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Lecture 5 The Open Economy
Li GanDepartment of EconomicsTexas A&M University
Contents
Trade Basic facts about trade Why trade
International Finance Exchange rates How exchange rates are determined The Mundell-Fleming model
Trade as a percentage of GDP
Least internationalMost international
1-4
Trade as a percentage of GDP, US: 1960-2005 From 4.5% to 11% (export) or 16% (import)
US Trade deficit as a percentage of GDP
US – a surplus in services
US Export/Import (Services, 2008)
0
50,000
100,000
150,000
200,000
250,000
300,000
Tra
vel
Pa
sse
ng
er
Fa
res
Oth
er
Tra
nsp
ort
atio
n
Ro
yalti
es
an
dL
ice
nse
Fe
es
Oth
er
Pri
vate
Se
rvic
es
Tra
nsf
ers
Un
de
r U
.S.
Mili
tary
Sa
les
Co
ntr
act
s
U.S
.G
ove
rnm
en
tM
isc.
Se
rvic
es
Export
Import
surplus
A deficit in goods, especially in consumer goods and industrial supplies
US Export/Import (Goods, 2008)
0
100,000
200,000
300,000
400,000
500,000
600,000
700,000
800,000
900,000
Foods, Feeds,& Beverages
IndustrialSupplies (2)
Capital Goods AutomotiveVehicles, etc.
ConsumerGoods
Other Goods
Export
Import
Trade as a percentage of GDP China: 1978-2007: From 5% 35% (export) & 30% (import)
1-8
Trade as a % of GDP: Low income countries have
higher percentage than high income countries
1-9
Source: World Development Indicators database, September 2009
Trade as a percentage of GDP in China and several developed countries
1-10
Source: World Development Indicators database, September 2009
US and China
China: in 2007, GDP is 3.251 trillion Export 1.22 trillion, 37.5% of GDP Import 956 billion, 29.4% of GDP Trade surplus 262.2 billion
US China (2007): Export: 65.24 billion Import: 321.4 billion Trade deficit: -256.2 billion
China’s Trade surplus with US as a percentage of China’s total trade surplus over time
1-12
Trade deficit with China in total deficit
Trade between US and China
Trade between US and China
-300000
-200000
-100000
0
100000
200000
300000
400000
1988 1993 1998 2003 2008
Year
bil
lio
n $ export
import
surplus
Trade between US and China
Over last twenty years: US export to China has grown 13 times. US import from China has grown by 39 times.
36.7% of the US total trade deficit is with China – or 83% of non-oil trade deficit is with China.
75% China’s trade surplus is with the US.
China’s Foreign Reserves: 1978-2008 billion dollars
1-16
China’s foreign reserve
About 30% of world’s foreign reserve.
Continue to rise. At the end of 2009, it reaches US$ 2.4 trillion.
A substantial part of China’s foreign reserve is used to purchase US treasury securities
Comparative advantages (trade of different goods)
Products US buys from ChinaProducts US buys from China Products China buys from USProducts China buys from US
1 Electrical machinery & equipment 1 Electrical machinery & equipment
including consumer electronics including consumer electronics
2 Power generation equipment 2 Power generation equipment
3 Toys and games 3 Air and spacecraft
4 Furniture 4 Oil seeds and fruits
5 Footwear 5 Plastics
6 Apparel 6 Optics and medical equipment
7 Iron and steel 7 Iron and steel
8 Plastics 8 Copper
9 Leather and travel goods 9 Organic chemicals
10 Vehicle and parts 10 Wood pulp
Trade of different goods
US buys toys, furniture, footwear, apparel, etc. from China.
China buys air and space crafts, agricultural and resource products (including wood pulps), medical equipments etc from US.
Comparative Advantage in Apparel, Textiles, and Wheat
Burlington Industries in US announced in January 1999 it would reduce production capacity by 25%.
After layoffs they employed 17,400 persons in the U.S. with sales of $1.6 billion in 1999.
Sales per employee were therefore $92,000.
This is the average for all U.S. apparel producers.
Textiles are even more productive with annual sales per employee of $140,000 in the U.S.
Comparative Advantage in Apparel, Textiles, and Wheat
US China US/China
Apparel (sales/employee) $92,000 $13,500 6.8
Textiles (sales/employee) $140,000 $9,000 15.6
Wheat (bushels/hour) 27.5 0.1 270
Comparative Advantage in Apparel, Textiles, and Wheat
US has absolute advantages in all three products.
The absolute advantage in wheat for the U.S. is even greater than in apparel and textiles, it has the comparative advantage in wheat.
China has the comparative advantage in apparel and textiles because its productive disadvantage relative to the U.S. is less than in wheat.
This explains why the U.S. imports apparel and textiles from China despite higher productivity in the U.S.
Misconceptions About Comparative Advantage
1. Free trade is beneficial only if a country is more productive than foreign countries.
But even an unproductive country benefits from free trade by avoiding the high costs for goods that it would otherwise have to produce domestically.
High costs derive from inefficient use of resources.
The benefits of free trade do not depend on absolute advantage, rather they depend on comparative advantage: specializing in industries that use resources most efficiently.
Misconceptions About Comparative Advantage
2. Free trade with countries that pay low wages hurts high wage countries.
While trade may reduce wages for some workers, thereby affecting the distribution of income within a country, trade benefits consumers and other workers.
Consumers benefit because they can purchase goods more cheaply.
Producers/workers benefit by earning a higher income in the industries that use resources more efficiently, allowing them to earn higher prices and wages.
Misconceptions About Comparative Advantage
3. Free trade exploits less productive countries. While labor standards in some countries are less than
exemplary compared to Western standards, they are so with or without trade.
Are high wages and safe labor practices alternatives to trade? Deeper poverty and exploitation (ex., involuntary prostitution) may result without export production.
Consumers benefit from free trade by having access to cheaply (efficiently) produced goods.
Producers/workers benefit from having higher profits/wages—higher compared to the alternative.
How patterns of trade are determined?
GDP equation:
Y = C + I + G + NXY – C – G = I + NXS = I + NX S – I = NX
Net capital outflow = Net exports
Example
Bill Gates sells a copy of windows to a Japanese consumer for 5,000 yen.
Export increases by 5,000 yen
How would he use this 5,000 yen?
Capital flow
(1) Invest in Japan by buying stocks of Sony corporation,
net capital flow increases (some of the US saving is flowing abroad).
(2) Buy a Sony Walkman import increases by 5,000 yen. No change in net
export.(3) Exchange the 5,000 Yen into US dollar. The bank has to either buy Japanese stocks or
deposit into a Japanese bank, or has to exchange the Yen into dollar with somebody else.
Saving and investment in an Open Economy
Assumptions: Fixed output. C = C(Y-T) = a + b(Y-T) I = I(r), interest rate is internationally
determined: r = r* -- caused by huge international capital mobility (see next slide)
NX = S – I = Y – C(Y-T) – G – I(r*)
1-31
International capital movementsAverage daily currency trading volumes (in billions of dollars)
Saving and Investment in an open economy
Saving and investment in an open economy
World interest is too high trade surplus.
World interest is too low trade deficit.
A increases in G S decreases S curves shifts left trade deficit
Twin deficits
Twin deficits
An international coordination of monetary policy during this financial crisis
11/04/08 World Summit for Financial Crisis
G-20: Finance ministers and central bank governors of 19 countries + EU
Argentina Australia Brazil Canada China France Germany India Indonesia Italy
Japan Mexico Russia Saudi Arabia South Africa Republic of Korea Turkey United Kingdom United States European central
bank
G-20 Summit
1st meeting: 2008, 11/14-15, Washington DC, George W Bush
2nd meeting: 2009, 4/2, London, Gordon Brown
3rd meeting: 2009, 9/24-25, Pittsburgh, Barack Obama
4th meeting: 2010, 6/26-27, Stephen Harper, Toronto
5th meeting: 2010, 11/11-12, Lee Myung-bak
G20-Summit
Year # Dates Location Host Leader
2008 1 11/14-15 Washington, DC George W. Bush
2009 2 4/2 London Gordon Brown
2009 3 9/24-25 Pittsburgh Barack Obama
2010 4 6/26-27 Toronto Stephen Harper
2010 5 11/11-12 Seoul Lee Myung-bak
2011 6 Nicolas Sarkozy
2012 7
Exchange rates
Real exchange rate = nominal exchange rate x price of domestic good / price of foreign good
Or:
Real exchange rate = Normal exchange rate * Ratio of price levels
*P
Pe
The Big Mac Index
Example: On 2/4/2009: Price of Big Mac 290 Yen in Japan, and 12.5
Yuan in China. Price of Big Mac in US is 3.54.
The nominal exchange rate is: 100 Yen/$, 6.83 Yuan/$ Real exchange rate b/w US and Japan = 100 *
3.54/290 = 1.22 Real exchange rate b/w US and China = 6.83 *
3.54/12.5 = 1.93
The Big Mac Index
Big Mac is 22% more expensive in US than in Japan, and 93% more expensive in US than in China.
Net export
Net export depends on real exchange rate: NX(ε).
Higher real exchange rate, lower the net trade balance.
S – I = NX(ε)
Saving-invest and net export
An increase G lower NX (twin deficits again).
An increase in world interest rate
An increase in investment
Trade policy
Nominal Exchange Rates
Nominal interest rate:
P
Pe
*
World price
Domestic priceReal exchange rate
Nominal exchange rate
Determined by relative prices. If domestic price is cheaper
appreciate
If world price is cheaper depreciate.
Nominal exchange rate
Purchasing Power of Parity
Purchasing Power Parity (Law of one Price)
The strong version of PPP: real change rate = 1
The weaker version of PPP: change in real change rate = 0
The Big Mac Index
Advantages:
Quality difference of the same good at different countries. The Big Mac across countries should be the same.
Coverage of countries. The McDonald’s has branches in almost all countries, so almost all countries would have the same Big Mac.
The Big Mac Index
Disadvantages: The Big Mac is essentially a non-tradable good. But we know the trade would ensure the PPP
for tradable goods, not necessarily for non-tradable goods. For example, housing (non-tradable goods) prices in California and in Texas differ substantially.
The PPP between the “California dollar” and “Texas dollar” should obviously be true.
Big-Mac Index
For Norway: For China: If we assume the real exchange is
to be one, we could derive the Big Mac exchange rate:
For Norway: Norway Kroner is over-valued. For China: Chinese Yuan is under-valued.
Summary
Trade Already very important and
increasingly important. Many reasons for trade – comparative
advantage suggests: even one party is absolutely more efficient than another one to produce all goods – it is still profitable to trade.
Summary
Net exports are essentially determined by national saving.
The long run exchange rate is determined by relative prices between two countries.
