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Implications for National
Economic Policies
Thorvaldur Gylfason

Outline
1.
Globalization and its implications for
 National incomes
 Prices and inflation
 Interest rates
2.
Policy coordination
 Monetary policies and institutions
 Fiscal policies
3.
Agricultural policy

Import Tariffs 1980-2000
25
20
15
10
5
0
Tariffs (% of imports)
Tariffs (% of tax revenue)
1980
2000

Export Duties 1980-2000
3
2
1
0
5
4
Duties (% of exports)
Duties (% of tax revenue)
1980
2000

50
40
30
20
10
0
Imports and Exports
1960-2000 (% of GDP)
Imports Exports
1960
1980
2000

10
8
6
4
2
0
FDI 1980-2000 (% of GDP)
FDI (net) FDI (gross)
1980
1990
2000

Further Evidence of
Globalization
Economic integration followed by political integration
Widening and deepening integration
Europe’s common currency rests, in part, on political arguments ( Austria vs. Sweden )
Even in North America, there is an ongoing debate about the pros and cons of adopting a common currency
Is NAFTA not enough?
But political and historical impetus is absent

International Linkages
National incomes of trading partners tend to move in tandem
Suppose country A exports to country B, so A’s exports are B’s imports
Then a boom in B increases demand for imports in B which means that exports – and output! – in A must also rise
Likewise, a slump in A can lead to a slump in B
 International business cycles , through trade

The Foreign Multiplier
Extra boost in US C
EU
US’
Demand boom in US
US
B
A
Imported boost in EU
GDP in EU

Other Linkages: Inflation
Prices move together
Inflation in country A increases the real exchange rate (i.e., makes the home currency appreciate in real terms), thus hurting exports which, in turn, diverts demand from imports to home production in country B, hence increasing aggregate demand and inflation in country B
 Imported inflation , through trade

Other Linkages: Inflation
Extra inflation in US C
EU
US’
Demand boom in US
US
B
A
Imported inflation in EU
Price level in EU

Two Cases
Fixed exchange rate
P = P*/e
As P* rises, so does P
With fixed e, a rise in P* leads to real depreciation, so BOP improves and M rises
Hence, P rises: Imported inflation
Flexible exchange rate
As P* rises, e rises (nominal appreciation)
Real depreciation is partly reversed
Hence, M and P rise less than otherwise

Still Other Linkages:
Interest Rates
Interest rates move together
An increase in interest rates in country A attracts capital inflows from country B, thus reducing the supply of capital in country B, and thereby driving up interest rates in country B
 Interest parity , through capital movements

Still Other Linkages:
Interest Rates r = real interest rate
S = saving
Home country I = investment r
B
S
Rise in I
A
S, I
I
I’

Still Other Linkages:
Interest Rates
Home country r
A
B
S
Rise in I
Foreign country r
B
S’
S
Fall in S
I’
A
I I
S, I S, I

Implications of Linkages
Economic integration means that economic policy in one country, especially if the country is large, influences economic developments in other countries, through international trade and investment
Economic integration calls for political integration, to some extent at least
Important driving force behind
European integration

Example of
Environmental Policy
Pollution respects no national boundaries
Therefore, need international cooperation on environmental protection and pollution control
Case in point: Kyoto protocol
Same general principle applies to some aspects of economic policy
Also: Law enforcement

Exchange Rate Policy
Cannot be conducted in a vacuum
Unless your country is very small
Country A’s decision to devalue its currency causes country B’s currency to appreciate, through trade
Therefore, countries may wish or need to cooperate on exchange rates
Currency unions
Case in point: Europe’s single currency
Or they may want to be alone

The Impossible Trinity
Currency union
Fixed
Free capital movements exchange rate
Floating exchange rate
Independent monetary policy
1945-1972

Fiscal Policy
Globalization also presents a challenge to fiscal policy through impending tax erosion
 E-commerce and electronic money
 Offshore activities and foreign shopping
 Financial capital
Globalization may, however, facilitate new and more efficient ways to collect revenue
 Tax harmonization
 Pollution fees

Monetary Policy
Main objective is price stability
Because high inflation hurts economic growth as well as the external position
Monetary restraint requires fiscal discipline
Monetary policy under floating exchange rates and perfect capital mobility
 Increased independence of central banks, and increased accountability
 Banking supervision
 Inflation targeting

Global Economic Performance since 1990: Four Features
I.
World inflation has been brought down to its lowest level in 40 years
 Inflation dispersion has also diminished
II.
International integration and liberalization of financial markets
III.
More complex financial linkages and policy transmission mechanisms
IV.
Flexible exchange rates have become more prevalent

Agricultural Subsidies per
Farmer 1999-2000 (USD)
35000
30000
25000
20000
15000
10000
5000
0
Iceland Norway EU US New
Zealand

Agri cultural Subsidies per
Farmer 1999-2000 (USD)
35000
30000
25000
20000
15000
10000
5000
0
Iceland Norway EU US New
Zealand

Agriculture
D
H
Slope = -P
I
/P
A
Domestic price ratio
E
Agricultural output (A)
O
C
As P
I
As P
A rises, I rises and A falls rises, A rises and I falls
G
Industrial output (I)

Agriculture
D
H
If output gain = E and price distortion
= c , then E = mc 2
Agricultural output
OC = industrial output
CA = agricultural output
OA = total output
O
Output gain
E
C
Industrial output
E = mc 2
World price ratio
Domestic, distorted price ratio
Price distortion
A
F
G
B

Agriculture
Implication:
The output gain varies directly with
1.
The magnitude of the transfer of resources between sectors ( m )
2.
The extent of the original price distortion ( c )
The greater the transfer of resources and the greater the distortion, the greater is the output gain

Numerical Example
E is the output gain from liberalization m is a constant equal to ½ times the share of the industrial sector in output after liberalization times the price elasticity of industrial output c is a measure of the price distortion in percent
The greater the initial distortion, the more ambitious the liberalization, and the more elastic the output, the greater the gain

The CAP: An Application
Suppose
 Farm protection keeps domestic agricultural prices 80% above world prices, so that c = 0.8/(1 + 0.8) = 0.44
 Industrial sector’s share in GDP will rise to
95% following farm policy liberalization
 Price elasticity of industrial output is 0.2
Accords with price elasticity of farm output of 4
Output gain from liberalization is then
E = 0.5*0.95*0.2*0.44
2 = 0.02, or 2%
 Larger effect if productivity gain is included

The CAP: An Application
When productivity gain is included, the total cost of the CAP rises to perhaps
3% of the EU’s GDP
Yet these cost estimates do not include
Environmental damage in agriculture
Effects on CEECs
Effects on LDCs

Agriculture:
Static Gains
Welfare gain
D
H
E
Agricultural output
Output gain
O
C
Industrial output
J
World price ratio
Exports
K
Domestic, distorted price ratio
Price distortion
A
F
G
B
Imports

Agriculture:
Transitional Pains
D
H
Agricultural output
O
Welfare gain
J
E
M
N
C
Industrial output
Q
Price distortion
F
G
A
Transition takes time:
From E to F via M, N, and Q
B

Agriculture:
Dynamic Gains AB = static gain
BC = dynamic gain
AC = AB + BC = total gain
Welfare gain
World price ratio
D
K
J
Productivity gain
E
Agricultural output
Price distortion
H
F
G
O Industrial output A B C

Conclusion
Globalization means interdependence
Policies influence not only those who make them
Need to find ways to share responsibility without giving up too much sovereignty
Not easy, but we must try