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To understand the causes and effects of trade its useful to look at models that focus on one
particular motive for trade separately.
Ricardian model
Trade arises because of differences in relative labor productivity between countries.
Opportunity costs: the costs of not being able to produce something because resources have
already been used to produce something else.
Comparative advantage: A country has a comparative advantage in producing a good if the
opportunity cost of producing that good is lower in that country than in other countries.
Gains from trade: More goods and services can be produced and consumed compared to the
situation where each country makes all goods and services itself.
Assumptions
1. Labor is the only factor of production.
2. Labor productivity varies across countries due to differences in technology, but labor
productivity in each country is constant.
3. The supply of labor in each country is constant.
4. Only two goods are important for production and consumption (wine and cheese).
5. Perfect competition between firms, free entry/exit of firms.
6. Perfect labor mobility between sectors.
7. The world consists of two countries: Home and Foreign.
8. No transportation costs.
Production possibilities depend on the amount of labor available and unit labor requirement.
(High unit labor requirement = low productivity).
L = total number of hours worked (constant by assumption)
QC = how many pounds of cheese are produced
QW = how many gallons of wine are produced
aLC = the unit labor requirement for cheese
aLW is the unit labor requirement for wine
Production possibility frontier: aLCQC + aLWQW =< L
In equilibrium: aLCQC + aLWQW = L
The PPF shows the maximum amount of goods that can be produced using a fixed amount of
resources.
QW = L/aLW (aLC/aLW) QC
aLC/aLW = opportunity cost of producing and extra unit of cheese in terms of wine. (how
much wine could be produced if one unit less of cheese would be produced?)
wC = PC/aLC
wW = PW/aLW
If wC = PC/aLC > PW/aLW = wW, workers will only make cheese, and vice versa.
Workers are only willing to make both wine and cheese if wC = wW PC/aLC = PW/aLW
PC/PW = aLC/aLW
Two countries, Home and Foreign
Suppose Home has an absolute advantage: aLC < a*LC and aLW < a*LW
3
Suppose Home has a comparative advantage in cheese production: aLC/aLW < a*LC/a*LW
lower opportunity cost of producing cheese in terms of wine. (less wine can be produced by
reducing cheese production in home)
Relative price reflects opportunity cost in each country.
If there is no trade: PC/PW = aLC/aLW < a*LC/a*LW = P*C/P*W
It will be profitable to ship cheese from Home to Foreign, and wine from Foreign to Home, this is
an incentive to trade.
World relative supply of cheese = quantity of cheese supplied by all countries relative to
quantity of wine supplied by all countries:
RS = (QC + Q*C)/(QW + Q*W)
1 If the relative price of cheese falls below the opportunity cost of cheese in BOTH countries
[PC /PW < aLC /aLW < a*LC /a*LW]
Nobody produces cheese: both foreign and domestic workers rather produce wine, where wages
are higher.
RS = 0
2 Similarly: if the relative price of cheese rises above the opportunity cost of cheese in BOTH
countries [aLC /aLW < a*LC /a*LW < PC /PW]
Everybody produces cheese: both foreign and domestic workers rather produce cheese, where
wages are higher.
RS = infinite
3 When the relative price of cheese equals the opportunity cost in the home country
[PC /PW = aLC /aLW < a*LC /a*LW]:
Domestic workers are indifferent about producing wine or cheese (wage when producing wine =
wage when producing cheese).
Foreign workers produce only wine.
0 =< RS =< (L / aLC) / (L*/ a*LW)
4 Similarly, when the relative price of cheese equals the opportunity cost in the foreign country
[aLC /aLW < PC /PW = a*LC /a*LW]:
Foreign workers are indifferent about producing wine or cheese (wage when producing wine
same as wage when producing cheese).
Domestic workers produce only cheese.
(L / aLC) / (L*/ a*LW) =< RS =< infinite
5 When the relative price of cheese settles strictly in between the opportunity costs of cheese
[aLC /aLW < PC /PW < a*LC /a*LW]
Domestic workers produce only cheese (where their wages are higher).
Foreign workers still produce only wine (where their wages are higher).
World relative supply of cheese equals Homes maximum cheese production divided by Foreigns
maximum wine production RS = (L / aLC) / (L*/ a*LW)
Relative price
of cheese, PC/PW
2
a*LC/a*LW
3
1
RS
aLC/aLW
L/aLC
*
L /a LW
Relative quantity
of cheese, QC + Q*C
QW + Q *W
Opening up to trade: PC/PW < PworldC/PworldW < P*C/P*W each country specializes in producing
the good in which they have a comparative advantage.
Their purchasing power remains the same in cheese and increases in wine (PC /PW <
PworldC /PworldW).
Foreign workers earn a higher (real) income from specializing in wine production since for them
the relative price of wine increases with trade: they can now buy more cheese with their wine.
With trade, they earn w* = PworldW / a*LW
, this wage buys them: w*/PworldW = 1/a*LW wine, or
w*/PworldC = PworldW /PworldC x 1/a*LW cheese
Before trade, they earned w* = P*W / a*LW
, that wage bought them:
w*/P*W = 1/a*LW wine, or
w*/P*C = P*W /P*C x 1/a*LW cheese
Their purchasing power remains the same in wine and increases in cheese (P*C /P*W >
PworldC /PworldW).
Trade expands a countrys consumption possibilities beyond its own production possibilities.
How do wages in the two countries compare when they trade?
Home: wC = PworldC / aLC
Foreign: w*W = PworldW / aLw
Relative wages: WC/W*W = (PworldC/PworldW) x (1/aLC)
WC/W*W < a*LC/aLC
1.
WC/W*W > a*LW/aLW
2.
(a*LW /aLW ) < (wC / w*W) < (a*LC /aLC )
Productivity (technological) differences between countries determine relative wage differences
across countries.
The home wage relative to the foreign wage will settle in between the ratio of how much better
Home is at making cheese and how much better it is at making wine compared to Foreign.
These relationships imply that both countries have a cost advantage in production!
- High wages can be offset by high productivity.
- Low productivity can be offset by low wages.
Comparative advantage with many goods
N goods: i = 1, 2, 3 N
Unit labor requirement: aLi and a*Li
To determine which country has a competitive advantage in which type of production, we need to
know their productivity differences and their wages.
Good i will be produced in the country where total wage payments to produce it are lowest.
If waLi < w*a*Li then only Home will produce good i. Total wage payments = total cost.
Or equivalently, if a*Li/aLi < w/w* if the relative productivity of a country in producing a good
is higher than the relative wage, then the good will be produced in that country.
Relative supply in our model is fixed by the amount of labor in each of the countries: RS = L/L*
Relative demand of domestic labor services falls when w/w* rises.
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If cloth labor is under food labor curve, then workers migrate to food sector. The triangle
from paralel points on both curves + eq point is how much world output increases!
Equilibrium wage and allocation of labour where labor demand functions intersect.
wF = wC MPLF x PF = MPLC x PC - MPLF / MPLC = - PC / PF; otherwise labor moves.
Price change
1. Proportional change in prices. Relative price stays the same. The wage also increases
proportionately. Since the wages and the prices both increase with the same amount, the
real wage stays the same. There is no reallocation of labor and production.
2. A change in relative prices.
Suppose PC increases and PF stays the same PC / PF increases.
- Allocation of labor between sectors changes. (move from f to c production)
- Welfare of workers, capital owners, and land owners changes.
WC increases, this attracts labor, the MPLC will drop because more people now work in the cars
sector. WC = MPLC x PC.
The wage doesnt increase as much as the price does.
Intuition: higher wages attract more workers, but because more people want to work in cars now,
employers can reduce wages a bit and still get enough people to do the job.
The output (QC) will also increase.
Capital owners are better off
1. They earn more: output goes up, and the price of cars rises by 7% whereas wages only
rise by less than 7%.
2. Also: they can buy more food for a given amount of cars they produce (relative price of
cars has risen).
Land owners are worse off
1. They earn less: output goes down, and wages rise by 7% whereas the price of food
remains unchanged.
2. Also: they can buy less cars for a given amount of food they produce (relative price of
cars has risen).
Workers
1. Wages go up
2. However, relative wage in terms of cars (PF/PC) falls.
3. However, PF stays the same, so the relative wage in terms of food (PC/PF) rises.
It is ambiguous whether workers are better or worse off, it depends on their preferences for food
and cars.
In the Specific Factors model, a change in relative prices will
- Benefit the owners of the factor specific to the sector whose relative price increases.
- Hurt the owners of the factor specific to the sector whose relative price decreases.
- And, the effect on the mobile factor is ambiguous.
Trade in the Specific Factors Model
Only trade if world relative prices are different from prevailing relative prices without
trade. Trade changes prices, because 1) relative demand changes, because people in other
countries have different preferences. 2) Relative supply changes, firms in other countries can
produce goods at higher or lower costs, because of different technologies and different resources.
Suppose Home can produce more cars relatively cheaper and has more capital / worker available
to produce cars. As a result, the price of cars in Home are relatively low compared to Foreigns
prices. When it opens to trade, other countries will demand cars, which increases the price of
cars. The relative price of cars (PC/PF) has increased.
Labor abundant produces labor intensive good -> after trade relative price will increase in
it. Owners of the other resource are hurt by it.
Gains from trade
With trade, the budget constraint looks like:
PC x DC + PF x DF = PC x QC +PF x QF
(DF - QF) = (PC / PF) x (QC DC)
Imports of food = relative price in terms of cars time exports of cars.
The part of the budget constraint that lies within the blue area, is the part in which the country
is definitely better off. For other parts of the budget constraint, it is possible that the country is
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6. Those hurt by trade are often better organized than those who gain, causing trade
restrictions to be adopted that are far from optimal.
Relative goods prices affect relative factor prices. Relative factor prices affect input choices.
Relative goods prices affect input choices.
If PC/PF increases, some firms switch from producing food to producing cars. Food production is
capital-intensive and cars production is labor-intensive. There will be excess supply of capital and
excess demand of labor, therefore w/r will increase. In both sectors, firms use relatively less
labor and more capital than before.
Heckscher-Ohlin theorem: An economy is predicted to export goods that are intensive in its
abundant factors of production and import goods that are intensive in its scarce factors of
production.
The Heckscher-Ohlin model also predicts:
3. Factor price equalization: opening up to trade causes relative goods prices to converge in the
two countries.
Perfect competition in both sectors implies that goods prices equal production costs.
Given identical technologies production costs are the same in both countries.
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Increase in wages of skilled people more than that of unskilled people. This is contrary to
what is predicted by the Heckscher-Ohlin model.
Firms will hire more skilled workers relative to unskilled workers.
Overall there is no conclusive evidence for neither the Heckscher-Ohlin model nor skills-biased
technological change.
Overall: The evidence to support the predictions made by the Heckscher-Ohlin model is weak.
However, it can explain trade patterns between high income countries and low/middle income
countries. The main explanation for this is that the Heckscher-Ohlin model does consider
technological differences between countries.
Summary
When countries do not trade:
Their differences in relative factor abundance, result in different relative goods
prices. Relative price of the good using a countrys abundant factor intensively is
lower.
When countries start trading:
Relative prices converge, this has important consequences:
Each country exports the good that uses its abundant factor intensively
Goods price equalization results in factor price equalization across countries
Overall, each country is better off with trade as it expands consumption possibilities
But, specific groups gain while other lose:
Owners of a countrys abundant factor gain
Owners of a countrys scarce factor lose
Winners could compensate losers while still being better off ( in theory)
Empirical evidence supporting HO-model is weak
Main reason for this appears to be that, by focusing only on
differences in resource endowments as a cause of trade it
abstracts from differences in technology (Ricardo)
In the real world:
trade happens BOTH because of differences in resources and differences in
technology
2.
3.
4.
5.
Equilibrium
relative price
If there is no trade, relative prices will adjust and will form an equilibrium where RD is tangent to
the PPF.
If there is trade:
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An import tariff by the domestic country can increase domestic welfare at the expense of
the foreign country.
An export subsidy by the domestic country reduces domestic welfare to the benefit of the
foreign country.
Caveats
1. If the country is really small, these effects will also be really small.
2. Tariffs and subsidies do not only change terms of trade, they also distort domestic
production and consumption incentives. This typically lowers welfare.
The overall welfare effect of an import tariff or export subsidy is a combination of this direct
effect and the terms of trade effect:
An export subsidy unambiguously lowers domestic welfare!
An import tariff raises domestic welfare if the terms of trade effect dominates the direct
distortion effect.
The findings that a tariff/subsidy has a different effect for the country which imposes them and
the other country, is based on the assumption that the world consists of two countries. This is not
the case in reality!
Export subsidies on a good decrease the relative world price of that good.
Import tariffs on a good decrease the relative world price of that good.
Export subsidies by foreign countries on goods that
A country imports reduce the price of its imports and increase its terms of trade +
welfare.
A country also exports reduce the price of its exports and decrease its terms of trade +
welfare.
Import tariffs by foreign countries on goods that
A country exports reduce the price of its exports and decrease its terms of trade +
welfare.
A country also imports reduce the price of its imports and increase its terms of trade +
welfare.
Summary
1. The Standard Trade Model captures some essential ideas of the Ricardian, the Specific
Factors, and the Heckscher-Ohlin model.
2. Countries trade because of differences in production possibilities
- When countries do not trade these differences result in different relative goods
prices.
- When they open up to trade, these differences in relative goods price mean that
countries have an incentive to actually start trading.
3. To analyze important issues in international economics, not necessary to specify where
these differences exactly come from.
4. Important effect of trade: it changes relative prices.
5. The terms of trade of a country refers to the price of goods the country exports relative to
the price of goods it imports.
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6. Export-biased growth reduces a countrys terms of trade, reducing its welfare and
increasing the welfare of foreign countries.
6. Import-biased growth increases a countrys terms of trade, increasing its welfare and
decreasing the welfare of foreign countries.
7. When a country imposes an import tariff, its terms of trade increase and its welfare may
increase.
8. When a country imposes an export subsidy, its terms of trade decrease and its welfare
decreases.
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An industry with external economies of scale usually consists of many small firms and is
characterized by perfect competition.
An industry with internal economies of scale usually consists of a few large firms and is
characterized by monopoly or oligopoly.
External economies of scale provide an explanation for specialization patterns in various
countries: Concentrating production of an industry in one or a few locations can reduce the
industrys costs, even if the individual firms in the industry remain small.
Reasons why external economies of scale occur
1. Specialized equipment or services (suppliers) may be only supplied by other firms if
the industry is large and concentrated.
2. Labor pooling: Concentrating production of an industry in one or a few locations can
reduce the industrys costs, even if the individual firms in the industry remain small.
3. Knowledge spillovers: workers from different firms can more easily share ideas that
benefit each firm when a large and concentrated industry exists. Also, easier to learn from
nearby concentration of competitors.
Without specifying the drivers of external economies of scale: The larger the industry, the lower
the average costs. Since under perfect competition prices reflect production costs: The larger the
industry, the lower the prices.
The form of the supply curve changes! It is not upward-sloping, but forward-falling. Because
there are always new firms willing to enter the market, offering lower prices.
Without trade: Each country will produce they quantity it demands.
With trade: The country that has the lowest average cost will end up producing everything.
Since the average costs fall, since one country needs to supply for world demand, world prices
fall because of trade!
However, some trade patterns are a result of differences in initial prices. If a country starts
producing first, it will reach a lower AC than a start-up in another country, even though in
the long run the AC of the other country will be lower.
- Historical events
- Chance.
Because of this, a country may have external economies of scale, and will end up producing more
than the other country, because it has an advantage.
Implications
1. The wrong location may end up producing it.
2. Lock-in may prevent more efficient producers from emerging. It is more efficient to
produce in the country with the lowest AC, but because of history or chance, the other
country has an advantage and will produce everything, even though this is not the most
efficient choice.
There is no guarantee that the right country will produce goods that are subject to external
economies of scale.
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3. Economies of scale can be internal (depending on the size of the firm) or external
(depending on the size of the industry).
4. Economies of scale can lead to a breakdown of perfect competition, unless they take the
form of external economies, which occur at the level of the industry instead of the firm.
5. External economies give an important role to history and accident in determining the
pattern of international trade.
- When external economies are important, a country starting with a large advantage
may retain that advantage even if another country could potentially produce the
same goods more cheaply.
6. When external economies are important: the free trade price can fall below the price
before trade in both countries
7. When external economies are important, countries can conceivably lose from trade.
8. Within countries: economies of scale typically even more important to determine
interregional pattern of trade and clustering of tradable goods production.
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27
Small country: Always a negative welfare effect, since there are no Terms of trade gains, but
only an efficiency loss.
Large country: Possible positive welfare effect if the Terms of Trade effect > efficiency loss.
2 Export subsidy
Specific
Ad valorem
In equilibrium firm should be indifferent between exporting and supplying the domestic market:
PS = P*S + s <=>
PS - s = P*S
An export subsidy raises the price of the good in the domestic market.
More focus on export
Less domestic supply Price increases
CS decreases
PS increases
Government revenue decreases by sQS
If a country is large enough: changes in domestic demand (decrease) and domestic supply
(decrease) will also affect world markets. Relative price will go down: Terms of trade
deteriorates.
Overall effect on welfare = CS + PS + government revenue
= efficiency loss + Terms of trade loss (this is a welfare gain for Foreign).
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3 Import quota
An import quota is a restriction on the quantity of goods that may be imported.
A binding import quota will increases prices of imports (quantity demanded exceeds quantity
supplied at home and abroad).
As a result of an import quota:
Producers benefit
Consumers lose
Government revenue does not change, because there is not import tariff.
Quota license holders get revenue (quota rents) from selling imports at high prices. If the
government is a quota license holder, the quota rents increase government revenue.
A voluntary export restraint (VER) is like an import quota, except it is requested by importing
country, often in return for relaxation of other trade policy. The profits or rents from this policy
are earned by foreign producers. There is a welfare loss for the importing country.
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A local content requirement (LCR) is a regulation that requires a specified fraction of a final
good to be produced domestically.
It may be specified in value terms: a minimum share of the value added must represent
value added in home.
Or in physical units.
For domestic producers or intermediates, it protects them in the same way an import quota would.
For firms using intermediates, it does not limit imports, but allows them to import more if they
also produced more Home parts.
However, it does raise the price of intermediates.
A LCR does not provide government revenue nor quota rents and its hard to enforce.
Export credit subsidies
- A subsidized loan to exporters
- U.S. Export-Import Bank subsidizes loans to U.S. exporters
= same effect as export subsidy
Government procurement
- Government agencies are obligated to purchase from home suppliers, even when they
charge higher prices (or have inferior quality) compared to foreign suppliers
= LCR only for government purchases
Bureaucratic regulations
- Safety, health, quality, or customs regulations can act as a form of protection and trade
restriction.
= same effect as import quota
Summary
1. Tariffs drive a wedge between foreign and domestic prices,
- In the small country case, a tariff is fully reflected in domestic prices.
- In the large country case, world price falls and domestic price rises by less than the
tariff.
2. The costs and benefits of a tariff or other trade policy instruments can be looked at using
the concepts of consumer and producer surplus.
- Domestic producers gain
- Domestic consumers lose
- The government collects tariff revenue (or not)
3. The overall welfare effect of a tariff, quota, or export subsidy can be measured by
- efficiency loss from consumption and production distortions
- terms of trade gain or loss (if country is large)
4. With import quotas, voluntary export restraints, and local content requirements, the
government of the importing country typically receives no revenue.
5. With voluntary export restraints and import quotas, foreigners typically gain by getting
quota rents.
Lecture 10 Trade policy in practice (no) free trade? (Ch. 10, 11, 12)
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If countries benefit from trade, why do we observe active trade policies and protests against free
trade?
1. Politics:
- Groups that lose from trade, actively lobby to protect their interests.
- Countries retaliate against other countries trade policy.
2. Other gains/disadvantages from trade not taken into account by models:
- Infant industry argument
- Environment
- Labor standards
1 Political economy of trade policy
In democratic societies: politicians have incentives to set policies that gains them the most votes.
But they also need money to campaign for votes.
Models: Politicians care about maximizing their own political success, rather than national
welfare.
- Median voter theorem: Parties pick policies to court the median voter and attract the
most votes.
- Collective action
Assumptions:
1. Two competing politic parties
2. Only one policy
3. Objective is to get majority of votes
4. Parties live up to their promises.
Choice of policy is determined by how many voters will be pleased.
So: no quota, export subsidies, and no import tariffs!
However, trade policy does not follow this principle.
Collective action problem:
- Consumers as a group have an incentive to advocate free trade, but each individual
consumer has no incentive, because his benefit is not large enough to compensate the cost
of advocating free trade.
- Policies that impose large losses for society as a whole, but small losses on each
individual may therefore not face strong opposition.
- For individuals with large individual losses, each individual has a strong incentive to
advocate the policy he desires: tariff, subsidy, or quota. For these individuals, there is no
collective action problem.
Collective action models explain why the median voter theorem does not work for trade policy.
Trade policy in practice
To advocate popular policies, politicians need money to campaign for them. Often, these funds
come from interest groups who do not have a collective action problem, but do have special
interest in a particular policy. Trade restrictions may stay intact, if consumers do not care too
much about them, and the interest groups strongly advocate them.
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Trade policies do not only have domestic consequences, but it also affects other countries, who
can retaliate against the restrictions. In an extreme case: trade wars. To prevent trade wars,
international trade agreements are very important.
Even if there is only a threat of restrictions being imposed:
- All countries could enact trade restrictions, even if it is in the interest of all countries to
have free trade
- To avoid this, countries need an agreement that prevents a trade war or eliminates
the existing protection.
Without coordination, countries will choose protectionism, although the best for everyone is free
trade. This explains why international negotiation are very important:
- World Trade Organization
- Bilateral agreements
- Regional Trade Agreements
Free trade, or not?
Models say: trade makes a country as a whole better off, restrictions decrease welfare.
Ricardian, Specific Factors, Heckscher-Ohlin models:
- Free trade expands consumption possibilities, restrictions decrease welfare.
- Losers can always be compensated, since countries as a whole gains from trade.
Increasing returns to scale: Restrictions:
- Limit gains from external economies of scale
- Reduce international competition
- Reduce learning (trade contains knowledge).
Make trade, not war! Trading countries are less likely to go to war.
Political arguments:
- If theres no free trade, policies will be manipulated by political groups welfare
decreases.
- Rent seeking: people spend time and other resources seeking quota rights and the profit
that they will earn, instead of using them for productive purposes
- Excessive policy making (bananas, cucumbers etc.)
No trade!
Theoretical argument:
A country can gain from imposing import tariffs because of a positive terms of trade effect. Only
if terms of trade effect dominates negative welfare effect and if other countries do not retaliate.
It is very doubtful that this works in practice.
Other arguments:
Domestic market failures
- High underemployment: restrictions on labor mobility, or on wages.
- Private firms can fully profit from technological benefits: lack of innovation.
- Badly functioning capital markets: less firm investment and growth.
- Environmental cost for society because of production, but firms do not fully pay for it: too
much pollution.
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In principle, its always the best option to tackle these failure directly, not through trade
restrictions. But sometimes, its hard to directly solve problems.
Suppose that externalities from production are not taken into account by private firms and
investors. With this market failure, marginal social benefit is not accurately calculated by the
producer surplus. Efficiency loss calculations are thus misleading. When a tariff increases
domestic production, the benefit to domestic society can increase by increasing the positive sideeffects of domestic production (more knowledge spillovers)!
This may work, but typically:
- Unclear when a market failure exists and its severity.
- Addressing of market failures by government may be influenced by lobbyists.
- Distortion of incentives to produce or consume may have unintended effects, that
deteriorate the situation.
Infant industry arguments
Only by first protecting own industries, will they ever be able to compete on world-markets.
Import-substitution policies were popular for developing countries in the 80s.
Encourage domestic industries, by protecting them from competing imports
- Extremely high tariffs (even prohibitively high)
- Import quotas
- Local content requirements.
However, countries adopting import-substitution policies grew slower than countries that didnt
adopt these policies.
The infant industry argument was not valid in practice:
- New industries did not become competitive
- Import-substitution industrialization involved costs and promoted wasteful use of
resources:
- It involved complex, time-consuming regulations.
- It set high tariff rates for consumers, including firms that needed to buy imported
inputs for their products.
- It promoted inefficiently small industries.
As a result, and because of the rapid growth of East-Asian countries, that did not adopt these
policies, many developing countries started to liberalize trade.
It is difficult to say, but the evidence points out that increasing exports of developing countries
led to growth.
Anti-globalization
Low wages and poor working conditions in developing countries. Situation is worse than in
developed counties. That is true, but would the country benefit if there was no trade?
On average, workers in developing countries are better off. And anti-globalization movement is
absent in developing countries. On the contrary, people advocate free trade. Furthermore,
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developing countries are against labor standards, because they are afraid it will be used as a
protectionism argument by rich countries. Poor conditions are set by the countries itself, not by
trade. However, a change in working conditions is desirable. Improving conditions in exporting
sectors will have a small effect, since most people dont work in exporting sectors, but it can set
an example.
Environmental standards are often opposed to by developing countries, afraid of standards
being used as a protectionism measurement, and afraid for their own development. But the
pollution haven effect is an issue. The solution is to promote sustainable development (this does
not depend on trade). Pollution haven - when economic activity becomes concentrated in one
region because of less strict regulations.
Culture arguments
Trade westernizes other cultures
This argument forgets that:
People, also in developing countries, make their own choices.
People do not have to consume foreign products, if they do, they typically like them.
They define their culture through the choices that they make, not through standards set
by others.
To trade or not to trade?
Overall, gains from trade depend on how you value all its pros and cons
Difficult to put a number on this, but evidence much (much) more towards trade being a good
thing
Just two final thoughts: If trade is really that bad,
1. Why do we see it happening everywhere?
2. Why dont we restrict trade between Rotterdam and Groningen, between New York and
San Francisco, or between Peking and Shanghai?
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Monopolist: MR = MC
Profits: (P AC) x Q
Trade liberalization = increase in market size. Demand curve and MR-curve shift outwards.
Monopolist realizes higher profits (incentive to export).
Assumption: no foreign monopolist exists and trade is costless.
Monopolistic competition: more common than pure monopoly.
Assumptions:
1. Single firms differentiate their varieties from their competitors.
2. When setting price, each firm takes prices of competitors as given.
Additionally:
1. Single firm sells more if aggregate demand for class of product increases and if price of
rivals increases.
2. Single firm sells less if number of competitors increases and if own price increases.
_
Demand function: q = S [1/n b(P P)]
q: a single firms sales
S: total sales of industry
n: number of firms in industry
b: parameter that indicates price sensitivity of sales
P: price charged by firm itself
Pbar: average price in industry
Additional assumption: All firms are symmetric: they have the same demand function, same cost
structure. Therefore, they have the same price.
P = Pbar
q = S/n
Single firm: AC = F/q + c = n x F/S + c
If n increases: AC increases
If S increases: AC decreases
Autarky equilibrium: MR = MC P = c + 1/bn
Assumption: Entry is free, entry occurs until its not profitable anymore.
Equilibrium: p = AC
P = c + 1/bn = nF/s + c = AC
n* = sqrt(S/bF)
Trade increases size AC decreases (market size increases S increases, AC = nF/S + c).
If AC decreases: P decreases, n increases.
Consumers gain since P decreases and n increases (lower prices, more varieties increases
utility).
Trade liberalization (integrating markets) has the same impact on P and n as economic growth in
a closed economy.
Undetermined: share of firms in Home and share of firms in Foreign.
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However, only a small share of firms is active on foreign markets. Because of (fixed) export costs
(administrative costs, costs of setting up a production plant abroad). However, the exporting firms
are usually huge.
Fixed export costs
Difficult to estimate, also costly: time needed to export.
Importance of trade costs
They explain why only a subset of firms export.
They explain why exporters are larger and more efficient than non-exporters.
-
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With price dumping: there is a kink in the MR-curve, where it turns in to a horizontal line, at the
point where the domestic MR-curve equals the foreign price. A firm can only attain this kinked
MR-curve if it limits domestic sales to the amount domestic sales, dumping.
From an economic point of view dumping may be good for domestic consumers, since they now
face a lower price.
Claim: anti-dumping tariff is only used as protection of domestic market.
Foreign Direct Investment (FDI): Investment in which a domestic firm controls or owns a
subsidiary abroad. (Only if +10% of voting shares).
Multinational: firm with a FDI.
Greenfield FDI: Company builds a foreign production plant from scratch.
Brownfield FDI: (Mergers & Acquisitions), domestic company buys at least 10% of voting
shares of foreign company.
Greenfield FDI is more stable; mergers and acquisitions occur in surges.
Horizontal FDI: Foreign affiliate replicates production processes of parent company.
Vertical FDI: Buyer-seller relationship between foreign affiliate and parent company; typically:
foreign affiliate produces intermediate goods for parent company.
Horizontal FDI dominates FDI-flows between developed countries. Main reason: locate
production close to large markets to avoid transport costs or tariffs (tariff-jumping FDI).
Vertical FDI dominates FDI-flows between developed and developing countries. This is driven
by production cost differences between countries (Heckscher-Ohlin argument). However, a recent
39
trend is reshoring foreign production back to the home country (because of poor institutional
environment).
Horizontal FDI and proximity-concentration trade-off: (leads to producing good in multiple
facilities)
High export costs incentive to locate production near customers.
IRS in production incentive to locate production in fewer locations.
FDI activity is concentrated in sectors with high trade costs. Multinationals are usually larger and
more efficient than other firms in the industry (including other exporters).
Additional trade-off:
Horizontal FDI: trade-off between per unit export cost t and fixed cost F for setting up a
production plant abroad.
IF t(Q) > F, the firm has an incentive to engage in horizontal FDI (likely when foreign
sales are large).
Vertical FDI
Trade-off between cost savings due to lower factor prices abroad and fixed cost of setting up a
production plant abroad.
Why not outsourcing or offshoring?
Internalization decision: whether to keep production in-house (vertical FDI) or to outsource it.
Vertical FDI instead of outsourcing:
1. Technology transfer: transfer of knowledge is easier within a company than through
market transactions with separate firms. Patents or property rights may be weak,
knowledge is not easily transferable.
2. Vertical FDI: different stages of production processes in-house. Avoiding hold-up.
However, possible economies of scale when outsourcing).
When do multinationals arise? (OLI)
Ownership advantages: beneficial for domestic firms to own foreign plant due to
patents or trademarks.
Location advantages: low input prices, high transport costs or tariffs.
Internalization advantages: cost-saving to undertake foreign production within the firm.
Zipfs Law: There is a statistical relationship between the size of a city and the geographical
concentration of economic activity. However, there appears to be no theoretical explanation of
this law.
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Current account
1. Merchandise
2. Services
3. Income receipts
The world as a whole always has a current account surplus or deficit, even though in theory it
should be equal to zero.
Capital account: records special transfers of assets; usually of minor importance.
Financial account: difference between sales of domestic assets to foreigners and purchases of
foreign assets by domestic citizens.
Financial inflow: foreigners loan to domestic citizens by buying domestic assets; sale of these
assets is a credit (+): domestic economy acquires money.
Financial outflow: domestic citizens loan to foreigners by buying foreign assets; purchase of
these assets is a debit (-): domestic economy gives up money.
We care about national income, GDP, and GNP because they are a way to rank countries.
However, a better measurement is the Human Development Index: 1/3 life expectancy, 1/3
literacy rate, and 1/3 GDP per capita.
No risk of unexpected inflation: borrowers gain from unexpected inflation, lenders lose overall
no impact on money demand.
Md = P x L(R, Y)
P: price level
Y: real income
R: interest rate on non-monetary assets
L(R, Y): aggregate real money demand
- +
Md/P = L(R, Y)
Interest rates adjust so that money demand equals money supply.
Ms = Md
Ms/P = L(R, Y)
Money supply and the exchange rate in the short run
US: Home country, EU: foreign country
E$/ depends on the return on dollar deposits and the expected return on euro deposits.
E$/ increases: depreciation of the dollar. (you need more dollars to get euros)
Return on deposits ($) are not influenced by E$/. However, return on deposits () decrease when
E$/ increases. Since changes in future E$/ are not related to changes in current E$/, a current
depreciation of the dollar decreases the return on assets (), since the investor has to pay more
now.
2. Demand for assets () decrease (lower return), demand for assets ($) increases.
3. EU investors supply $ and demand .
4. E$/ decreases: appreciation of the dollar.
Short run: Final goods prices and factor prices are fixed due to menu costs.
Long run: Final goods prices and factors prices are flexible.
Factor prices adjust to clear factor markets.
Real output and income level only depends on a countrys factor endowments and
technologies.
Real output and income level are independent of money supply.
Interest rate is independent of money supply.
Price level adjusts so that real money supply stays constant.
LM-curve: all combinations of R and Y. Only instrument of central bank is money supply, not
interest rates.
1. An increase in money supply shifts LM-curve to the right interest rate decreases to
reestablish equilibrium on money market domestic demand for investment goods
increases aggregate demand AD increases for a given price level short-run
equilibrium.
2. Since increase in money supply is permanent firms adjust their prices price level
increases. This shifts back the LM-curve to its initial position. R, Y and Ms/P are
unchanged long-run equilibrium. (Though price is increased)
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Positive (longrun) relationship between money supply and price level especially important for
countries with no simultaneous changes in L!
Economic mechanisms
If Ms increases:
Interest rate R decreases
Lower interest rates imply higher demand for investment goods.
Aggregate demand increases.
Uncertainty of firms: increase in MS temporary or permanent? Firms keep prices fixed
(menu costs) and just increase production (workers work harder and longer).
However, if workers demand wage compensation:
Wages increase
Production costs increase
Prices increase
Real money supply Ms/P decreases
Interest rate R increases
Smaller domestic demand for investment goods.
An increase in the price level exactly compensates the increase in money supply!
Open economy
1. Increase in US money supply decreases R$.
2. Since we now consider the long run, expectations are also important. Investors expect
inflation for the future. Expected euro return-curve shifts right.
3. Demand for assets ($) decreases, demand for assets () increases. Supply of $ and demand
for increases, E$/ increases: depreciation of the dollar.
4. US price level increases in the long run, real money supply in the US decrease, returns on
assets ($) increase.
5. Demand for assets ($) increases, demand for assets () decreases. Supply of and demand
for $ increases, E$/ decreases: appreciation of the dollar.
Notice: new exchange rate is still above initial exchange rate, because the expected euro returncurve shifted to the right.
Exchange rate overshooting (Dornbusch)
Initially a large devaluation/depreciation of the currency, later a slight appreciation of the
currency.
Crucial for exchange rate overshooting: sticky prices, i.e. change in nominal money supply has a
shortterm effect on real money supply!
Lecture 15 Price levels and the exchange rate in the long run (1) (Ch.16)
Long-run approach: prices are completely flexible, and goods and money markets are in
equilibrium; changing prices influence interest rate and exchange rate in the long-run.
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Law of One Price (LOP): If free trade is costless and if competition is perfect, the same good is
sold at the same price in all trading countries. Hardly holds in reality.
Reasons for violation of LOP:
Different taxes across countries.
Transportation costs and different production costs under multinational activity.
Transportation costs and different forms of competition.
Purchasing Power Parity (PPP): Application of LOP for all goods and services (or a
representative basket of goods and services) across countries.
PNL = PCH x E/CHF (how many e it costs to get 1 frank)
PNL = Aggregate/average price level in the Netherlands
PCH = Aggregate/average price level in Switzerland
-
Absolute PPP: Holds if exchange rates equal level of average prices across countries:
E/CHF = PNL/PCH
Relative PPP: Holds if the change in exchange rates equals the change in relative prices.
PNL/P PCH/PCH = E/CHF / E/CHF
NL, t CH, t = (E/CHF, t - E/CHF, t-1) / E/CHF, t-1 with t = inflation rate from t-1 to t.
If absolute PPP holds, relative PPP holds as well. NOT vice versa!
implies
Absolute LOP for individual goods absolute PPP
implies
implies
Relative LOP for individual goods relative PPP
Monetary approach to exchange rates
Long run: prices are flexible prices always adjust so that absolute PPP holds.
PEU = MsEU / L(REU, YEU)
PUS = MsUS / L(RUS, YUS)
If absolute PPP holds, the equilibrium exchange rate is determined by Ms, R, and Y of both
countries.
PEU / PUS = E/S
Ms increases:
Proportional increase in PEU.
Proportional depreciation of relative to $, since PPP holds.
Comparable prediction as previous long-run model without PPP.
REU increases:
L(REU, YEU) decreases
PEU increase to maintain equilibrium on European money market.
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YEU increases:
L(REU, YEU) increases
PEU decreases to maintain equilibrium on money market.
Proportional appreciation of relative to $, since PPP holds.
Causal relationships:
Exogenous change (Ms, R, Y):
Prices adjust to maintain equilibrium on money market.
This leads to an adjustment of the exchange rate, since PPP holds.
Fisher effect
Relationship between nominal interest rates and inflation.
Interest parity condition: REU RUS = (Ee/$ - E/$) / E/$ <- Fisher equation
When the equation holds, there is no incentive for investors to relocate their investments, if they
expect the higher interested to be outweighed by a depreciation of the currency.
If relative PPP holds, changes in relative aggregate prices equal relative change in exchange rates.
REU RUS =eEU, t eUS, t
Fisher effect: An increase in the expected domestic inflation rate ceteris paribus leads to an equal
increase in the interest rate on domestic assets.
An increase in RUS decreases real money demand: PUS has to increase for an equilibrium on the
US money market. Due to PPP, the increase in the PUS leads to a depreciation of $.
Reasons for failure of PPP
Trade barriers and non-traded goods:
Transportation costs and trade restrictions imply that some goods are not traded.
Services are often non-tradable.
Even if good is traded, due to transportation costs: prices differ between countries.
Imperfect competition:
Pricing to market: same good is sold at different prices in different markets, depending
on market structure.
Lecture 16 Price levels and exchange rates in the long run (2) (Ch.16)
Real exchange rate approach: Composition of basket of goods is allowed to differ between
countries; households also demand non-tradable goods, goods which are uniquely supplied to one
country.
Real exchange rate: Rate of exchange for goods and services across countries. Relative price of
goods and services across countries.
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only partially influenced by changes in relative demand. Still, real exchange rate
decreases, since the price level in US relative to the price level in EU increases.
The effect of an increase in relative demand for domestic goods has an ambiguous effect
on the nominal exchange rate.
4. Increase in relative supply of domestic (US) products. (1) Price level in US decreases and
(2) income in US increases. (1) Has a negative effect on the nominal exchange rate, since
EU demand for tradable US goods increases. (2) Has a positive or negative effect on the
nominal exchange rate, since US demand for tradable EU goods increases PEU
increases. Real exchange rate increases a real depreciation of the dollar, US goods
become relatively cheaper.
Crucial for real exchange rate approach: Real changes (demand/output) do not translate 1:1 into
foreign exchange market since part of the goods is non-traded.
Summary
Determinants of nominal exchange rate:
Changes in monetary factors: no changes of real exchange rate.
Changes in relative demand/supply for/of domestic goods:
Changes of the real exchange rate
Increase in RD for domestic goods decrease real exchange rate, nominal exchange
rate changes as well.
Increase in RS of domestic goods: ambiguous effect on nominal exchange rate.
Monetary factors do not change the real value of goods, only the nominal exchange rate.
Real factors change the real value of goods, also the real exchange rate.
Interest rate differences
Fisher effect is too simplistic, since relative PPP does not hold.
q$/ = E$/ x PEU / PUS
(qe$/ - q$/) / q$/ = (Ee$/ - E$/) / E$/ - (eUS eEU)
Expected change in real exchange rate = expected change in nominal exchange rate + expected
inflation.
Combining with interest parity condition (RUS REU = (Ee$/ - E$/) / E$/
RUS REU = (qe$/ - q$/) / q$/ + (eUS eEU)
Nominal interest rate differences = real depreciation of domestic currency + expected inflation
rate differences between countries.
Differences in real interest rates
re R e
r: real interest rate
R: nominal interest rate
e: expected inflation rate
Correct expression: (1+R) / (1+) = 1+r (1+R) / (1+) - 1 = r
For derivation: see slides.
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50
Due to international capital mobility, interest parity condition must hold: RUS REU = (Ee$/ - E$/) /
E$/
Money market equilibrium: M/P = L(R, Y)
Short-run equilibrium on money market
Increase in real income Y
1. Real money demand increases (MD-curve shifts downwards)
2. Interest rate R increases
3. Nominal exchange rate E decreases (interest parity condition).
Negative relationship between Y and E in order to keep domestic money market and foreign
exchange market in equilibrium.
AA-curve: all combinations of output and nominal exchange rate.
Increase in money supply
1. R decreases
2. Depreciation of domestic currency (E increases)
3. AA-curve shifts upwards.
Increase in price level
1. Real money supply decreases
2. R increases for equilibrium on money market
3. Appreciation of domestic currency (E decreases)
4. AA-curve shifts downwards.
Decrease in preference for liquidity
1. Real money demand decreases
2. R decreases
3. Depreciation of domestic currency (E increases)
4. AA-curve shifts upwards.
Increase in R*
1. Demand for foreign assets increases
2. Demand for foreign currency increases
3. Depreciation of domestic currency (E increases)
4. AA-curve shifts upwards.
Increase in Ee
1. Investors expect domestic currency to depreciate in the future
2. Demand for foreign deposits increases
3. Depreciation of domestic currency (E increases)
4. AA-curve shifts upwards.
Equilibrium values for nominal exchange rate and aggregate supply imply:
Equilibrium on goods market (YS = YD)
Equilibrium on money market (M/P = L(R, Y))
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Simultaneous equilibrium on goods market and money market (DD-curve and AA-curve
combined)
Above DD-curve: excess demand since nominal exchange rate is too high.
Above AA-curve: either (1) nominal exchange rate too high for equilibrium on foreign exchange
market, or (2) Y too high for equilibrium on money market.
Adjustment of nominal exchange rate: equilibrium on foreign exchange market and money
market, but there is still excess demand for domestic goods.
Appreciation of domestic currency and increase in output: demand for domestic goods decreases
and supply of domestic goods increases until equilibrium is realized.
Foreign exchange market: The increase in nominal interest rate R increases demand for domestic
deposits and currency domestic currency appreciates (E decreases).
Move on the AA-curve to the right/downwards (No shift on AA-curve since negative
relationship between E and Y is already represented by the negative slope of the AA-curve).
A decrease in taxes T, which increases consumption, has the same qualitative effect.
Policies to maintain full employment
Assumption: There is initially no involuntary unemployment and output is at its natural level.
There may be unemployment, but that is completely voluntary.
Exogenous shock: temporary shift of world preferences against domestic goods.
1. Decrease in demand for domestic goods DD-curve shifts to the left.
Potential stabilization policies:
2. Increase in money supply: domestic currency depreciates and income Y increases.
3. Increase in government spending: leads to initial equilibrium
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In the long run, output returns to its initial level (only determined by factor endowments and
technology, nominal changes do not affect real output).
Permanent increase in G (or permanent decrease in T)
Increase in public demand Y increases
Money market: Real money demand increases interest rate increases appreciation of
domestic currency (E decreases, move on AA-curve) and expected further appreciation of
domestic currency (Ee decreases, since increase in G is permanent, AA-curve shifts downwards).
Net effect on Y: No changes, since output is only determined by factor endowments and
technology. The positive and negative effect on Y compensate each other.
Increase in public demand decreases private demand for domestic goods!
Current account
A large current account deficit is not desirable, since future generation has to save more.
All combination of nominal exchange rate E and income Y which lead to the desired level of the
current account:
+
CA (E x P*/P, Y T) = X
Positive effect of E x P*/P: higher foreign price leads to more foreign demand for domestic
goods: more exports CA increases
Negative effect of Y T: More demand more imports CA decreases
XX-curve: All combinations of E and Y that lead to the desired level of the current account.
The slope of the XX-curve is flatter than the slope of the DD-curve.
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E is constant, but the real exchange rate decreases: q$/ = E$/ x PEU/PUS
Depreciation/appreciation: value of currency changes due to market forces. This happens under
flexible exchange rates.
Devaluation/revaluation: value of currency changes due to central bank intervention on the
foreign exchange market. This happens under fixed exchange rates.
Devaluation: Higher fixed E
Revaluation: Lower fixed E
Currency devaluation
1. E increase and Ms increases
2. Increase in E increases demand for domestic goods: output Y increases.
3. Increase in money demand without increase in money supply.
4. R increases E decrease
However, increase in money supply decreases R and leaves R* unchanged: R decreases E
increases to a higher level.
Financial crises and capital flight
Demand for domestic currency decreases central bank constantly buys domestic currency in
exchange for foreign currency to fix the exchange rate. When reserves are used up, the domestic
currency devaluates. Investors may expect further devaluation: investors sell domestic assets
and buy foreign assets demand for domestic currency decreases this accelerates the
decrease of foreign exchange reserves of the central bank domestic currency devaluates.
Capital flight: Financial capital moves out of the country Investments and demand for
domestic goods decreases.
A higher domestic R is needed:
1. Central bank reduced domestic money supply further
2. Higher interest rate reduces demand for domestic goods domestic output and
employment decrease.
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Expectations of foreign investors decrease demand for domestic assets and crucially contribute to
financial crises.
Investors expectations are influenced by:
1. Expectations about the central banks foreign currency reserves.
2. Expectations about development of demand for domestic goods (Decrease in Yd
increase in E).
Speculative attack: speculators expect that central banks foreign currency reserves are scarce.
Speculators exchange domestic currency into foreign currency at favorable exchange rate.
When central banks reserves are used up, domestic currency is devalued.
Investors change foreign currency back into domestic currency, again at a favorable
exchange rate.
Real wealth increases if prices are fixed in the short run.
Currency crisis
Investors lose confidence in an economy:
Investors sell domestic assets
Excess supply and devaluation of domestic currency
With a fixed exchange rate regime, monetary policy is not independent anymore, monetary policy
cannot be used to keep interest rates low or to fight inflation. R R* = (Ee E) / E, there is a
direct relationship between interest rates and exchange rate. Policies which influence domestic
money market (change in R) influence foreign exchange market, i.e. monetary policy is not
independent with fixed E.
Imperfect asset substitutability
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Bonds which are denominated in different currencies imply different risk levels (higher risk
investors demand a higher return).
Types of risk
1. Default risk, the risk that the loan will not be paid back and investors lose their money.
2. Exchange rate risk, a depreciation of a currency lowers (expected) returns from
investments into that currency.
Adjusted interest parity condition: R R* = (Ee - E) / E +
: risk premium for investing in domestic assets (increase in increases R).
An increase in shifts interest parity condition to the right depreciation of domestic currency
due to lower demand for domestic assets.
Alternatively, central bank changes money supply and adjusts to keep E constant
Ms increases R decreases E increases
Central bank simultaneously decreases risk of investing in domestic assets () interest parity
condition curve shifts to the left E decreases.
Net effect: E remains constant, since there is a fixed exchange rate.
How can the central bank or government influence the risk premium ?
depends on investment alternatives, differences between:
Returns on regular stocks and on government bonds
Returns on government bonds of different countries.
Risk premium of regular stocks: securing trade credits, expropriation, war.
Risk premium on government bonds: reducing government debt, controlling exchange rate.
Domestic equilibrium
+ - ++ +
Y = Y(C, T, I, G, E)
Y-axis: E
X-axis: G, T
Downward-sloping line that reflects domestic equilibrium.
Above curve: higher inflation / overemployment.
Below curve: unemployment.
Negative slope, because a decrease in E (less private demand for domestic goods) has to be
compensated by increase in G to keep employment/inflation constant.
External equilibrium
+ - +
CA = CA(G, T, E)
Y-axis: E
X-axis: G, T
Upward-sloping line that reflects external equilibrium.
Above curve: CA surplus
Below curve: CA deficit.
Positive slope, because increase in E (more private demand for domestic goods) has to be
compensated by increase in G (Y, which increases private demand for foreign goods) to keep
trade balanced.
G0 / E0 leads to internal and external equilibrium.
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However, there are also problems with flexible exchange rate into which direction should the
government start.
An economy can only achieve both equilibria if the government first realizes domestic
equilibrium and then external equilibrium. The other way around does not work.
Gold Standard (1870-1914)
(Implied) fixed exchange rate regime.
Currencies valued in terms of gold.
Reality: exchange rates fluctuated in narrow margins: shipping costs of gold.
Disadvantages
1. Discoveries of new gold sources: Ms increases inflation
2. Growing economies require increase in central banks gold reserves, otherwise deflation
and unemployment.
3. Countries with large gold reserves can influence worldwide inflation.
4. No monetary policy available to fight unemployment.
World wars and recession (1914-1945)
Countries printed more money to finance the war no convertibility into gold anymore.
Great Depression 1929 devaluations and capital controls in order to support domestic economy.
Consequences: aggravation of crisis, unemployment, outbreak of World War II.
Bretton Woods Era (1945-1971)
Establishment of International Monetary Fund (IMF) and World Bank
New system of international economic order:
Free trade
No beggar-thy-neighbor policies
Stable international monetary system to encourage free trade.
US dollar as international reserve currency (value fixed to gold price).
Other currencies pegged their currency to the USD with 1% margin, expect China
and Eastern Block.
Change of margin only with IMF-approval.
The n-1 problem
The USD was the anchor currency: all countries pegged their currency to USD.
US had complete monetary policy independence.
High inflation in the US other countries had to buy USD.
Enormous USD reserves of other countries, breakdown of Bretton Woods system.
Speculation against USD by German central bank.
Consequence: other currencies had to be revalued with approval of IMF break down of the
Bretton Woods system.
Floating exchange rates (1971-now)
Exchange rates are not freely determined by market forces.
No separate legal tender (formal dollarization or euroization).
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1. Inflation: less than 1.5 percentage points higher than average of three lowest
inflation rates among EU member states.
2. Interest rate: less than 2 percentage points higher than long-term interest rate in
average of three low-inflation countries.
3. EMS membership: no devaluation in the two years before entry into EMU.
4. Budget deficit: (new debt) less than 3% of GDP.
5. Public debt: (accumulated debt) less than 60% of GDP.
ESCB:
1. ECB + national central banks of EMU member states (Euro system).
2. National central banks of non-member states.
The goal is to keep inflation below 2% per year.
Theory of optimum currency areas
Advantage of monetary union in general: currency crisis can be avoided.
Suppose the following situation:
Positive demand shock in the Netherlands. Negative demand shock in France.
Demand and employment increase (decrease) in the Netherlands (France).
In a monetary union, E is fixed. Therefore, real exchange rate q has to be changed via changes in
goods prices PNL and PFR. However, the goods prices depend on wages wNL and wFR. A problem
arises, because wages are inflexible in the Netherlands and France.
1st alternative adjustment mechanism: unemployment in France, overemployment in the
Netherlands workers could migrate from France to the Netherlands. However, labor mobility
within Europe is small.
2nd alternative adjustment mechanism: transfer of additional tax revenues in the Netherlands to
France, used for unemployment benefits in France. However, only feasible is EU budget were
large and there would be a sufficient degree of solidarity.
Whether an adjustment is really necessary, depends on:
Size of shock
The less diversified the economy, the more serious the effect of the shock.
European countries are highly diversified (real) exchange rate adjustment is less necessary.
In case of symmetric shock: identical reaction by both countries only in case of homogeneous
preferences.
EMU optimum currency area, if EU had
Wage flexibility (goods prices can adjust to the shock)
Labor mobility (migration can cushion the shock)
Large budget (monetary transfers can cushion the shock)
Solidarity between countries (monetary transfers can cushion the shock)
Diversified production structure (shock less severe)
Homogeneous preferences (identical reaction to a shock).
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However, a monetary union evolves over time, so EMY can still become an optimum currency
area.
Benefits of common currency
Elimination of transaction costs
Price transparency: better arbitrage opportunities, more competition
Less uncertainty with respect to foreign prices
Less uncertainty with respect to future prices
International currency: common currency can be reserve currency of other countries.
Seigniorage gains (difference between value of money and costs of issuing money) by
central bank of currency union.
Costs of common currency
Loss of monetary policy independence for stabilizing output.
No reaction of exchange rates to changes in aggregate demand.
However, costs depend on degree of market integration.
Simple decision rule: A country should join currency area if benefits exceed costs of joining.
Most EMU countries benefit from common currency. There is at least a high degree of economic
integration:
Large intra-EU trade.
Large amount of foreign financial and direct investment.
However, there is no empirical research on benefits of Euro.
However, arguments in favor of Euro:
Euro leads to more trade (less transaction costs) and more trade leads to more growth
Appreciation of domestic currency increases price of domestic goods on world markets
less exports.
Monetary integration leads to political integration.
However:
Size of intra-EU trade hasnt increased relative to extra-EU trade.
Importance of transaction costs is unclear.
Before the introduction of the Euro, there already was a fixed exchange rate regime.
Appreciation of domestic currency makes imports cheaper and forces domestic firms to
become more productive.
Costs of having the Euro
Exchange rates not determined by market forces, fixed at level of 1.
Who pays for having artificially low/high exchange rate? Consumers (imports overly
expensive) and workers (low real wages); weak countries would benefit from flexible
exchange rates.
EU countries outside EMU have not performed worse in last decade.
Higher inflation: real value of debt in debtor countries decreases, but real wealth in
creditor countries decreases.
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