Preface xv Introduction 1 What Is International Economics About? 3 The Gains from Trade 4 The Pattern of Trade 5 How Much Trade? 5 Balance of Payments 6 Exchange Rate Determination 6 International Policy Coordination 7 The International Capital Market 8 International Economics: Trade and Money 8 Part 1 Exchange rates and Open-Economy Macroeconomics 11 National Income Accounting and the Balance of Payments 11 The National Income Accounts 13 National Product and National Income 14 Capital Depreciation and International Transfers 15 Gross Domestic Product 15 National Income Accounting for an Open Economy 16 Consumption 16 Investment 16 Government Purchases 17 The National Income Identity for an Open Economy 17 An Imaginary Open Economy 18 The Current Account and Foreign Indebtedness 18 Saving and the Current Account 21 Private and Government Saving 22 box: The Mystery of the Missing Deficit 23 The Balance of Payments Accounts 24 Examples of Paired Transactions 25 The Fundamental Balance of Payments Identity 27 The Current Account, Once Again 27 The Capital Account 28 The Financial Account 29 Net Errors and Omissions 30 Official Reserve Transactions 30 case study: The Assets and Liabilities of the World's Biggest Debtor 32 Summary 35 Exchange Rates and the Foreign Exchange Market: An Asset Approach 40 Exchange Rates and International Transactions 41 vii Domestic and Foreign Prices 42 Exchange Rates and Relative Prices 43 The Foreign Exchange Market 44 The Actors 44 box: Exchange Rates, Auto Prices, and Currency Wars 45 Characteristics of the Market 46 Spot Rates and Forward Rates 48 Foreign Exchange Swaps 49 Futures and Options 49 The Demand for Foreign Currency Assets 50 Assets and Asset Returns 50 box: Nondeliverable Forward Exchange Trading in Asia 51 Risk and Liquidity 53 Interest Rates 54 Exchange Rates and Asset Returns 55 A Simple Rule 56 Return, Risk, and Liquidity in the Foreign Exchange Market 58 Equilibrium in the Foreign Exchange Market 59 Interest Parity: The Basic Equilibrium Condition 59 How Changes in the Current Exchange Rate Affect Expected Returns 60 The Equilibrium Exchange Rate 61 Interest Rates, Expectations, and Equilibrium 64 The Effect of Changing Interest Rates on the Current Exchange Rate 64 The Effect of Changing Expectations on the Current Exchange Rate 65 case study: What Explains the Carry Trade? 66 Summary 68 Appendix: Forward Exchange Rates and Covered Interest Parity 74 Money, Interest Rates, and Exchange Rates 77 Money Defined: A Brief Review 78 Money as a Medium of Exchange 78 Money as a Unit of Account 78 Money as a Store of Value 79 What Is Money? 79 How the Money Supply Is Determined 79 The Demand for Money by Individuals 80 Expected Return 80 Risk 81 Liquidity 81 Aggregate Money Demand 81 The Equilibrium Interest Rate: The Interaction of Money Supply and Demand 83 Equilibrium in the Money Market 83 Interest Rates and the Money Supply 85 Output and the Interest Rate 86 The Money Supply and the Exchange Rate in the Short Run 87 Linking Money, the Interest Rate, and the Exchange Rate 87 U.S. Money Supply and the Dollar/Euro Exchange Rate 89 Europe's Money Supply and the Dollar/Euro Exchange Rate 90 Money, the Price Level, and the Exchange Rate in the Long Run 92 Money and Money Prices 92 The Long-Run Effects of Money Supply Changes 93 Empirical Evidence on Money Supplies and Price Levels 94 Money and the Exchange Rate in the Long Run 95 Inflation and Exchange Rate Dynamics 96 Short-Run Price Rigidity versus Long-Run Price Flexibility 96 box: Money Supply Growth and Hyperinflation in Zimbabwe 98 Permanent Money Supply Changes and the Exchange Rate 99 Exchange Rate Overshooting 101 case study: Can Higher Inflation Lead to Currency Appreciation? The Implications of Inflation Targeting 103 Summary 106 Price Levels and the Exchange Rate in the Long Run 111 The Law of One Price 112 Purchasing Power Parity 113 The Relationship between PPP and the Law of One Price 113 Absolute PPP and Relative PPP 114 A Long-Run Exchange Rate Model Based on PPP 115 The Fundamental Equation of the Monetary Approach 115 Ongoing Inflation, Interest Parity, and PPP 117 The Fisher Effect 118 Empirical Evidence on PPP and the Law of One Price 121 Explaining the Problems with PPP 123 Trade Barriers and Nontradables 123 Departures from Free Competition 124 Differences in Consumption Patterns and Price Level Measurement 125 box: Some Meaty Evidence on the Law of One Price 125 PPP in the Short Run and in the Long Run 128 case study: Why Price Levels Are Lower in Poorer Countries 129 Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates 130 The Real Exchange Rate 131 Demand, Supply, and the Long-Run Real Exchange Rate 133 box: Sticky Prices and the Law of One Price: Evidence from Scandinavian Duty-Free Shops 133 Nominal and Real Exchange Rates in Long-Run Equilibrium 136 International Interest Rate Differences and the Real Exchange Rate 138 Real Interest Parity 139 Summary 141 Appendix: The Fisher Effect, the Interest Rate, and the Exchange Rate under the Flexible-Price Monetary Approach 146 Output and the Exchange Rate in the Short Run 149 Determinants of Aggregate Demand in an Open Economy 150 Determinants of Consumption Demand 150 Determinants of the Current Account 151 How Real Exchange Rate Changes Affect the Current Account 152 How Disposable Income Changes Affect the Current Account 153 The Equation of Aggregate Demand 153 The Real Exchange Rate and Aggregate Demand 153 Real Income and Aggregate Demand 154 How Output Is Determined in the Short Run 155 Output Market Equilibrium in the Short Run: The DD Schedule 156 Output, the Exchange Rate, and Output Market Equilibrium 156 Deriving the DD Schedule 157 Factors that Shift the DD Schedule 157 Asset Market Equilibrium in the Short Run: The AA Schedule 160 Output, the Exchange Rate, and Asset Market Equilibrium 161 Deriving the AA Schedule 162 Factors that Shift the AA Schedule 163 Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together 164 Temporary Changes in Monetary and Fiscal Policy 166 Monetary Policy 166 Fiscal Policy 167 Policies to Maintain Full Employment 168 Inflation Bias and Other Problems of Policy Formulation 169 Permanent Shifts in Monetary and Fiscal Policy 170 A Permanent Increase in the Money Supply 171 Adjustment to a Permanent Increase in the Money Supply 172 A Permanent Fiscal Expansion 173 Macroeconomic Policies and the Current Account 175 Gradual Trade Flow Adjustment and Current Account Dynamics 176 The J-Curve 176 Exchange Rate Pass-Through and Inflation 178 The Current Account, Wealth, and Exchange Rate Dynamics 179 The Liquidity Trap 179 case study: How Big Is the Government Spending Multiplier? 182 Summary 183 Appendix 1: Intertemporal Trade and Consumption Demand 188 Appendix 2: The Marshall-Lerner Condition and Empirical Estimates of Trade Elasticities 190 Fixed Exchange Rates and Foreign Exchange Intervention 193 Why Study Fixed Exchange Rates? 194 Central Bank Intervention and the Money Supply 195 The Central Bank Balance Sheet and the Money Supply 195 Foreign Exchange Intervention and the Money Supply 197 Sterilization 198 The Balance of Payments and the Money Supply 198 How the Central Bank Fixes the Exchange Rate 199 Foreign Exchange Market Equilibrium under a Fixed Exchange Rate 200 Money Market Equilibrium under a Fixed Exchange Rate 200 A Diagrammatic Analysis 201 Stabilization Policies with a Fixed Exchange Rate 202 Monetary Policy 203 Fiscal Policy 204 Changes in the Exchange Rate 205 Adjustment to Fiscal Policy and Exchange Rate Changes 206 Balance of Payments Crises and Capital Flight 207 Managed Floating and Sterilized Intervention 210 Perfect Asset Substitutability and the Ineffectiveness of Sterilized Intervention 210 case study: Can Markets Attack a Strong Currency? The Case of Switzerland 211 Foreign Exchange Market Equilibrium under Imperfect Asset Substitutability 213 The Effects of Sterilized Intervention with Imperfect Asset Substitutability 213 Evidence on the Effects of Sterilized Intervention 215 Reserve Currencies in the World Monetary System 216 The Mechanics of a Reserve Currency Standard 216 The Asymmetric Position of the Reserve Center 217 The Gold Standard 218 The Mechanics of a Gold Standard 218 Symmetric Monetary Adjustment under a Gold Standard 218 Benefits and Drawbacks of the Gold Standard 219 The Bimetallic Standard 220 The Gold Exchange Standard 220 case study: The Demand for International Reserves 221 Summary 225 Appendix 1: Equilibrium in the Foreign Exchange Market with Imperfect Asset Substitutability 230 Demand 230 Supply 231 Equilibrium 231 Appendix 2: The Timing of Balance of Payments Crises 233 Part 2 International Macroeconomic Policy 236 International Monetary Systems: An Historical Overview 236 Macroeconomic Policy Goals in an Open Economy 237 Internal Balance: Full Employment and Price Level Stability 238 External Balance: The Optimal Level of the Current Account 239 box: Can a Country Borrow Forever? The Case of New Zealand 241 Classifying Monetary Systems: The Open-Economy Monetary Trilemma 245 International Macroeconomic Policy under the Gold Standard, 1870�C1914 246 Origins of the Gold Standard 246 External Balance under the Gold Standard 247 The Price-Specie-Flow Mechanism 247 The Gold Standard ��Rules of the Game��: Myth and Reality 248 Internal Balance under the Gold Standard 249 case study: The Political Economy of Exchange Rate Regimes: Conflict over America's Monetary Standard during the 1890s 250 The Interwar Years, 1918�C1939 251 The Fleeting Return to Gold 251 International Economic Disintegration 252 case study: The International Gold Standard and the Great Depression 253 The Bretton Woods System and the International Monetary Fund 254 Goals and Structure of the IMF 255 Convertibility and the Expansion of Private Financial Flows 256 Speculative Capital Flows and Crises 257 Analyzing Policy Options for Reaching Internal and External Balance 258 Maintaining Internal Balance 258 Maintaining External Balance 260 Expenditure-Changing and Expenditure-Switching Policies 260 The External Balance Problem of the United States under Bretton Woods 262 case study: The End of Bretton Woods, Worldwide Inflation, and the Transition to Floating Rates 263 The Mechanics of Imported Inflation 264 Assessment 265 The Case for Floating Exchange Rates 266 Monetary Policy Autonomy 266 Symmetry 267 Exchange Rates as Automatic Stabilizers 268 Exchange Rates and External Balance 270 case study: The First Years of Floating Rates, 1973�C1990 270 Macroeconomic Interdependence under a Floating Rate 274 case study: Transformation and Crisis in the World Economy 275 What Has Been Learned since 1973? 281 Monetary Policy Autonomy 281 Symmetry 282 The Exchange Rate as an Automatic Stabilizer 283 External Balance 283 The Problem of Policy Coordination 284 Are Fixed Exchange Rates Even an Option for Most Countries? 284 Summary 285 Appendix: International Policy Coordination Failures 292 Financial Globalization: Opportunity and Crisis 295 The International Capital Market and the Gains from Trade 296 Three Types of Gain from Trade 296 Risk Aversion 298 Portfolio Diversification as a Motive for International Asset Trade 298 The Menu of International Assets: Debt versus Equity 299 International Banking and the International Capital Market 300 The Structure of the International Capital Market 300 Offshore Banking and Offshore Currency Trading 301 The Shadow Banking System 303 Banking and Financial Fragility 303 The Problem of Bank Failure 303 Government Safeguards against Financial Instability 306 Moral Hazard and the Problem of ��Too Big to Fail�� 308 box: The Simple Algebra of Moral Hazard 309 The Challenge of Regulating International Banking 310 The Financial Trilemma 310 International Regulatory Cooperation through 2007 312 case study: The Global Financial Crisis of 2007�C2009 313 box: Foreign Exchange Instability and Central Bank Swap Lines 316 International Regulatory Initiatives after the Global Financial Crisis 318 How Well Have International Financial Markets Allocated Capital and Risk? 320 The Extent of International Portfolio Diversification 320 The Extent of Intertemporal Trade 322 Onshore-Offshore Interest Differentials 323 The Efficiency of the Foreign Exchange Market 323 Summary 327 Optimum Currency Areas and the Euro 332 How the European Single Currency Evolved 334 What Has Driven European Monetary Cooperation? 334 The European Monetary System, 1979�C1998 335 German Monetary Dominance and the Credibility Theory of the EMS 336 Market Integration Initiatives 337 European Economic and Monetary Union 338 The Euro and Economic Policy in the Euro Zone 339 The Maastricht Convergence Criteria and the Stability and Growth Pact 339 The European Central Bank and the Eurosystem 340 The Revised Exchange Rate Mechanism 341 The Theory of Optimum Currency Areas 341 Economic Integration and the Benefits of a Fixed Exchange Rate Area: The GG Schedule 342 Economic Integration and the Costs of a Fixed Exchange Rate Area: The LL Schedule 344 The Decision to Join a Currency Area: Putting the GG and LL Schedules Together 346 What Is an Optimum Currency Area? 348 Other Important Considerations 348 case study: Is Europe an Optimum Currency Area? 349 The Euro Crisis and the Future of EMU 353 Origins of the Crisis 353 Self-Fulfilling Government Default and the ��Doom Loop�� 358 A Broader Crisis and Policy Responses 360 ECB Outright Monetary Transactions 361 The Future of EMU 362 Summary 363 Developing Countries: Growth, Crisis, and Reform 368 Income, Wealth, and Growth in the World Economy 369 The Gap between Rich and Poor 369 Has the World Income Gap Narrowed Over Time? 370 Structural Features of Developing Countries 372 Developing-Country Borrowing and Debt 375 The Economics of Financial Inflows to Developing Countries 375 The Problem of Default 377 Alternative Forms of Financial Inflow 379 The Problem of ��Original Sin�� 380 The Debt Crisis of the 1980s 382 Reforms, Capital Inflows, and the Return of Crisis 383 East Asia: Success and Crisis 386 The East Asian Economic Miracle 386 box: Why Have Developing Countries Accumulated Such High Levels of International Reserves? 387 Asian Weaknesses 389 box: What Did East Asia Do Right? 390 The Asian Financial Crisis 391 Lessons of Developing-Country Crises 392 Reforming the World's Financial ��Architecture�� 394 Capital Mobility and the Trilemma of the Exchange Rate Regime 395 ��Prophylactic�� Measures 396 Coping with Crisis 397 case study: China's Pegged Currency 398 Understanding Global Capital Flows and the Global Distribution of Income: Is Geography Destiny? 401 box: Capital Paradoxes 402 Summary 406 Mathematical Postscripts 411 Postscript to Chapter 9: Risk Aversion and International Portfolio Diversification 411 An Analytical Derivation of the Optimal Portfolio 411 A Diagrammatic Derivation of the Optimal Portfolio 412 The Effects of Changing Rates of Return 414 ONLINE APPENDICES (www.pearsonhighered.com/krugman) Appendix A to Chapter 17 in International Economics (Chapter 6 in International Finance): The IS-LM Model and the DD-AA Model Appendix A to Chapter 18 in International Economics (Chapter 7 in International Finance): The Monetary Approach to the Balance of Payments