TRADE & DEVELOPMENT CAPITAL FLOWS EXCHANGE RATES PURCHASING POWER PARITY

1. TRADE & DEVELOPMENTCAPITAL FLOWSEXCHANGE RATESPURCHASING POWER PARITY Chapters 11, 12, 14,15

2. Comparative Advantage in agricultural products TRADITIONAL TRADE THEORY Is this a static analysis irrelevant for development ? YES NO Development Specialized industry If developing nations remain underdeveloped If its possible to incorporate dynamic effects to the process Changing: factor supply technology capital accumulation Shifting Comparative advantage over time

3. TRADE WAS an ENGINE of GROWTH Export from new regions USA, Australia, Argentina, etc. Rapid growth in these nations Emigration from Europa Transfer of capital and knowledge Creation of new capital This is a base for sustainable growth Great Brittan developed industry Need for import of inputs

4. CONDITIONS TODAY ARE DIFFERENT Elasticity of income to the demand of agriculture is low Synthetic products reduce demand for natural products (rubber etc.) Technological advances have reduced the need for raw materials The output of services has grown faster than output of commodities (less need for raw materials) Developed nations have imposed tariffs reducing trade from less developed countries. Overpopulated developing countries (food needed for domestic use) Developing nations have less endowments of raw materials (except petroleum) Much less international flow of capital flows to developing nations. Developing nations face an outflow of skilled labour rather than inflow.

5. The CONTRIBUTION of TRADE to DEVELOPMENT In general Trade can contribute to the use of domestic resources, otherwise not used. Expanding markets – economies of scale Transmission of new ideas Facilitate flow of capital In big nations (India ,Brasil etc.) import may stimulate efficiency Trade may frame anti monopoly Endogenous Growth Theory Absorb technology Benefits from research and development Promoting economies of scale Reduce price distortion Encouraging efficiency Introduction of new products

6. TERMS OF TRADE Income TT is more important for developing nations because the amount of trade may offset possible decrease in commodity TT Commodity TT Price Index Exp / Price Index Import Income TT (Price Index Exp / Price Index Import) x Qx Qxis the volume of export Single Factor TT (Price Index Exp / Price Index Import) x Z Z is the Nations productivity in export Increasing Z makes the nation better off

7. p EXPORT INSTABILITY AND ECONOMIC DEVELOPMENT • D • S Inelastic price + unstable D & S Leads to big price fluctuations. D : Households in developed countries consume small amounts S : Internal rigidities in resource use and weather conditions • q The causes of instability in developing countries Big price effects means big changes in income in developing nations Export instability is larger in developing countries

8. Marketing boards purchasing output of domestic producers pay lower prices than World Price in good years disburse in bad years EXPORT INSTABILITY and COMMODITY AGREEMENTS Commodity agreements (preferred by developing nations) Buffer stocks when price falls bellow an agreed minimum PURCHASE TO A STOCK when price rises above an agreed amount SELL IT Disadvantages : some commodities cannot be stored if minimum price is above world price stocks tend to grow Export Controls Regulate the quantities to export (+) avoid costs of stocks (-) Introduce inefficiencies Purchase contracts Long term multi lateral MINIMUM price that import nation agree to purchase MAXIMUM price that export nation agree to sell REASON : To stabilize export prices of individuals producers

9. IMPORT SUBTITUTION OR EXPORT ORIENTATION 1 Industrialization by import-substitution (+) - Market already exists - Easier to protect domestic markets, than to force developed nations to lower their barriers - Foreign firms can establish (-) - No incentives for domestic factories to increase efficiency - Small markets do not allow for efficient production - Costs increase when more capital intensive is needed 2 Industrialization by export-oriented measures (+) - Overcomes smallness of domestic market - Stimulates efficiency - It is not limited to the growth of domestic markets (-) - It is difficult to enter other markets - Developed nations provide a high level of own protection

10. CURRENT PROBLEMS FOR DEVELOPING COUNTRIES Poverty prevailing Unsustainable foreign debt Remaining trade protectionism of developed countries

11. CAPITAL FLOWS and MULTINATIONAL CORPORATIONS WHY Direct Foreign Investments Increase profitability Large corporations have unique production knowledge (more difficult to residents to borrow and invest) Managerial skills and possibility to retain control Horizontal Integration Control of raw material or other important input (to guarantee supply) Vertikal Integration To avoid tariffs or other restrictions Share Oligopoly profits WHY Capital Flows Higher returns is the main motive Risk may give rise to opposite movements (bankruptcy and variations) More next course

12. EXCHANGE RATES Why do we want to buy a foreign currency? (demand) - Tourists visiting another country - Domestic firms that import from abroad - Individuals/Organizations want to invest abroad Why do we want to sell a foreign currency? (supply) - Coming foreign tourists expenditures - Export earnings - From receiving investments

13. S (€) Surplus of € EQUILIBRIUM EXCHANGE 2 OBS: Flexible Exchange rate Equilibrium price 1 $/€ (dollar price of one EURO) D (€) 0.5 Shortageof € Quantity € Equilibrium Quantity Appreciation Depreciation

14. D2 S $/€ D1 Equil2 BALANCE of PAYMENTS - EQUILIBRIUM Equilibrium 1 if Demand is D1 Equil1 If demand shifts to D2 Equilibrium 2 EURO APPRECIATES Dollar depreciates BUT , if government wants to fix exchange rate to the initial level (Equil1) USA has to use reserves in EURO corresponding to surplus (red line) EMU purchases dollars and increases reserves in Europe OTHERWISE IT WILL BE CREATED A DEFICIT IN THE US BALANCE OF PAYMENTS

15. PURCHASING POWER PARITYPPP The Golden Rule to compare countries 1 THE ABSOLUTE PPP (FOR ONE COMMODITY) Equilibrium exchange rates equals the price levels in the two countries Exch Rate R = P/P* p - price level home p* - price level foreign Ex: Price X Price X R= $/€ USA EUROPE 1$ 1€ 1 0.5$ 1€ 0.5 OBS This definition disregards capital that is the most common variable in international transactions

16. PURCHASING POWER PARITYPPP The Golden Rule to compare countries 2 THE RELATIVE PPP Change in exchange rate over one period shall be proportional to the relative changein the price level of all commodities in the two nations Equilibrium exchange rates equals the price levels in the two countries R1 = R0 Ph - general price level home Pf - general price level foreign periods 0 and 1 R - Exchange Rate If price level remains the same home Ph1/Ph0 = 1 price level in foreign country increases by 10% Pf1/Pf0= 1.1 R1 = 1 / 1.1 R0 Exchange rate of 1 $ is 6 SEK IF the price level in USA is 20% lower than in Sweden Price of 1 $PPP is 6 x 1.2 = 7.2 To compare a given income in Sweden with the USA the rate PPP should be used