Economics for CED

1. Economics for CED Noémi GiszpencSpring 2004Lecture 9: Macro: International Trade June 2, 2004

2. Why trade among nations? • Why not practice self-sufficiency? • Mercantilists (17th & 18th C.): if you can export more than you import, that • creates jobs in your country and • Gives you gold reserves to pay mercenaries • Free-traders (late 18th & 19th C.): • Because trade is mutually beneficial: • Creates larger markets, which means more division of labor--more specialization--therefore more production, and higher real incomes. • David Ricardo: theory of comparative advantage Economics for CED: Lecture 9, Noémi Giszpenc

3. David Ricardo(1772-1823) Comparative advantage • Best understood using a numerical example: • 2 countries: England and Portugal • 2 goods: wine and cloth • Portugal takes fewer man-hours to produce both: • Opportunity cost of cloth in Portugal is 3 barrels wine • Opportunity cost of cloth in England is 2 barrels wine Economics for CED: Lecture 9, Noémi Giszpenc

4. England and Portugal trade • England exports cloth to Portugal: • At Portuguese prices, each roll of cloth buys 3 barrels of wine • In England a roll of cloth is worth only 2 barrels • Portugal exports wine to England: • At English prices, a barrel of wine buys half a roll of cloth • In Portugal a barrel is worth only 1/3 roll of cloth • Thus, Portuguese get cloth cheaper by producing wine to trade for cloth than by producing cloth at home • despite the fact that they can produce more cloth per unit of labor than the English can. Economics for CED: Lecture 9, Noémi Giszpenc

5. Trade with comparative advantage • Prices will probably be somewhere between two extremes: say, 2.5 rolls of cloth per barrel of wine • At these prices, both countries still better off with trade than without • Key point: England has a comparative advantage in cloth • Even though Portugal has the absolute advantage in both goods. • Relative price of cloth (in wine) is less in England. Economics for CED: Lecture 9, Noémi Giszpenc

6. Realistic qualifications • David Ricardo believed in the Labor Theory of Value--that “natural” prices derived from amount of labor. • Prices depend on at least 3 factors of production: land, labor, capital • Still, different countries have different resource endowments, so comparative advantage still holds. • As in other markets, prices determined largely by supply and demand. Economics for CED: Lecture 9, Noémi Giszpenc

7. Realistic qualifications (cont.) • Most trade is multi-lateral (among many countries with many goods) not bilateral (2 countries) with only 2 goods • Doesn’t undermine idea of comparative advantage though • Some trade is in roughly similar products • “counter-trade”: Jaguars for Toyotas • Different tastes in different countries can lead to mutually beneficial trades Economics for CED: Lecture 9, Noémi Giszpenc

8. Realistic qualifications (cont.) • Monopoly power: • Could make both countries worse off. • Openness to trade could limit monopoly power. • Unemployment • Comparative advantage model assumes full employment • If mercantilist trade policies can promote more employment, policy makers face dilemma: • Will the country be better off with trade according to comparative advantage, which is efficient? • or are more, inefficient jobs better than no jobs at all? Economics for CED: Lecture 9, Noémi Giszpenc

9. Realistic qualifications (cont.) • Static or dynamic? • In model, poorer country is better off from trade, but remains relatively poor • This is because improving productivity is outside of the model Economics for CED: Lecture 9, Noémi Giszpenc

10. What Herman Daly says • One of the unmentioned assumptions of the model is that both labor and capital are moored to their respective nations. • Under such conditions, comparative advantage takes over. • But with mobile capital, only absolute advantage matters. • Capital picks up and moves to more productive locale--in the example’s case, Portugal. Economics for CED: Lecture 9, Noémi Giszpenc

11. How does money flow? • Often needs to change from one monetary unit to another • Like other exchanges, the relative prices of national moneys are determined by supply and demand • People in one country demand units of foreign countries to buy foreign goods • (and to make gobs of money speculating) • So demand for currency is related to demand for real goods and services. • (and to different interest rates paid) Economics for CED: Lecture 9, Noémi Giszpenc

12. 2 ways of determining FX rates • Purchasing Power Parity • Assumption: if goods cost different amounts in different countries, arbitrage will whittle down the differences • Interest Rate Parity • Assumption: if different currencies earn different rates of return, exchange rates will adjust to reflect differential demands Economics for CED: Lecture 9, Noémi Giszpenc

13. Purchasing Power Parity • Say basket of goods in country A costs pAy • Same basket of goods in country B costs pBy • So pAy/pBy = pA/pB should = EA/B • Say pA goes up: EA/B goes up, meaning more A for every B: a devaluation of A relative to B. • What causes changes in pA? • Inflation • Changes in productivity • Changes in E from other causes Economics for CED: Lecture 9, Noémi Giszpenc

14. Problems with PPP theory • Transportation costs and trade restrictions • Costs of Non-Tradable Inputs • Such as rent • Perfect information • Needed for effective arbitrage • Other market participants • PPP is about goods. Total world trade is approx. $100 billion/day. Activity on the FX market is approx. $1 trillion/day. What else is going on? Economics for CED: Lecture 9, Noémi Giszpenc

15. Interest Rate Parity • Say interest rate in country A is iA. • After one year’s investment, A1 A(1+iA) • Where A is the symbol of A’s currency; B is B’s currency. • Say interest rate in country B is iB, and the exchange rate is EA/B. • If you converted A1 B(1/EA/B), after one year’s investment you’d get B(1/EA/B (1 + iB)). • If the exchange rate in one year is EA/B*, then you could get back AEA/B*(1/EA/B (1 + iB)) • Which, if the rates of return are equal for both investments, ought to be equal to A(1+iA). Economics for CED: Lecture 9, Noémi Giszpenc

16. Rearranging… • You obtain: • Where iA is rate of return on investment in country A; RHS is return on investment in B. • Shows that the expected rate of return on the asset from country B depends on two things: • interest rate in country B, and • the expected percentage change in the value of B • If B appreciates, rate of return is higher--so investors would be willing to accept a lower interest rate. Economics for CED: Lecture 9, Noémi Giszpenc

17. EA/B SB DB QB How are FX rates determined? • Supply and Demand for B: • If B appreciates (EA/B rises), holders of B more willing to sell; holders of A less willing to buy B. • Say FX market is in equilibrium. Now say iA goes up. What happens? Economics for CED: Lecture 9, Noémi Giszpenc

18. EA/B SB DB QB Effect of interest rates on FX • If iA goes up, rate of return on holding A goes up. • Sellers more willing to sell B for A. • Buyers less willing to buy B--prefer to hold on to A. • EA/B falls to new equilibrium • A appreciates relative to B • Rate of return now equal. Economics for CED: Lecture 9, Noémi Giszpenc

19. Effect of expectations on FX • Say investors raise their expected future exchange rate, E*. • This will raise the rate of return on holding B. • Sellers will want to sell less B • Buyers will want to buy more B. • Equilibrium exchange rate rises. • A case of self-fulfilling expectations. EA/B SB DB QB Economics for CED: Lecture 9, Noémi Giszpenc