International Economics - Miriam Manchin, Dispense di Ingegneria Gestionale

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INTERNATIONAL ECONOMICS Miriam Manchin Summary Introduction to basic concepts ......................................................................................................................................... 4 Gains from trade ........................................................................................................................................................... 4 Patterns of trade ........................................................................................................................................................... 4 Effects of government policies on trade ....................................................................................................................... 4 Open macro .................................................................................................................................................................. 4 Gravity model .................................................................................................................................................................... 5 The model ..................................................................................................................................................................... 5 Impediments to trade ................................................................................................................................................... 5 Ricardian model ................................................................................................................................................................ 6 Opportunity cost and comparative advantage ............................................................................................................. 6 The model ..................................................................................................................................................................... 6 Gains from trade ........................................................................................................................................................... 7 Productivity and wages ................................................................................................................................................. 7 Misconceptions about comparative advantage............................................................................................................ 8 Many goods ................................................................................................................................................................... 8 Conclusion ..................................................................................................................................................................... 8 Specific factors model ....................................................................................................................................................... 9 Prices, Wages, and Labor Allocation ............................................................................................................................. 9 Trade in specific factors model ................................................................................................................................... 10 Trade and inequality ................................................................................................................................................... 11 Migration..................................................................................................................................................................... 11 Heckscher-Ohlin Model................................................................................................................................................... 12 The model ................................................................................................................................................................... 12 Equilibrium in autarky ................................................................................................................................................. 13 Trade in the model ...................................................................................................................................................... 14 Income distribution ..................................................................................................................................................... 15 Factor price equalization............................................................................................................................................. 15 Standard Trade Model .................................................................................................................................................... 16 Indifference curves ..................................................................................................................................................... 16 The model ................................................................................................................................................................... 16 Impact of trade ........................................................................................................................................................... 17 Impact of growth ........................................................................................................................................................ 18 Tariffs and subsidies .................................................................................................................................................... 19 Lending and borrowing ............................................................................................................................................... 20 Economies of scale .......................................................................................................................................................... 21 Introduction ................................................................................................................................................................ 21 External scale economies ............................................................................................................................................ 21 Economies of scale and trade ..................................................................................................................................... 21 Introduction to basic concepts Nations are now more closely linked than ever before. Exports and imports as shares of gross domestic product have been on a long-term upward trend. International trade has tripled in importance compared to economy as a whole in the past 50 years. Gains from trade There are important potential gains from trade. Countries selling goods and services to each other can generate mutual benefits. When a buyer and a seller engage in a voluntary transaction, both can be made better off (example: Norwegian consumer import oranges that they would have a hard time producing). Countries use finite resources to produce what they are most productive at, then they trade those products for goods and services that they want to consume. Countries can specialize in production, while consuming many goods and services thought trade. Trade benefits countries by allowing them to export goods made with relatively abundant resources and imports goods made with relatively scarce resources. When countries specialize, they may be more efficient due to larger-scale production. Countries may also gain by trading current resources for future resources and due to international migration. Trade is predicted to benefit countries as a whole in several ways, but trade may harm particular groups within a country. International trade can harm the owners of resources that are used relatively intensively in industries that compete with imports. Trade may therefore affect the distribution of income within a country. Patterns of trade The pattern of trade describes who sells what to whom. Effects of government policies on trade Policy makers affect the amount of trade through: - Tariffs: a tax on imports or exports - Quotas: a quantity restriction on imports or exports - Export subsidies: a payment to producers that export - Other regulations that exclude foreign products from the market, but still allow domestic products Trade policies are often chosen to cater to special interest group, rather than to maximize national welfare. Governments tend to adopt tariffs, then negotiate them down in exchange for reduction in trade barriers of other countries. Open macro Exchanging risky assets such as stocks and bonds can benefit all countries by diversification that reduces the variability of income. Most international trade involves monetary transactions. Many monetary events have important consequences for international trade. Governments measure the value of exports and imports, as well as the value of financial assets that flow into and out their countries. The official settlements balance, or the balance of payments, measures the balance of funds that central banks use for official international payments. All three values are measured in the government’s national income accounts. Exchange rates are an important financial issue for most governments. Exchange rates measure how much domestic currency can be exchanged for foreign currency. One country’s economic policy can affect other countries, leading to the need for policy coordination. Capital markets, where money is exchanged for promises to pay in the future, have special concerns in an international setting: currency fluctuation can alter the value paid; countries might default on debt. International trade focuses on transaction involving movement of goods and services across nations. International finance focuses on financial or monetary transactions across nations. Gravity model The size of the economy is directly related to the volume of imports and exports. Larger economies produce more goods and services, so they have more to sell in the export market. Larger economies generate more income from the goods and services sold, so they are able to buy more imports. Trade between any two countries is larger, the larger is either country. The model The gravity model assumes that size and distance are important for trade in the following way: 𝑇𝑖𝑗 = 𝐴 𝑌𝑖 ∙ 𝑌𝑗 𝐷𝑖𝑗 𝑇𝑖𝑗: value of the trade between country i and country j 𝐴: costant 𝑌𝑖: Gross Domestic Product (GDP) of country i 𝑌𝑗: Gross Domestic Product (GDP) of country j 𝐷𝑖𝑗: distance between country i and country j Impediments to trade There are other things besides size matter for trade: - Distance between markets influences transportation costs and therefore the cost of imports and exports - Cultural affinity: common language, historical reasons, etc. - Geography: lake of mountain barriers makes transportation and trade easier - Multinational corporations: corporations spread across different nations import and export many goods between their divisions - Borders: crossing border involves formalities that take time, often different currencies need to be exchanged, and perhaps monetary costs like tariffs reduce trade - Trade agreement and tariffs: reduce the formalities and tariffs needed to cross borders, and therefore to increase trade Estimates of the effect of distance from the gravity model predict that 1% increase in the distance between countries is associated with a decrease in the volume of trade of 0,7% to 1%. Besides distance, borders increase cost and time needed to trade. Trade agreements between countries are intended to reduce formalities and tariffs needed to cross borders, and therefore to increase trade. Ricardian model The Ricardian Model says differences in productivity of labor between countries cause productive differences, leading to gains from trade. Differences in productivity are usually explained by differences in technology. Opportunity cost and comparative advantage The Ricardian model uses the concepts of opportunity cost and comparative advantage. The opportunity cost of producing something measures the cost of not being able to produce something else with the resources used. Comparative advantage will be determined by comparing opportunity costs across countries. A country has a comparative advantage in producing a good if the opportunity cost of producing that good is lower in the country than it is in other countries. A country with a comparative advantage in producing a good uses its resources most efficiently when it produces that good compared to producing other goods. A limited number of workers could be employed to produce either hazelnuts or mobile phones. The opportunity cost of producing mobile phones is the number of hazelnuts not produced. A country faces a trade-off: how many mobile phones or hazelnuts should it produce with the limited resources that it has? Suppose that in Italy 10 million hazelnuts can be produced with the same resources that could produce 100.000 mobile phones. In Turkey 10 million hazelnuts or 30.000 mobile phones can be produced. For Turkey, the opportunity cost if it decides to produce 10 million hazelnuts is 30.000 mobile phones. Turkey has a lower opportunity cost of producing hazelnuts: Turkey can produce 10 million hazelnuts, compared to 30.000 mobile phones that it could otherwise produce; Italy can produce 10 million hazelnuts compared to 100.000 mobile phones that it could otherwise produce. Turkey has a comparative advantage in hazelnuts production (it uses its resources more efficiently in producing hazelnuts compared to other uses). Italy has a lower opportunity cost in producing mobile phones: Turkey can produce 30.000 mobile phones, compared to 10 million hazelnuts that is could otherwise produce; Italy can produce 100.000 mobile phones, compared to 10 million hazelnuts that is could otherwise produce (Italy can produce 30.000 mobile phones, compared to 3,3 million hazelnuts that it could otherwise produce). Italy has a comparative advantage in mobile phones production (it uses its resources more efficiently in producing mobile phones compared to other uses). The model In this model we have two countries, two goods and one factor of production (labor). There are different technologies between countries. For trade to take place, countries have different comparative advantages. Once countries start to trade, they export the goods in which they have comparative advantage and import the one in which they have comparative disadvantage. Italy requires 5 workers to produce a car and 1 worker to produce a clothing product; Germany requires 3 workers for a car and 2 workers for a clothing product. Germany has comparative advantage in cars, Italy in clothing. Germany will export cars and import clothing products. One factor Ricardian model using the following assumption: - Labor is the only resource important for production (we could also have other resource instead of labour, such as capital, land, etc.) - Labor productivity varies across countries (in each country the productivity is constant across time) - The supply of labor in each country is constant - Constant returns to scale in production - Only two goods are important for production and consumption - There is perfect competition - Only two countries are modeled: domestic and foreign The unit labor requirement indicates the number of hours of labor required to produce one unit of output. A high unit labor requirement means low labor productivity. Labor productivity is how much output one hour of labor creates. Specific factors model The specific factors model allows trade to affect income distribution. In this model we have two goods, three factors of production (labor, capital, and land), and perfect competition. Cloth is produced using capital and labor (but not land). Food is produces using land and labor (but not capital). Labor is a mobile factor. Land and capital are both specific factors used only in the production of one good. The production function for cloth gives the quantity of cloth that can be produced given any input of capital and labor: 𝑄𝐶 = 𝑄𝐶(𝐾, 𝐿𝐶). The production function for food gives the quantity of food that can be produced given any input of land and labor: 𝑄𝐹 = 𝑄𝐹(𝑇, 𝐿𝐹). When labor moves from food to cloth, food production falls while output of cloth rises. The shape of the production function reflects the law of diminishing marginal returns: adding one worker to the production process (without increasing the amount of capital) means that each worker has less capital to work with. Therefore, each additional unit of labor adds less output than the last. For the economy as a whole, the total labor employed in cloth and food must be equal to the total labor supply. Putting this together with the production functions, we can derive the production possibilities frontier (PPF) of the economy: Prices, Wages, and Labor Allocation In each sector, employers will maximize profits by demanding labor up to the point where the value produced by an additional hour equals the marginal cost of employing a worker for that hour. The demand curve for labor in the cloth sector: 𝑀𝑃𝐿𝐶 ∙ 𝑃𝐶 = 𝑤 The wage equals the value of the marginal product of labor in manufacturing. The demand curve for labor in the food sector: 𝑀𝑃𝐿𝐹 ∙ 𝑃𝐹 = 𝑤 The wage equals the value of the marginal product of labor in food. The two sectors must pay the same wage because labor can move between sectors. If the wage were higher in the cloth sector, workers would move from making food to making cloth until the wages become equal. Where the labor demand curves intersect gives the equilibrium wage and allocation of labor between the two sectors. 𝑀𝑃𝐿𝐶 ∙ 𝑃𝐶 = 𝑀𝑃𝐿𝐹 ∙ 𝑃𝐹 = 𝑤 Which means that: 𝑀𝑃𝐿𝐹 𝑀𝑃𝐿𝐶 = − 𝑃𝐶 𝑃𝐹 Slope of the PPF measures the opportunity cost of cloth in terms of food: 𝑀𝑃𝐿𝐹 𝑀𝑃𝐿𝐶 At the production point, the Production Possibility Frontier must be tangent to a line whose slope is − 𝑃𝐶 𝑃𝐹 What happens to the allocation of labor and the distribution of income when the prices change? 1. An equal-proportional change in prices: when both prices change in the same proportion, no real changes occur. The wage rate 𝑤 rises in the same proportion as the prices, so real wages are unaffected. The real incomes of capital owners and landowners also remain the same. 2. A change in relative prices: when only 𝑃𝐶 rises, labor shifts from the food sector to the cloth sector, and the output of cloth rises while that of food falls. The wage rate 𝑤 does not rise as much as 𝑃𝐶 since cloth employment increases and thus the marginal product of labor in that sector falls. Economic effects of this price increase: - Owner of capital are definitely better off - Landowners are definitely worse off - Workers: cannot say whether workers are better or worse off. It depends on the relative importance of cloth and food in workers’ consumption. Trade in specific factors model Free trade relative price of cloth is determined by the intersection of world relative supply of cloth and world relative demand. Opening up to trade increases the relative price of cloth in an economy whose relative supply of cloth is larger than for the world as a whole. World supply curve can be different because of differences in technology or resources. We assume no differences in preferences across countries, hence identical demand curve. Without trade, the economy’s output of a good must equal its consumption. International trade allows the mix of cloth and food consumed to differ from the mix produced. The country cannot spend more than it earns: 𝑃𝐶 ∙ 𝐷𝐶 + 𝑃𝐹 ∙ 𝐷𝐹 = 𝑃𝐶 ∙ 𝑄𝐶 + 𝑃𝐹 ∙ 𝑄𝐹 The economy as a whole gain from trade: - It imports an amount of food equal to the relative price of cloth times the amount of cloth exported. - It is able to afford amounts of cloth and food that the country is not able to produce itself. - The budget constraint with trade lies above the Production Possibilities Frontier. Trade and inequality International trade often has strong effects on the distribution of income within countries: it produces losers as well as winners. Income distribution effects arise for two reasons: - Factors of production cannot move costless and quickly from one industry to another. - Changes in an economy’s output mix have differential effects on the demand for different factors of production. International trade affects the distribution of income in the specific factors model: - Factors specific to export sectors in each country gain from trade, while factors specific to import-competing sectors lose. - Mobile factors that can work in either sector may either gain or lose. Trade nonetheless produces overall gains in the sense that those who gain could in principle compensate those who lose while still remaining better off than before. Most economists would prefer to address the problem of income distribution directly, rather than by restricting trade. Those hurt by trade are often better organized than those who gain, causing trade restrictions to be adopted. Labor migrates to countries with higher labor productivity and higher real wages, where labor is scarce: - Real wages fall due to immigration and rise due to emigration. - World output increases. Real wages across countries are far from equal due to differences in technology and due to immigration barriers. Migration Movements in factors of production include: - Labor migration - The transfer of financial assets through international borrowing and lending - Transactions of multinational corporations involving direct ownership of foreign firms Like movements of goods and services (trade), movements of factors of production are politically sensitive and are often restricted. Workers migrate to wherever wages are highest. Consider movement of labor across countries instead of across sectors. Suppose two countries produce one non- traded good (food) using two factors of production: land cannot move across countries, but labor can. Assume that real wage in Home (C) is lower than in Foreign (B). Initially, OL1 workers are employed in Home, while OL1* workers are employed in Foreign. Workers in Home want to migrate to Foreign where they can earn more. If no obstacles to labor migration, workers move from Home to Foreign, until the purchasing power of wages is equal across countries (A). Emigration from Home decreases the supply of labor and raises real wages of the workers who remain there. Workers initially in Home benefit while workers in Foreign are hurt by inflows of other workers. Landowners in Foreign gain from the inflow of workers decreasing real wages and increasing output. Landowners in Home are hurt by the outflow of workers increasing real wages and decreasing output. An increase in the relative price of cloth is predicted to: - Raise income of workers relative to that of capital owners (w/r). - Raise the ratio of capital to labor service (K/L), used in both industries - Raise the real income (purchasing power) of workers, and lower the real income of capital owners. With perfect competition, factors of production are paid their marginal product. When L/K falls in producing, the marginal product of labor increases, resulting in higher real wages. Opposite happens for capital owners. Stolper-Samuelson theorem: if the relative price of a good increases, then the real wage or rental rate of the factor used intensively in the production of that good increases, while the real wage or rental rate of the other factor decreases. Any change in the relative price of goods alters the distribution of income. Rybczynsky theorem: if you hold output prices constant as the amount of a factor of production increases, then the supply of the good that uses this factor intensively increases and the supply of the other good decreases. Assume an economy’s labor force grows, which implies that its ratio of labor to capital L/K increases. Expansion of production possibilities is biased toward cloth. At a given relative price of cloth, the ratio of labor to capital used in both sectors remains constant. To employ the additional workers, the economy expands production of the relative labor-intensive good cloth, and contracts production of the relatively capital-intensive good food. Aggregate employment of labor to capital can be written as a weighted average of labor-capital employed in the cloth and food sectors: … This means both capital and labor move to the cloth sector. An economy with a high ratio of labor to capital produces a high output of cloth relative to food. Suppose that Home is relatively abundant in labor and Foreign in capital (Home is relatively scarce in capital and Foreign in labor): L/K > L*/K* -> Home will be relatively efficient at producing cloth because cloth is relatively labor intensive. Trade in the model The countries are assumed to have the same technology and the same tastes. With same technology, each country has a comparative advantage in producing the good that relatively intensively uses the factors of production in which the country is relatively well endowed. With the same tastes, the two countries will consume cloth to food in the same ratio when faced with the same relative price of cloth under free trade. Since cloth is relatively labor intensive, at each relative price of cloth to food, Home will produce a higher ratio of cloth to food than Foreign. Home will have a larger relative supply of cloth to food than Foreign. Home’s relative supply curve lies to the right of Foreign. Like Ricardian model, H-O model predicts a convergence of relative prices with trade. With trade, the relative price of cloth rises in the relatively labor abundant country (Home), and falls in the relatively labor scarce country (Foreign). In Home, the rise in the relative price of cloth leads to a rise in the relative production of cloth and a fall in relative consumption of cloth. Home becomes an exporter of cloth and an importer of food. The decline in the relative price of cloth in Foreign leads it to become an importer of cloth and an exporter of food. Income distribution Under autarky, relative price is low for the good that uses abundant factor intensively. With trade, price equalization between countries resulting in factor price convergence: trade increases demand for goods intensive in the abundant factors raising the rewards to these abundant factors. Changes in relative prices affect the earnings of labor and capital. A rise in the price of cloth raises the purchasing power of labor in terms of both goods while lowering the purchasing power of capital in terms of both goods. A rise in the price of food has the reverse effect. Thus, international trade can affect the distribution of income, even in the long run: owners of a country’s abundant factors gains from trade, but owners of a country’s scarce factors lose. Factors of production that are used intensively by the import-competing industry are hurt by the opening trade, regardless of the industry in which they are employed. The H-O model predicts that owners of relatively abundant factors will gain from trade, and owners of relatively scarce factors will lose from trade: 1. According to the model, a change in the distribution of income occurs through changes in output prices. 2. According to the model, wages of unskilled workers relative to skilled should increase in unskilled labor abundant countries, but in some cases the reverse has occurred. Trade likely has been an indirect contributor to increases in wage inequality, by accelerating the process of technological change. Factor price equalization Unlike the Ricardian mode, the H-O model predicts that factor prices will be equalized among countries that trade. Free trade equalizes relative output prices. Due to the connection between output prices and factor prices, factor prices are also equalized. Trade increases the demand of goods produced by relatively abundant factors, indirectly increasing the demand of these factors, raising the prices of the relatively abundant factors. In real world, factor prices are not equal across countries. Reasons for difference: - The model assumes that trading countries produce the same goods, but countries may produce different goods if their factor ratios radically differ. - The model also assumes that trading countries have the same technology, but different technologies could affect the productivities of factors and therefore the wages/rates paid to these factors. Standard Trade Model Standard trade model is a model that includes Ricardian, specific factors, and Heckscher-Ohlin model as special cases: Supply-side: multiple factors of production and a concave production possibility frontier (as in H-O); cross country differences in factor endowments and production technology (as in Ricardo or H-O). Demand-side: representative consumer, aggregate indifference curve (as in H-O, specific factors, or Ricardo). In this model, we have two goods (food and cloth). Each country’s PPF is a smooth curve. Differences in labor, labor skills, physical capital, land, and technology between countries cause productive differences, leading to gain from trade. These productive differences are represented as differences in production possibility frontiers, which represent the productive capacities of nations. A country’s PPF determines its relative supply curve. National relative supply curves determine world relative supply, which along with world relative demand determines an equilibrium under international trade. Using this general model, we have same predictions on gains from trade, same predictions on trade patterns. We can study effects of different shocks to open economies. Indifference curves The budget constraint is the limit on the consumption bundles that a consumer can afford. The slope of the budget constraint is the rate at which the consumer can trade one good for the other. The indifference curve shows consumption bundles that give the consumer the same level of satisfaction. The slope of indifference curve is the marginal rate of substitution (rate at which a consumer is willing to trade one good for another), and it is not the same at all points. The consumer’s preferences are represented with indifference curves, which show the combinations of two goods that make the consumer equally satisfied. Because the consumer prefers more of a good, points on a higher indifference curve are preferred to point on a lower indifference curve. Four properties of indifference curves: - Higher indifference curves are preferred to lower ones (higher indifference curves more goods) - Indifference curves are downward sloping - Indifference curves do not cross - Indifference curves are bowed inward The consumer chooses the point on his budget constraint that lies on the highest indifference curve: best combination of goods available to the consumer; slope of indifference curve equals slope of budget constraint. The model Relative prices determine the economy’s output: what a country produces depends on the relative price of cloth to food 𝑃𝑐 𝑃𝐹 . An economy chooses its production of cloth 𝑄𝐶 and food 𝑄𝐹 to maximize the value of its output. Produce at point where PPF is tangent to isovalue curve. The slope of the isovalue line is − 𝑃𝑐 𝑃𝐹 . If the relative price of cloth rises, the isovalue lines become steeper. As a result, the economy produces more cloth and less food. Panel (b) shows the relative supply curve associated with the production possibilities frontier TT. The rise in the relative price of cloth leads to an increase in the relative production of cloth. Biased growth and the resulting shift in relative supply causes a change in the terms of trade: - Biased growth in the cloth industry will lower the relative price of cloth and lower the terms of trade for cloth exporters. - Biased growth in the food industry will raise the relative price of cloth and raise the terms of trade for cloth exporters. If biased growth in cloth industry, suppliers are more able to sell cloth relative to food, so that the relative supply curve shift right. In the new trade equilibrium, the relative quantity of cloth bought and sold increases. If the home country exports cloth and imports food, the price of exports relative to the price of imports for the domestic country decreases (terms of trade decreases). Export-biased growth is growth that expands a country’s PPF disproportionally in production of that country’s exports. Biased growth in the food industry in the foreign country is export-biased growth for the foreign country. Export- biased growth reduces a country’s terms of trade, generally reducing direct benefits of growth for the country, and increasing the welfare of foreign countries. Import-biased growth is growth that expands a country’s PPF disproportionally in production of that country’s imports. Biased growth in cloth production in the foreign country is import-biased growth for the foreign country. Import- biased growth increases a country’s terms of trade, generally increasing its welfare and decreasing the welfare of foreign countries. Tariffs and subsidies Import tariffs are taxes levied on imports. Export subsidies are payments given to domestic producers that export. Both policies influence the terms of trade and therefore national welfare. (The terms of trade refers to the relative value of a country’s exports and a country’s imports. Since exports and imports are traded in world markets, the terms of trade measures external prices). Import tariffs and export subsidies drive a wedge between prices in world markets and prices in domestic markets. If the home country imposes a tariff on food imports, the price of food relative to the price of cloth rises for domestic consumers. Likewise, the price of cloth relative to the price of food that domestic consumers and producers pay is lower. Domestic producers will receive a lower relative price of cloth, and therefore will be more willing to switch to food production: relative supply of cloth will decrease. Domestic consumers will pay a lower relative price of cloth, and therefore be more willing to switch to cloth consumption: relative demand for cloth will increase. When the home country imposes an import tariff, the terms of trade increase and the welfare of the country may increase. The magnitude of this effect depends on the size of the home country relative to the world economy. If the country is a small part of the world economy, its tariff policies will not have much effect on world relative supply and demand, and thus on the terms of trade. But for large countries, a tariff may maximize national welfare at the expense of foreign countries. An import tariff on food imposed by Home both reduces the relative supply of cloth and increases the relative demand for the world as a whole. If the home country imposes a subsidy on cloth export, the price of cloth relative to the price of food rises for domestic consumers. Domestic producers receive higher relative price of cloth when they export, and therefore will be more willing to switch to cloth production (relative supply of cloth will increase). Domestic consumers must pay a higher relative price of cloth to producers, and therefore will be more willing to switch to food consumption (relative demand for cloth will decrease). When the home country imposes an export subsidy, the terms of trade decreases and the welfare of the country decreases to the benefit of the foreign country. The standard trade model predicts that an import tariff by the home country can increase domestic welfare at the expense of the foreign country. But we have ignored the effects of tariffs and subsides that occur in a world with many countries and many goods. Export subsidies on a good decrease the relative world price of that good by increasing relative supply of that good and decreasing relative demand of that good. Import tariffs on a good decrease the relative world price of that good (and increase the relative world price of other goods) by increasing the relative supply of that good and decreasing the relative demand of that good. Lending and borrowing The standard trade model can be modified to analyze international borrowing and lending. We consider two goods: current and future consumption (same good at different times, rather than different goods at the same time). countries usually have different opportunities to invest to become able to produce more in the future. A special kind of Production Possibility Frontier, an Intertemporal Production Possibilities Frontier, depicts different possible combination of current output and future output. A country can trade current consumption for future consumption in the same way that it can produce more of one good by producing less of another. Suppose that Home has production possibilities biased towards current output, while Foreign has production possibilities biased towards future output. Foreign has better opportunities to invest now to generate more output in the future. If you borrow 1 unit of output, you must repay (principal + interest) = 1+r in the future, where r is the real interest rate. The price of future consumption relative to current consumption is 1 1+𝑟 . 1 unit of current consumption is worth 1+r of future consumption, so 1 unit of future consumption is worth 1 1+𝑟 units of current consumption. Home exports current consumption and imports future consumption. Home lends to Foreign by consuming less than it produces now. Home able to consume more than produces in the future wen Foreign pays back the loan. Foreign borrows to be able to consume more than produces now, and pays back the loan by consuming less than produces in the future. When international borrowing and lending are allowed, the world real interest rate is determined by the intersection of world relative demand and world relative supply. The world real interest rate will be between the real interest rates that existed in the two country’s prior to intertemporal trade. The real interest rate rises in the country that lends (Home), and falls in the country that borrows (Foreign) due to intertemporal trade. Home and Foreign have the same relative demand for future consumption, which is also the relative demand for the world. The equilibrium interest rate is determined by the intersection of world relative supply and demand. Economies of scale Introduction Cross-country differences in pre-trade prices as the reason for international trade in previous models. Different prices arises from cross-country differences in productivity (Ricardian model) or factor endowments (H-O model). In these models, countries trade is different, and countries have comparative advantage in different sectors and trade is inter- sectoral. However, big part of world is between similar countries, and intra-industry. The models of comparative advantage thus far assumed constant returns to scale: when inputs to an industry increase at a certain rate, output increases at the same rate. If inputs were doubled, output would double as well. But there may be increasing returns to scale or economies of scale: when inputs to an industry increase at a certain rate, output increases at a faster rate. A larger scale is more efficient: the cost per unit of outputs falls as a firm or industry increases output. Mutually beneficial trade can arise as a result of economies of scale. International trade permits each country to produce a limited range of goods without sacrificing variety in consumption. With trade, a country can take advantage of economies of scale to produce more efficiently than if it tried to produce everything for itself. External scale economies Economies of scale could mean either that larger firms or larger industry would be more efficient: - External economies of scale occur when the cost per unit of output depends on the size of the industry. - Internal economies of scale occur when the cost per unit of output depends on the size of a firm. Both external and internal economies of scale are important causes of international trade. They have different implications for the structure of industries: - An industry where economies of scale are purely external will typically consist of many small firms and be perfect competitive. - Internal economies of scale result when large firms have a cost advantage over small firms, causing the industry to become imperfectly competitive. We focus here on external economies. For a variety of reasons, concentrating production of an industry in one or a few locations can reduce the industry’s costs, even if the individual firms in the industry remain small. External economies may exist for a few reasons: 1. Specialized equipment or service may be needed for the industry, but are only supplied by other firms if the industry is large and concentrated. 2. Labor pooling: a large and concentrated industry may attract a pool of workers, reducing employee search and hiring costs for each firm. 3. Knowledge spillovers: workers from different firms may more easily share ideas that benefit each firm when a large and concentrated industry exists. Economies of scale and trade We can represent external economies simply by assuming that the larger the industry, the lower the industry’s costs. There is a forward-falling supply curve: the larger the industry’s output, the lower the price at which firms are willing to sell. Prior to international trade, the equilibrium point is where domestic supply curve intersects the domestic demand curve. The trade leads to prices that are lower than the prices in either country before trade. It is very different from the implication of models without increasing returns. In the standard trade model, relative prices converge as a result of trade (if cloth is relatively cheap in the home country and relative expensive in the foreign country, the effect of trade was to raise cloth prices in home and reduce them in foreign). With external economies, by contrast, the effect of trade is to reduce prices everywhere. Introduction Internal economies of scale result when large firms have a cost advantage over small firms. Internal economies of scale imply that a firm’s average cost of production decreases the more output it produces. Perfect competition that drives the price of a good down to marginal cost would imply losses for those firms because they would not be able to recover the higher costs incurred from producing the initial units of output. In most sectors, goods are differentiated from each other. Integration causes the better-performing firms to expand, while worse-performing to contract. Additional source of gain from trade: as production is concentrated toward better-performing firms, the overall efficiency of the industry improves. Monopolistic competition Monopolistic competition is a model of an imperfectly competitive industry that assumes that each firm can differentiate its product, and takes the prices charged by its rivals as given. There is a large number of firms, such that a price change by a single firm has no effect on other firms’ demand level. Firms have some market power in the sense that it faces a downward-sloping demand curve. Profit is driven down to zero (new firms can enter the market and start producing as long as there are positive profits). Assume that consumers prefer product variety (either individual consumers prefer variety or different consumers prefer different varieties). Demand is downward sloping for each firm. Can be many firms in the industry, but each firm differentiate its product. For now, assume identical firms, facing identical demand, product technologies, and cost structures. A firm in a monopolistically competitive industry is expected to sell: - More as total sales in the industry increase, and as prices charged by rivals increase. - Less as the number of firms in the industry increases, and as the firm’s price increases. These concepts are represented by the function: 𝑄 = 𝑆 ∙ [ 1 𝑛 − 𝑏 ∙ (𝑃 − 𝑃𝑎𝑣𝑔)] Q: individual firm’s sales S: total sales of the industry n: number of firms in the industry b: constant term representing the responsiveness of a firm’s sales to its price P: price charged by the firm itself Pavg: average price charged by its competitors A firm charging more than the average price of other firms will have a smaller market share. A firm charging less will have a larger market share. In order to find the market equilibrium, we will find the equilibrium average price (Pavg) and number of firms (n). To do this, we derive the relationship between: 1. n and the AC (will be upward sloping): Assume that firms are symmetric: all firms face the same demand function and have the same cost function. Thus, all firms should charge the same price and have equal share of the market: 𝑄 = 𝑆 𝑛 Average costs should depend on the size of the market and the number of firms: 𝐴𝐶 = 𝐶 𝑄 = 𝐹 𝑄 + 𝑐 = 𝑛 ∙ 𝐹 𝑆 + 𝑐 As the number of firms n in the industry increases, the average cost increases for each firm because each produces less. As total sales S of the industry increase, the average cost decreases for each firm because each produces more. 2. n and Pavg (will be downward sloping): Monopolistic firms face linear demand functions: 𝑄 = 𝐴 − 𝐵 ∙ 𝑃, where A and B are constant. When firms maximize profits, they should produce until marginal revenue equals marginal costs: 𝑀𝑅 = 𝑃 − 𝑄 𝐵 = 𝑐 𝑄 = 𝑆 ∙ [ 1 𝑛 − 𝑏 ∙ (𝑃 − 𝑃𝑎𝑣𝑔)] = ( 𝑆 𝑛 + 𝑆 ∙ 𝑏 ∙ 𝑃𝑎𝑣𝑔) − 𝑆 ∙ 𝑏 ∙ 𝑃 = 𝐴 − 𝐵 ∙ 𝑃 𝑀𝑅 = 𝑃 − 𝑄 𝑆 ∙ 𝑏 = 𝑐 → 𝑃 = 𝑐 + 𝑄 𝑆 ∙ 𝑏 If all firms charge the same price, each will sell an amount 𝑄 = 𝑆 𝑛 . Hence the average price is: 𝑃 = 𝑐 + 1 𝑏 ∙ 𝑛 As the number of firms n in the industry increases, the price that each firm charges decreases due to increased competition. Each firm’s markup over marginal cost (P-c) decreases with the number of competing firms. The higher demand elasticity b is, the more substitutable different firms’ products are, and the lower the optimal markup. Trade in monopolistic model Because trade increases market size, trade is predicted to decrease average cost in an industry descripted by monopolistic competition: PP curve unchanged, CC curve shifts down. Industry sales increases with trade leading to decreased average costs. The curves CC and PP are descripted from the equations: 𝐴𝐶 = 𝑛 ∙ 𝐹 𝑆 + 𝑐 𝑃 = 𝑐 + 1 𝑏 ∙ 𝑛 If n increases (variety-increasing effect): trade increases the variety of goods that consumers can buy under monopolistic competition, so the welfare of consumers increase. If AC decreases, p decreases (pro-competitive effect): consumers benefit from decreased price, this increases welfare. As a result of trade, each individual firm is larger, spreading fixed costs over larger market, hence consumers benefit from lower prices. As a result of trade, the number of firms in a new international industry is predicted to increase relative to each national market (but it is unclear if firms will locate in the domestic country or foreign country). Trade has the same effects as growth of a market within a single country. Product differentiation and internal economies of scale lead to trade between similar countries with no comparative advantage differences between them. Intra-industry trade refers to two-way exchanges of similar goods. Two new channels for welfare benefits from trade: - Benefit from a greater variety at a lower price. - Firms consolidate their production and take advantage of economies of scale. A smaller country stands to gain more from integration than a larger country. Firm heterogeneity Increased competition tends to hurt the worst-performing firms, and they are forced to exit. The best-performing firms take the greatest advantage of new sales opportunities and expand the most. When the better-performing firms expand, and the worse-performing ones contract, overall industry performance improves. Trade and economic integration improve industry performance as much as the discovery of a better technology does. Assume Firm 1 has lower MC than Firm 2. Both face same Demand and Marginal Revenue curve. Firm 1 sets lower price and produces more. Firm 1 sets a higher markup over marginal costs: 𝑃1 − 𝐶1 > 𝑃2 − 𝐶2 Firm 1 earns higher operating profits than Firm 2: 𝑃1𝑄1 − 𝐶1𝑄1 > 𝑃2𝑄2 − 𝐶2𝑄2 Given market size, operating profits can be plotted as a function of marginal cost. Operating profits decrease with increasing marginal cost. Any firm with marginal cost higher than c* cannot operate profitably and will shut down. With trade, there is more competition, so the demand curve shifts: - Vertical intercept decreases (as n decreases) - Slope decreases (as market size S increases) So, the shift is inward for the smaller firms, and outward for the larger firms. Up to now, we assumed trade leads to increased market size. In reality, trade costs often remain. Firms must incur additional trade cost when supplying the foreign country market. So, only larger and more productive firms can export. Dumping Dumping is the practice of charging a lower price for exported goods than for goods sold domestically. Dumping is an example of price discrimination: the practice of charging different customers different prices. Price discrimination and dumping may occur only if there is imperfect competition (firms are able to influence market prices), and markets are segmented so that goods are not easily bought in one market and resold in another. Dumping can be a profit-maximizing strategy. A firm with a higher marginal cost chooses to set a lower markup over marginal cost. Therefore, an exporting firm will respond to the trade cost by lowering its markup for the export market. This strategy is considered to be dumping, regarded by most countries as an “unfair” trade practice. Most economists believes that the enforcement of dumping claims is misguided. Trade costs have a natural tendency to induce firms to lower their markups in export markets. Such enforcement is used as an excuse for protectionism. Outsourcing and Foreign Direct Investment Foreign Direct Investment (FDI) refers to investment in which a firm in one country directly controls or owns a subsidiary in another country. If a foreign company invests in at least 10% of the stock in a subsidiary, the two firms are classified as a multinational corporation. 10% or more of ownership in stock is deemed to be sufficient for direct control of business operations. Greenfield FDI is when a company builds a new production facility abroad. Brownfield FDI (or cross-border mergers and acquisitions) is when a domestic firm buys a controlling stake in a foreign firm. Greenfield FDI has tended to be more stable, while Brownfield tend to occur in surges. There are two main types of FDI: - Horizontal FDI: when the affiliate replicates the production process (that the parent firm undertakes in its domestic facilities) elsewhere in the world. Horizontal FDI is dominated by flows between developed countries (both the multinational parent and the affiliates are located in developed countries). The main reason for this type of FDI is to locate production near a firm’s large customer bases. - Vertical FDI: when the production chain is broken up, and parts of the production processes are transferred to the affiliate location. Vertical FDI is mainly driven by production cost differences between countries. Proximity-concentration trade-off: high trade costs associated with exporting create an incentive to locate production near customers. FDI activity concentrated in sectors with high trade costs. Export subsidies An export subsidy can also be specific (it is a payment per unit exported) or ad valorem (it is a payment as a proportion of the value exported). An export subsidy raises the price in the exporting country, decreasing its consumer surplus (consumers worse off) and increasing its producer surplus (producers better off). Government revenue falls due to paying s for the export subsidy. The subsidy lowers the price paid in importing countries: 𝑃𝑆 ∗ = 𝑃𝑆 − 𝑠 In contrast to a tariff, an export subsidy worsen the terms of trade by lowering the price of exports in world markets. An export subsidy damages national welfare. The triangles b and d represent the efficiency loss. The export subsidy distorts production and consumption decisions: producers produce too much, and consumers consume too little compared to the market outcome. The area b+c+d+e+f+g represents the cost of the subsidy paid by the government. The terms of trade decreases because the price of exports falls. Import quota An import quota is a restriction on the quantity of a good that may be imported. This restriction is usually enforced by issuing licenses or quota rights. A binding import quota will push up the price of the import because the quantity demanded will exceed the quantity supplied by Home producers and from imports. Voluntary export restraints Local content requirements A voluntary export restraint works like an import quota, except that the quota is imposed by the exporting country rather than the importing country. These restraints are usually requested by the importing country. The profits or rents from this policy are earned by foreign governments or foreign producers. Foreigners sell a restricted quantity at an increased price. Local content requirements A local content requirement is a regulation that requires a specified fraction of a final good to be produced domestically. It may be specified in value terms (some minimum share of the value of a good represent home value added) or in physical units. From the viewpoint of domestic producers of input, a local content requirement provides protection in the same way that an import quota would. From the viewpoint of firms that must buy home inputs, the requirement does not place a strict limit on imports, but allows firms to import more if they also use more home parts. Local content requirement provides neither government revenue nor quota rents. Instead, the difference between the prices of home goods and imports is averaged into the price of the final good and is passed on to consumers. Rules of origin Rules of origin define the conditions that a product must satisfy to be deemed as originating in the country from which preferential access in being sought. The main justification for rules of origin is to prevent trade deflection, whereby products from non-participating countries are redirected through free trade partners to avoid the payment of duties. There are three main approaches to determine origin: - Change of tariff heading: substantial transformation has to be undertaken to result in a different tariff heading to that of the input materials used. - Value added criteria: minimum value has to be added locally. - Specific manufacturing process requirement Administrative costs can importantly vary with different documentation and certification methods. This can be based on self-declarations, or different certificates. Some of these certificates expire after a certain time period. Traders usually have to provide/keep evidence of the originating status for a number of years. Ù Political economy of trade Cases for free trade The first case for free trade is the argument: producers and consumers allocate resources most efficiently when governments do not distort market prices through trade policy. National welfare of a small country is highest with free trade. With restricted trade, consumers pay higher prices and consume too little while firms produce too much. Tariff rates are already low for most countries. Estimated benefits of moving to free trade are only a small fraction of national income for most countries. The gains from free trade are somewhat smaller for advanced economies such as the US and EU and somewhat larger for poorer developing countries. Free trade allows firms or industry to take advantage of economies of scale. Protected markets limit gains from external economies of scale by inhibiting the concentration of industries: too many firms to enter the protected industry, and the scale of production of each firm becomes inefficient. Free trade provides competition and opportunities for innovation (dynamic benefits). By providing entrepreneurs with an incentive to seek new ways to export or compete with imports, free trade offers more opportunities for learning and innovation. Free trade avoids the loss of resources through rent seeking. Spend time and other resources seeking quota rights and the profit that they will earn. The political argument for free trade says that free trade is the best feasible political policy, even through there may be better policies in principle. Any policy that deviates from free trade would be quickly manipulated by political groups, leading to decreased national welfare. Cases against free trade For a large country, a tariff lowers the price of imports in world markets and generates a terms of trade gain. This benefit may exceed the losses caused by distortions in production and consumption. A small tariff will lead to an increase in national welfare for a large country. But at some tariff rate, the national welfare will begin to decrease as the economic efficiency loss exceeds the terms of trade gain. A tariff rate that completely prohibits imports leaves a country worse off, but a tariff rate may exist that maximize national welfare: it is the optimum tariff. An export tax (a negative export subsidy) that completely prohibits exports leaves a country worse off, but an export tax rate may exist that maximize national welfare through the terms of trade. An export subsidy lowers the terms of trade for a large country; an export tax raises the terms of trade for a large country. An export tax may raise the price of exports in the world market, increasing the terms of trade. For some larger economies like the EU, an import tariff and/or export tax could improve national welfare at the expense of other countries. But other countries may retaliate against large countries by enacting their own trade restrictions. A second argument against free trade is that domestic market failures may exist that cause free trade to be a suboptimal policy. The economic efficiency loss calculations using consumer and producer surplus assume that markets function well. Types of market failures include: - Persistency high underemployment of workers. - Surpluses that are not eliminated in the market for labor because wages do not adjust. - Persistency high underutilization of structures, equipment, and other forms of capital. - Surpluses that are not eliminated in the market for capital because prices do not adjust. - Property rights not well defined or well enforced. - Technological benefits for society discovered through private production, but from which private firms cannot fully profit. - Environmental costs for society caused by private production, but for which private firms do not fully pay. - Sellers that are not well informed about the (opportunity) cost of production o buyers that are not well informed about value from consumption. Domestic market failure Economists calculate the marginal social benefit to represent the additional benefit to society from private production. With a market failure, marginal social benefit is not accurately measured by the producer surplus of private firms, so that economic efficiency loss calculations are misleading. It is possible that when a tariff increases domestic production, the benefit to domestic society will increase due to a market failure. The domestic market failure argument against free trade is an example of a more general argument called the theory of the second best. Government intervention that distorts market incentives in one market may increase national welfare by offsetting the consequences of market failures elsewhere. If the best policy, fixing the market failures, in not feasible, then government intervention in another market may be the second best way of fixing the problem. Economists supporting free trade counter-argue that domestic market failures should be corrected by a first best policy: a domestic policy aimed directly at the source of the problem. If persistently high underemployment of labor is a problem, then the cost of labor or production of labor-intensive products could be subsidized by the government. This policy could avoid economic efficiency losses due to a tariff. Unclear when and to what degree a market failure exists in the real world. Government policies to address market failures are likely to be manipulated by politically powerful groups. Due to distorting the incentives of producers and consumers, trade policy may have unintended consequences that make a situation worse, not better. Political models Models of governments maximizing political success rather than national welfare. The median voter theorem predicts that democratic political parties pick their policies to court the voter in the middle of the ideological spectrum. The median voter theorem implies that a two-party democracy should enact trade policy based on how many voters it pleases. A policy that inflicts large losses on a few people (import-competing producers), but benefits a large number of people (consumers) should be chosen. But trade policy doesn’t follow this prediction. Political activity is often described as a collective action problem. While consumers as a group have an incentive to advocate free trade, each individual consumer has no incentive because his benefit is not large compared to the cost and time required to advocate free trade. Policies that impose large losses for society as a whole, but small losses on each individual may therefore not face strong opposition. However, for groups who suffer large losses from free trade, each individual in that group has a strong incentive to advocate the policy he desires. In this case, the cost and time required to advocate restricted trade is small compared to the cost of unemployment. Politicians win elections partly because they advocate popular policies, but they require funds to run campaigns. These funds often come from groups who do not have a collective action problem, or willing to advocate a special interest policy. Models of trade restrictions try to measure the trade-off between the reduction in welfare of constituents as a whole and the increase in campaign contributions from special interests. Multilateral trade organization Multilateral negotiations mobilizes exporters to support free trade if they believe export markets will expand. This support would be lacking in a unilateral push for free trade. Multilateral negotiations help avoid a trade war between countries. A trade war could result if each country has an incentive to adopt protection, regardless of what other countries do. All countries could enact trade restrictions, even if it is in the interest of all countries to have free trade. Countries need an agreement that prevents a trade war or eliminates the protection from one. World Trade Organization (WTO) negotiations address trade restrictions in at least three ways: - Reducing tariff rates - Binding tariff rates: a tariff is bound by having the imposing country agree not to raise it in the future. excess profits from a foreign firm to a domestic firm. A government policy to give a domestic firm a strategic advantage in production is called a strategic trade policy. Criticism in this analysis include: - Practical use of strategic trade policy requires more information about firms than is likely available - Foreign retaliation also could result - Strategic trade policy, like any trade policy, could be manipulated by politically powerful groups. Trade and wages Some argue to include labor standards in trade negotiations. However, labor standards imposed by foreign countries are opposed by governments of low and middle income countries. International standards could be used as a protectionist policy or a basis for lawsuits when domestic producers did not meet them. Standards set by high-income countries would be expensive for low and middle income producers. A policy that could be agreeable for governments of low and middle income countries is a system that monitors wages and working conditions and makes this information available to consumers. Products could be certified as made with acceptable wage rates and working conditions. But this policy would have a limited effect, since a large majority of workers in low and middle income countries do not work in the export sector. Trade and environment Compared to rich-country standards, environmental standards in low and middle income countries are lax. Some have opposed free trade for this reason. Trade can also negatively impact the environment though shipping. Some environmental activists want to include environmental standards in trade negotiations. However, environmental standards imposed by foreign countries are opposed by governments of low and middle income countries. International standards could be used as a protectionist policy or a basis for lawsuits when domestic producers did not meet them. Standards set by high income countries would be expensive for low and middle income producers. As poor countries grow richer, possibly partly due to trade, they produce more and can consume more, leading to more environmental degradation. But as countries grow richer, they want to pay for more stringent environment protection. Both of these ideas are represented as an environmental Kuznets curve: an inverted U-shaped curve relationship between environmental degradation and income per person. National Income Accounting and Balance of Payments Accounts Until now, we primarily discusses microeconomic concepts (discussing problems from the perspective of individual firms and consumers). Microeconomics works from the bottom up. It shows how individual economic actors, by pursing their own interests, collectively determine how resources are used. We have learned how individual production and consumption decisions produce patterns of international trade and specialization. Here we shift focus to macro questions: how can economic policy ensure that factors of production are fully employed? What determines how an economy’s capacity to produce goods and services changes over time? Like microeconomics, macroeconomics is concerned with the effective use of scares resources. But while microeconomics focuses on the economic decisions of individuals, macroeconomics analyzes the behavior of an economy as a whole. In our study of international macroeconomics, we will learn how the interaction of national economies influence the worldwide pattern of macroeconomic activity. The main issues which macroeconomic analysis emphasizes are: - Unemployment: a main concern in international macroeconomics is the problem of ensuring full employment in open economies. Macroeconomics studies the factors that cause unemployment and the steps governments can take to prevent it. - Saving: until now we assumed all income is consumed. In reality part is put aside for future consumption or money can be borrowed for more spending. Saving/borrowing impacts employment and future levels of national wealth. - Trade imbalance: countries’ exports do not have to equal their imports. Trade imbalances redistribute wealth among countries. Main channel through which one country’s macroeconomic policies affect its trading partners. It can become a source of international discord. - Money and price level: until now goods were exchanged for goods, without the introduction of money. Fluctuations in supply/demand for money, and price levels have consequences for the economy. Stability in money price levels is an important goal of international macroeconomic policy. National income accounting National income accounting refers to record all the expenditures that contributes to a country’s income and output. National income is often defined to be the income earned by a nation’s factors of production. Gross National Product (GNP) is the value of all final goods and services produced by a nation’s factors of production in a given time period. GNP is calculated by adding up the value of expenditure on final goods and services produced: - Consumption: expenditure by domestic consumers - Investment: expenditure by firms on buildings and equipment - Government purchases: expenditure by governments on goods and services - Current account balance: net expenditure by foreigners on domestic goods and services GNP a country generates over some time period must equal its national income (income earned in that period by its factors of production). GNP is one measure of national income, but a more precise measure of national income is GNP adjusted for the following: - Depreciation of physical capital results in a loss of income to capital owners, so the amount of depreciation is subtracted from GNP. GNP less depreciation is called Net National Product (NNP). - Unilateral transfer to and from other countries can change national income (payments of expatriate workers sent to their home countries, foreign aid and pension payments sent to expatriate retirees, etc.). To calculate national income, unilateral transfers are added to NNP. 𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 = 𝐺𝑁𝑃 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝑁𝑒𝑡 𝑢𝑛𝑖𝑙𝑎𝑡𝑒𝑟𝑎𝑙 𝑡𝑟𝑎𝑛𝑠𝑓𝑒𝑟 Another approximate measure of national income is Gross Domestic Product (GDP). Gross Domestic Product measures the final value of all goods and services that are produces within a country in a given time period. 𝐺𝐷𝑃 = 𝐺𝑁𝑃 − 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑓𝑟𝑜𝑚 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑜𝑢𝑛𝑡𝑟𝑖𝑒𝑠 𝑓𝑜𝑟 𝑓𝑎𝑐𝑡𝑜𝑟𝑠 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 + 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑡𝑜 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑜𝑢𝑛𝑡𝑟𝑖𝑒𝑠 𝑓𝑜𝑟 𝑓𝑎𝑐𝑡𝑜𝑟𝑠 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 Open economy While in a close economy saving and investment equals, in an open economy this does not have to be the case. Countries can save in the form of foreign wealth by exporting more than they import, or they can dissave doing the opposite. Consumption: part of GNP which is purchased by private households to fulfill current wants. Investment: the part of output used by private firms to produce future output. Government purchases: any purchase made by regional or national governments. The national income identity (Y) for an open economy is: 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝐸𝑋 − 𝐼𝑀 = 𝐶 + 𝐼 + 𝐺 + 𝐶𝐴 where C, I, and G are expenditures by domestic individuals and institutions, and CA is net expenditure by foreign individual and institutions (for now, we will only include exports and imports). 𝐶𝐴 = 𝐸𝑋 − 𝐼𝑀 = 𝑌 − (𝐶 + 𝐼 + 𝐺) When a country exports more than it imports, it earns more income from exports than it spends on imports. Net foreign wealth is increasing. When a country exports less than it imports, it earns less income from exports than it spends on imports. Net foreign wealth is decreasing. Since RHS gives total expenditures over domestic output changes, CA can be associated with changes in output and thus employment. CA also measures size and direction of international borrowing. If a country imports more than it exports, it has to borrow the difference from foreigners. CA deficit increases the net foreign debt by the amount of deficit. Saving and current account The national saving (S) is the national income that is not spent on consumption or government purchases: 𝑆 = 𝑌 − 𝐶 − 𝐺 An open economy can save by building up its capital stock or by acquiring foreign wealth: 𝑆 = 𝐼 + 𝐶𝐴 This shows that an open economy can save either by building up its capital stock or by acquiring foreign wealth, but a closed economy can save only by building up its capital stock. Government saving decisions often aim to effect output and employment. Distinguishing private saving from government saving allows us to analyze the channels through which government savings can have an influence on domestic macroeconomic conditions. Private saving is the part of disposable income that is saved rather than consumed: 𝑆𝑃 = 𝑌 − 𝑇 − 𝐶 Government saving is net tax revenue minus government purchases: 𝑆𝐺 = 𝑇 − 𝐺 Private and government saving add up to national saving: 𝑆 = 𝑌 − 𝐶 − 𝐺 = (𝑌 − 𝑇 − 𝐶) + (𝑇 − 𝐺) = 𝑆𝑃 + 𝑆𝐺 Rewriting the national income identity in a form that allows analyzing the effects of government saving decisions: 𝑆 = 𝑆𝑃 + 𝑆𝐺 = 𝐼 + 𝐶𝐴 𝑆𝑃 = 𝐼 + 𝐶𝐴 − 𝑆𝐺 = 𝐼 + 𝐶𝐴 − (𝑇 − 𝐺) = 𝐼 + 𝐶𝐴 + (𝐺 − 𝑇) Hence, a country’s private saving can take three forms: investment in domestic capital (I), purchase of wealth from foreigners (CA), and purchase of the domestic government’s newly issued debt (G-T). Demand of currency deposit Factors that influence the return on assets determine the demand of those assets. The most important factors are interest rate and the expected change in the currency’s exchange. Rate of return: the percentage change in value that an asset offers during a time period. Real rate of return: inflation-adjusted rate of return, which represent the additional amount of goods and services that can be purchased with earnings from the asset. If prices are fixed (inflation rate is 0%), rates of return equal real rates of return. Because trading of deposit in different currencies occurs on a daily basis, we often assume that prices do not change from day to day (a good assumption to make for the short run). Risk: risk of holding assets also influences decisions about whether to buy them. Liquidity: liquidity of an asset, or ease of using the asset to buy goods and services, also influences the willingness to buy assets. We assume that risk and liquidity of currency deposits in foreign exchange markets are essentially the same, regardless of their currency denomination. Risk and liquidity are only of secondary importance when deciding to buy or sell currency deposits. Importers and exporters may be concerned about risk and liquidity, but they make up a small fraction of the market. We therefore say that investors are primarily concerned about the rates of return on currency deposits. Rates of return that investors expect to earn are determined by the interest rates that the assets will earn, and by expectations about appreciation or depreciation. A currency deposit’s interest rate is the amount of a currency that an individual or institution can earn by lending a unit of the currency for a year. The rate of return for a deposit in domestic currency is the interest rate that the deposit earns. To compare the rate of return on a deposit in domestic currency with one in foreign currency, we consider the interest rate for the foreign currency deposit, and the expected rate of appreciation or depreciation of the foreign currency relative to the domestic currency. When deciding which asset to hold, the saver will also consider its riskiness and liquidity. Even if the rate of return is higher on one deposit, if there is higher risk attached, savers, might be reluctant to choose it. For now, we will assume away riskiness and liquidity. Model of foreign exchange market Construct model of foreign exchange markets using the demand of (rate of return on) dollar denominated deposits, and the demand of (rate of return on) foreign currency denominated deposits. Interest parity: model in equilibrium when deposits of all currencies offer the same expected rate of return. It implies that deposits in all currencies are equally desirable assets, and that arbitrage in the foreign exchange market is not possible. Interest parity says: 𝑅$ = 𝑅€ + 𝐸$/€ 𝑒 − 𝐸$/€ 𝐸$/€ 𝑅$: expected rate of return = interest rate on dollar deposits 𝑅€: interest rate on euro deposits 𝐸$/€ 𝑒 : expected exchange rate 𝐸$/€: current exchange rate 𝐸$/€ 𝑒 −𝐸$/€ 𝐸$/€ : expected rate of appreciation of the euro Depreciation of the domestic currency today lowers the expected rate of return on foreign currency deposits. When the domestic currency depreciates, the initial cost of investing in foreign currency deposits increases, lowering the expected rate of return of foreign currency deposits. Appreciation of the domestic currency today raises the expected return of deposits on foreign currency deposits. When the domestic currency appreciates, the initial cost of investing in foreign currency deposits decreases, raising the expected rate of return of foreign currency deposits. Putting together the understanding of why interest parity condition must hold, and how today’s exchange rate affects the expected return on foreign currency deposits, we can determine the equilibrium. To determine the equilibrium in the foreign exchange market, we will continue to assume that only current exchange rate changes. The dollar interest rate, the euro interest rate, and the expected future dollar/euro exchange rate are given. Equilibrium in the foreign exchange market is at point 1, where the expected dollar returns on dollar and euro deposits are equal. Assuming we are in point 2: the rate of return on euro deposit is below that of the dollar deposit. Owners of euro deposits try to sell them for dollar deposits. But no holder of dollar deposits willing to sell at that rate. As euro holders try to convince dollar holders to trade, they offer better price for dollars. The dollar/euro exchange rate falls until it reaches E1 with the deposits offering equal returns. Increase in the interest rate paid on deposits denominated in a particular currency will increase the rate of return on those deposits. This leads to an appreciation of the currency. Higher interest rates on dollar-denominated assets cause the dollar to appreciate. Higher interest rate on euro-denominated assets cause the dollar to depreciate. A rise in the interest rate offered by dollar deposits causes the dollar to appreciate from point 1 to point 2. At unchanged exchange rate we are at point 1’, where the dollar rate of return is higher than the euro return. People try to sell euro deposit and buy dollar deposit. Exchange rate adjusts. A rise in the interest rate paid by euro deposits causes the dollar to depreciate from point 1 to point 2. A rise in expected future price of euros in terms of dollars raises the dollar’s expected depreciation rate. A rise in expected future price of euros in terms of dollars raises the expected dollar return on euro deposits. The downward-sloping schedule shifts to the right. At E1 now there is excess supply of dollar deposits, with euro deposits offering higher expected return, The dollar then has to depreciate against the euro until E2. If people expect the euro to appreciate in the future, then euro-denominated assets will pay in valuable euros, so that these future euros will be able to buy many dollars and many dollar-denominated goods. The expected rate of return on euro therefore increases. An expected appreciation of a currency leads to an actual appreciation (a self-fulfilling prophecy). An expected depreciation of a currency leads to an actual depreciation (a self-fulfilling prophecy). Money Money is a medium of exchange (without it, barter trade), a unit of account (recognized measure of value), and a store value (can be used to transfer purchasing power from the present into the future). Money is an asset that is widely used as a mean of payment. Different groups of assets may be classified as money: - Liquid asset (monetary asset): it can be easily used to pay for goods and service, or to repay debt without substantial transaction costs. But monetary or liquid assets earn little or no interest. - Illiquid asset (non-monetary asset): it requires substantial transaction costs in terms of time, effort, or fees to convert them to funds for payment. It generally earns a higher interest rate, or rate of return, than monetary asset. The demarcation between the two is arbitrary, but currency in circulation, checking deposits, debit card account, saving deposits are generally more liquid than bonds, loans, deposits of currency in the foreign exchange markets, stocks, real estate, and other assets. The central bank controls the quantity of money that circulates in an economy, the money supply. Money demand represents the amount of monetary assets that people are willing to hold (instead of illiquid assets). We will consider individual demand of money and aggregate demand of money. The factors that influences demand of money for individuals and institutions are: - Interest rates: expected rates of return on monetary assets relative to the expected rates of returns on non- monetary assets. - Risk: the risk of holding monetary assets principally comes from unexpected inflation, which reduces the purchasing power of money. - Liquidity: a need for greater liquidity occurs when the price of transactions increases, or the quantity of goods bought in transactions increases. The factors that influences the aggregate demand of money are: - Interest rates/expected rates of return: monetary assets pay little or no interest, so the interest rate on non- monetary assets like bonds, loans, and deposits is the opportunity cost of holding monetary assets. A higher interest rate means a higher opportunity cost of holding monetary assets. It implies lower demand of money. - Prices: the prices of goods and services bought in transactions will influence the willingness to hold money to conduct those transactions. A higher level of average prices means a greater need for liquidity to buy the same amount of goods and services. It implies higher demand of money. - Income: greater income implies more goods and services can be bought, so that more money is needed to conduct transactions. A higher real national income (GNP) means more goods and services are being produced and bought in transactions, increasing the need for liquidity. It implies higher demand of money. Aggregate demand of money can be expressed as: 𝑀𝑑 = 𝑃 ∙ 𝐿(𝑅, 𝑌) P: price level Y: real national income R: measure of interest rates on non-monetary assets. Aggregate demand of real monetary assets is a function of national income and interest rate: 𝑀𝑑 𝑃 = 𝐿(𝑅, 𝑌)