Economics for CED

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Economics for CED

• Noémi GiszpencSpring 2004Lecture 9 Macro
  International Trade
  
• June 2, 2004

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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

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Comparative advantage
David Ricardo(1772-1823)

• 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

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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.

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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.

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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.

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Realistic qualifications (cont.)

• Most trade is multi-lateral (among many countries
  with many goods) not bilateral (2 countries) with
  only 2 goods
  
• Doesnt 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

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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?

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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

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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 examples case, Portugal.

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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)

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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

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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

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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?

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Interest Rate Parity

• Say interest rate in country A is iA.
• After one years investment, A1 ? A(1iA)
• Where A is the symbol of As currency B is Bs
  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 years
  investment youd 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(1iA).

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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.

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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?

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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.

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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