Trade and the Economy
The Macro-Economics of European Economies
MSc in Economic Policy Studies
John FitzGerald, March 2015
Course Outline
1. How does an economy work? JF 16-1-2015
2. The genesis of macroeconomics AM 23-1-2015
3. Modern macroeconomics AM 30-1-2015
4. Banks and financial markets AM 6-2-2015
5. The recent crisis AM 13-2-2015
6. The labour market JF 20-2-2015
7. Fiscal Policy JF 6-3-2015
8. Trade JF 13-3-2015
9. The economics of global warming JF 20-3-2015
10. The future of the Irish economy AM and JF 27-3-2015
Outline of Lecture
• Theory
•
•
•
•
•
Imports, exports and the goods market
Benefits of Trade
Comparative advantage
Other aspects of trade
Policy Instruments
• Applied – examples of comparative advantage, competitiveness etc.
•
•
•
•
Freeing of trade
Shifting comparative advantage
Openness
Drivers of exports – Vietnam and Ireland
The Goods market - 1
• Demand for Goods (and Services)
• C+I+G : Closed economy
• C+I+G+X : Open economy
• C=Private Consumption; I= Investment; G= Government consumption; X=Exports
• Supply of Goods (and Services)
• Y : Closed economy
• Y+M : open Economy
• Y = Domestic Output; M=Imports
• Disequilibrium?
• Inflation, Current account of the balance of payments
The Goods market - 2
• Y=C+I+G (+X-M)
• Y= GDP, output = expenditure = income – demand for goods (and services)
• Y=Q
• Q= National output – supply of goods (and services)
• C=a + b(Y - T)
• T=Government revenue; a and b are coefficients, where b is 0<b<1
• Y=a + bY – bT + I + G + (X - M)
• Y(1-b)= a + I + (X - M) + G - bT
1
• 𝑌=
[𝑎 + 𝐼 + 𝑋 − 𝑀 + 𝐺 − 𝑏𝑇]
1−𝑏
• Assumes output will respond to an increase in demand
1
•
is the “multiplier”
1−𝑏
The Goods market - 3
• Y=C+I+G (+X-M)
• Y= GDP, output = expenditure = income – demand for goods (and services)
• C=a + b(Y - T)
• M=α + βY where α and β are coefficients, 0<β<1
• Y=a + bY – bT + I + G + (X - α - βY )
• Y(1-b+β)= a+ α + I + X - M + G - bT
• 𝑌=
1
[𝑎
1−𝑏+𝛽
+ 𝛼 + 𝐼 + 𝑋 + 𝐺 − 𝑏𝑇]
• Assumes output will respond to an increase in demand
•
1
1−𝑏+𝛽
is the “multiplier”
The Goods market - 4
• The Multiplier measures the change in Y for a change in one of the
components of final demand e.g. G,I,X
•
•
•
•
•
•
•
•
1
1−𝑏+𝛽
is the “multiplier”
Assume b, the marginal propensity to consume, is .8
Assume a closed economy i.e. β=0
1
Then multiplier is
=5
1−.8
Assume propensity to import is β=.4
1
Then multiplier is
=1.67
1−.8+.4
Leakage from imports makes a big difference
(Other leakages from multiplier include taxation)
Propensity to Import
• Import content differs by sector.
• For 1998 for Ireland
• Consumption: 0.34; Government:0.16; Investment, building: 0.26
• Investment machinery: 0.63; Industrial exports: 0.53
• For exports, in addition you have to deduct profits paid abroad: 0.25
• Thus the value added sticking in Ireland from industrial exports was low
• The value added sticking in Ireland from exports is even lower today
• This makes interpreting export and import data difficult
• Concentrate on change in current account of balance of payments
The benefits from trade
• Who gains?
• Who loses?
• Do the gains exceed the losses?
Free trade & welfare in exporting country
Before Trade
Price of
Software
Price after
trade
Domestic Supply
A
Consumer surplus before trade A+B
World Price
B
Price before
trade
C
Producer surplus before trade C
Domestic Demand
Quantity of software
Free trade & welfare in exporting country
After Trade
Consumer surplus after trade A
Price of
Software
Price after
trade
Domestic Supply
A
B
Price before
trade
Exports
D
World Price
Producer surplus after trade B+C+D
C
Domestic Demand
Quantity of software
How free trade affects welfare in exporter
• Two conclusions:
• Domestic producers better off and domestic consumers worse off
• Total welfare – of consumers and producers – is higher after trade
• A+B+C+D>A+B+C
• How are the gains from trade shared?
• How does it affect wage rates?
• Redistribution by the state
Free trade & welfare in importing country
Before Trade
Price of
Software
Domestic Supply
Consumer surplus before trade A
A
Price before
trade
Price after
trade
B
World Price
C
Producer surplus before trade B+C
Domestic Demand
Quantity of software
Free trade & welfare in importing country
After Trade
Price of
Software
Domestic Supply
Consumer surplus after trade A+B+D
A
Price before
trade
Price after
trade
B
C
D
World Price
Imports
Producer surplus after trade C
Domestic Demand
Quantity of software
How free trade affects welfare in importer
• Two conclusions
• Domestic producers are worse off and domestic consumers are better off
• Trade improves overall welfare because gain of consumers exceeds producers’
loss (A+B+C+D>A+B+C)
• However, the distribution of these gains may be affected by:
• The state, through taxation
• Through changes in wage rates etc.
Gains and losses from Free Trade
• The gains of the winners exceed the losses of the losers in each case
• However, how these gains are distributed is affected:
• By the behaviour of the economy
• By Government action
• Lobbying
• Enhanced imports good for consumers
• Enhanced exports good for producers
• EU entry – good for producers but consumers voted for it
• Gains and losses within producers and consumers
• Moving from protection to free trade – incumbents (& their employees) may lose
• Potential winners may not easily be identified
Law of Comparative Advantage
• Due to differences in productivity
• Referred to as the Ricardian model
• Simplified – one factor of production – labour
• Comparative advantage
• Absolute v Comparative
Comparative advantage
• Ann has an absolute advantage in both
ironing and cooking – her productivity is
Barry
2
60
higher
Ann
1
20
• Should she do it all?
• Barry has a comparative advantage in
Table shows productivity of Ann and Barry
ironing. He would trade 30 shirts for 1
Each of them have:
dinner
20 shirts to be ironed
• Ann has a comparative advantage in
1 dinner to be cooked
cooking: 20 shirts for 1 dinner.
• By concentrating on their comparative
advantage the total time spent (cost) is
reduced.
If each do their own, Barry will spend 100 and Ann 40
However, if Barry does the ironing and Ann the cooking
• While the winner is Barry, he could
Barry will spend 80 and Ann 40.
compensate Ann (by washing the floor)
and they would all be better off
By trading Ann is no worse off but Barry is much better off
Iron shirt
Cook dinner
Comparative advantage in action
• India is cheaper for producing clothing than Ireland
• India is cheaper for producing software than Ireland
• However, in Ireland there is a comparative advantage in software and
in India in clothing
• What one would expect is that countries will tend to specialise in
sectors where their productivity is high relative to other sectors
where it is low (and where they import)
• An examination of trade patterns can help identify where
comparative advantage lies
• However, it can change. e.g. Ireland
Comparative cost trade theories
• We have discussed a model with one factor of production - labour:
• Differences in labour productivity (Ricardo)
• Additional model with two or more factors of production:
• Differences in endowments of factors (Hecksher-Ohlin)
• Remuneration increases in factor employed most intensively in commodity
where price increases
• e.g. returns to skilled labour
• Implications for India and China – short skilled labour
• India returns to skilled labour high
• Should India specialise in software for export?
• Ireland skilled labour is “abundant” returns to education much less than India
Some other effects of free trade
• Competition and contestability
• Economies of scale (e.g. producing cars)
• Lower prices
• Greater product variety
• Welfare / utility gains
• Infant industry argument
• A long history
• Will they ever be ready? Ireland 1930-60
Fragmentation of the production process
• Thirty years ago Germany made cars, their transmissions, tyres etc.
• Today Germany makes some parts of cars, much of the assembly takes place in Poland
and Slovakia
• Increasingly the production process for goods & services is being split up: outsourcing
• Previously you could choose German labour and capital or Polish labour and capital to
make cars. The choice depended on the relative abundance of factors or production –
capital in Germany
• However, today by breaking up the production process you can mix Polish and German
capital and labour to produce cars more efficiently
• The parts of the production process takes place in the country with the comparative
advantage / relative factor abundance.
• Car assembly is more labour intensive that manufacturing car electronics – assembly
takes place in Poland
Pricing
• Where firms are world leaders they can set the price
• e.g. Siemens
• However, where there is perfect competition, firms are price takers
• Butter producer
• Where firms have market power they can pass on some of costs
• While they can set their price, competitiveness affects exports and, hence, output.
Effectively they can pass on some, but not all, of a cost increase
• However, where firms are price takers they take the world price
• Given the price, if costs rise, profits fall. They produce only if profitable
• Comparison of costs of production relative to foreign competitors important
• Comparison of export prices may not be useful under these circumstances
• In Ireland most of manufacturing is a price taker
• The foreign owner sets the price in dollars for all its factories
Terms of Trade
• Beginning with current account balance
• Exports=imports
• If price of oil rises and nothing else changes
• Imports> exports
• There may have been no change in volume of trade but price changes matter
Trade Policy Instruments
• Quotas (what happens to rents)
• Tariffs
• Anti-dumping
• Regulatory regimes
• “Industrial” policy
• FDI
• FDI
• Brings, capital, technology, management expertise
Examples
• Effects of freeing of trade and Irish EU entry 1973
• EU Single Market 1992
• Composition of trade
• Comparative advantage
• Openness matters
• Trade and the Irish economy
EU Entry
• Between 1930 and 1960 very high protection
• Quotas – created rents (Corruption?)
• Very high tariffs
• Industry developed for domestic market
• Low productivity
• No exports
• Were then infant industries – would they transition to free trade?
• Gradual opening culminating with EU entry 1973
• Good for agriculture – opened a large market – much higher prices
• Existing Irish manufacturing did not transition
• FDI began before 1973, anticipating EU entry
EU Single Market 1992
• Changed rules on public procurement
•
•
•
•
•
Public sector buys cheapest
Allowed pharmaceuticals and health care and communications equipment
Allows more competition to supply government
Reduces cost of government
Difference with US
• Changed rule on trade in services
• Massive growth in trade in services
• Improved harmonised regulation
Shifting comparative advantage
• Factors affecting composition of exports:
• Factor endowment – skilled v unskilled labour
• Changes in market access – EU and Single Market
Human Capital by Sector
1966
Agriculture, Forestry and Fishing
1.057
Textiles, clothing, footwear and leather
1.074
Building and Construction
1.077
Mining
1.082
Wood and wood products
1.087
Glass, pottery and cement
1.095
Manufacturing Industries
1.102
Food
1.107
Metals, metal products, machinery etc.
1.113
Beverages and Tobacco
1.117
Other Manufacturing (incl transport equip.
1.121
Total at Work in all Industries
1.123
Paper, paper products, & publishing
1.124
Transport, Communications and Storage
1.124
Other Industries
1.134
Commerce
1.136
Chemical, rubber and plastic products
1.148
Electricity, Gas and Water
1.151
Public Admin. and Defence
1.225
Other Services (Total Professional and Personal Services)
1.248
Insurance, Finance and Business Services
1.259
2006
1.202
1.259
1.252
1.238
1.271
1.265
1.356
1.297
1.383
1.402
1.299
1.363
1.372
1.308
1.210
1.309
1.426
1.372
1.413
1.443
1.501
Labour Force by level of education
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1966
1971
1981
Primary
1986
Junior
1991
Leaving
1996
Third level
2002
2006
Merchandise and Services Exports: Ireland
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1970
1975
1980
1985
1990
Merchandise/Total exports
1995
2000
Services/Total Exports
2005
2010
Composition of merchandise exports
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1973
1978
1983
1988
1993
1998
2003
Food (0)
Drink (1)
Crude materials (2)
Mineral fuels (3)
vegetable oils (4)
Chemicals (5)
Manufactured goods (6 less 65)
Clothing etc (65)
Machinery (7)
Miscellaneous (8)
Commodities (9)
2008
2013
Openness of the economy
• Important in determining effects of outside world on economy
• Easier to grow from a high base – relevant today
Exports as a % of GDP, Ireland
120
100
80
60
40
20
0
1970
1975
1980
1985
1990
1995
2000
2005
2010
Openness – Exports/GDP
1.1
1.0
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
00
01
02
03
04
05
Ireland
06
07
08
Germany
09
10
11
Greece
12
13
14
Openness – Exports/GDP
1.1
1.0
0.9
0.8
0.7
0.6
0.5
00
01
02
03
04
05
Ireland
06
07
08
Estonia
09
10
11
Netherlands
12
13
14
Openness Exports/GDP
1.1
1.0
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
00
01
02
03
04
05
Ireland
06
07
Italy
08
09
10
11
Portugal
12
13
14
What drives trade
• Relative openness
• Important – a 10% rise in exports has a bigger impact on GDP if open
• Sensitivity to growth in markets – price and income
• Growth in relevant foreign markets
• Competitiveness on foreign markets
• Measure competitiveness by relative export prices OR relative production costs
• Example of Vietnam
• Example of Ireland
Model of Vietnamese Exports
• Log(X)= -14.8+1.24log(YU)+1.28log(YC)-0.42log(P/PC)
• Where X= exports, is YU is US GDP, YC is Chinese GDP, P is prise, PC is Chinese
prices
• A 1% increase in US GDP raises Vietnamese exports by 1.24%
• A 1% increase in Chinese GDP raises Vietnamese exports by 1.28%
• A 1% increase in Chinese prices raises Vietnamese exports by 0.4%
Chinese prices rise by 10%: Effect on Vietnamese GDP
GDP (Percent Deviation)
1.3
1.2
1.1
1.0
0.9
0.8
0.7
0.6
0.5
0.4
01
02
03
04
05
06
07
08
09
10
11
12
Ireland, Foreign Prices +1%
Growth, prices, employment
GDP
GNP
Value added in industry
Value added in market services
Consumption
Investment
Exports of Goods and Services
Consumption deflator
Wages (non-agricultural)
Total employment
Employment in services sector
Balances
Unemployment Rate (ILO)
Current account of BOP as % of GDP
General Government Deficit as % of GDP
General Government Debt as % of GDP
Net Emigration
The shock
Foreign Prices *
2013
2014
2015
2016
2017
2018
%Δ
%Δ
%Δ
%Δ
%Δ
%Δ
%Δ
%Δ
%Δ
%Δ
%Δ
0.5
0.0
1.6
0.1
0.0
0.4
0.0
0.2
0.0
0.1
0.1
0.6
0.2
1.7
0.3
0.2
0.6
0.3
0.2
0.2
0.2
0.2
0.7
0.3
1.7
0.4
0.3
0.8
0.4
0.3
0.4
0.2
0.2
0.8
0.4
1.8
0.5
0.5
0.8
0.4
0.3
0.5
0.2
0.2
0.8
0.5
1.8
0.5
0.6
0.7
0.4
0.3
0.6
0.2
0.2
0.8
0.5
1.7
0.5
0.6
0.7
0.4
0.3
0.6
0.2
0.2
Δ
Δ
Δ
Δ
Δ
-0.1
0.2
-0.1
-1.5
0.0
-0.2
0.3
-0.2
-1.9
0.1
-0.2
0.4
-0.2
-2.1
-0.4
-0.2
0.4
-0.2
-2.4
-0.7
-0.2
0.4
-0.2
-2.5
-0.7
-0.1
0.5
-0.2
-2.6
-0.5
1%
1%
1%
1%
1%
1%
Ireland, World Output +1%
Growth, prices, employment
GDP
GNP
Value added in industry
Value added in market services
Consumption
Investment
Exports of Goods and Services
Consumption deflator
Wages (non-agricultural)
Total employment
Balances
Unemployment Rate (ILO)
Current account of BOP as % of GDP
General Government Deficit as % of GDP
General Government Debt as % of GDP
The shock
2013
2014
2015
2016
2017
2018
%Δ
%Δ
%Δ
%Δ
%Δ
%Δ
%Δ
%Δ
%Δ
%Δ
0.8
0.5
1.3
0.9
-0.1
1.1
3.2
0.0
0.0
0.3
0.9
0.7
1.3
1.2
0.2
1.6
3.4
0.1
0.3
0.4
1.0
0.8
1.3
1.3
0.3
1.4
3.5
0.1
0.4
0.5
1.1
0.9
1.3
1.4
0.5
1.3
3.6
0.1
0.5
0.6
1.1
1.0
1.3
1.4
0.6
1.3
3.7
0.1
0.6
0.6
1.1
1.0
1.3
1.5
0.6
1.3
3.8
0.1
0.7
0.6
Δ
Δ
Δ
Δ
-0.2
0.1
-0.1
-0.9
-0.4
0.2
-0.2
-1.3
-0.4
0.2
-0.2
-1.6
-0.4
0.2
-0.3
-2.0
-0.4
0.2
-0.3
-2.2
-0.4
0.3
-0.3
-2.4
Questions
• Should a country diversify its markets
• Is there a role for “industrial” policy
• What could be the effect of a US-EU Trade deal?
Presentations
1. The origins and resolution of the current crisis in Estonia, Bulgaria,
Greece and Spain (20th March)
• What were the origins? How is it resolving? Look at disequilibria in markets
2. The origins and resolution of the current crisis in Latvia, Portugal,
Spain and Italy (20th March)
• What were the origins? How is it resolving? Look at disequilibria in markets
3. The crisis in Scandinavia (Finland, Sweden, Denmark) 1988-1995
(13th March)
• What were the origins? How was it resolved? Look at disequilibria in markets
Reading for this lecture
• Basic text:
• “International Economics, Theory and Policy”, Krugman, Obstfeld and Melitz.
Probably more theory than you need, but provides the basics
• Chapters 3-5
• The rest of the reading discusses real economic situations.
Look at one or two of these publications for the EU and its component economies
• IMF World Economic Outlook, October 2014. http://www.imf.org/external/pubs/ft/weo/2014/02/pdf/text.pdf
• OECD Economic Outlook, November 2014, http://www.oecd.org/eco/outlook/General-assessment-of-themacroeconomic-situation.pdf
• European Commission: European Economic Forecast, Winter 2014
http://ec.europa.eu/economy_finance/publications/european_economy/2014/pdf/ee2_en.pdf
• CPB World Trade Monitor
• http://www.cpb.nl/sites/default/files/cijfer/CPB%20World%20Trade%20Monitor%20%28including%20December%2
02014%29/cpb-world-trade-monitor-december-2014.pdf
AMECO Database
• Many annual variables for EU economies, US, Japan etc.
• Don’t assume that the data are always right!
• Where available, runs from 1960. Includes EU forecasts to 2016
• Be careful that 2014 onwards are EU forecasts!
• Three approaches to accessing it:
1.
Online: http://ec.europa.eu/economy_finance/ameco/user/serie/SelectSerie.cfm
2.
Excel File: AMECONov14.xlsx plus list_of_variables.pdf
3.
Excel File: AMECOTCD.xlsx – a limited number of variables, 1 variable per sheet
• House prices from BIS database:
• Online: http://www.bis.org/statistics/pp_detailed.htm#selected