International Economics

1. Increasing Openness of the World Economy

• Global trade has significantly increased, reflecting deeper economic interdependence.
• Example: Germany's trade balance shows a strong export of industrial products and imports of raw materials and industrial goods.
• Most trade occurs between countries with similar economic structures.

2. Absolute Costs and Autarky

• Autarky: Economic self-sufficiency where a country or individual consumes only what it produces.
• Under autarky, the production possibilities frontier (PPF) equals the consumption possibilities frontier (CPF).
• No gains from trade since consumption is limited to domestic production.

3. Gains from Trade and Comparative Advantage

• Comparative Advantage: The ability to produce a good at a lower opportunity cost than another producer.
• Trade benefits arise when parties specialize according to their comparative advantages.
• Even if one party has an absolute advantage in all goods, both can gain from trade by specializing in goods with lower opportunity costs.

4. Scientific Foundations of Trade Theory

5. Reality of International Trade Patterns

• Countries like Germany export mainly industrial products.
• Imports include raw materials and industrial goods.
• Trade is often conducted between countries with similar economic profiles.
• This pattern reflects comparative advantage and specialization beyond simple factor endowments.

Key point: Comparative advantage based on differences in opportunity costs is the fundamental reason for gains from trade, enabling specialization and mutual benefits even when one party is absolutely more efficient.

1. Comparative Advantage and Specialization

Comparative advantage is the ability of a country to produce a good at a lower opportunity cost than another country. It explains why countries benefit from trade by specializing in the production of goods for which they have a comparative advantage.

Specialization occurs when countries focus their production on goods where they hold a comparative advantage, leading to increased overall efficiency and gains from trade.

2. Key Concepts

3. Determinants of Net Exports

Net exports depend on several factors:

• Consumer preferences for domestic vs. foreign goods.
• Relative prices of goods at home and abroad.
• Exchange rates determining the cost of foreign currency in domestic terms.
• Income levels of consumers domestically and internationally.
• Transportation costs affecting the feasibility of trade.

To remember:
Countries gain by specializing in goods where they have a comparative advantage and trading with others, leading to more efficient global resource allocation.

1. Net Capital Outflow (NCO)

• Definition: Net capital outflow is the difference between the purchase of foreign assets by domestic residents and the purchase of domestic assets by foreigners.
• Examples:
  • When a UK resident buys shares in a German company (BMW), UK’s NCO increases.
  • When a Japanese resident buys UK government bonds, UK’s NCO decreases.
• Determinants of NCO:
  • Real interest rates on foreign assets.
  • Real interest rates on domestic assets.
  • Perceived economic and political risks of holding foreign assets.
  • Government policies affecting foreign ownership of domestic assets.

2. Equality of Net Exports (NX) and Net Capital Outflow (NCO)

• Key identity: For the entire economy, net exports must equal net capital outflow:

  $$NCO = NX$$

• GDP identity including net exports:

  $$Y = C + I + G + NX$$

• National saving (S) is income left after consumption and government spending:

  $$S = Y - C - G$$

• Saving-investment relation including trade balance:

  $$S = I + NX$$

• Combining these, since $NX = NCO$:

  $$S = I + NCO$$

3. Summary Table: Key Relationships

To remember: In an open economy, net exports always equal net capital outflow, linking the trade balance to international financial flows.

1. Trade Balance and Capital Flows

a) Import Demand Curve (Home Country)

• Definition: Maximum quantity of imported goods consumed at each price level.
• Formula:
  $MD = D(P) - S(P)$
  where $D(P)$ is domestic demand and $S(P)$ is domestic supply at price $P$.

b) Export Supply Curve (Foreign Country)

• Definition: Maximum quantity of goods the foreign country is willing to export at each price.
• Formula:
  $XS = S_F(P_F) - D_F(P_F)$
  where $S_F(P_F)$ is foreign supply and $D_F(P_F)$ is foreign demand at foreign price $P_F$.

c) World Market Equilibrium

• Achieved where import demand equals export supply:
  $MD = XS$
• International trade increases economic welfare by allowing countries to specialize and consume beyond their production possibilities.

2. Trade Policy Instruments

a) Forms of Tariffs

Key point: Tariffs affect import prices and quantities, influencing trade balance and capital flows.

1. Market Equilibrium and International Trade Effects

a) Effects of Tariff Introduction

• Initial situation: Without tariff, the world price $P_w$ is the same for home and foreign countries.

• In the home country:

  • Tariff raises domestic price to $P_T > P_w$.
  • Higher price increases domestic supply and decreases domestic demand.
  • Result: Import demand falls, reducing the quantity traded internationally.

• In the foreign country:

  • Reduced exports due to lower import demand.
  • Excess supply emerges in the foreign market.
  • Foreign price may fall to $P_F^T$.

• Price difference: The gap between home and foreign prices equals the tariff rate $t$:

  $$P_T - P_F^T = t$$

b) Welfare Effects of a Tariff

• Tariffs protect domestic producers by raising prices.
• They reduce consumer surplus due to higher prices.
• Government gains tariff revenue.
• Overall welfare effect depends on the balance between consumer loss, producer gain, and government revenue.

c) Effects of Import Quota

• Definition: Import quota is a direct quantitative limit on imports.
• Implementation: Licenses are given to certain importers or countries.
• Direct effects:
  1. Domestic price rises above world price.
  2. Quantity traded internationally decreases.
  3. Domestic consumers face higher prices and reduced availability.

Key point: Both tariffs and import quotas raise domestic prices and reduce import quantities, but quotas impose a direct volume limit, while tariffs impose a price increase.

1. Welfare Effects of Quotas

• Domestic buyers lose welfare due to higher prices.
• Domestic sellers gain welfare from higher prices.
• License holders profit by buying at the world price and selling at the higher domestic price.
• Overall, quotas cause greater welfare losses than equivalent tariffs.

2. Voluntary Export Restraints (VER)

3. Effects of Export Subsidies

• Export Subsidies: government payments to encourage exports; can be specific (fixed amount) or ad valorem (percentage of value).
• Direct effects include changes in domestic and world prices, impacting welfare and trade balances (details not provided in the source).

Key takeaway: Quotas and VERs generally reduce welfare more than tariffs, with VERs transferring income abroad and causing losses to the importing country.

1. Export Subsidies: Effects and Welfare Implications

• Export subsidy: A government payment to domestic producers for each unit exported, lowering their costs and encouraging exports.

• Effects on trade and prices:

  1. Domestic production and exports increase.
  2. The internationally traded quantity rises.
  3. The foreign (importing) country's price for the good decreases.

• Welfare effects:

  • Producers gain due to higher sales and subsidies.
  • Consumers lose because domestic prices rise.
  • The government incurs a cost by paying the subsidy.
  • Export subsidies worsen the terms of trade for the exporting country by lowering the export price.

Key result: An export subsidy always causes a net welfare loss for the country implementing it.

2. Political Economy of Trade Restrictions: The Prisoner's Dilemma (PD) Applied

• Trade restrictions often lead to a vicious circle of protectionism where countries retaliate with their own barriers.
• Example: The Smoot-Hawley Act (1930) raised U.S. tariffs to an average of 53%, provoking retaliatory tariffs worldwide.
• Result: A sharp decline in world trade and deepening of the Great Depression (1929–1933).

3. Short-Term Macroeconomic Supply: IS-LM Model Context

• In the short run, the aggregate supply curve is horizontal at a fixed price level $P^*$.

• Firms supply any quantity demanded at this price, limited only by production capacity.

• Therefore, macroeconomic demand determines output and income.

• Components of macroeconomic demand:

  • Private consumption ($C$)
  • Investments ($I$)
  • Government expenditures ($G$)

To remember: Export subsidies increase exports but reduce national welfare due to terms of trade deterioration and government costs. Trade restrictions can trigger retaliations, harming global trade and economic growth. In the short run, fixed prices mean demand drives output.

1. Macroeconomic Demand Function

• Macroeconomic demand ($AD$) includes:

  $$AD = C(Y - T) + I(r) + G + NX(e)$$

  where:

  • $C$ = Consumption (depends on disposable income $Y - T$)
  • $I$ = Investment (depends negatively on interest rate $r$)
  • $G$ = Government spending (exogenous)
  • $NX$ = Net exports (depends on exchange rate $e$)

• Net demand of foreign countries is captured by net exports ($NX = Exports - Imports$).

2. Keynesian Cross (45-Degree Diagram)

Assumptions:

• Price level ($P$) and interest rate ($r$) are exogenous and fixed in the short term.
• Economic agents plan demand and supply for goods.
• Planned demand is always met by the market (no excess demand).
• Planned supply is produced but not necessarily sold, leading to inventory changes.
• No foreign trade transactions (closed economy).

Equilibrium condition:

$$Y = AD$$

where $Y$ is the macroeconomic income/output.

3. Fiscal Policy and the Fiscal Multiplier

• Changes in government spending ($G$) or taxes ($T$) affect aggregate demand and thus output.
• The fiscal multiplier measures the total change in output resulting from a change in fiscal policy: $$\text{Multiplier} = \frac{1}{1 - MPC}$$ where $MPC$ is the marginal propensity to consume.

4. IS Curve: Goods Market Equilibrium

• The IS curve represents all combinations of interest rate ($r$) and income ($Y$) such that the goods market is in equilibrium:

  $$Y = C(Y - T) + I(r) + G + NX(e)$$

• Slope: Negative

  • Lower $r$ → higher investment $I(r)$ → higher output $Y$.

• Shifts:

  • Increase in $G$ or $C$ shifts IS curve right (higher $Y$ at given $r$).
  • Increase in $T$ shifts IS curve left.

5. Money Market and Interest Rate Formation

• Interest rate ($r$) is determined in the money market, not fixed.
• Money demand depends on income and interest rate.
• Money supply is exogenous (set by central bank).

Key point: The Keynesian model assumes fixed prices and interest rates in the short term, focusing on output determination through aggregate demand and fiscal policy, with the IS curve capturing goods market equilibrium.

1. Money Supply and Demand in the IS-LM Model

• Nominal money supply ($M$) is fixed by the central bank.

• With fixed prices, the real money supply ($M/P$) is also fixed.

• Money demand ($L$) depends on:

  • Transactions motive ($L_T$)
  • Precautionary motive ($L_V$)
  • Speculative motive ($L_S$)

• Aggregate money demand is a function of interest rate ($r$) and income ($Y$):

  $$L = L(r, Y)$$

2. Money Market Equilibrium and the LM Curve

• The LM curve represents all combinations of interest rate ($r$) and income ($Y$) where the money market is in equilibrium:

  $$M/P = L(r, Y)$$

• Slope of LM curve: positive.

• Intuition: Higher income ($Y$) increases money demand; with fixed money supply, interest rates ($r$) must rise to restore equilibrium.

3. Shifts in the LM Curve

• Changes in nominal money supply ($M$) shift the LM curve.
• An increase in $M$ shifts LM rightward (lower $r$ for given $Y$).
• A decrease in $M$ shifts LM leftward.

4. Simultaneous Equilibrium: IS and LM Curves

• The short-term equilibrium in a closed economy is the intersection of:
  • IS curve (goods market equilibrium)
  • LM curve (money market equilibrium)
• This intersection determines the equilibrium interest rate ($r^*$) and income/output ($Y^*$).

5. Stabilization Policies in the IS-LM Framework

6. Money and Its Functions

• Money: any item widely accepted for purchasing goods and services.
• Primary functions of money:
  1. Medium of exchange: accepted by buyers to pay sellers.
  2. (Other functions not detailed in this portion)

Key point: The LM curve captures money market equilibrium by linking income and interest rates through money demand and fixed money supply.

1. Money Market and the LM Curve

a) Functions of Money

Money serves three essential functions:

• Medium of exchange: widely accepted for buying goods and services.
• Unit of account: a standard measure to post prices and record debts; must be small and divisible.
• Store of value: preserves purchasing power over time; must be durable.

The better a good fulfills these three criteria (acceptance, divisibility, durability), the more it functions effectively as money.

b) Monetary Base and Money Supply

• Monetary Base + Bank Money = Money Supply
• Money Supply: total quantity of money available in the economy for transactions.
• In economies with fiat money (money without intrinsic value), a regulatory agency controls the money supply.

c) Money Multiplier

• The money multiplier ($m$) measures how much the banking system can expand the money supply from each unit of deposits.
• It reflects the leverage effect of banks creating money through lending.

d) European Central Bank (ECB) and Eurosystem

The ECB and Eurosystem regulate the money supply and monetary policy within the Eurozone.

Key point: The LM curve represents equilibrium in the money market, where money demand equals money supply, linking interest rates and income levels.

1. Independence and Objectives of the ECB

• The primary objective of the European Central Bank (ECB) and the Eurosystem is to promote price stability throughout the euro area.
• A key feature of the ECB and Eurosystem is their independence from political influence, ensuring objective monetary policy decisions.

2. Tools of Monetary Control by the Central Bank

• The key interest rates (Leitzinsen) are the interest rates at which commercial banks can obtain credit from the ECB.

3. Interest Rate Corridor

• The interest rate corridor is defined by the rates on standing facilities and open market operations, guiding short-term market interest rates.
• It helps maintain monetary policy targets by influencing liquidity and credit conditions.

4. The Taylor Rule

• The Taylor Rule provides a formula to determine the central bank’s key interest rate that achieves price stability.
• It adjusts the interest rate based on deviations of inflation from target and output from potential.
• Named after economist John B. Taylor (born 1946).

5. Classical Theory of Inflation and Price Stability

• Price stability means the absence of inflation and deflation, which is the ECB's primary goal.
• Inflation is defined as an economy-wide, ongoing reduction in the value of money (general increase in price levels).
• Maintaining price stability ensures economic predictability and preserves purchasing power.

Price stability is the cornerstone objective of the ECB, achieved through independent monetary policy and effective use of tools like open market operations and interest rate management.

1. The Economy’s Medium of Exchange and Inflation

• Inflation is observed as a continuous increase in the overall price level.

• The Quantity Equation explains the long-run determinants of the price level and inflation rate:

  $$M \cdot V = P \cdot VT$$

  where

  • $M$ = quantity of money
  • $V$ = velocity of money circulation
  • $P$ = price level
  • $VT$ = volume of trade (quantity of output)

2. The Classical Theory of Inflation

• The Quantity Equation is an identity that always holds: any increase in $M$ must be reflected by changes in $P$, $Y_r$, or $V$.
• Possible adjustments when $M$ increases:
  • Price level $P$ rises (inflation)
  • Quantity of output $Y_r$ rises
  • Velocity of money $V$ falls

a) Classical Assumptions

b) Classical Conclusion

• Changes in money supply do not affect real output in the long run, only the price level.
• Money is neutral: it influences nominal variables but not real variables.
• Short-run exception: prices may be sticky, so changes in money supply can temporarily affect output.

3. Money Supply and Inflation: Costs and Examples

a) Problems of Inflation: Shoeleather Costs

• Inflation reduces the real value of money holdings.
• People minimize cash holdings to avoid loss of purchasing power.
• This leads to shoeleather costs: resources wasted due to more frequent trips to the bank or managing money to reduce cash holdings.
• Shoeleather costs represent the actual cost of holding less money in an inflationary environment.

Key point: In the long run, inflation is primarily driven by money supply growth, and money is neutral; however, inflation imposes real costs such as shoeleather costs.

1. Inflation and Its Costs

• Inflation reduces the real value of money, meaning each unit of currency buys fewer goods and services over time.
• This leads to menu costs: businesses must frequently update prices, incurring costs for printing new menus, catalogs, or price tags.
• Inflation causes money to have different real values at different times, complicating the comparison of real revenues, costs, and profits over time.
• It distorts relative prices, leading to inefficient allocation of resources as consumer decisions are based on misleading price signals.
• Inflation affects tax liabilities, especially under progressive tax systems, because nominal gains (like capital gains or interest) are taxed more heavily despite not reflecting real increases in wealth.

2. Money: Definition and Functions

3. Money Creation and Control

• Banks create money by loaning out deposits, increasing the total money supply through the money multiplier effect.
• The central bank controls the money supply via:
  • Open market operations (buying/selling government securities),
  • Adjusting the refinancing rate (interest rate at which banks borrow from the central bank),
  • Modifying reserve requirements or other monetary policy tools.

Key point: Inflation reduces the purchasing power of money and imposes costs on the economy through menu costs, distorted prices, and tax inefficiencies.

1. Problems and Costs of Inflation

Inflation is the sustained increase in the general price level of goods and services in an economy over a period of time. While moderate inflation is common in growing economies, high or unpredictable inflation causes several problems and costs.

2. Key Problems of Inflation

• Menu Costs: Firms must frequently change prices in catalogs, menus, and systems, incurring real costs.
• Shoe Leather Costs: Inflation reduces the real value of money holdings, leading people to minimize cash balances and make more frequent trips to the bank.
• Uncertainty and Distorted Price Signals: Inflation makes it harder for consumers and firms to distinguish between relative price changes and overall inflation, leading to inefficient resource allocation.
• Tax Distortions: Inflation can push taxpayers into higher nominal tax brackets (bracket creep), increasing tax burdens even if real income hasn’t changed.
• Wealth Redistribution: Unexpected inflation redistributes wealth from lenders to borrowers because debts are repaid with less valuable money.
• Menu Costs and Inflation Variability: Higher and more variable inflation increases the frequency and size of price adjustments, raising menu costs.

3. Costs of Inflation in Detail

4. Inflation and Money Supply Control

• Central banks influence inflation primarily by controlling the money supply.
• However, control is imperfect because:
  • Banks decide how much to lend.
  • Households decide how much to deposit.
• This imperfect control can lead to unexpected inflation or deflation.

To retain: Inflation imposes real economic costs through menu costs, shoe leather costs, uncertainty, tax distortions, and wealth redistribution, and central banks’ control over inflation is limited by banking and household behavior.

1. Exchange Rate Appreciation and Depreciation

• Appreciation of a currency: increase in its exchange rate.
  Example: If the Euro (€) appreciates, € buys more foreign currency → exchange rate of € increases, exchange rate of $ decreases.

• Depreciation of a currency: decrease in its exchange rate.
  Example: If the Euro (€) depreciates, € buys less foreign currency → exchange rate of € decreases, exchange rate of $ increases.

2. Short-Run Exchange Rate Changes

• Exchange rates fluctuate in the short run mainly due to differences in interest rates (returns on assets) between countries.
• Demand for foreign currency deposits depends on expected returns, similar to any other asset demand.

3. Exchange Rates and Asset Returns

• If the return on Dollar deposits is higher than on Euro deposits, investors will demand more Dollars to buy Dollar deposits.
• Increased demand for $ causes the Dollar to appreciate.
• As the $ appreciates, the relative benefit of holding Dollar deposits decreases, balancing demand.

4. Interest Parity Condition

• Interest Parity holds when deposits in all currencies offer the same expected rate of return.
• Under interest parity, there is no incentive to shift asset holdings between currencies.
• This implies the foreign exchange market is in short-term equilibrium.

Key point: Exchange rates adjust in the short run to equalize expected returns on deposits across currencies, ensuring interest parity and short-term equilibrium in foreign exchange markets.

1. Purchasing Power Parity (PPP) and Exchange Rates

Long-run exchange rate determination relies on differences in price levels between countries, as goods markets adjust slowly.

a) Basic Logic of PPP

• If a good is cheaper in the USA than in Europe, consumers will demand dollars ($) to buy it in the US.
• Increased demand for $causes the$ to appreciate.
• As $ appreciates, the price advantage diminishes, reducing arbitrage incentives.
• Eventually, prices converge across countries due to arbitrage.

b) Law of One Price

• A good must sell for the same price in all countries when expressed in a common currency.
• If prices differ, arbitrage forces them to converge.
• When prices are equal, consumers are indifferent between buying domestically or abroad.

c) PPP Condition

• Purchasing power at home = purchasing power abroad
• Exchange rate ($E$) relates the price levels ($P$) of two countries:

$$E = \frac{P_{\text{home}}}{P_{\text{foreign}}}$$

where $E$ is the nominal exchange rate expressed as home currency per unit of foreign currency.

2. Money, Prices, and Nominal Exchange Rates

• PPP links exchange rates to relative price levels.
• It assumes goods are tradable and arbitrage is frictionless.

a) Limitations of PPP

• Many goods are non-tradable or costly to ship.
• Market frictions, tariffs, and transportation costs prevent perfect arbitrage.
• Thus, PPP explains long-run trends but not short-run exchange rate fluctuations.

To retain: In the long run, exchange rates adjust to equalize purchasing power across countries, reflecting relative price levels (PPP), but short-run deviations occur due to market frictions and non-tradable goods.

1. Purchasing Power Parity (PPP) and Exchange Rates

Purchasing Power Parity (PPP) states that in the absence of transaction costs and trade barriers, the price of identical goods should be the same across countries when expressed in a common currency. This implies that exchange rates adjust to equalize the purchasing power of different currencies.

• Key limitation:
  • Tradable goods are not always perfect substitutes internationally.
  • Transaction costs and trade barriers exist, preventing perfect arbitrage.

Despite these limitations, PPP is a powerful tool to explain long-term exchange rate movements.
Example: The Big Mac Index compares the price of a Big Mac across countries to assess currency valuation.

2. Summary of Exchange Rate Determination

• Returns on foreign deposits depend on domestic and foreign interest rates and expected exchange rate changes.

• Interest parity condition:
  Equilibrium in the foreign exchange market requires that the expected returns on deposits in different currencies are equalized, given interest rates and expected future exchange rates.

  $(1 + i) = (1 + i^*) \times \frac{E^e}{E}$

  where:

  • $i$ = domestic interest rate
  • $i^*$ = foreign interest rate
  • $E$ = current exchange rate (domestic currency per unit of foreign currency)
  • $E^e$ = expected future exchange rate

• Implications:

  • An increase in domestic interest rates (e.g., dollar rates) causes the domestic currency to appreciate against foreign currencies.
  • Changes in the expected future exchange rate affect today's exchange rate.

3. Stabilization Policy in Open Economies: Mundell-Fleming Model

Assumptions:

• Small open economy with perfect capital mobility
• Domestic interest rate equals world interest rate:
  $r = r^*$

Trade effects:

• Exports (EX): Increase domestic demand
• Imports (IM): Decrease domestic demand
• Net exports (NX):
  $NX = EX - IM$
  are a function of the nominal exchange rate $e$.

Goods market equilibrium:

• The IS curve shifts with changes in net exports depending on $e$.

Key takeaway:
PPP provides a benchmark for long-term exchange rate levels, while interest parity governs short-term exchange rate dynamics through interest rates and expectations.

1. IS Curve in Open Economy

• The IS curve in an open economy is given by the equilibrium condition on the goods market:

  $$Y = C(Y - T) + I(r^*) + G + NX(e)$$

• Here, $Y$ is output, $C$ consumption depending on disposable income $(Y - T)$, $I$ investment depending on the world interest rate $r^*$, $G$ government spending, and $NX$ net exports depending on the exchange rate $e$.

2. LM Curve in Open Economy

• Central assumption: The domestic interest rate equals the world interest rate, $r = r^*$ (small open economy with perfect capital mobility).

• The LM curve represents money market equilibrium:

  $$\frac{M}{P} = L(r^*, Y)$$

• Since $r = r^*$ is fixed, money market equilibrium determines a unique level of income $Y$, independent of the exchange rate $e$.

• The LM curve is therefore vertical in the $(e, Y)$ space: for given $r^*$ and money supply, only one $Y$ satisfies money market equilibrium regardless of $e$.

3. Simultaneous Equilibrium

• Equilibrium in the open economy is found at the intersection of the IS and LM curves, determining the output $Y$ and exchange rate $e$.

4. Fiscal Policy under Flexible Exchange Rates

5. Monetary Policy under Flexible Exchange Rates

Key takeaway: In small open economies with flexible exchange rates and perfect capital mobility, monetary policy is effective in stabilizing output, while fiscal policy is neutral due to exchange rate adjustments offsetting its impact.