Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley Chapter 11 GROWTH IN THE OPEN ECONOMY

Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley

Chapter 11GROWTH IN THE

OPEN ECONOMY

Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-2

We live in a globally integrated world …• More integrated than never• Both in goods and financial markets

But globalization is not a novel phenomenon (Victorian age, previous globalization period)

Open economy = Globalization


Two globalization waves: end of 1800 and today (last 50 years or so)


Transport and Communication Costs (1930=100)

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1930 1940 1950 1960 1970 1980 1990

Ocean Freight andport charges per tonof cargo

Air transport costper passenger mile

Cost 3 minute phonecall New York-London

Growth in trade partly boosted by lower transport and communication costs, particularly in the first half of the century

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Moore’s Law as Seen in Intel Microprocessors – how the availability of a global technology ..

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.. Has driven down the price of computers, hence the cost of information and communication processing


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1994T

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ffs

Globalization (especially in second half of century) also boosted by declining tariffs – hence role of policy


Despite progress towards freer trade,globalization is still very incomplete

How do we know? Look at Law of One PriceDomestic price of bananas = (exchange rate) x (price of bananas

abroad)Yet: Law of one price does not hold• Neither statically: Price of similar goods more different across than within

countries• Nor dynamically: Not much evidence of decreasing price differentials

over time

Also: persisting home bias in consumption• US share of world GDP = .25; rest of world GDP = .75• With same preferences and full integration, expect GDP share of imports

= .75 • Instead: =.12, one sixth of its frictionless value• About the same for EU as a whole and Japan


Theory- Why are countries so eager to trade? The comparative advantage principle

If countries trade so much and Governments are so eager to embrace free trade, there must be a reason. There must be GAINS FROM TRADE!

Why? Rationale from the principle of comparative advantage (David Ricardo first, Eli Heckscher and Bertil Ohlin then).

Comparative advantage Even if the US is more productive than the rest of the world in producing all goods (“has an absolute advantage” in all productions), there may still be a case for the US to specialize in producing a subset of all goods and import the others

This is because of specialization gains: if the US specializes in producing goods where its productivity advantage is relatively bigger, this generates welfare gains. Resources are therefore more efficiently allocated


The more different countries are as to resource endowments, the bigger the scope for specialization• Countries will benefit from trade even if they are not low cost producers• Even poor countries may benefit from trade (exchange is NOT unequal within a competitive environment)• Each country specializes in those goods where, given resource endowments, its comparative advantage is greater

• L-abundant countries will export L-intensive goods (Chinese toys)• K or technology abundant countries will export K-intensive tech-intensive goods (US aircraft)

Being closed to trade (“autarkyc”) means being stuck producing goods that could be more efficiently imported from abroad

Comparative advantage has huge implications


Is the Heckscher-Ohlin theory of comparative advantage a good theory?

Look at two pictures in the next slides. Then ask: Is comparative advantage a powerful theory?

• Yes, if goal is to explain trade between rich and poor countries, such as Japan vs. China or US vs. Mexico

• No, if goal is to explain trade between similarly endowed rich countries– Italians and French similarly well equipped to produce and export wine. – Yet Italians keep drinking Champaigne and French (may) drink some

Spumante. Why? Taste for variety and scale economies from specializing in intermediate goods

So comparative advantage theory is useful to understand one half of world trade --- Subset of varieties in which each country specializes often follows resource endowments– Example: which cars do Germans and Italians sell to each other?

Mercedes and Fiat


Most international trades occur among rich countries which sell varieties of same goods to each other


Chinese - U.S. trade consistent with Hecksher-Ohlin

U.S. export capital intensive goods and import labor intensive ones


Extent of Intra-industry trade (as a share of total trade) --- more important for rich countries


Policy implications

Under principle of comparative advantage:• Free trade max permanent GDP through efficiency

gains (higher TFP). These are static gains from trade• Trade restrictions = bad thingThere may also be dynamic gains from trade• By trading with the world (multinationals, imports,

learning-by-exporting), a country may import technical change, ability to reorganize production and the like


If trade so beneficial why do trade restrictions exist at all?

Examples of trade restrictions Tariffs: taxes on imports Quotas: quantity restrictions on foreign imports Voluntary Export Restrictions (VER’s): Foreign producers “voluntarily” restrict quantities Administrative and technical standards Domestic Content Requirements (“buy Italian”) Government Procurement

• Why do they exist at all?• To minimise adverse distributional effects of trade• To raise revenue


Globalization and growth

• Look at trade of goods and services only

• Is the degree of openness (= (exports + imports)/ Gdp) of a country related to its per capita income? Is it related to its rate of economic growth?


Openness and GDP per Capita: a positive correlation – A proof of what?


Trade and growthAmong closed economies, low growth and no sign of convergence


Trade and growth – Among open economies, higher growth and evidence of convergence


If capital perfectly mobile in a competitive world, MPK = rworld. Hence: Ak-1=rw


Remarks on the Solow model in the open economy

In a closed economy: kss would depend on domestic factors such as the saving rate

In an open economy (with perfect capital mobility), domestic saving should be irrelevant

• kss would only depend on the world interest rate

• So would yss


Gdp in the steady state in the open-economy Solow model


How close is the real world to the open-economy Solow model?

Not very close, seemingly. The link between saving and investment is tight


No-global economics

If trade according to comparative advantage is so beneficial and is laso conducive to growth

why all this no-global fuss over immiserizing effects of trade, exploitation of the poor and the like?

In a nutshell, there is something to discuss but evidence is not against globalization. If anything, quite the opposite


Why no-globals may have a point: international trade causes winners and losers

Trade between countries with different resource endowments, though beneficial for the economy as a whole, causes winners and losers

• Workers in exporting industries cash higher wages and employment -- winners– IT workers in the US, workers in mechanical industries in Italy

• Workers in import-competing industries suffer wage and employment losses -- losers– Steel workers in the US, textile workers in Italy

Comparative advantage theory says that winners gain enough to compensate losers. But how is unclear in practice.

Government redistribution of part of the export proceeds implied in principle. Rarely carried out in practice …


Cross-country wage differentials – a proof of exploitation …


Wages differ because labor productivity differs: high-productivity countries can still pay higher wages and be competitive on unit costs (Source: Trefler, 1993, Journal of Political Economy)

.. Or simply a proof of labor productivity differentials?


Who are the “trade winners” in poor countries?

In poor countries the winners from international trade are the owners of the resource available in abundant supply in the opening-up country (Stolper-Samuelson theorem – a consequence of Heckscher-Ohlin’s comparative advantage model)

Who are these winners? Two categories of people• The owners of the land where natural resources are located and

primary products are grown– This worsens income distribution for they are rich to start with

• The plantation workers and small producers of primary products– This improves income distribution for they are the poor

So effect of opening up on income distribution in poor countries not obvious (and may actually be positive)

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Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley Chapter 11 GROWTH IN THE OPEN ECONOMY