coal and
gold, the country of Mongolia in central Asia will be flooded
with natural resource-related revenues for many years.
According to a New York Times article (July 2012), “The
surging mining trade has made Mongolia the world’s fastest
growing economy…the country [is] on the brink of prosperity.”
A. But some economists have questioned whether the
exploitation of natural resources will lead to long-run economic
growth. Why would the exploitation of natural resources and the
export of commodities such as oil and minerals fail to generate
substantial economic progress?
B. What is the global experience with the exploitation of natural
resources? Have increased oil exports, for example, resulted in
increased economic growth? What is the evidence on this issue?