Economic and Financial Integration

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Economic and Financial Integration

• Dr. Gerhard Kling and Dr. Hein Roelfsema

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Structure of the course

• Two lectures per week Monday and Tuesday
  3.15pm-5pm in UCU-U 116
• One tutorial (two groups) per week Thursday
  9am-10.45am or 11am-12.45am
• Written exam 50
• Term paper 50 group of two students
• Project assignment on Thursday this week
• Topics on WebCT

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What is economic and financial integration?

• Globalization
• International trade
• Political process (WTO, trading blocks, etc.)
• Migration and integration of labor markets
• Capital flows (FDI, portfolio investment, foreign
  exchange markets etc.)
• MNE Outsourcing and slicing up the value chain
  (new aspect of modern form of globalization)
• Development issues inequality, convergence etc.
• The history of globalization two phases of
  globalization and deglobalization periods
  (1920s)
• Focus of this course Trade and FDI

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Historical overview

• Two periods of globalization
• 1850-1913
• 1950-present
• What are common features?
• Rapid increase in international trade
• Strong migration (labor migration)
• Increase in capital flows
• Convergence of countries (poor countries
  exhibited higher growth rates)
• What is different?
• Slicing up the value chain

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Convergence of real wages
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Wage-rent ratio converges Heckscher-Ohlin
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Decline of transport costs
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Mass migration 1820-1920

• 60 million migrated from Europe to US (60) and
  other countries
• Strong migration from Italy to France and Germany
• Mainly driven by economic reasons (but also
  religious and political aspects)
• Impact on wages in the US (see Boyer, Hatton,
  O'Rourke, 1994, Hatton, Williamson, 1998, and
  OGrada, 1994) real wages dropped by 8-15 due
  to migration negative impact on unskilled labor
  increase in inequality

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Migrants in of population
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In poor countries higher inequality because of
trade and migration?
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Integration of capital markets over time

• Measured by Feldstein-Horioka coefficient
• If coefficient is equal to 1 national investment
  rate depends on national savings rate low level
  of integration
• Coefficient is determined by running the
  following regression Investment rate Constant
  FHSavings rate et
• Studies by Taylor (1996,1997) and
  O'Rourke/Williamson 1999
• FDI reached 7 of GNP in 1914 and also in 1966,
  but later strong increase of FDI
• Capital flows into rich (resources) countries
  contributes to divergence

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Feldstein-Horioka coefficient
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Summing up

• 1850 to 1914, strong economic and financial
  integration
• FDI less important in first phase, but strong
  migration
• Globalization is not a one-way street
  deglobalization' period in 1920s
• Still unclear whether globalization affects
  inequality
• Our course focuses on trade (inequality) and FDI
  (modern form of globalization)

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Neo-classical trade models

• Chapter 1 (First part)

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Ricardian model

• 2 goods
• One factor (labor)
• Technological differences
• Notation indicates foreign country
• ai units of labor needed for one unit of good I
• L total labor force (endowment)
• Labor mobile between industries but not across
  countries implies same wages within country
• Hence wages (marginal costs)pricemarginal
  product of labor (marginal utility) labor market

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Ricardian model

• dyi/dLi 1/ai (ai units of labor produce one
  output) MPL (marginal product of labor)
• Same wages in both industries implies
• p1/a1 p2/a2 (Note that pi is the price of good
  i)
• p p1/p2 a1/a2 MPL2/ MPL1 (Decline in
  relative price indicates higher relative
  productivity)

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Ricardian model Figures

• Home country

• Foreign country

y2
y2
L/a2
y1
y1
L/a1
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Summing up Ricardian model

• In autarky slope of production possibility
  frontier (PPF) dy2/dy1 is equal to relative price
  p MPL2/ MPL1
• Relative prices changes due to trade (technology
  stays the same)
• Complete specialization of countries
• Relative not absolute advantages are relevant

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Two goods and two factor model

• Two factors (Labor L and capital K)
• Two goods yi (i1,2)
• One country
• Prices are exogenous (small country)
• Production function yi fi(Li, Ki)
• Increasing (positive marginal products)
• Concave (decreasing marginal products)
• Homogenous of degree one fi(?Li, ?Ki) ?yi
  hence Constant returns to scale
• Factors are mobile between industries

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Production possibility frontier (PPF)

• Maximization problem
• Max y2 f2(L2,K2)
• s.t. y1 f1(L1,K1) f1(L-L2,K-K2) (insert
  constraints!)
• Lagrange approach (try it at home!)
• Condition for optimum MPL2/MPK2 MPL1/MPK1
• Production possibility set is convex (figure)

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GDP function

• Max prices times quantities given that the
  production is on the PPF (guarantees efficiency
  of production)
• G(p1,p2,L,K)max p1y1p2y2 (exogenous prices!)
• s.t. y2 h(y1,L,K) (PPF)
• FOC

Slope of PPF relative price
Relative price determines optimal production
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What happens if relative price changes?

• Example change of p1

See FOC indirect effect sums up to zero
Indirect effect
Tiny change close to the optimum of production
This is called envelope theorem!
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Equilibrium conditions

• Conditions
• Profits are equal to zero (free market entry and
  perfect competition)
• Full employment of factors
• Unit-cost functions

Minimum costs for one unit of output aiL and aiK
are optimal choices
Application of the envelope theorem
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Determination of factor prices

• Factor price insensitivity
• Both good produced
• No factor intensity reversals (K/L)
• Then each price vector (p1 p2) corresponds to a
  unique factor price vector (w r)
• Note Endowment K, L does not matter!
• Figures
• Unit-cost functions ci(w,r) are equal to
  respective price pi (zero profit condition)
• Two cases no intensity reversals and with
  reversals

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Determination of factor prices Figures

• dr/dw - aiL/aiK (total differential of ci)

• Slopes differ at point A and B

r
r
Equilibrium determined by L, K
w
w
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Samuelson 1949

• If factor price insensitivity applies
• Both countries trade
• Prices (p1,p2) equal in both countries
• Hence w,r equal in both countries
• Trade is a substitute for the exchange of factors
• Empirical evidence (see above)
• Convergence of factor prices
• But factors are mobile across countries

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Gradient vector

• Vector of partial derivatives

Orthogonal to unit-cost curves in production
point A Vector product of tangent curve (slope of
unit-cost curve in A) and gradient vector is
equal to zero Maybe a figure is required?
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Inversion of a matrix

• Example

Inversion not possible if determinant 0
Cofactor matrix
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Inversion of a matrix

• Final step

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Change in product prices impact on factor prices

• Total differentiation of zero profit condition
• Rewrite in changes and cost shares

In matrix notation We can solve for factor price
vector by pre-multiplying the inverse matrix
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Change in product prices impact on factor prices

• Assume industry 1 is labor intensive ?1Lgt
  ?2L(cost shares!)
• Increase in relative price of good 1 p1
• Wage increases by more than price of good 1
• Hence labor can buy more of both goods
• Real wages increase and real returns fall
• Stolper-Samuelson (1941) theorem
• Jones (1965) magnification effect winner and
  losers due to product price change

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Illustration of Stolper-Samuelson (1941) theorem
r
Note unit-cost function is homogenous of degree
one in factor prices
p1 shift in unit-cost curve due to zero profit
condition
Point A would suggest no change of real wages
and real returns
w
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Additional literature

• ORourke, Kevin und Jeffrey Williamson
  Globalization and History. Cambridge 1999.