International Economics

International Economics THEORY & POLICY NINTH EDITION GLOBAL EDITION Paul R. Krugman Princeton University Maurice Obstfeld University of California, Berkeley Marc J. Melitz Harvard University Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City Sao Paulo Sydney Hong Kong -Seoul Singapore Taipei Tokyo

Brief Contents Contents Preface 1 Introduction 9 21 31 Part 1 Part 2 2 3 4 5 6 7 8 9 10 11 12 International Trade Theory World TradeT An Overview 40 Labor Productivity and Comparative Advantage: The Ricardian Model 54 Specific Factors and Income Distribution 80 Resources and Trade: The Heckscher-Ohlin Model 110 The Standard Trade Model 141 External Economies of Scale and the International Location of Production 167 Firms in the Global Economy: Export Decisions, Outsourcing, and Multinational Enterprises 185 International Trade Policy The Instruments of Trade Policy The Political Economy of Trade Policy Trade Policy in Developing Countries Controversies in Trade Policy 40 222 222 249 286 301 Part 3 13 14 Part 4 15 16 17 18 19 20 21 22 Exchange Rates and Open-Economy Macroeconomics National Income Accounting and the Balance of Payments Exchange Rates and the Foreign Exchange Market: An Asset Approach Money, Interest Rates, and Exchange Rates Price Levels and the Exchange Rate in the Long Run Output and the Exchange Rate in the Short Run Fixed Exchange Rates and Foreign Exchange Intervention International Macroeconomic Policy International Monetary Systems: An Historical Overview Optimum Currency Areas and the European Experience Financial Globalization: Opportunity and Crisis Developing Countries: Growth, Crisis, and Reform 323 323 350 384 414 451 493 534 534 587 616 649

Brief Contents Mathematical Postscripts Postscript to Chapter 5: The Factor Proportions Model 691 Postscript to Chapter 6: The Trading World Economy 695 Postscript to Chapter 8: The Monopolistic Competition Model 703 Postscript to Chapter 21: Risk Aversion and International Portfolio Diversification 705 Credits 713 Index 715

Preface 21 Introduction 31 What Is International Economics About? 33 The Gains from Trade 34 The Pattern of Trade 35 How Much Trade? 35 Balance of Payments r.'. 36 Exchange Rate Determination 36 International Policy Coordination 37 The International Capital Market 37 International Economics: Trade and Money 38 Part 1 International Trade Theory 40^ [g] World Trade: An Overview 40 Who Trades with Whom? 40 Size Matters: The Gravity Model 41 Using the Gravity Model: Looking for Anomalies : 43 Impediments to Trade: Distance, Barriers, and Borders * 44 The Changing Pattern of World Trade 46 Has the World Gotten Smaller? 46 What Do We Trade? 47 Service Outsourcing 49 Do Old Rules Still Apply? 51 Summary 51 [ j Labor Productivity and Comparative Advantage: The Ricardian Model 54 The Concept of Comparative Advantage '. 55 A One-Factor Economy 56 Production Possibilities 57 Relative Prices and Supply 58 Trade in a One-Factor World 59 Determining the Relative Price After Trade 60 BOX: Comparative Advantage in Practice: The Case of Babe Ruth 63 The Gains from Trade 64 A Note on Relative Wages 65 BOX: The Losses from Nontrade 66 Misconceptions About Comparative Advantage 67 Productivity and Competitiveness 67 The Pauper Labor Argument 67 BOX: DO Wages Reflect Productivity? 68 Exploitation 69 Comparative Advantage with Many Goods 70 Setting Up the Model 70. Relative Wages and Specialization '. 70 Determining the Relative Wage in the Multigood Model 72

10 Contents Adding Transport Costs and Nontraded Goods 73 Empirical Evidence on the Ricardian Model 75 Summary 77 Specific Factors and Income Distribution 80 The Specific Factors Model 81 BOX: What Is a Specific Factor? 82 Assumptions of the Model 82 Production Possibilities 83 Prices, Wages, and Labor Allocation 86 Relative Prices and the Distribution of Income 90 International Trade in the Specific Factors Model 92 Income Distribution and the Gains from Trade 93 The Political Economy of Trade: A Preliminary View 95 CASE STUDY: Trade and Unemployment 96 Income Distribution and Trade Politics 98 International Labor Mobility 99 CASE STUDY: Wage Convergence in the Age of Mass Migration 100 CASE STUDY: Foreign Workers: The Story of the GCC 101 Summary 103 Appendix: Further Details on Specific Factors 107 Marginal and Total Product 107 Relative Prices and the Distribution of Income \ 108 Resources and Trade: The Heckscher-Ohlin Model 110 A Model of a Two-Factor Economy Ill Prices and Production Ill Choosing the Mix of Inputs 114 Factor Prices and Goods Prices 116 Resources and Output 118 Effects of International Trade Between Two-Factor Economies 119 Relative Prices and the Pattern of Trade 120 Trade and the Distribution of Income '. 121 CASE STUDY: North-South Trade and Income Inequality 122 Factor-Price Equalization 127 Empirical Evidence on the Heckscher-Ohlin Model 128 Trade in Goods as a Substitute for Trade in Factors 128 Patterns of Exports Between Developed and Developing Countries 131 Implications of the Tests 132 Summary 134 Appendix: Factor Prices, Goods Prices, and Production Decisions 137 Choice of Technique 137 Goods Prices and Factor Prices 138 More on Resources and Output 139 @ The Standard Trade Model 141 A Standard Model of a Trading Economy 142 Production Possibilities and Relative Supply 142 Relative Prices and Demand 143 The Welfare Effect of Changes in the Terms of Trade '. 146 Determining Relative Prices 147 Economic Growth: A Shift of the RS curve 147

Contents 11 Growth and the Production Possibility Frontier 149 World Relative Supply and the Terms of Trade 149 International Effects of Growth 151 CASE STUDY: Has the Growth of Newly Industrializing Countries Hurt Advanced Nations? 152 Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD 154 Relative Demand and Supply Effects of a Tariff 155 Effects of an Export Subsidy 156 Implications of Terms of Trade Effects: Who Gains and Who Loses? 156 International Borrowing and Lending 157 Intertemporaf Production Possibilities and Trade 158 The Real Interest Rate 158 Intertemporal Comparative Advantage 160 Summary 160 Appendix: More on Intertemporal Trade 164 \ ] External Economies of Scale and the International Location of Production 167 Economies of Scale and International Trade: An Overview 168 Economies of Scale and Market Structure 169 The Theory of External Economies 170 Specialized Suppliers 170 Labor Market Pooling 171 Knowledge Spillovers \ 172 External Economies and Market Equilibrium 172 External Economies and International Trade 173 External Economies, Output, and Prices 173 External Economies and the Pattern of Trade 175 BOX: Holding the World Together 177 Trade and Welfare with External Economies 177 Dynamic Increasing Returns 179 Interregional Trade and Economic Geography 180 BOX: Tinseltown Economics 181 Summary 182 [ ] Firms in the Global Economy: Export Decisions, Outsourcing, and Multinational Enterprises 185 The Theory of Imperfect Competition 186 Monopoly: A Brief Review 187 Monopolistic Competition 189 Monopolistic Competition and Trade 194 The Effects of Increased Market Size 194 Gains from an Integrated Market: A Numerical Example 196 The Significance of Intra-Industry Trade 199 CASE STUDY: The Emergence of the Turkish Automotives Industry 201 Firm Responses to Trade: Winners, Losers, and Industry Performance 202 Performance Differences Across Producers 202 The Effects of Increased Market Size 204 Trade Costs and Export Decisions 206 Dumping "...208 CASE STUDY: Antidumping as Protectionism 209 Multinationals and Outsourcing 210

12 Contents CASE STUDY: Patterns of Foreign Direct Investment Flows Around the World 210 The Firm's Decision Regarding Foreign Direct Investment 213 Outsourcing 215 Consequences of Multinationals and Foreign Outsourcing 216 Summary 217 Appendix: Determining Marginal Revenue 221 Part 2 International Trade Policy 222 The Instruments of Trade Policy 222 Basic Tariff Analysis 222 Supply, Demand, and Trade in a Single Industry 223 Effects of a Tariff 225 Measuring the Amount of Protection 226 Costs and Benefits of a Tariff.228 Consumer and Producer Surplus 228 Measuring the Costs and Benefits 229 BOX: Tariffs for the Long Haul 232 Other Instruments of Trade Policy 232 Export Subsidies: Theory 233 CASE STUDY: Europe's Common Agricultural Policy 234 Import Quotas: Theory 235 CASE STUDY: An Import Quota in Practice: U.S. Sugar 236 Voluntary Export Restraints \ 238 CASE STUDY: A Voluntary Export Restraint in Practice: Japanese Autos 238 Local Content Requirements 239 BOX: American Buses, Made in Hungary 240 Other Trade Policy Instruments 240 The Effects of Trade Policy: A Summary ; 241 Summary 241 Appendix: Tariffs and Import Quotas in the Presence of Monopoly 245 The Model with Free Trade 245 The Model with a Tariff 246 The Model with an Import Quota 247 Comparing a Tariff and a Quota 247 ) The Political Economy of Trade Policy 249 The Case for Free Trade 250 Free Trade and Efficiency 250 Additional Gains from Free Trade 251 Rent-Seeking 252 Political Argument for Free Trade 252 CASE STUDY: The Gains from 1992 253 National Welfare Arguments Against Free Trade 254 The Terms of Trade Argument for a Tariff 255 The Domestic Market Failure Argument Against Free Trade 256 How Convincing Is the Market Failure Argument? 257 Income Distribution and Trade Policy 259 Electoral Competition 259 Collective Action 260 BOX: Politicians for Sale: Evidence from the 1990s 261 Modeling the Political Process 262 Who Gets Protected? 263

Contents 13 International Negotiations and Trade Policy 264 The Advantages of Negotiation 265 International Trade Agreements: A Brief History 266 The Uruguay Round 268 Trade Liberalization 268 Administrative Reforms: From the GATT to the WTO 269 Benefits and Costs 270 BOX: Settling a Dispute and Creating One 271 CASE STUDY: The Salmon War 272 The Doha Disappointment 273 BOX: DO Agricultural Subsidies Hurt the Third World? 274 Preferential Trading Agreements 275 BOX: Free Trade Area versus Customs Union, 276 BOX: DO Trade Preferences Have Appeal? 278 CASE STUDY: Trade Diversion in South America 279 Summary 279 Appendix: Proving That the Optimum Tariff Is Positive 283 Demand and Supply 283 The Tariff and Prices 283 The Tariff and Domestic Welfare 284 JMl] Trade Policy in Developing Countries 286 Import-Substituting Industrialization 287 The Infant Industry Argument " 288 Promoting Manufacturing Through Protection 289 CASE STUDY: Mexico Abandons Import-Substituting Industrialization 291 Results of Favoring Manufacturing: Problems of Import-Substituting Industrialization 292 Trade Liberalization Since 1985 293 Trade and Growth: Takeoff in Asia 295 BOX: India's Boom 297 Summary '. 298 p Controversies in Trade Policy 301 Sophisticated Arguments for Activist Trade Policy 302 Technology and Externalities 302 Imperfect Competition and Strategic Trade Policy 304 BOX: A Warning from Intel's Founder 307 CASE STUDY: When the Chips Were Up 308 Globalization and Low-Wage Labor 309 The Anti-Globalization Movement 310 Trade and Wages Revisited 310 Labor Standards and Trade Negotiations 312 Environmental and Cultural Issues 313 The WTO and National Independence 314 CASE STUDY: Bare Feet, Hot Metal, and Globalization 315 Globalization and the Environment 316 Globalization, Growth, and Pollution,...316 The Problem of "Pollution Havens" 317 The Carbon Tariff Dispute 319 Summary 320

14 Contents Part 3 Exchange Rates and Open-Economy Macroeconomics 323 [ij j National Income Accounting and the Balance of Payments 323 The National Income Accounts 325 National Product and National Income 326 Capital Depreciation and International Transfers 327 Gross Domestic Product 327 National Income Accounting for an Open Economy 328 Consumption 328 Investment 328 Government Purchases -r.- 329 The National Income Identity for an Open Economy 329 An Imaginary Open Economy 329 The Current Account and Foreign Indebtedness 330 Saving and the Current Account 332 Private and Government Saving 333 CASE STUDY: Government Deficit Reduction May Not Increase the Current Account Surplus 334 The Balance of Payments Accounts 336 Examples of Paired Transactions 337 The Fundamental Balance of Payments Identity 338 The Current Account, Once Again 339 The Capital Account 340 The Financial Account.\ 340 Net Errors and Omissions 341 Official Reserve Transactions 342 CASE STUDY: The Assets and Liabilities of the World's Biggest Debtor 343 Summary 346 [Ml Exchange Rates and the Foreign Exchange Market: An Asset Approach 350 Exchange Rates and International Transactions 351 Domestic and Foreign Prices 351 Exchange Rates and Relative Prices 353 The Foreign Exchange Market 354 The Actors..; 354 Characteristics of the Market 355 Spot Rates and Forward Rates 356 Foreign Exchange Swaps 358 Futures and Options 358 The Demand for Foreign Currency Assets 358 Assets and Asset Returns 359 BOX: Nondeliverable Forward Exchange Trading in Asia 360 Risk and Liquidity 362 Interest Rates 362 Exchange Rates and Asset Returns 364 A Simple Rule 364 Return, Risk, and Liquidity in the Foreign Exchange Market 366 Equilibrium in the Foreign Exchange Market 367 Interest Parity: The Basic Equilibrium Condition 367 How Changes in the Current Exchange Rate Affect Expected Returns 368 The Equilibrium Exchange Rate " 369 Interest Rates, Expectations, and Equilibrium 371 The Effect of Changing Interest Rates on the Current Exchange Rate 372 The Effect of Changing Expectations on the Current Exchange Rate 373

Contents 15 CASE STUDY: What Explains the Carry Trade? 374 Summary 376 Appendix: Forward Exchange Rates and Covered Interest Parity 381 Money, Interest Rates, and Exchange Rates 384 Money Defined: A Brief Review 385 Money as a Medium of Exchange 385 Money as a Unit of Account 385 Money as a Store of Value 386 What IfMoney?..., ::.'. 386 How the Money Supply Is Determined 386 The Demand for Money by Individuals 387 Expected Return 387 Risk 388 Liquidity 388 Aggregate Money Demand 388 The Equilibrium Interest Rate: The Interaction of Money Supply and Demand 390 Equilibrium in the Money Market 390 Interest Rates and the Money Supply 392 Output and the Interest Rate : 393 The Money Supply and the Exchange Rate in the Short Run 393 Linking Money, the Interest Rate, and the Exchange Rate.' 394 U.S. Money Supply and the Dollar/Euro Exchange Rate 395 Europe's Money Supply and the Dollar/Euro Exchange Rate 396 Money, the Price Level, and the Exchange Rate in the Long Run 398 Money and Money Prices 399 The Long-Run Effects of Money Supply Changes 399 Empirical Evidence on Money Supplies and Price Levels 400 Money and the Exchange Rate in the Long Run 401 Inflation and Exchange Rate Dynamics 402 Short-Run Price Rigidity versus Long-Run Price Flexibility 402 BOX: Money Supply Growth and Hyperinflation in Bolivia 404 Permanent Money Supply Changes and the Exchange Rate 404 Exchange Rate Overshooting 407 CASE STUDY: Can Higher Inflation Lead to Currency Appreciation? The Implications of Inflation Targeting 408 Summary 411 Levels and the Exchange Slate in the Long Run 414 The Law of One Price 415 Purchasing Power Parity 416 The Relationship Between PPP and the Law of One Price 416 Absolute PPP and Relative PPP 417 A Long-Run Exchange Rate Model Based on PPP 418 The Fundamental Equation of the Monetary Approach 418 Ongoing Inflation, Interest Parity, and PPP 420 The Fisher Effect 421 Empirical Evidence on PPP and the Law of One Price.424 Explaining the Problems with PPP 425 Trade Barriers and Nontradables 426 Departures from Free Competition 427 Differences in Consumption Patterns and Price Level Measurement 427

16 Contents BOX: Some Meaty Evidence on the Law of One Price 428 PPP in the Short Run and in the Long Run 430 CASE STUDY: Why Price Levels Are Lower in Poorer Countries 431 Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates 433 The Real Exchange Rate 434 Demand, Supply, and the Long-Run Real Exchange Rate 435 BOX: Sticky Prices and the Law of One Price: Evidence from Scandinavian Duty-Free Shops 436 Nominal and Real Exchange Rates in Long-Run Equilibrium 438 International Interest Rate Differences and the Real Exchange Rate 440 Real Interest Parity 442 Summary 443 Appendix: The Fisher Effect, the Interest Rate, and the Exchange Rate Under the Flexible-Price Monetary Approach 448 Output and the Exchange Rate in the Short Run 451 Determinants of Aggregate Demand in an Open Economy 452 Determinants of Consumption Demand 452 Determinants of the Current Account 453 How Real Exchange Rate Changes Affect the Current Account 454 How Disposable Income Changes Affect the Current Account 454 The Equation of Aggregate Demand 455 The Real Exchange Rate and Aggregate Demand 455 Real Income and Aggregate Demand 455 How Output Is Determined in the Short Run 456 Output Market Equilibrium in the Short Run: The DD Schedule 458 Output, the Exchange Rate, and Output Market Equilibrium, 458 Deriving the DD Schedule 459 Factors That Shift the DD Schedule 459 Asset Market Equilibrium in the Short Run: The AA Schedule 462 Output, the Exchange Rate, and Asset Market Equilibrium 462 Deriving the AA Schedule '. 464 Factors That Shift the AA Schedule 464 Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together 465 Temporary Changes in Monetary and Fiscal Policy 467 Monetary Policy 468 Fiscal Policy, 468 Policies to Maintain Full Employment 469 Inflation Bias and Other Problems of Policy Formulation 471 Permanent Shifts in Monetary and Fiscal Policy 472 A Permanent Increase in the Money Supply 472 Adjustment to a Permanent Increase in the Money Supply 472 A Permanent Fiscal Expansion 474 Macroeconomic Policies and the Current Account 476 Gradual Trade Flow Adjustment and Current Account Dynamics 477 The J-Curve 477 Exchange Rate Pass-Through and Inflation 479 BOX: Exchange Rates and the Current Account 480 The Liquidity Trap 481 Summary 484

Contents 17 Appendix 1: Intertemporal Trade and Consumption Demand 488 Appendix 2: The Marshall-Lerner Condition and Empirical Estimates of Trade Elasticities 490 [ Fixed Exchange Rates and Foreign Exchange Intervention 493 Why Study Fixed Exchange Rates? 494 Central Bank Intervention and the Money Supply 495 The Central Bank Balance Sheet and the Money Supply 495 Foreign Exchange Intervention and the Money Supply 497 Sterilization.-.-, 497 The Balance of Payments and the Money Supply 498 How the Central Bank Fixes the Exchange Rate 499 Foreign Exchange Market Equilibrium Under a Fixed Exchange Rate 499 Money Market Equilibrium Under a Fixed Exchange Rate 500 A Diagrammatic Analysis 501 Stabilization Policies with a Fixed Exchange Rate 502 Monetary Policy 502 Fiscal Policy 503 Changes in the Exchange Rate. l 504 Adjustment to Fiscal Policy and Exchange Rate Changes 506 Balance of Payments Crises and Capital Flight 506 Managed Floating and Sterilized Intervention 509 Perfect Asset Substitutability and the Ineffectiveness of Sterilized Intervention' 509 BOX: Brazil's 1998-1999 Balance of Payments Crisis : 510 Foreign Exchange Market Equilibrium Under Imperfect Asset Substitutability 511 The Effects of Sterilized Intervention with Imperfect Asset Substitutability 512 Evidence on the Effects of Sterilized Intervention 513 Reserve Currencies in the World Monetary System. 514 The Mechanics of a Reserve Currency Standard 515 The Asymmetric Position of the Reserve Center 515 The Gold Standard 516 The Mechanics of a Gold Standard 516 Symmetric Monetary Adjustment Under a Gold Standard 517 Benefits and Drawbacks of the Gold Standard.517 The Bimetallic Standard 518 The Gold Exchange Standard 519 CASE STUDY: The Demand for International Reserves 519 Summary 523 Appendix 1: Equilibrium in the Foreign Exchange Market with Imperfect Asset Substitutability 528 Demand 528 Supply 529 Equilibrium ; 529 Appendix 2: The Timing of Balance of Payments Crises 531 Part 4 International Macroeconomic Policy 534 jjogj International Monetary Systems: An Historical Overview 534 Macroeconomic Policy Goals in an Open Economy 535 Internal Balance: Full Employment and Price Level Stability 536 External Balance: The Optimal Level of the Current Account 537 Classifying Monetary Systems: The Open-Economy Trilemma 539

18 Contents International Macroeconomic Policy Under the Gold Standard, 1870-1914 540 Origins of the Gold Standard 541 External Balance Under the Gold Standard 541 The Price-Specie-Flow Mechanism 541 The Gold Standard "Rules of the Game": Myth and Reality 542 Internal Balance Under the Gold Standard 543 BOX: Hume versus the Mercantilists 544 CASE STUDY: Gold Smuggling and the Birth of the UAE Dirham 544 The Interwar Years, 1918-1939 546 The>Fleeting Return to Gold....'"."...-.: 546 International Economic Disintegration 546 CASE STUDY: The International Gold Standard and the Great Depression 547 The Bretton Woods System and the International Monetary Fund 548 Goals and Structure of the IMF 549 Convertibility and the Expansion of Private Financial Flows 550 Speculative Capital Flows and Crises 551 Analyzing Policy Options for Reaching Internal and External Balance 551 Maintaining Internal Balance 552 Maintaining External Balance 553 Expenditure-Changing and Expenditure-Switching Policies 554 The External Balance Problem of the United States Under Bretton Woods 555 CASE STUDY: The End of Bretton Woods, Worldwide Inflation, and the Transition to Floating Rates V 556 The Mechanics of Imported Inflation " 558 Assessment 559 The Case for Floating Exchange Rates 559 Monetary Policy Autonomy. 560 Symmetry 561 Exchange Rates as Automatic Stabilizers 561 Exchange Rates and External Balance 563 CASE STUDY: Monetary Regimes in Europe Post Bretton Woods 563 Macroeconomic Interdependence Under a Floating Rate 567 CASE STUDY: Transformation and Crisis in the World Economy' 568 What Has Been Learned Since 1973? 574 Monetary Policy Autonomy 574 Symmetry 575 The Exchange Rate as an Automatic Stabilizer 576 External Balance 576 The Problem of Policy Coordination 577 Are Fixed Exchange Rates Even an Option for Most Countries? 577 Summary 578 Appendix: International Policy Coordination Failures 584 Optimum Currency Areas and the European Experience 587 How the European Single Currency Evolved 589 What Has Driven European Monetary Cooperation? 589 The European Monetary System, 1979-1998 590 German Monetary Dominance and the Credibility Theory of the EMS 591 Market Integration Initiatives 592 ~ European Economic and Monetary Union 593 The Euro and Economic Policy in the Euro Zone 594 The Maastricht Convergence Criteria and the Stability and Growth Pact 594

Contents 19 The European System of Central Banks 595 The Revised Exchange Rate Mechanism 596 The Theory of Optimum Currency Areas 596 Economic Integration and the Benefits of a Fixed Exchange Rate Area: The GG Schedule 596 Economic Integration and the Costs of a Fixed Exchange Rate Area: The LL Schedule 598 The Decision to Join a Currency Area: Putting the GG and LL Schedules Together 600 What Is an Optimum Currency Area? 602 CASE STUDY: IS Europe an Optimum Currency Area? 602 The Future of EMU 608 BOX: The Euro Zone Debt Crisis of 2010 610 Summary.,-..77 612 jlpjj Financial Globalization: Opportunity and Crisis 616 The International Capital Market and the Gains from Trade 617 Three Types of Gain from Trade 617 Risk Aversion. 618 Portfolio Diversification as a Motive for International Asset Trade 619 The Menu of International Assets: Debt versus Equity 620 International Banking and the International Capital Market 620 The Structure of the International Capital Market 621 Offshore Banking and Offshore Currency Trading 622 The Growth of Eurocurrency Trading 623 The Importance of Regulatory Asymmetries 624 The Shadow Banking System.' 624 Regulating International Banking 625 The Problem of Bank Failure 625 CASE STUDY: Moral Hazard 627 Difficulties in Regulating International Banking 628 BOX: The Simple Algebra of Moral Hazard 629 International Regulatory Cooperation 629 CASE STUDY: TWO Episodes of Market Turmoil: LTCM and the Global Financial Crisis of 2007-2009 631 BOX: Foreign Exchange Instability and Central Bank Swap Lines 636 How Well Have International Financial Markets Allocated Capital-and Risk? 638 The Extent of International Portfolio Diversification 638 The Extent of Intertemporal Trade 640 Onshore-Offshore Interest Differentials 641 The Efficiency of the Foreign Exchange Market 641 Summary 645 H Developing Countries: Growth, Crisis, and Reform 649 Income, Wealth, and Growth in the World Economy 650 The Gap^Between Rich and Poor 650 Has the World Income Gap Narrowed Over Time? 651 Structural Features of Developing Countries 653 Developing-Country Borrowing and Debt 656 The Economics of Financial Inflows to Developing Countries 656 The Problem of Default 657 Alternative Forms of Financial Inflow 659 The Problem of "Original Sin" 661 The Debt Crisis of the 1980s,...662 Reforms, Capital Inflows, and the Return of Crisis 663 East Asia: Success and Crisis 666 The East Asian Economic Miracle 666

20 Contents BOX: Why Have Developing Countries Accumulated Such High Levels of International Reserves? 667 Asian Weaknesses 669 BOX: What Did East Asia Do Right? 670 The Asian Financial Crisis 671 Spillover to Russia 672 CASE STUDY: Can Currency Boards Make Fixed Exchange Rates Credible? 674 Lessons of Developing-Country Crises 676 Reforming the World's Financial "Architecture" 677 Capital Mobility and the Trilemma of the Exchange Rate Regime 678 "Prophylactic" Measures - 679 Coping with Crisis u 680 CASE STUDY: China's Undervalued Currency 681 Understanding Global Capital Flows and the Global Distribution of Income: Is Geography Destiny? 683 Summary 686 Mathematical Postscripts 691 Postscript to Chapter 5: The Factor Proportions Model 691 Factor Prices and Costs 691 Goods Prices and Factor Prices 693 Factor Supplies and Outputs 694 Postscript to Chapter 6: The Trading World Economy 695 Supply, Demand, and Equilibrium 695 Supply, Demand, and the Stability of Equilibrium 697 Effects of Changes in Supply and Demand 699 Economic Growth 699 A Transfer of Income 700 A Tariff : 701 Postscript to Chapter 8: The Monopolistic Competition Model 703 Postscript to Chapter 21: Risk Aversion and International Portfolio Diversification 705 An Analytical Derivation of the Optimal Portfolio 705 A Diagrammatic Derivation of the Optimal Portfolio, 706 The Effects of Changing Rates of Return 709 Credits 713 Index 715 Online Appendices (www.pearsonglobaleditions.com/krugman) Appendix A to Chapter 6: International Transfers of Income and the Terms of Trade The Transfer Problem Effects of a Transfer on the Terms of Trade Presumptions About the Terms of Trade Effects of Transfers Appendix B to Chapter 6: Representing International Equilibrium with Offer Curves Deriving a Country's Offer Curve International Equilibrium Appendix A to Chapter 9: Tariff Analysis in General Equilibrium A Tariff in a Small Country A Tariff in a Large Country Appendix A to Chapter 17: The IS-LM Model and the DD-AA Model Appendix A to Chapter 18: The Monetary Approach to the Balance of Payments