UNIT THREE

3. COMPONENTS OF IPE
3.1Basic terminologies

Terms of Trade (ToT)

Terms of trade refers to the value of a nation’s exported goods relative to the value of goods that
are imported. It is a measure of prices paid for import relative to the price received from exports.

Balance of Payment (BoP)

Balance of payment is a tabulation of all international transactions involving a nation in a given year
measured in current dollars ($). In simple terms the BoP measures the inflows and the outflows of
money from one nation to other nations. Each international transaction involves both substance and
shadow which gives BoP a dual importance. The substance refers to the goods, services and
ownership claims that move from country to country- are what really count. They are too hard to
quantify in themselves and pretty much impossible to add-up in their natural state. So, the BoP
records the shadows-the equal and opposite money movements- the real resource transfer. The BoP is

a best indicator of the nation’s economic status. The most important parts of BoP
are the Current Account and Capital Account.

Current account
Current account is a part of a nation’s BoP that records financial flows due to international trade in
goods and services and unilateral transfers (aids or gifts between nations). It measures the way
international transactions affect national income. A Current Account deficit means the nation is
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International Political Economy (IPE) Instructor: Melese T. (MA) JU, 2022
paying out more for goods and services than it receives for goods and services it sells on the
international market. Current account also includes Balance of Trade.

Balance of Trade (BoT)

Balance of trade is part of the current account which measures the dollar value of
payments in receipts for goods and services. BoT usually gets a lot of attention in
ordinary circles as an indicator of the nature of international competition. However, it is
an incomplete measure of the impact of international transactions on the economy since
it does not take into account payments and receipts of investment income and unilateral
transfers. The current account which includes all these items in addition to those in BoT
is a better indicator of international economic relations impact a nation.

Capital account

Capital account is the part of BoP that records international borrowing, lending and investment. It is a
receipt of foreign private and lending and investment in excess of repayment in of principal and interest
on former loans and investments. It measures the impact of international transactions on a nation’s
wealth. If a nation has a capital account surplus, it means that it is net debtor during a particular period.

3.2 International trade

3.2.1 What is international trade?

International trade is the inter-country flow of goods and financial resources. It is considered to
be part of the production structure (a set of relationships that determine what is produced, where, by
whom, how, for whom and at what price) of political economy. When elements of this structure
cross international boundaries the result is international trade, which assumes forms of
interaction between states and other actors such as international business.

Trade is always political and the economics of trade cannot be separated from its political aspect. Not
only does trade continue to gain an importance for national officials but also a number political actors
and institutions outside the nation states that shape developments in this area has grown significantly
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since the end of the Cold War. Trade ties countries together and in so doing generates a good deal
of political and economic interdependence. Partly because of this, states, today, are compelled more
than ever to regulate international trade so as to capture its benefits and limit its costs to their
economies.

3.2.2 Why states trade?

3.2.1.1 The absolute advantage (Adam Smith model)

Adam Smith (father of liberalism and economical science) brought the argument in his book
“The Wealth of Nations”, published in 1776, about absolute advantage. Adam Smith’s theory
starts with the idea that export is profitable if you can import goods that could satisfy better the
necessities of consumers instead of producing them on the internal market. The essence of Adam
Smith theory is that the rule that leads the exchanges from any market, internal or external, is to
determine the value of goods by measuring the labour incorporated in them.

In order to demonstrate his theory, Adam Smith analyzed using one country (say A), using one
factor of production, the productivity of labour (evaluated in the necessary of hours needed to
produce a unit of measure of the products X and Y). Because all the economies have limited
resources, there are limits in the level of production, and if a country wants to produce much of
one product it has to give up producing another goods, existing in this case renounce of trade.

Country A is more productive than B in the production of X and it has an absolute advantage in
this product and country B is more productive in producing product Y. It is reasonable and in
the benefit of the two countries to concentrate all resources of labour to the product for which

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they have an absolute advantage. After specialization, exchanging products, both countries can
gain from trade.

3.2.1.2 The comparative advantage (David Ricardo model)

The main distinguishing feature of international trade singled out by Ricardo was the
international immobility of factors of production. Factors were regarded as perfectly mobile
within countries and completely immobile among countries, whereas goods were perfectly mobile
within and among countries (at zero transport cost). Ricardo rather glossed over the question of
the interdependence of industries, treating them as integrated, producing one output and using
one primary input (labor). The latter being mobile internally, the unit cost of each good was
constant, depending only on the amount of labor required to produce it.

In his celebrated example of trade in cloth and wine between England and Portugal, he says "England
may be so circumstanced, that to produce the cloth may require the labour of 100 men for one year; and
if she attempts to make the wine, it might re-quire the labour of 120 men for the same time. England
would therefore find it her interest to import wine, and to purchase it by the exportation of
cloth."

Country A is more productive in X than Y. and country B is more productive in Y than in X.

each country should specialize in the production in which it has less opportunity cost.

3.2.1.3 Mill's law of international value

In his remarkable essay, “On the Laws of Interchange between Nations”, Mill set out to find a
precise solution to the problem left open by Ricardo. It was implicit in his discussion that an
intermediate price ratio would necessitate complete specialization, entailing a fixed supply of
each good.

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The problem was then whether there would exist a price ratio for which "the demand shall be
exactly sufficient to carry off the supply". He recognized the possibility of "an extreme case" in
which demand might be so rigid that no such intermediate price ratio would exist; in that case,
the equilibrium price ratio would have to correspond to one of the limiting cost ratios, and there
would be partial specialization in the corresponding country

3.3 The H-O model

One of the most popular model advanced in explaining the concept of comparative advantage was
provided by two Swedish economists Eli Heckscher and Bertil Ohlin is known as the Heckscher-
Ohlin model or the factor endowments or factor proportions model. Since its development in the
early 1930s this model has been accepted as the standard explanation of international trade.

Heckscher-Ohlin (or H-O) model of comparative costs or advantage postulates that a country will
specialize in the production and export of those products in which it has a cost advantage over
other countries. This model suggests that a country will have a comparative advantage in, and
therefore will tend to export, those goods whose production requires the intensive use of a factor
of production with which that country is well endowed.

This theory implies that:

(1) A country will export those products that are intensive in its abundant factor; that is, a
capital-rich country will export capital- intensive goods.
(2) Trade will benefit the owners of locally abundant factors and harm owners of the scarce
factors. Thus, although all countries will benefit in absolute terms, there will be important
distributive consequences that will favor either capital or labor in trading countries.
(3) Trade in factors (capital or labor) and trade in goods will have the same effect and can fully
substitute for one another.
(4) Under certain circumstances, trade in goods will over time equalize the return (wages to
labor and profits to capital) for each factor of production.

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The basic problem with the H-O model or theory is that actual trading patterns frequently differ from
what the theory predicts. A notable example is found in intra-industry trade among countries with
similar factor endowments. Indeed, most trade among industrialized countries takes place largely in the
same product sectors; for example, the United States both exports to and imports from other
industrialized countries.

Another important intellectual development that has undermined the H-O theory of international trade
is a shift among economists from emphasizing “comparative” to emphasizing “competitive” advantage,
especially in high-tech sectors. International competitiveness and trade patterns frequently result from
arbitrary specialization based on increasing returns rather than from efforts to take advantage of
fundamental national differences in resources or factor endowment. This new thinking about the
arbitrary or accidental nature of international specialization and competitiveness emphasizes the
increasing importance of technology in determining trade patterns.

Mainstream economists have been hesitant to acknowledge the increased importance of such factors as
technology and learning by doing in the determination of trade patterns. Nevertheless, the fundamental
idea that comparative or competitive advantage is largely arbitrary and a product of human intervention
rather than a fixed gift of nature is accepted by growing numbers of mainstream economists.

Some economists regard actual trade patterns as resulting from many factors other than natural
endowments, factors including historical accidents, government policies, and cumulative causation.
Moreover, the standard H-O theory itself has been modified and expanded to include such important
factors as human capital (skilled labor), “learning by doing,” technological innovation, and especially
economies of scale. Revisions have so transformed the original H-O model that some economists now
argue that the theory of international trade is not much more than an eclectic enumeration of the many
factors that determine comparative advantage and trade flows.

However, it is very difficult to incorporate these newly recognized factors into a formal model, and
because there is no satisfactory alternative model, economists continue to support the standard H-O
theory of trade based on factor endowments. As Richard Caves and Ronald Jones have argued, the
Heckscher-Ohlin theory, with its emphasis on factor endowments, is still largely valid. Moreover, as
economists argue national specialization and the benefits of a territorial division of labor remain valid
concepts that are of overwhelming importance for the efficient use of the world’s scarce resources.
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True! But this generalization does not explain or determine which country will produce what, and
nation-states will always be very reluctant to leave that decision entirely up to the market.

These important considerations that “international comparative advantage in the production of and sale
of high-technology goods must be struggled for and earned through superior technological
innovativeness” has significantly intensified what F. M. Scherer has labeled “international high-
technological competition.” The drive for technological superiority has notably increased the
receptivity of governments to the “new trade theory.”

3.4 New trade theory

The most important and certainly the most controversial development challenging the conventional
theory of international trade is the “new trade theory,” more commonly known as “strategic trade

theory” (STT).

Strategic trade theory is the culmination of earlier challenges to conventional trade theory because it
incorporates a growing appreciation of imperfect competition, economies of scale, economies of scope,
learning by doing, the importance of R & D, and the role of technological spillovers. STT is significant
because it challenges the theoretical foundations of the economics profession’s unequivocal
commitment to free trade. In fact, STT originated with the development of new analytical tools and
growing dissatisfaction with conventional trade theory and its inability to explain the increasing trade
problems of the United States, especially with respect to Japan in the 1980s.

Before we consider the theory, however, we will discuss oligopolistic competition briefly. Under
conditions of perfect competition, strategic behavior is not possible because the behavior of one or just
a few firms cannot significantly change market conditions for other firms. However, if unit costs in
certain industries do continue to fall as output increases (economies of scale), the total output of firms
will expand but the number of firms will decrease. Economies of scale in an industry mean that the
market will support only one or just a few large firms; that is, the industry will become oligopolistic,
and the market will eventually be dominated by a few firms. This would permit the behavior of one
firm to make a difference and to alter the decisions of other firms. If imperfect or oligopolistic
competition exists, then monopoly rents or abnormally high profits can exist in that economic sector;
the resultant rents or super-profits could then be captured by a small number of firms or even by one
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firm. Individual firms, then, may well pursue corporate strategies to increase their profits or economic
rents.

Oligopolistic firms can and do consciously choose a course of action that anticipates the behavior of
their competitors. If successful, such action enables them to capture a much larger share of the market
than would be the case under conditions of perfect competition. For example, oligopolistic firms can
and do follow strategies in which they adjust their own prices and output in order to alter the prices and
output of competitor firms. Two of the most important strategies used to increase a firm’s long-term
domination of an oligopolistic market are dumping (selling below cost to drive out competitors in the
product area) and preemption (through huge investment in productive capacity to deter other entrants
into the market).

Imperfect or oligopolistic competition is most likely found in certain high-tech industries characterized
by economies of scale and learning by doing. The sectors most likely to become oligopolistic include
computers, semiconductors, and biotechnology; these technologies, of course, are identified by most
governments as the “commanding heights” of the information economy. Many are dual technologies,
because they are very important to both military weaponry and to economic competitiveness. Many
countries consider it essential for both commercial and security reasons to take actions that will ensure
a strong presence in some or all of these sectors. The importance of a head start in these industries
encourages firms to pursue a “first-mover” strategy so that cumulative processes and path dependence
will strengthen their market position.

The theory of strategic trade takes the existence of imperfect or oligopolistic competition one step
further and suggests that a government can take specific actions to help its own oligopolistic
firms. Government policies can assist national firms to generate positive externalities (e.g.,
technological spillovers) and to shift profits from foreign firms to national firms. Economists have long
appreciated that a nation with sufficient market power could enact an optimum tariff and thereby shift
the terms of trade in its favor. By restricting imports and decreasing the demand for a product, a large
economy may be able to cause the price of the imported good to fall. Strategic trade theory, however,
goes much farther than optimum trade theory in recognizing the capacity of a nation to intervene
effectively in trade matters and thus to gain disproportionately.

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A government’s decision to support a domestic firm’s plans to increase its productive capabilities
(preemption) or even to signal intention to build excess productive capacity exemplifies a strategic
trade policy. Through use of a direct subsidy to a firm or outright protection of a domestic industry, the
government might deter foreign firms from entering a particular industrial sector. Since a minimum
scale of production is necessary to achieve efficiency, especially in many high-tech industries, the
advantage of being first (“first-mover advantage”) encourages a strategy of preemptive investment.

Strategic trade theory departs from conventional trade theory in its assumption that certain
economic sectors are more important than others for the overall economy and therefore warrant
government support. Manufacturing industries, for example, are considered more valuable than
service industries because manufacturing has traditionally been characterized by higher rates of
productivity growth and has produced higher profits, higher value-added, and higher wages.

Some economic sectors, especially such high-tech industries as computers, semiconductors, and
information processing, are particularly important because they generate spillovers and positive
externalities that benefit the entire economy. Because a new technology in one sector may have indirect
benefits for firms in another sector, firms that do extensive research and development are valuable to
many others.

However, because firms may not be able to capture or appropriate the results of their research and
development activities, many will under-invest in these activities. Proponents of strategic trade
theory argue that such a market failure indicates that firms should be assisted through direct
subsidy or import protection, particularly in high-tech industries, which frequently raise the skill
level of the labor force and thus increase human capital. If, as the proponents of strategic trade
believe, such special industries do exist, then free trade is not optimal, and government
intervention in trade matters can increase national welfare.

Strategic trade theory has become a highly controversial subject within the economics profession. Some
critics argue that strategic trade theory is a clever, flawed, and pernicious idea that gives aid and
comfort to proponents of trade protectionism. Other opponents of the theory agree with this negative
assessment and maintain that the theory itself adds nothing really new to dubious arguments favoring
trade protection. Perhaps in response to the severe denunciations of strategic trade theory by leading

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International Political Economy (IPE) Instructor: Melese T. (MA) JU, 2022
mainstream economists, some of its earliest and strongest proponents have moderated their initial
enthusiasm.

3.3 Perspectives in international trade: free trade versus protectionism

The different perspectives on IPE provide different motivations for trade to take place. The
system of international trade pulls in three directions at once. There is a large but far from universal
consensus that a liberal international trading system is desirable. Within that liberal structure, however,
individual nation states try to pursue mercantilist policies while worrying about becoming dependent
and being exploited by other nations. Thus, it is possible for national leaders apparently to believe in all
three perspectives at once: a global system of free trade (liberal), but protection for domestic firms
and workers (mercantilist) by promoting high wage or high technology industrialization
(structuralist). No wonder, international trade policy is so controversial. In the coming sections, an
attempt will be made to shade light on the three perspectives of international political economy and
their respective positions on international trade.

As noted in the foregone sections one of the significant perspective on international trade is liberalism,
formalized through the theory of absolute / comparative advantage by Adam Smith and David Ricardo.

The liberal doctrine of free trade is based on the principles of the market system formulated by
classical economists. Adam Smith and David Ricardo argued that removing the impediments to the free
movement of goods would permit national specialization and facilitate optimal utilization of the
world’s scarce resources. Trade liberalization would lead to efficient trade patterns determined by the
principle of comparative advantage; that is, by relative factor prices (of land, capital, and labor).
Adoption of the principle of “comparative advantage” or “comparative cost” would ensure that a
country would achieve greater economic welfare through participation in foreign trade than
through trade protection. Underlying this liberal commitment to free trade is the belief that the
purpose of economic activity is to benefit the consumer and maximize global wealth. Free trade
also maximizes consumer choice, reduces prices, and facilitates efficient use of the world’s scarce
resources. From this perspective, the primary purpose of exports is to pay for imports rather
than to enhance the power of the state.

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According to its advocates, trade liberalization produces a number of specific benefits. In the first
place, trade liberalization increases competition in domestic markets, and thereby undermines
anticompetitive practices, lowers prices, increases consumer choice, and increases national efficiency.
In addition, free trade increases both national and global wealth by enabling countries to specialize and
to export those goods and services in which they have a comparative advantage while importing those
goods and services in which they lack comparative advantage. Free trade also encourages the
international spread of technology and know-how around the globe and thus provides developing
economies with the opportunity to catch up in income and productivity with more advanced economies.
Last, but not least, free trade and the international cooperation that it entails increase the prospects of
world peace. Trade protection also has a negative impact on income distribution. A tariff or other
restrictive measure creates economic or monopoly rents and shifts income from consumers and non-
protected sectors to the protected sectors of the. Finally, one of the most serious dangers of trade
restrictions is that they tend to protect declining noncompetitive industries.

The one important exception to economists’ universal belief in the superiority of free trade over
trade protection is the protection of infant industries. Many economists accept the argument first set
forth by Alexander Hamilton (a mercantilist) that nourishing infant industries can provide an acceptable
rationale for trade protection. An infant industry is one that, if protected from international
competition, will become sufficiently strong and competitive to enable it to survive when
protection is eventually removed. A major problem with infant industry protection, however, is
that protection too frequently becomes permanent.

From eighteenth-century mercantilists to present-day protectionists, advocates of trade

protection have desired to achieve certain political, economic, and other objectives more than the
economic benefits for the entire society of free trade. However, the specific objectives sought by
protectionists have varied over time and space. Economic nationalists regard trade protection as a
tool of state creation and statecraft; for example, a trade surplus is considered beneficial for national
security. Many representatives’ of less developed countries believe that trade with industrialized
countries is a form of imperialism; they fear that free trade benefits only the developed economy and
leads to dependence of the less developed countries on the developed ones.

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Opponents of free trade in developing economies also include advocates of the “developmental state”
who believe that the state rather than free markets should have the principal role in the process of
economic development. In developed economies, proponents of trade protection reject free trade and
other forms of globalization as threats to jobs, wages, and domestic social welfare; organized labor in
industrialized countries increasingly advocates protection against imports from low-wage economies
with inadequate labor standards. In recent decades, more and more environmentalists have denounced
trade as a threat to the environment.

The most systematic economic rationale for economic nationalism and trade protection was provided
by Friedrich List. Strongly influenced by Alexander Hamilton’s protectionist ideas, List argued in his
National System of Political Economy (1841) that every industrial nation has pursued and should
pursue protectionist policies in order to safeguard its infant industries. List maintained that once their
industries were strong enough to withstand international competition, these countries lowered their
trade barriers, proclaimed the virtues of free trade, and then sought to get other countries to lower their
barriers. Free trade, List believed, was the policy of the strong. If one were to translate List’s ideas into
modern parlance, one would say that every successful industrial power at some point in its history has
carried out an activist industrial policy.

At the beginning of the twenty-first century, many trade protectionists advocate promotion through
national industrial policies of high tech and certain other favored sectors in order to build the nation’s
industrial strength and increase its competitiveness. They believe that the state should guide and shape
the overall industrial and technological structure of the society through trade protection, industrial
policy, and other forms of government intervention. In addition to such high tech industries as
computers and electronics, economic nationalists also favor support for more traditional manufacturing
industries such as the automobile and other mass-production industries characterized by high value-
added and high wages. Although in its efforts to catch up with the West, Japan has conspicuously and
aggressively pursued an industrial policy, industrial policies have also been employed by the United
States, Western Europe, and many developing economies to promote industries believed important for
national security and economic development.

Economists have strongly disputed the alleged benefits of trade protection. Trade protection, they point
out, reduces both national and international economic efficiency by preventing countries from

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exporting those goods and services in which they have a comparative advantage and from importing
those goods and services in which they lack comparative advantage. Protection also decreases the
incentive of firms to innovate and thus climb the technological ladder; it also discourages shifting
national resources to their most profitable use.

Despite economists’ arguments supporting trade liberalization, trade protectionism persists, and its
advocates too frequently succeed. Endogenous trade theory explains the success of protectionism
by calling attention to the fact that the political process generally favors special interests desiring
protection rather than general consumer interests. Whereas the benefits of free trade diffuse
across a society, the benefits of protection are concentrated in a few groups of producers.

3.4 Instruments of trade policy: utilization and impacts

Contemporary trade policy is deeply conditioned by all the three IPE perspective on trade. As noted
earlier, there seems to be a consensus on the liberal international trade system whose most important
justification is contained in the H-O model. However, states tend to behave as mercantilist when
national interests are threatened.

3.4.1 Instruments of trade policy

(A)Tariffs: a tariff is a tax on an import that is usually a percentage of the price of that import.
They are used as a way of raising revenue for the government and can also be used to raise the price of
an imported good up to a certain level to prevent foreign competition for domestic producers of that
good. There are different kinds of tariffs.
Imports tariffs are usually two kinds:
i. Specific tariff: this refers to a monetary sum that must be paid to import physical one unit
of a product. The advantage is it is easy to collect. The disadvantage is it doesn’t take price
changes into account.
ii. Ad valorem tariff: this is a percentage of the monetary value of one unit of import. The
advantage it takes price changes into account. The Disadvantage is you need to know the
monetary value of the good and seller is tempted to undervalue the price.

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Other tariff instruments include: import subsidy and export tariff. In the first case, the home
government may intentionally encourage some products via subsidy that are produced outside the
country while discouraging others. That is why it sometimes called negative import tariff. On the other
hand, export tariff or subsidy is levied or paid on home-produced goods that are destined for export.

Features of tariff schedules

 Preferential duties- products from certain countries are subject to lower tariffs than the
normal tariff rate.
 Generalized System of Preferences (GSP) for developing countries
 Most-favoured-nation (MFN) treatment, equivalent to what is sometimes called normal
trade relations (NTR) “if country A grants country B the status of most favoured nation, it
means that B’s exports will face tariff that are no higher (nor lower) than those applied to
any other country that A calls a MFN”.

(B)Non-tariff barriers to trade

There are many forms of non-tariff barriers to trade and some of these barriers will be discussed
as follows.
Import Quotas: a government agency allocates the rights to import by limiting the number of
goods (not the price) for a given time period. It is a limit imposed up on the amount of a
particular good that can be imported in to a country. Quotas may be imposed or can be achieved
through Voluntary export restraints [VER]: foreign suppliers agree to “voluntarily” refrain from
sending some exports.

Exchange controls: there are a number of different ways in which to control foreign exchange.
These includes limits on the amount of foreign exchange made available to importers or citizens
travelling abroad or limits on the amount of foreign exchange to be for investment purposes and
also charges made when purchasing foreign currency.

Import licensing: this occurs when importers obtain licenses so that the government can better
enforce restrictions.

Embargos: an embargo is imposed when a government decides to completely ban imports or

exports to certain country.

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Export taxes: these can be used to increase the price of a country’s goods when that country has a
monopoly on the supply of that good.

Subsidies: subsidies can be imposed on the production of goods made at home for the home
market to prevent competition otherwise lower priced foreign goods. Subsidies can also imposed
on exports to artificially increase trade (known as dumping).

Domestic content provisions and Administrative barriers- Domestic content provisions require a
given percentage of the value of a good must consist of domestic components or labour.
Administrative barriers may take different forms different Domestic policies affecting trade:
health, environment and safety standards; packaging and labeling requirements; inconsistent
treatment of intellectual property rights; subsidies to domestic firms, etc.

3.5 International monetary and financial relations

3.5.1 International monetary relations

3.5.1.1 The vocabulary of international money (exchange rate)

Before we go deep in to the discussion of the political economy of international monetary relations, let
us first define some of the most frequently used terminologies in international monetary systems. We
will begin our discussion with exchange rate. The foreign exchange system organizes the terms and
conditions for international payments and set the method for determining the exchange rate between
different countries’ currencies. Exchange rate refers to the ratio of exchange between the currencies of
different countries. At a very general level, the foreign exchange is simply the price of foreign currency
which clears the market for foreign exchange, or the rate at which one currency is exchanged for
another.

In the contemporary world, a nation’s money is like a ticket which can be exchanged for goods and
services in the country that issues it. The behavior of exchange rate is so vital to any state as it links a
country’s macro and micro economies to the rest of the world through the asset market and goods
market. In macro- economic terms, this happens in two ways. First, in the goods market, the higher the
exchange rate, the higher the prices of the imported goods in the home currency will be. For a given

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level of domestic costs and prices, a higher exchange rare will make foreign goods less attractive to
domestic consumers whilst domestic goods will become attractive to consumers in the rest of the world.
Second, in the asset market the exchange rate is an important variable when decisions are being made
by domestic wealth holders over how that wealth is to be held. Such choices are dependent up on the
trade-off between risk and return. The higher the return on foreign assets compared to domestic assets
in the home currency- provided there is no increase in the level of risk- the more chance there is that
domestic residents will move their wealth in to foreign asset.

In micro-economics terms, the exchange links a country to the rest of the world in ways that are vital to
resource allocation. In goods market, when an exchange rate change makes an economy more
competitive, the number of tradable goods increases. More goods then become exportable, and fewer
goods are imported as a result. On the other hand, when a change in the exchange rate makes an
economy less competitive, resources are largely utilized in the domestic market. More goods are
imported and fewer exported. Exchange rate changes, therefore, affect the resource allocation in an
economy because the distribution of income between different groups or sectors is often dependent up
on the level of competitiveness.

The three main types of foreign exchange systems (which will be examined in greater detail in the
coming sections) are:
 Fixed or pegged FX- where FX rate is most heavily influenced by states actions;
 Flexible or floating FX- where international FX markets (demand and supply) are the
principal determinants of exchange rate and;
 Managed or coordinated FX- where states and markets are important determinants.

Special vocabularies used in discussing changes of FX rate are depreciation and appreciation. When a
currency becomes more valuable relative to other currencies it is said to be appreciated and when it
becomes less valuable relative to other currencies it is said to be depreciated. While many economic
forces affect exchange rate two of the most important are the inflation rate and interest rate. All else
being equal, a nation’s currency tends to depreciate when that nations experiences higher inflation
rates. Inflation, a rising of overall prices, means that the currency has less real purchasing power within
its home country. This makes the currency less attractive to foreign buyers. In the same way, if a nation

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has lower inflation rate, its currency tends to appreciate reflecting the relatively higher power of its
money,

Interest rate also affect exchange rate because they influence the value and desirability of the
investment that a particular currency can purchase. For instance lower interest rate can lead to a
lower demand for a hard currency making a hard-currency- dominated investment less attractive to
foreigners. For borrowers, the rate of interest basically measures the cost of borrowing for investment
purposes; the lower the cost of borrowing is, other things being equal the more borrowers will wish to
invest. For lenders, the rate of interest measures the rate of return which will be received when their
wealth is invested. Consequently, the higher the return, the more wealth those lenders will wish to
invest.

3.5.1.2 The political economy of international monetary relations

Although analysts readily acknowledge that international trade and foreign investment have
important implications for distribution of wealth and power among nations, no such similar
agreement exists regarding the significance of international monetary systems. Many economists
believe that money and international monetary systems are economically and politically neutral.
However the norms and conventions governing the system have important distributive effects on the
power of states and the welfare of groups within the states.

Despite the believe of many economists that the monetary system is a neutral mechanism, every
monetary regime imposes differential costs and benefits up on groups and states as it specifies the
nature of international money, the instruments of national policy that are acceptable for balance of
payments adjustment and the legitimacy of different objectives of national policy. Every state
therefore desires not only efficient international monetary systems, but also the one that does not
harm it s own interests.

Money has of course always been an important factor in the world of politics. Rulers have acquired
money to finance and support their armies, to support their allies, and bribe their enemies. The
importance of money in the modern world has multiplied many times and its character has changed
profoundly. In fact the enhanced role of international monetary systems in the affairs of the modern
states constitutes a virtual revolution in world politics. Its significance can be appreciated through a
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chronological examination of the changing role of money, economic and political implications of these
changes in the international economy.

A. The era of the specie money

In the pre modern period, precious metals, principally silver, served as a basis of the international
monetary system. Local and international trade tended to be separated from each other. Whereas local
trade tended to dependent up on barterer locally recognized money, international trade was, served by
great currencies minted from gold and silver. Thus the solidus of the Constantine, the dinar of the
Arabs or the ducat of the Venice were universally accepted and held their values for centuries.
Whether minted in to coin or left in the form of bullion, gold and silver constituted a neutral medium of
international exchange; one states gold and silver are as good as the other ones and in effect
international currencies enjoyed political and economic autonomy.

The nature and role of the system began to change in the sixteen century with the discovery of
gold in the Americas and the expansion of international trade. The separation of local and
international money begun to break down as the consequence of great influx in to Europe of precious
metals of the new world, the growing monetization of national economies, and the increasing
interdependence. In time gold and silver drove out local currencies leading to the increasing
intertwining of local and international money and consequently governments were unable to manipulate
local economic activities as domestic economic activity and price levels had become subject to
international changes.

This has led to the development of the science of economics which subsequently become the basis for
the development of the liberal economics. In his price-specie flow theory, David Hume responded to
the growing obsession of the mercantilist state to accumulate precious metals through a trade surplus
and their fear that trade deficit would result in the loss of precious metals. He demonstrated that, if a
country gained precious metals in payment for an excess export over imports would cause its
domestic and then its export price to rise. This would in turn discourage others from buying its
products. At the same time its citizens would be able to import more because of the relative value of it’s
their currency had risen and foreign prices would fallen because of the decrease money supply abroad.
As a result a nation’s export would decline and its imports would increase.

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Although Hume’s price-specie flow mechanism continued to characterize international monetary
relations in to the twenty first century, the nature of the monetary system was revolutionized in the
modern world due to a number of economic and political reasons. Stated simply money had been
transformed from a gift of nature to the creation of a state. State controls over the supply and
demand for money become a principal determinant of the level of international and national
economic activity. To understand the significance of this transformation, it is first necessary to
comprehend what is known as the financial revolution.

During the18th and 19th century sates begun to issues paper money, modern banking arose, and public
and private credit instruments proliferated. For the first time in history governments acquired the
extensive control over money supply; at least in theory could influence the level of economic activity
through the creation of money. The change in the nature of money brought about a serious clash
between domestic economic autonomy and international monetary order. And hence bringing with
itself the political economy of international monetary relations and the questions of who gets what,
when and how. Monetary stability and the efficient operation of the international monetary system
require the subordination of domestic policies to international rules and conventions. If individual
governments create too much money, the resulting inflation can destabilize international monetary
relations. The conflict between domestic economic autonomy and international economic stability
has become the fundamental dilemma of monetary relations. The manner in which this dilemma
has or has not been resolved defines the phases in history of international monetary relations.

B. The classic gold standard

The international gold standard, which reached its zenith in the late nineteen century, was the classic
resolution of the aforementioned dilemma. Gold is a monetary arrangement under which the basic
unit of currency of is defined by stated quantity of gold. This monetary system prevailed between
1875 and 1914. Participating countries were committee to fixing the prices of their domestic currencies
in terms a specified amount of gold. The countries maintained this fixed prices by being willing to buy
and sell gold to anyone at that price. These feature provided a fixed exchange rate mechanism for
adjusting the international balance of payments as trade and payment imbalances among nations were
brought back in to equilibrium through the flow of gold.

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During its reign the classic gold standard provided an effective foundation for the 19 th century
international and economic order. It was not, however, as liberal economists would like us to believe,
an automatic, impersonal and politically symmetrical political order. It was not automatic as banks
manipulated the buying and selling of gold in a manner that reduces the effect of the flow of gold on
domestic economy. The system did not operate impersonally as it was organized and managed by
Britain and the city of London through its hegemonic position in the world commodity, money and
capital market, enforced the rules of the system up on world economies. The monetary system was
not politically symmetrical in its effects on various economies as the balance of payment
adjustment had very different consequences on advanced economies and less developed once.

The clash between domestic autonomy and international order achieved under the gold standard
provides an example of a dominant hegemonic power enforcing the rules of the game and managing
world economic affairs. As the world’s preeminent industrial, trading and capital exporting country in
the nineteen century Britain performed this task in an interest of a stable and smoothly functioning
international monetary system; as it has the power and the will to do so.

Near the end of the nineteenth century, the rise of the new industrial powers and the relative decline of
the British hegemony began to undermine the basis of the British global economic leadership. France,
Germany and other nations disliked a monetary order that benefited Britain and most importantly the
less developed countries grew frustrated with paying the costs of the adjustment. Raising social
discontent and the revolt against laissez faire begun to shake the system. The force of economic inertia,
however, continued British dominance in money and finance long after the British dominance in
manufacturing vanished. The First World War destroyed the political foundation of this economic era
and plunged the world in to monetary and economic chaos for the next three decades.

C. The interwar period (1914-1944)

A major consequence of the First World War was the nationalization of the world’s monetary
system. Upon the outbreak of hostilities, the belligerents acted quickly to safeguard their gold supplies
and disengage from the system of fixed exchange rates to facilitate the freeing and mobilization of their
economy for war. The gold standard collapsed and its place was taken by a makeshift of arrangement of
floating (freely exchangeable) currencies. With the end of British leadership and collapse of economic

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interdependence, the determination of currency values became the responsibility of national authorities.
Domestic economic autonomy triumphed over international monetary order due to the requirements of
war.

The implication of the collapse of the international monetary order and the states acquisition of control
over domestic activity was viewed differently by economists. On the one hand, those who subscribe to
Keynesian economics focused on the opportunity that this transformation provided for the elimination
of the evils of the free market such as unemployment, and recession. Through manipulation of few
monetary variables like government spending, interest rate and money supply public spirited economics
and their science could achieve social justice and economic progress.

On the other hand, conservative liberal economists considered the undisciplined monetary power of the
modern state to be an invitation to political irresponsibility because it eliminated economic safeguards
against inflation and other evils. They feared that the state would use its new taxing and borrowing
powers to shift the distribution of national income from the producer and saver to the non producer. In
a world without restraints and the gold standard and other international norms, democratic governments
seeking to court popularity and appease special interests through the expansion of costly government
programs would subject to ever increasing inflationary pressure; this could undermine both capitalism
and democracy.

In the immediate aftermath of the war there was an attempt to return back to the gold standard.
However, it survived for just few years and its collapse was the major factor in precipitating the great
depression of the 1930s. There were many reasons for the collapse, and these are: first, governments
begun to value domestic welfare objectives like full employment and stability than an
international monetary order. Second, Britain has no longer the power to manage international
monetary order due its industrial decline and the rise of new economic powers.

The ensuing economic chaos led to fragmentation of the international monetary systems in to several
competing monetary blocs. At the Ottawa conference in 1932, the British and its trading partners
created the sterling bloc. Soon after the dollar bloc was created around the United States and gold bloc
around France. Finally Germany, Japan and Italy taking the advantage of the world economic crisis
attempted to create autarchic empires. The world economy entered an era of unprecedented economic

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warfare, with competitive devaluations and fluctuating currencies as each economic bloc attempted to
solve its payments and employment problems at the expense of the other.

The event of the interwar period meant the end of an automatic equilibrium that on the whole,
characterized the era of gold standard. The simultaneous achievement of internal and external
balance through the achievement of Hume’s price-specie flow mechanism was decreasingly applicable
to a world where central banks tried to counter the effects and prices/wages were not permitted to fall
automatically in response to tight monetary policies; the era of government intervention and
management of the economy had arrived.

D. The Bretton woods system (1944-1976)

Following the trauma of the great depression and the scarifies imposed on the citizenry during the
Second World War, the western powers established two sets of economic priorities, namely the
achievement of economic growth and full employment at the domestic scene and the creation of a
stable international economic order that would prevent a return of the destructive economic nationalism
of the 1930s, which is often called the Bretton wood system.

The Bretton wood system had several key features. It envisions a world in which governments could
have considerable freedom to pursue national economic objectives, yet the monetary order would be
based on fixed exchange rates in order to prevent the destructive competitive depreciation and policies
of the 1930s. Another principle adopted was currency convertibility for current account transactions.
The international monetary fund was created to supervise the operation of the monetary system and
provide medium term lending to countries experiencing temporary balance of payment difficulties. And
finally in the event of fundamental disequilibrium the system allowed a nation to change its exchange
rate with international consent.

The Bretton woods systems reflected fundamental in social purposes and political objectives.
Whereas the nineteen century gold standard and the ideology of laissez faire had subordinated domestic
stability to international norms and the interwar period had reversed these objectives, the post regime
tried to achieve both. Under this system the American economy became the principal engine
world economic growth; American monetary policy became world monetary policy. United sates
assumed primarily responsibility for the management of the world monetary systems beginning
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with the marshal plan. The Federal Reserve became the world’s banker and the dollar became the
basis of international monetary system. The classic Bretton woods system was quickly replaced by
what the French call the dollar hegemony.

Several key elements characterize what in effect become a gold exchange standard based the dollar. As
other nations pegged their currency to the dollar, a system of fixed exchange rate; the adjustment
process involved simply taking actions that changed the par value of a currency against the dollar. The
basis of the system was the pledge of the united to keep the dollar convertible in to gold at $ 35 per
ounce and because of this the dollar become the principal medium of exchange, unit of account and
store value.

Nevertheless, there was a fundamental contradiction at the heart of this dollar-based system. While the
huge outflow of American dollars to finance the rebuilding of Western Europe and Japan and the
American military buildup during both the Korean and Vietnam Wars helped solve certain problems,
this outflow of dollars meant that the United States would one day be unable to redeem in gold, and at
the agreed price of $35 per ounce, those dollars held by private investors and foreign governments.
Robert Triffin, in a series of writings, predicted that confidence in the dollar would be undermined as
the American balance of payments shifted from a surplus to a deficit. This problem did become acute
late in the 1960s when escalation of the Vietnam War and its inflationary consequences caused
deterioration in international confidence in the value of the dollar. As that confidence declined, the
foundations of the Bretton Woods System of fixed rates began to erode.

Decreased confidence in the dollar also led to intensifying speculation in gold, and this was followed by
futile attempts to find ways to recreate confidence in the system. For example, in the late 1960s, Special
Drawing Rights (SDRs) were created by the IMF as a new reserve asset, although they were never
utilized extensively. However, as Benjamin Cohen has convincingly argued, it was only when a
political solution was devised that maintenance of the dominant position of the dollar was ensured.
America’s Cold War allies, notably Western Europe and Japan, fearing that collapse of the dollar would
force the United States to withdraw its forces from overseas and to retreat into political isolation,
agreed to continue to hold overvalued dollars. The dollar was also bolstered for a period of time
because such export-oriented economies as West Germany and, at a later date, Japan, wanted to retain

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access to the lucrative American market and therefore supported the high dollar. However, as soaring
inflation undercut the value of the dollar, a more fundamental economic solution was needed

E. The end of fixed exchange rates

In the early 1970s, the deteriorating position of the dollar became the central issue in the world
economy. Escalation of the Vietnam War and the simultaneous launching of the Great Society Program
by the Johnson Administration (1963–1969) had caused the global rate of inflation to accelerate and to
threaten the value of the dollar. The U.S. government, attempting to hide the financial cost of the
Vietnam War from the American people, refused to increase taxes and chose instead to pay for its
warfare and welfare policies through inflationary macroeconomic policies. The succeeding Nixon
Administration (1969–1974) compounded the problem of inflation. In addition, the Federal Reserve
threw caution to the wind as it stimulated the economy, a move that critics labeled a blatant attempt to
reelect Nixon. Subsequent intensification of speculative attacks on the overvalued dollar and
ballooning of the American trade/payments deficit resulted in the Nixon Administration’s decision on
August 15, 1971, to force devaluation of the dollar.

The international monetary system was thus changed, at least de facto, from one based on fixed
exchange rates to one based on flexible rates. Subsequent efforts of an international committee to
develop a new system of stable exchange rates failed. The overwhelming problems posed by increased
capital mobility, along with fundamental differences between the United States and Western Europe
over any new system, made agreement impossible. Moreover, the huge OPEC monetary surplus
following the first oil crisis, and the need to recycle those funds, proved important in the development
of the international financial market. Before the end of the 1970s, the scale and velocity of international
financial flows had expanded enormously and had truly transformed the international economic system.
As a consequence of this impasse, the major industrial powers accepted economic reality at the Jamaica
Conference (1976) and instituted flexible rates. This situation was described by some as a “non-
system”, because there were no generally recognized rules to guide the flexible rates or any other
decisions on international monetary affairs.

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3.6 International financial relations
3.6.1 Meaning and scope

Financial structure comprises the set of relationships, institutions, and practices that bind together
creditors and debtors, borrowers and lenders. These relationships exist within the framework provided
by the international monetary system. The finance structure creates a pattern of rights and
obligations that conditions the behaviour of nations, businesses and individuals. The finance
structure is both local and international in its scope.

International finance is a major force in integrating world economy. Since the period of renaissance and
the development of modern banking private capital has nourished the international political economy in
the form of loans and portfolio investment (stocks and bonds). In the contemporary period, foreign
directed investment by multinational corporations has augmented these traditional means of capital
flow. Government and international organizations have also become important sources of capital
through the making of loans and official aid particularly to the less developed countries.

From the perspective of liberal economics, the primary function of international finance to transfer
accumulated capital to the location where its marginal rate of return is highest and where it can
therefore be employed most efficiently. International finance links the international economy and also
contributes to its dynamic nature. In a world divided among competitive a state, however, international
finance has also has significant political consequences. It creates dependency relationships and is a
major source of national power. Both foreign investment and official aid involve extensive penetration
of an economy and in many cases lead to continuing external influence over domestic activities.
Although trade and monetary relations may impinge up on an economy, foreign investment, loan and
aid have a greater tendency to create superior subordinate relationships. Stockholders and creditors
have been known to call up on their own governments to intervene in other societies to protect their
investment; foreign investment and international finance have always aroused political and nationalistic
passions.

3.6.2 International finance and balance of payments

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The set of relationships that form the financial structure bind together those who pay and those who
receive. As with other IPE structures the nature of these ties is complex and controversial. The ideas of
international finance are built around the concept of Balance of Payment (BoP). Under normal
circumstances a surplus in one account must be offset by the deficit in the other. This is the balance in
the balance of payments. A nation that has a current account deficit, for example, must either borrow a
fund from abroad or sell of its assets to foreign buyers its international bills, thus, achieve an overall
payments balance. A current account deficit, therefore, requires a capital account surplus. In the
same way, a nation with a current account surplus has excess funds to purchase foreign assets creating a
capital account deficit.

Each international transaction involves foreign exchange. And, for foreign exchange market to balance
it is necessary for inflows and outflows of a currency to balance. Essentially a nation can continue to
experience deficit in the current account as long as it can obtain the necessary funds through a capital
account surplus- that is as long as it is able to borrow funds from abroad or to find buyers for its assets.
When these assets are exhausted or more realistically when foreign lenders are unwilling to extend
additional credit a predictable but unfortunate chain of events set in motion, a balance of payment
crisis. Because of the iron logic of the balance of payments, a nation that is unable to borrow (capital
account) cannot afford to import (current account). International trade is disrupted and needed imports
are often impossible to obtain.

A balance of payment crisis is a bad thing both for the nation that experiences it and for the other
nations of the world, since trade and international finance relationships are distorted by such a
crisis. It is conceivable that crisis in one nation along with that nation’s attempt to deal with its
problems could spawn additional problems elsewhere. Economic peril can spread from one nation to
another as it did during the Great Depression of the 1930s and the Global Financial Meltdown of 2010.
Although a balance of payment crisis is fundamentally an economic problem it quickly translates into
political problems since it usually falls to the state and its political leadership to propose and implement
the frequently harsh policies that may be necessary to bring international payments back into balance.
To prevent international debt calamities the architects of the Post-War Bretton Woods system of
international finance sought to provide a lender of last resort, a term that refers to a hegemonic state or
international institutions that continue to lend after all others cease in order to provide stability.

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 3.6.3 The globalization of international finance

Along with the increased levels of trade that have been a characteristics of post WWII period has come
the phenomenon of highly mobile capital. This has been aided by the widespread removal of capital
controls among industrialized nations and the internationalization of financial and banking practices,
such that the amount of financial trade that now takes place far outstrips its goods trade equivalent.
Capital flows have grown dramatically since 1980s with net private capital flows growing in
significance. There has also been a major shift towards so-called equity financing, in the form of either
foreign direct investment or portfolio investment.

There are powerful reasons to study the political economy of international capital movements.
Economic theory shows that factor movements are substitutes for international trade, and may
even perform similar functions more rapidly. If a labor-rich country maximizes its welfare by
exporting labor-intensive and importing capital-intensive goods, it does so even more directly by
exporting labor and importing capital; the converse holds for a capital-rich country. Indeed,
international capital markets are today the pivot around which the world economy rotates in a way of
investment abroad in traditional portfolio and direct forms.

To this end, the future of international financial relations, and especially the degree of conflict involved
in them, is a function of both economic and political considerations. A political economy approach to
the international financial relations is only in its infancy. We suggest, here, that the starting point for a
political economy of international finance should be the relationship between international investment
interests and the foreign economic policy preferences they imply.

3.7 Foreign Directed Investment and MNCs

3.7.1 The nature and significance of MNC

Although there are many more technical definitions of a multinational firm, a MNC refers simply to a
firm or corporation of a particular nationality with partially or wholly owned subsidiaries within at least

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one other national economy. Tens of thousands of MNCs with numerous subsidiaries conduct business
around the world. Such firms expand overseas primarily through foreign direct investment (FDI),
whose purpose is to achieve partial or complete control over marketing, production, or other facilities in
another economy; such investments may be in services, manufacturing, or commodities. FDI can entail
either the purchase of existing businesses or the building of new facilities (called “greenfield”
investment).

Whereas the purpose of portfolio investment is to obtain a financial return on the investment, FDI, as
well as alliances, mergers, and similar ventures, are usually part of an international corporate strategy to
establish a permanent position in another economy.

In one sense, multinational firms have existed for a very long time. The Dutch East India Company, the
Massachusetts Bay Company, and other companies of merchant-adventurers were forerunners of
today’s MNCs like IBM, Sony, and Daimler-Chrysler. These earlier transnational firms, however, were
far more powerful than contemporary MNCs are; they commanded armies and fleets, had their own
foreign policies, and controlled vast expanses of territory: the sub- Asian continent (India, Pakistan, and
Bangladesh), the East Indies (Indonesia), and South Africa. Modern MNCs are much more modest.

Another major difference between those early transnational firms and today’s is that the former were
principally interested in agricultural products and extractive industries in particular regions of the
world, whereas major firms in the early twenty-first century are principally involved in manufacturing,
retailing, and services, tend to operate on a regional or worldwide basis, and usually pursue an
international corporate strategy

3.7.2 The multinationals and the international economy

The world’s largest MNCs account for approximately four-fifths of world industrial output while
typically employing two-thirds of their work force at home; they are not nearly as footloose as many
critics charge. Foreign direct investment (FDI) has been growing at a rapid rate. Between 1985 and
1990, FDI grew at an average rate of 30 percent a year, an amount four times the growth of world
output and three times the growth rate of trade. FDI has in fact become a major determinant of trade
patterns. The annual flow of FDI has doubled since 1992 to nearly $350 billion. Intra firm trade—that

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is, trade among subsidiaries of the same firm—accounted for one-third of American exports and two-
fifths of U.S. imported goods in 1994.

About one-half of the trade between Japan and the United States is actually intra firm trade. This intra
firm trade takes place at transfer prices set by the firms themselves and within a global corporate
strategy that does not necessarily conform to the conventional trade theory based on traditional
concepts of comparative advantage. Evidence suggests that these trends will continue and could even
accelerate.

The gross statistics, however, hide noteworthy aspects of FDI and of other activities of MNCs. Despite
much talk of corporate globalization, FDI is actually highly concentrated and is distributed unevenly
around the world. Although FDI has grown rapidly in developing countries, most FDI has been placed
in the United States and Europe, while only a small percentage of U.S. foreign direct investment has
gone to developing countries. This concentration of FDI is due to the simple fact that the United States
and Europe are at present the world’s largest markets. Nevertheless, throughout most of the 1990s, FDI
in less developed countries (LDCs) grew at about 15 percent annually. However, FDI in LDCs has been
highly uneven and concentrated in a small number of countries, including a few in

The increasing importance of MNCs has profoundly altered the structure and functioning of the global
economy. These giant firms and their global strategies have become major determinants of trade flows
and of the location of industries and other economic activities. Most FDI is in capital and technology-
intensive sectors. These firms have become central in the expansion of technology flows to both
industrialized and industrializing economies and therefore are important in determining the economic,
political, and social welfare of many nations.

Controlling much of the world’s investment capital, technology, and access to global markets, such
firms have become major players not only in international economic but in international political affairs
as well, and this has triggered a backlash in many countries. According to DeAnne Julius, one of the
world’s most knowledgeable experts on the MNC, the huge expansion of FDI, inter-corporate alliances,
and intra-firm trade throughout the 1980s and 1990s reached a level where “a qualitatively different set
of linkages” among advanced economies was created; some have estimated that more than twenty
thousand corporate alliances were formed in the years 1996–1998. The growing importance of FDI and
inter-corporate cooperation means that the world economy has reached a “takeoff” point comparable to
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that wrought by the great expansion of international trade in the late 1940s and the subsequent
emergence of the highly interdependent international trading system. The growth in FDI and in the
activities of multinational corporations of many nationalities has linked nations more tightly to one
another, and this has further affected the global economy.

The role of MNCs in the world economy remains highly controversial. Critics charge that foreign
direct investment and the internationalization of production are transforming the nature of international
economic and political affairs in ways that undermine the nation-state and integrate national economies.
Impersonal market forces and corporate strategies are believed to dominate the nature and dynamics of
the international economic and political system.

While many believe such a development to be highly beneficial for mankind, others regard the MNC as
exploiters. These critics believe that giant firms, answerable only to themselves, are integrating
societies into an amorphous mass in which individuals and groups lose control over their own lives and
are subjugated to firms’ exploitative activities. The world, these critics charge, is coming under the
sway of a ruthless capitalist imperialism where the only concern is the bottom line.

Many and perhaps most professional economists (with the important exception of business
economists), on the other hand, discount the significance of multinational firms in the functioning of
the world economy. The neoclassical interpretation acknowledges that large oligopolistic firms may be
politically important and may also affect the distribution of income within national economies.
However, these economists deny that the investment, marketing, and other economic activities of these
firms around the world have any great impact on the “real” economy of international trade, location of
economic activities, or national rates of economic or productivity growth. In neoclassical economics,
the global location of economic activities and patterns of international trade are determined according
to location theory and the principle of comparative advantage.

Both extreme positions are exaggerations. Critics exaggerate the evils of the MNCs and their role in the
world economy. Although some MNCs do exploit and damage the world, the MNC as an institution is
beneficial to many people worldwide; it is, for example, a major source of capital and technology for
economic development. On the other hand, the proponents of the MNCs exaggerate their importance
and overstate the internationalization of services and production.

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The nation-state remains the predominant actor in international economic affairs, and domestic
economies are still the most important feature of the world economy. Although some convergence has
been occurring, national societies retain their essential characteristics and are not becoming part of any
homogenized amorphous mass. In an era of oligopolistic competition and rapid technological
innovation, location theory and the conventional theory of comparative advantage cannot tell the whole
story of what is happening in the world economy.

One of the most important recent developments in the world economy has been the internationalization
of services and of industrial production, a development facilitated by falling costs for communication
and transportation that have enabled firms to integrate production and other activities around the globe.
Continuing restructuring of services and manufacturing was extremely important in the nature of the
world economy as it entered the new millennium.

Nevertheless, the importance of this development is frequently misunderstood and exaggerated. FDI in
the year 2000 is only a small part of the total domestic investment of the rich countries. Furthermore,
contrary to the often stated opinion that MNCs have “globalized” technology and put their own firms
everywhere on an equal footing for reasons internal to the firms themselves, and because of conditions
prevailing in many developing countries, technology tends to diffuse from industrialized to
industrializing countries relatively slowly.

Moreover, internationalization of services and production is highly concentrated among the major
powers and within particular regions notably Japan in southeast Asia, the euro zone in Eastern Europe,
and the US in the NAFTA area. Evidence thus suggests that regionalism as well as globalism
characterizes the strategies of multinational firms. While economic competition and financial markets
have become increasingly global, production and services are increasingly regional.

The increased importance of regionalization in the world economy raises some disturbing possibilities.
The trend toward regionalization could lead to weakening of the post–World War II movement toward
trade liberalization. While the MNCs of the major economic powers continue to pursue global
strategies and to invest in one another’s economies (with the exception caused by Japan’s relatively low
level of inward FDI), they are also concentrating their own FDI in neighboring countries. Creation of
regional rather than global production and sourcing networks has become a notable trend.

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