This is a summary of chapters 1-10 of Krugman's International Economics: theory and policy book,required for the class of International Trade taught at the VUB. It also includes graphs and notes from class
International Economics
Theory and Policy
1. Introduction
1.1 What is international economics about
➢ International economics uses the same fundamental method of analysis as other branches of
economics because the motives and behaviors or individuals are the same in international trade as
they are in domestic transactions
➢ The subject matter of international economics consists of issues raised by the special problems of
economic interaction between sovereign states
➢ 7 themes:
1. Gains from trade
▪ When countries sell goods and services to each other, this exchange is almost
always to their mutual benefit
▪ The range of circumstances under which international trade is beneficial is much
wider than most imagine
• Common misconception: trade is harmful if large disparities exit between
countries in productivity or wages
o 2 countries can trade to their mutual benefit even when one of
them is more efficient than the other at producing everything and
when producers in the less-efficient country can compete only by
paying lower wages
o Trade provides benefits by allowing countries to export goods
whose production makes relatively heavy use of resources that are
locally abundant while importing goods using resources that are
locally scarce
o Trade also allows countries to specialize in producing narrower
ranges of goods, giving them greater efficiencies of large-scale
production
▪ The benefits from trade are not limited to tangible goods
• International migration and borrowing and lending are also forms of
mutually beneficial trade
▪ Although nations generally gain from international trade, it is possible that it may
hurt particular groups within those nations
• Trade might have strong effects on the distribution of income
2. Pattern of trade
▪ Attempts to explain who sells what to whom have been a major preoccupation of
international economists
3. Protectionism
▪ Debate on how much trade to allow is the most important policy theme
▪ Since the emergence of modern nation-states in the 16th century, governments have
worried about the effect of international competition on the prosperity of domestic
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, industries and have tried either to shield industries from foreign competition by
placing limits on imports or to help them in world competition by subsidizing
exports
4. Balance of payments
▪ Surplus/deficit
▪ A country’s balance of trade must be placed in the context of an economic analysis
to understand what it means
5. Exchange rate determination
▪ A key difference between international economics and other areas of economics is
that countries usually have their own currencies
• The relative values of currencies can change over time
6. International policy coordination
▪ The international economy comprises sovereign nations, each free to choose its
own economic policies
• Unfortunately, in an integrated world economy, one country’s economic
policies usually affect other countries as well
▪ Differences in goals among countries usually lead to conflicts of interest
• Even with similar goals, countries may suffer losses if they fail to coordinate
their policies
▪ A fundamental problem is determining how to produce an acceptable degree of
harmony among the international trade and monetary policies of different countries
in the absence of a world government that tells countries what to do
7. International capital market
▪ In any sophisticated economy, there is an extensive capital market: a set of
arrangements by which individuals and firms exchange money now for promises to
pay in the future
• The growing importance of international trade has been accompanied by
the growth in the international capital market, which links capital markets
of individual countries
▪ International capital markets differ from domestic ones because:
• They must cope with special regulations that many countries impose on
foreign investment
• They sometimes odder opportunities to evade regulations placed on
domestic markets
▪ Special risks are associated with international capital markets:
• Currency fluctuations
• National default
1.2 International economics: trade and money
➢ The economics of the international economy can be divided into 2 broad subfields:
o International trade
▪ Focuses primarily on the real transactions in the international economy
o International money
▪ Focuses on the monetary side (financial transactions)
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,➢ In the real world, there is no simple dividing line between trade and monetary issues
o Most international trade involves monetary transactions, while many monetary events have
important consequences for trade
2. World trade: an overview
2.1 Who trades with whom?
2.1.1 Size matters: the gravity model
3 of the top 15 US trading partners are
Germany, the UK and France
o Why does the US trade more
with these 3 European
countries than others?
3 largest European
economies in terms of
GDP
There is a strong
empirical relationship
between the size of a
country’s economy and
the volume of its
imports and its exports
Each country’s share of US trade with
Europe (fig. 2-2) is roughly equal to that
country’s share of Western European GDP
The following formula predicts the volume of trade between any 2 countries fairly accurately:
o A = constant term
o Tij = the value of trade between country i and j
o Yi = GDP of i
o Yj = GDP of j
o Dij = distance between the 2 countries
The value of trade between any 2 countries is proportional, other things equal, to
the product of the countries’ GDPs and diminishes with the distance between
countries
= Gravity model of world trade
o More general model:
o 3 things that determine the volume of trade between 2 countries:
▪ Size of GDPs
▪ Distance between the countries
o The model doesn’t assume that trade is proportional to the product of the 2 GDPs and
inversely proportional to distance
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, ▪ a, b and c are chosen to fit the actual data as closely as possible
➢ Why does the gravity model work?
o Large economies tend to spend large amounts on imports because they have larger incomes
o They also tend to attract large shares of other countries’ spending because they produce a
wide range of products
2.1.2 Using the gravity model: looking for anomalies
➢ On of the principal uses of the gravity model is that it helps us identify anomalies in trade
o When trade between 2 countries is either much more or much less than the model predicts,
economists search for an explanation
➢ Eg.: the US trades more with Belgium, the Netherlands and Ireland than predicted
o For Ireland, it’s a case of cultural affinity
o For Belgium and the Netherlands, geography and transport costs probably explain their
large trade with the US
2.1.3 Impediments to trade: distance, barriers and borders
➢ All estimated gravity models show a strong negative effect of distance on international trade
o Typical estimates say that a 1% increase in distance between 2 countries is associated with a
fall of 0.7 to 1% in trade between them
o This drop partly reflects increased costs of transporting goods and services
o Economists also believe that less tangible factors play a crucial role
▪ Trade tends to be intense when countries have close personal contact, which
diminishes when distances are large
➢ Economists use gravity models as a way of assessing the impact of trade agreements on actual
international trade
o If a trade agreement is effective, it should lead to significantly more trade among its
partners than one would otherwise predict given their GDPs and distances
➢ Important to note: although trade agreements often end all formal barriers to trade between
countries, they rarely make borders irrelevant
o Even when most goods and services shipped across a national border pay no tariffs and face
few legal restrictions, there
is much more trade
between regions of the
same country than between
equivalently situated
regions in different
countries
o Table 2-1 was used to
calculate that the US-
Canadian border, although one of the most open ones in the world, has as much effect in
deterring trade as if the countries were between 1500 and 2500 miles apart
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