SOLUTION MANUAL
International Economics 18/E By Thomas Pugel
Chapter 1: International Economics Is Different
Overview
The introduction to the subject of international economics has three major purposes:
1. Show that international economics addresses important and interesting current events and
issues.
2. Show why international economics is special.
3. Provide a broad overview of the book.
We begin with four controversial developments that show the importance of current issues
addressed by international economics.
The first controversy examines the economic effects of the global COVID-19 pandemic. The
pandemic led to great harm to global health and millions of deaths. The global pandemic crisis
also had global economic effects, including a swift, deep global recession in the first half of
2020. With the effects of the pandemic and the recession, international trade also collapsed,
declining by 8% in 2020.
A surprising development was the difference in the declines of good trade and services trade
globally. In previous global recessions, the trade decline was large for goods, especially durable
goods, and small for services. But in 2020, the decline in good trade was smaller than the decline
in services trade. Economists usually examine trade drivers through the demand for imports and
focus on the roles of relative product prices and changes in real income. For goods, these drivers
predicted a decline of 10%, but it was only 6%. For services, these drivers predicted a decline of
8%, but it was 25%.
The COVID-19 recession was different from previous recessions in many ways. Two help us to
understand why the predictions from the standard demand drivers were so wrong.
Why did goods trade fall by less, even though lockdowns limited goods production and created
problems for international transport of goods? The pandemic recession led to a shift in demand,
away from services and toward goods, especially durable goods like electronics, furniture, and
appliances. Trade in goods did not decline by as much as the standard drivers would predict.
Why did services trade fall so much? Much of the shift in demand was a very large decrease in
international travel and tourism, which declined by 80% in the second quarter of 2020 and
remained at that much lower level through 2021.
In a pandemic, access to medical goods is crucial. In the United States, access to imports from
China became controversial. Of the four main types of medical goods, the United States was
dependent on China for a large part of its total supply of personal protective equipment (PPE).
China has a comparative advantage in producing PPE, based on its relative abundance of
medium-skill workers.
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,How did the United States end up short of PPE as the pandemic hit in March 2020? First, the
pandemic had hit China in January, and Chinese exports fell off as demand within China
increased. Second, U.S. stockpiles of PPE were low, in part because U.S. tariffs imposed on
imports from China in 2019 reduced U.S. buying.
With strong U.S. demand and limited supply, prices rose dramatically. That incentivized
additional supply. For U.S. production, the U.S. government added subsidies to the incentives.
But, increased U.S. production was not enough. The higher prices also incentivized Chinese and
other foreign export producers, and U.S. imports increased. By early to mid-2021, the global
shortage of PPE was resolved.
Concerns about the availability of imports spread to other goods, especially those produced
through sometimes complex global supply chains (GSCs). At their core, GSCs are also based on
comparative advantage. To lower the cost of producing a final product, site each production step
in its lowest cost location. The COVID-19 pandemic exposed GSCs to a range of risks including
lockdowns and restrictions that cut access to components. How could production of the final
products be made more resilient? Should all or most of the production steps be brought back
(“reshored”) to a firm’s main country? Each business manages its supply chain risks, and most
GSCs turned out to be more resilient than many initially feared. (An exception was automobiles,
because the auto firms could not regain their access to enough semiconductors.) Reshoring
sounds like a way to reduce risk, but it would actually concentrate risks in a single country. And,
in eliminating international trade within the GSC, the gains from trade (discussed in Chapters 2–
6) would be lost.
The economic effects of the global COVID-19 pandemic crisis appear throughout the rest of the
book:
• The trade collapse (Chapter 2)
• Export restrictions on PPE and other goods (Chapter 8)
• The decline and rebound of migrant remittances (Chapter 15)
• The increases in the U.S. trade and current account deficits (Chapter 16)
• Financial disruptions and increased deviations from covered interest parity (Chapter
18)
• A large new allocation of SDRs and expanded emergency lending by the IMF
(Chapters 20 and 21)
• U.S. inflation rates first declined then went much higher (Chapter 22)
• The U.S. fiscal response and the effects on private saving and government dissaving
(Chapter 24)
• Investors’ “dash for cash” in March 2020 and the expansion of central bank liquidity
swaps (Chapter 24)
• The EU suspension of national fiscal policy rules and its first large unionwide fiscal
policy (Chapter 25)
The second controversy arises from international migration, especially the increasingly vehement
complaints about immigrants in many of the major receiving countries. In these countries, a
rather large (10% or more) and rising percentage of the population is foreign-born, including
many who are undocumented. Opponents accuse immigrants of causing general economic harm,
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,imposing fiscal costs as immigrants use government services, and increasing crime. International
economics is often about emotional issues like immigration, yet we do our best to use economic
analysis to think objectively about actual economic effects. In a preview of the analysis of
Chapter 15, we highlight two key conclusions about the effects of immigration on the receiving
country. First, as with many issues in international economics, there are both winners and losers
in the receiving country. Second, we can determine the net effect on the receiving country. As
we often conclude when we examine freer international exchange, the net national effect of
immigration is positive according to the basic economic model, in this case even if we ignore the
gains to the immigrants themselves.
The third controversy is about Britain’s exit from the European Union (EU). A slim majority of
U.K. voters in 2016 voted to leave the EU. While proponents of “remain” stressed the economic
benefits of being part of the EU, proponents of “leave” stressed the need to reassert national
control in such areas as business regulation and control of immigration. After the controversial
vote, the process of leaving (Brexit) brought new controversies, because the vote itself said
nothing about the relationship that Britain would have with the EU after Britain separated. A
“hard Brexit” would reassert British sovereignty but would be very disruptive to businesses and
markets. A “soft Brexit” would be less disruptive but would mean that Britain would remain
subject to many EU laws and regulations. Britain formally withdrew from EU the in early 2020,
and on January 1, 2021, the EU-UK Trade and Cooperation Agreement established a free trade
area for goods. Britain had pursued a hard Brexit, and the EU had agreed. One feature has
continued to be controversial. To prevent a hard border on the Irish island, Northern Ireland
remains part of the EU’s single market. Instead, there is a customs border “in the Irish Sea,”
dividing the United Kingdom.
Chapter 12 presents the economics of a free trade area, as well as the evolution of the EU from a
customs union toward a single market and increasing economic union. Nontariff barriers, which
remain and are important in the new EU-UK free trade area, are discussed in Chapter 9.
The fourth controversy is the exchange rate value of the Swiss franc. Many countries are
skeptical of the exchange rate policies used by other countries, because exchange rates have
effects that cross national boundaries, especially effects on relative prices that influence imports
and exports. The United States has two laws, one more qualitative and one more quantitative,
that direct the U.S. Department of the Treasury to monitor the exchange rate practices of other
countries. These laws have seldom been used, but in late 2020 the Treasury Department
concluded that the Swiss government was a currency manipulator. How did Switzerland, a well-
regarded high-income, low-risk country, come to be so labeled?
Before September 2011, Switzerland’s exchange rate policy was managed floating, and the
exchange rate with the euro was key to Swiss international price competitiveness. With the
beginning of euro crisis in March 2010, international investors shifted their investments to safe
havens, including Switzerland. The Swiss franc appreciated against the euro, with the Swiss
central bank sometimes intervening in the foreign exchange market to resist this appreciation.
When the euro crisis intensified in mid-2011, the Swiss government shifted to a one-sided
pegged exchange, in which the franc could not appreciate past 1.2 Swiss francs per euro. This
worked well until early 2015. Under renewed pressure for appreciation, the Swiss government
decided to shift back to a managed float (a very messy exit from the pegged rate). The Swiss
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, central bank then intervened, sometimes in large amounts, to stabilize the franc–euro exchange
rate, including in 2020, when again international investors sought safe havens as the global
COVID-19 pandemic crisis hit. The large Swiss interventions to prevent the franc from
appreciating were part of the evidence cited by the U.S. Treasury Department.
In the controversy over the Switzerland’s exchange rate policy, we can see many issues that we
will examine in the second half of the book, including a country’s balance of payments (Chapter
16), foreign financial investment (Chapters 18 and 19), exchange rate policy (Chapters 20 and
25), and exchange rates in macroeconomic analysis (Chapters 22–24).
These four controversies show that international economics addresses important current issues.
They also can be used to show why international economics is special—why national boundaries
matter in economics. The first reason that international economics is special is that some
resources do not move freely between countries. Land is essentially immobile. There are
substantial impediments to the movement of labor internationally, as we see in the analysis of
international migration, because of the personal and economic costs to people of moving from
one country to another, and because of restrictive government policies. Financial capital moves
more freely, but there still seems to be a home bias to many people’s financial investments.
The second reason that international economics is special is that national government policies
matter—in fact, they matter in two ways. One way is that national governments can adopt and
change policies toward international transactions, as we see in in the decision by the UK
government to leave the EU. The other way is that national governments adopt different
economic policies. These national policies usually are designed to serve national interests, but
they often have international effects. We see the tension between national interests and
international effects in the discussion of Switzerland’s exchange rate policy.
Tips for teaching
One good way to begin the first class session is with a look at current events, even before the
mechanics and requirements of the course are presented. The instructor might use the day’s
newspaper (for instance, the Financial Times or Wall Street Journal) or the week’s magazine
(for instance, the Economist or Business Week) to highlight a few stories related to the content of
the course. We have found that this is a good way to get the students’ attention and interest.
Another good beginning would be to provide a discussion that updates one or more of the four
controversies in Chapter 1. For example, the instructor could look at the most recent information
about the effects of the COVID-19 pandemic and its aftermath or about the effects of Brexit.
You may want to consider beginning other class sessions of the course (not only the first class
session) with a look at one or two stories in that day’s newspaper. The stories should relate in
some way to the material covered in the course, but they do not necessarily have to relate to the
specific material covered in that day’s session. We have found that this look at current events
reinforces the relevance of international economic analysis. It also encourages students to read
good news sources and to keep up with current events. In addition, we can model critical
reading, if we both summarize the article’s information and offer our own opinion or analysis (or
ask the students for their opinions).
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