Dominick-Salvatore-International-Economics.pdf

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International Economics

Eleventh Edition

Dominick Salvatore
Fordham University

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Salvatore, Dominick.
International economics [electronic resource] / Dominick Salvatore. – 11th ed.

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1. International economic relations. I. Title.
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Salvatore fpref.tex V2 – 11/10/2012 7:35 A.M. Page v

Preface

This is the eleventh edition of a text that has enjoyed a flattering market success,
having been adopted by more than 600 colleges and universities throughout
the United States, Canada, and other English-speaking countries and more
than 1,000 in other countries around the world. The text has been translated
into Chinese, French, Greek, Indonesian, Italian, Korean, Polish, Portuguese
(Brazilian), Spanish, Russian, and other languages. All the features that have
made the previous editions of this text one of the leading texts of International
Economics in the United States and around the world have been retained in the
eleventh edition. However, the content has been thoroughly updated and expanded
to include many new significant topics and important recent developments.

Significant International Developments

The main objective of the eleventh edition of International Ecconomics is to present
a comprehensive, up-to-date, and clear exposition of the theory and principles
of international economics that are essential for understanding, evaluating, and
suggesting solutions to the important international economic problems and issues
facing the United States and the rest of the world today, and that countries are
likely to face in the coming years. These are:

1. Slow growth and high unemployment in advanced economies after the
“Great Recession” — the deepest financial and economic crisis since the Great
Depression of 1929.

2. Rising protectionism in the United States and in other advanced countries in
the context of a rapidly globalizing world reduces the level of specialization
and trade, and it raises the specter of trade wars that would be very detrimental
to the welfare of all nations.

3. Excessive volatility and large and persistent misalignments of exchange rates
discourage the international flow of trade and investments and could lead to
international financial and monetary crises.

4. Deep structural imbalances in the United States, slow growth in Europe and
Japan, and insufficient restructuring in the transition economies of Central and
Eastern Europe reduce the volume of international trade and could cause the
collapse of the dollar and/or the euro.

v

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vi Preface

5. The deep poverty in many developing countries and the widening international inequal-
ities pose serious moral, political, and developmental problems for the United States
and other advanced countries.

6. Resource scarcity, environmental degradation, and climate change put at risk contin-
ued growth in the United States and other advanced countries, as well as sustainable
development in emerging markets.

These events significantly affect the well-being of the United States and the rest of the world
but are, to a large extent, beyond U.S. control.

New to the Eleventh Edition
Chapter 1 has been thoroughly revised and updated to reflect the dramatic economic and
financial changes that have taken place in the world economy since the last edition of this
text. Section 1.6 has been thoroughly revised to identify the major international economic
(trade and financial) problems facing the United States and the world today, and so has the
discussion in Chapter 21 (Section 21.6), which examines how they can be resolved.

The rapid globalization of the world economy is providing major benefits to most coun-
tries, but it is also presenting many challenges to poor countries that are unable to take
advantage of globalization, as well as to the United States and other advanced countries that
face increasing competition from some emerging markets, especially China. These topics are
discussed in several new sections and case studies in the trade and finance part of the text.

The dollar–euro exchange rate is as much in the news these days as the huge and
unsustainable trade deficits of the United States and sovereign debts in the Eurozone. The
relationship between U.S trade deficits, trade protectionism and misaligned exchange rates,
as well as the crisis in the Euro Area are examined, both theoretically and empirically, and
in all of their ramifications, in several trade and finance sections and case studies in this
new edition of the text.

Besides their effect on international trade and international competitiveness, the contin-
uing globalization of the world economy and liberalization of international capital markets
have further eroded governments’ control over national economic and financial matters.
Exchange rates exhibit great volatility and large misalignments, both of which interfere
with the flow of international trade and investments and distort the comparative advan-
tage of nations. At the same time, international macroeconomic policy coordination has not
progressed sufficiently to deal adequately with the potential problems and challenges that
increased interdependence in world financial markets create.

The eleventh edition of this book also presents an in-depth analysis of the dangerous
structural imbalances in the world economy and provides an evolution of the policy options
available to deal with them. The major imbalances in the world economy today are the
huge trade and budget (twin) deficits of the United States, the slow growth and high
unemployment in Europe, the decade-long stagnation in Japan, the serious competitive
challenge for both advanced and developing countries provided by the competition from
China, the danger of financial and economic crises in emerging market economies, world
poverty, resource scarcity, and environmental degradation. All of these topics are addressed
in this edition of the text.

There are 122 case studies in the text. Many are new, and the others have been thoroughly
revised.

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Preface vii

The extended annotated Selected Bibliography at the end of each chapter has been thor-
oughly updated and extended, and it represents a major resource for further study and
research on various topics.

The Internet section at the end of each chapter has been updated and expanded and
gives the most important Internet site addresses or links to data sources, information, and
analyses for the topics presented in each chapter to show how to access and use the wealth
of information available on the Internet.

The Companion Web Site for the Text has also been thoroughly updated and expanded,
and it presents for each chapter additional examples, cases, and theoretical points, as well
as questions and problems that can be answered or solved using the Internet.

New, extended, and revised sections and case studies in the trade theory and policy
parts of the text include benefits and challenges of globalization; the gravity model; the
changing pattern of comparative advantage; variety gains from international trade; EU–US
trade disputes and protectionism; the pervasiveness of nontariff trade barriers; strategic
trade and industrial policies; the emergence of new economic giants; job losses in high
U.S. import-competing industries; international trade and de-industrialization of the United
States and other advanced countries; international trade and U.S. wage inequalities; benefits
and costs of NAFTA; international trade and environmental sustainability; globalization and
world poverty; trade and growth in developing countries; the collapse of the Doha Round;
and the debate over U.S. immigration policy.

New sections and case studies in international finance include size, currency, and
geographical distribution of the foreign exchange market; the carry trade; fundamental
forces and “news” in exchange rate forecasting; the exploding U.S. trade deficit with
China; the euro–dollar exchange rate defies forecasting; the Balassa–Samuelson effect in
transition economies; structural imbalances and exchange rate misalignments; the effective
exchange rate of the dollar and U.S. current account deficits; exchange-rate pass-through
to import prices; petroleum prices and growth; inflation targeting and exchange rates;
the global financial crisis and the Great Recession; slow recovery and growth after the
Great Recession; the Eurozone crisis and the future of the euro; internationalization of
the renminbi (yuan); exchange rate arrangements of IMF members; and reforms of the
international monetary system.

More international trade and finance data are included throughout the text.

Audience and Level
The text presents all the principles and theories essential for a thorough understanding of
international economics. It does so on an intuitive level in the text itself, and more rigorously
in the appendices at the end of most chapters. In addition, partial equilibrium analysis is
presented before the more difficult general equilibrium analysis (which is optional). Thus,
the book is designed for flexibility. It also overcomes the shortcomings of other international
economics texts in which the level of analysis is either too complicated or too simplistic.

Organization of the Book
The book is organized into four parts. Part One (Chapters 2–7) deals with trade theory (i.e.,
the basis and the gains from trade). Part Two (Chapters 8–12) deals with trade policy (i.e.,
obstructions to the flow of trade). Part Three (Chapter 13–15) deals with the measurement of

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viii Preface

a nation’s balance of payments, foreign exchange markets, and exchange rate determination.
Part Four (Chapters 16–21) examines open-economy macroeconomics or the macro rela-
tionships between the domestic economy and the rest of the world, as well as the operation
of the present international monetary system.

In the typical one-semester undergraduate course in international economics, instructors
may wish to cover the 11 core chapters (1, 2–3, 5, 9, 13–17, 21) as well as the few other
asterisked sections in other chapters, and exclude the appendices. Undergraduate courses in
international trade could cover Chapters 1 to 12 and 21, whereas undergraduate courses in
international finance could cover Chapters 1 and 13 to 21. The many examples and real-world
case studies presented also make the text very suitable for international economics courses
in business programs. In first-year graduate courses in international economics and business,
instructors may want to cover the appendices also and assign readings from the extensive
annotated bibliography at the end of each chapter.

For the Student

• The same example is utilized in all the chapters dealing with the same basic concept .
This feature is unique to this text. For example, the same graphical and numerical model
is used in every chapter, from Chapters 2 through 11 (the chapters that deal with trade
theory and policy). This greatly reduces the burden on the student, who does not have
to start fresh with a new example each time. It also shows more clearly the relationship
among the different topics examined.

• Actual numbers are used in the examples and the graphs are presented on scales . This
makes the various concepts and theories presented more concrete, accessible, and per-
tinent to the student, and the graphs easier to read and understand.

• There are 122 case studies (from 4 to 9 per chapter). These real-world case studies are
generally short and to the point and serve to reinforce understanding and highlight the
most important topics presented in the chapter.

• The sections of each chapter are numbered for easy reference. Longer sections are broken
into two or more numbered subsections. All of the graphs and diagrams are carefully
explained in the text and then summarized briefly in the captions.

• The judicious use of color and shading enhances the readability of the text and aids
student understanding .

• Each chapter ends with the following teaching aids :

• Summary — A paragraph reviews each section of the text.

• A Look Ahead — Describes what follows in the subsequent chapter.

• Key Terms — Lists the important terms introduced in bold face type in the chapter.
A glossary of all these terms is provided at the end of the book.

• Questions for Review — Fourteen review questions are presented (two or more for
each section in the chapter).

• Problems — Fourteen to fifteen problems are provided for each chapter. These
ask the student to calculate a specific measure or explain a particular event.

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Preface ix

Brief answers to selected problems (those marked by an asterisk) are provided at
www.wiley.com/college/salvatore for feedback.

• Appendices — These develop in a more rigorous but careful and clear fashion certain
material that is presented on an intuitive level in the chapter.

• Selected Bibliography — The most important references are included, along with
specific notes indicating the topic they cover. A separate Author Index is included
at the end of the book.

• Internet — A section at the end of each chapter provides relevant Internet site
addresses or links to data sources, information, and analyses to show the student
how to access and use the wealth of information available on the Internet.

• Accompanying the text, there are also:
• A Web Site — Each chapter presents additional examples, cases, and theoretical

points and questions as well as problems that can be answered or solved using the
Internet. The web site is continuously updated to reflect important new developments
in the international economy as they unfold.

• An Online Study Guide prepared by Professor Arthur Raymond of Muhlenberg
College is available for students. This provides extensive review of key concepts,
numerous additional illustrative examples, and practice problems and exercise sets.

• A Schaum Outline on the Theory and Problems of International Economics (4th
edition, 1996), prepared by the author, can be purchased at a very low price in most
bookstores. This provides a problem-solving approach to the topics presented in the
traditional way in this and other international economics texts.

For the Instructor
• An Instructor’s Manual prepared by the author is available. It includes chapter objec-

tives and lecture suggestions, answers to the end-of-chapter problems, a set of 15 to 20
multiple-choice questions, with answers, and additional problems and essays for each
chapter.

• PowerPoint Presentations, prepared by Professor Leonie L. Stone of the State Univer-
sity of New York at Geneseo, provide brief outline notes of the chapter and also contain
all the figures and tables in the text. These are available on the Instructor Companion Site.

• A Test Bank, also prepared by Professor Stone, contains at least 25 multiple-choice
questions per chapter and is available on the Instructor Companion Site. A computerized
version for easy test preparation is also available.

Acknowledgments
This text grew out of the undergraduate and graduate courses in international economics that
I have been teaching at Fordham University during the past 30 years. I was very fortunate
to have had many excellent students who, with their questions and comments, contributed
much to the clarity of exposition of this text.

http://www.wiley.com/college/salvatore

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x Preface

I have received much useful advice in writing this text by Professors Robert Bald-
win (University of Wisconsin), Jagdish Bhagwati (Columbia University), Alan Blinder
(Princeton University), William Branson (Princeton University), Phillip Cagan (Columbia
University), Richard Cooper (Harvard University), W. M. Corden (Johns Hopkins Uni-
versity), Rudi Dornbusch (MIT), Martin Feldstein (Harvard University), Ronald Findlay
(Columbia University), Gerald Helleiner (University of Toronto), Lawrence Klein (Univer-
sity of Pennsylvania), Ronald McKinnon (Stanford University), Robert Mundell (Columbia
University), Edmund Phelps (Columbia University), Jeffrey Sachs (Columbia University),
Amartya Sen (Harvard University), T. N. Srinivasan (Yale University), Robert Stern (Univer-
sity of Michigan), Joseph Stiglitz (Columbia University), and Lawrence Summers (Harvard
University).

I greatly appreciate the feedback provided by reviewers of the eleventh edition: Werner
Baer (University of Illinois), Stefania Garetto (Boston University), Guoqiang Li (University
of Macao), Steven J. Matusz (Michigan State University), Leonie Stone (State University
of New York at Geneseo), and Elizabeth Wheaton (Southern Methodist University).

The following professors read through previous editions of the text and made many
valuable suggestions for improvement: Adelina Ardelean (Santa Clara University), Sven
Arndt (Claremont McKenna College), Taeho Bark (Georgetown University), Harry Bowen
(New York University), Joseph C. Brada (Arizona State University), Janice Boucher Breur
(University of South Carolina, Columbia), Francis Casas (University of Toronto), Bas-
anta Chaudhuri (Rutgers–State University of New Jersey), Menzie Chinn (University of
California — Santa Cruz), Nora Colton (Drew University), Manjira Datta (Arizona State Uni-
versity), Denise Dimon (University of San Diego), Martine Duchatelet (Barry University),
Liam P. Ebril (Cornell University), Zaki Eusufazai (Loyola Marymount University — Los
Angeles), Phillip Fanchon (California Polytechnic State University), Khosrow Fatemi (Cali-
fornia Imperial Valley), Michele Fratianni (Indiana University), Stephen Galub (Swarthmore
College), Ira Gang (Rutgers University), Darrin Gulla (University of Kentucky), Harish C.
Gupta (University of Nebraska), John W. Handy (Morehouse College), Roy J. Hensley
(University of Miami), David Hudgins (University of Oklahoma), Geoffrey A. Jehle (Vas-
sar College), Robert T. Jerome Jr. (Madison University), Mitsuhiro Kaneda (Georgetown
University), Evert Kostner (Gotenberg University in Sweden), W. E. Kuhn (University of
Nebraska–Lincoln), Stanley Lawson (St. John’s University), Robert Lipsey (Queens Col-
lege), Craig MacPhee (University of Nebraska, Lincoln), Margaret Malixi (California State
University at Bakersfield), Daniel W. Marsh (University of Dallas), Jerome L. McElroy
(Saint Mary’s College of Indiana), Patrick O’Sullivan (State University of New York),
Michael Plummer (Brandeis University), David Raker (University of California at San
Diego), Silke Reeves (George Washington University), Rupert Rhodd (Florida Atlantic Uni-
versity), Donald Richards (Indiana State University), Don J. Roussland (George Washington
University), Sunil Sapra (California State University, Los Angeles), Stefania Scandizzo
(Texas A&M University), Siamack Shojai (Marcy College), Michael Szenberg (Pace Univer-
sity), Wendy Takacs (University of Maryland), C. Richard Torrisi (University of Hartford),
Joseph L. Tryon (Georgetown University), Hendrik van den Berg (University of Nebraska,
Lincoln), Jim Wang (Eureka College), Frank Weiss (Johns Hopkins University), and Harold
R. Williams (Kent State University).

Other professors and economists who provided valuable comments are Richard Baltz
(Millsaps College), Reza Barazesh (Director of Research at Equifax), Andrew Blair (Univer-
sity of Pittsburgh), Luca Bonardi (partner at KPMG), Roger Bove (West Chester University),

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Preface xi

Francis Colella (Simpson College), Evangelos Djinopolos (Fairleigh Dickinson University),
Ali Ebrahimi (Pace University), Dawn Elliott (Texas Christian University), Holger Engberg
(New York University), Marcel Fulop (Kean College), George Georgiou (Towson State Uni-
versity), Reza Ghorashi (Stockton College), Fred Glahe (University of Colorado), Henry
Golstein (University of Oregon), Michael Halloran (partner at Ernst & Young), Sunil Gulati
(Columbia University), Francis J. Hilton (Loyola of Baltimore), Syed Hussain (University of
Wisconsin), William Kaempfer (University of Colorado), Demetrius Karantelis (Assumption
College), Samuel Katz (Georgetown University), James Kokoris (Northeastern Illinois Uni-
versity), Kishore Kulkarni (Metropolitan State College in Denver), J. S. LaCascia (Marshall
University), Leroy Laney (Federal Reserve Bank of Dallas), Mary Lesser (Iona College),
Cho Kin Leung (William Patterson College), Richard Levich (New York University), Farhad
Mirhady (San Francisco State University), Kee-Jim Ngiam (Carleton University), Shreekant
Palekar (University of Mexico), Anthony Pavlick (University of Wisconsin), Ruppert Rhodd
(Florida Atlantic University), T. S. Saini (Bloomburg University), Vedat Sayar (Brooklyn
College), Gerald Scott (Florida Atlantic University), Jeffrey R. Shafer (Managing Director
of Salomon Smith Barney), Lezcek Stachow (St. Anselm College), Stanislaw Wasowski
(Georgetown University), Bernard Wolf (York University in Canada), Behzad Yaghmaian
(Ramapo College of New Jersey), Darrel Young (University of Texas), Helen Youngelson
(Portland State University), and Eden Yu (University of Oklahoma).

Mary Burke, Fred Campano, Edward Dowling, Ralf Hepp, Baybars Karacaovali,
Darryl McLeod, Subha Mani, Erick Rengifo, Henry Schwalbenberg, Booi Themeli, and
Greg Winczewski, my colleagues at Fordham University, read through the entire manuscript
and provided much useful advice. Joseph Mauro, Michael Mebane, and Shannon Pullaro
my graduate assistants, provided much help with many aspects of the project.

Finally, I express my gratitude to George Hoffman, vice president and executive publisher
at Wiley; Joel Hollenbeck, executive editor; Jennifer Manias, content editor; Jesse Cruz,
marketing manager; Erica Horowitz, editorial assistant; and the entire staff at Wiley for
their kind and skillful assistance. And my thanks to Angela Bates and Josephine Cannariato
(department secretaries) for their efficiency and cheerful disposition.

Dominick Salvatore
Distinguished Professor of Economics

Fordham University

New York 10458

Tel. 718-817-4045

Fax 718-817-3518

e-mail: [email protected]

mailto:[email protected]

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Brief Contents

Preface v

1 Introduction 1

Part 1 International Trade Theory

2 The Law of Comparative Advantage 31
3 The Standard Theory of International Trade 57
4 Demand and Supply, Offer Curves, and the Terms of Trade 85
5 Factor Endowments and the Heckscher–Ohlin Theory 109
6 Economies of Scale, Imperfect Competition, and International Trade 157
7 Economic Growth and International Trade 189

Part 2 International Trade Policy

8 Trade Restrictions: Tariffs 221
9 Nontariff Trade Barriers and the New Protectionism 257

10 Economic Integration: Customs Unions and Free Trade Areas 301
11 International Trade and Economic Development 331
12 International Resource Movements and Multinational Corporations 367

Part 3 The Balance of Payments, Foreign Exchange Markets,
and Exchange Rates

13 Balance of Payments 397
14 Foreign Exchange Markets and Exchange Rates 423
15 Exchange Rate Determination 463

Part 4 Open-Economy Macroeconomics and the International
Monetary System

16 The Price Adjustment Mechanism with Flexible and Fixed Exchange Rates 507
17 The Income Adjustment Mechanism and Synthesis of Automatic Adjustments 541
18 Open-Economy Macroeconomics: Adjustment Policies 573
19 Prices and Output in an Open Economy: Aggregate Demand and Aggregate Supply 617
20 Flexible versus Fixed Exchange Rates, the European Monetary System, and

Macroeconomic Policy Coordination 645
21 The International Monetary System: Past, Present, and Future 687

Glossary of Key Terms 729
Name Index 743
Subject Index 751

xiii

Contents

1 Introduction 1

1.1 The Globalization of the World Economy 1

1.1A We Live in a Global Economy 1

� Case Study 1-1 The Dell PCs, iPhones, and iPads Sold in the
United States Are Anything but American! 2

� Case Study 1-2 What Is an “American” Car? 3

1.1B The Globalization Challenge 3

� Case Study 1-3 Is India’s Globalization Harming the United States? 5

1.2 International Trade and the Nation’s Standard of Living 6

� Case Study 1-4 Rising Importance of International Trade to the
United States 8

1.3 The International Flow of Goods, Services, Labor, and Capital 9

1.3A The International Flow of Goods and Services: The Gravity Model 9

1.3B The International Flow of Labor and Capital 10

� Case Study 1-5 Major Net Exporters and Importers of Capital 11

1.4 International Economic Theories and Policies 11

1.4A Purpose of International Economic Theories and Policies 11

1.4B The Subject Matter of International Economics 12

1.5 Current International Economic Problems and Challenges 13

1.6 Organization and Methodology of the Text 15

1.6A Organization of the Text 15

1.6B Methodology of the Text 16

Summary 17

A Look Ahead 18

Key Terms 18

Questions for Review 18

Problems 19

A1.1 Basic International Trade Data 20

A1.2 Sources of Additional International Data and Information 24

Selected Bibliography 26

INTERNet 28

xv

xvi Contents

Part 1 International Trade Theory

2 The Law of Comparative Advantage 31

2.1 Introduction 31

2.2 The Mercantilists’ Views on Trade 32

� Case Study 2-1 Munn’s Mercantilistic Views on Trade 33
� Case Study 2-2 Mercantilism Is Alive and Well in the

Twenty-first Century 33

2.3 Trade Based on Absolute Advantage: Adam Smith 34

2.3A Absolute Advantage 34

2.3B Illustration of Absolute Advantage 35

2.4 Trade Based on Comparative Advantage: David Ricardo 36

2.4A The Law of Comparative Advantage 36

2.4B The Gains from Trade 37

2.4C The Case of No Comparative Advantage 39

2.4D Comparative Advantage with Money 39

� Case Study 2-3 The Petition of the Candlemakers 41

2.5 Comparative Advantage and Opportunity Costs 41

2.5A …

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