14–1 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 14 An Introduction

Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank

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Chapter 14An Introduction to the Open Economy


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Chapter 14: An Introduction to the Open Economy

• Open economy issues• Global trends and patterns in international trade• A supply and demand perspective on trade• Protectionist policies: tariffs and quotas


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Some Facts

• World trade grows faster than world production• Asia, Europe and US are large traders compared

with Africa, Middle East and Latin America• Large trade imbalances, with US in deficit and Asia

in surplus• Reduction of tariff barriers over time• Growth of regional trade agreements since 1992

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Global Exports and Production

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Share of World Exports and Imports

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Regional Trade Agreements


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Import Demand

• Domestic demand curve for product• Domestic supply curve for product• For a small country, domestic price is given by the

world price• Import demand = domestic demand – domestic

supply at that world price• These products are called ‘importables’

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Illustration: Importables


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Export Supply

• Domestic demand curve for product• Domestic supply curve for product• For a small country, domestic price is given by the

world price• Export supply = domestic supply – domestic

demand at that price • These products are called ‘exportables’

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Illustration: Exportables


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Trade Pattern Depends on Price

• As price rises, the quantity demanded falls and the quantity supplied by domestic producers increases, causing import volume to fall

• If this continues, the country produces a surplus for export

• Whether a commodity is an importable or an exportable for a country depends on its price


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Price Impact of Restricting Trade

• For an importable, the introduction of trade lowers price, and restricting trade would raise price

• For an exportable, the introduction of trade raises price, and restricting trade would lower price


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Who Gains (Loses) from Trade?

• Trade lowers the domestic price of importables, so domestic consumers gain and domestic producers lose

• Trade raises the domestic price of exportables, so domestic consumers lose and domestic producers gain


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Trade Gains Exceed Losses

• Trade causes the domestic prices of importables to fall

• For importables, domestic demand always exceeds domestic production

• So, for a given fall in price, the fall in costs for consumers must be less than the fall in income for producers

• Consumers gain more than producers lose• Consumers could compensate producers and still

be better off


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Trade Gains Exceed Losses

• Trade causes the domestic price of exportables to rise

• For exportables, domestic production exceeds domestic consumption

• So, for a given rise in price, the increase in income for domestic producers must exceed the rise in costs for consumers

• Producers gain more than consumers lose• Producers could compensate consumers and still

be better off


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Why Losers Oppose Trade

• With compensation for losers, everyone could be made better off by trade

• But compensation is rarely made• So losers usually oppose trade


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Restricting Imports – Tariffs

• Tariffs raise domestic price above world price• Quantity demanded falls• Quantity supplied rises• Volume of imports falls

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The Impact of a Tariff


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Winners and Losers from Tariffs

• Consumers lose from higher prices• Producers gain from higher prices• Government gains from tariff revenue• But consumers lose more than producers and

government gain


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Restricting Imports – Quotas

• Government allows tariff-free entry of goods at world prices

• But imposes a physical limit on the volume of imports by the issue of licences to import

• Domestic supply = domestic production + quota on imports

• Domestic price rises and volume of imports falls to quota level

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Import Quota


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Tariffs vs Quotas

• For any given tariff rate, an alternative import quota could be imposed with the same effects on price and quantities

• Tariff generates revenue for the government• Quota generates profits for the lucky recipients of

the quotas who import goods at world prices and sell at higher domestic prices

• Quotas are administratively cumbersome


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Third Parties May Oppose Trade

• Sympathy for the uncompensated losers in both poor and rich countries who may already be at the lower end of their income distributions

• Trade changes cultures• Trade introduces new products which consumers

may not have the expertise/backup to use wisely: infant milk formula requires access to clean water

• If rich countries gain more from trade than poor countries, even though all gain, there is a perception that the distribution of world income has worsened

• Farm/export subsidies hurt poor countries


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Trade and the Environment

• Also a concern for third parties• Trade, combined with pollution-emission controls

in rich countries, sometimes shifts emissions to poorer countries, who may have deliberately chosen lower environmental standards because of their lower incomes

• This does not mean that total emissions must have increased

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Income and Environment


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Trade and the Environment

• The ultimate cause of environmental problems is lack of, or inappropriate, emission controls, not trade

• So these problems should be solved by using the right emission controls, not by restricting trade

• The income-enhancing effects of trade increase both the desire and the means to improve the environment


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Free Trade and World Inequality

• Inequality between rich and poor countries tends to fall, because free trade causes real wages to converge between rich and poor countries

• Wages earned by low-skilled labour engaged in producing traded goods tend to rise in poor countries and fall in rich countries

• In its effect on wages, trade in goods is like free immigration of labour


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But Trade is Not Free

• Europe and the US subsidise farm exports• This reduces their world price• This hurts farmers in poor countries• This turns the terms of trade against poor

countries and is a factor which tends to increase world inequality


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Income Distribution at Home

• The reduction of unskilled wages in rich countries and the increase in the return to human and physical capital raises inequality in rich countries

• This was illustrated in Chapter 5• The rise in unskilled wages in poor countries and

the fall in the return to physical capital reduces inequality in poor countries

Documents

14–1 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 14 An Introduction