Transcript Lecture 8 International Trade and Finance

Lecture 5
The Open Economy
Li Gan
Department of Economics
Texas A&M University
Contents
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Trade


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Basic facts about trade
Why trade
International Finance
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Exchange rates
How exchange rates are determined
The Mundell-Fleming model
Trade as a percentage of GDP
Most international
Least international
Trade as a percentage of GDP, US: 1960-2005
From 4.5% to 11% (export) or 16% (import)
Source: U.S. Bureau of Economic Analysis
1-4
US Trade deficit as a percentage of GDP
U.S.
Government
Misc. Services
Transfers
Under U.S.
Military Sales
Contracts
Other Private
Services
Royalties and
License Fees
Other
Transportation
Passenger
Fares
Travel
US – a surplus in services
US Export/Import (Services, 2008)
300,000
surplus
250,000
200,000
150,000
100,000
50,000
0
Export
Import
A deficit in goods, especially in consumer goods and
industrial supplies
US Export/Import (Goods, 2008)
900,000
800,000
700,000
600,000
500,000
Export
Import
400,000
300,000
200,000
100,000
0
Foods, Feeds,
& Beverages
Industrial
Supplies (2)
Capital Goods
Automotive
Vehicles, etc.
Consumer
Goods
Other Goods
Trade as a percentage of GDP China: 1978-2007:
From 5%  35% (export) & 30% (import)
40.0
35.0
Export
Import
30.0
25.0
20.0
15.0
10.0
5.0
0.0
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
1-8
Trade as a % of GDP: Low income countries have
higher percentage than high income countries
80.0
72.2
70.0
75.4
64.9
High Income
countries
60.0
50.8
50.0
OECD countries
40.0
Low Income
countries
30.0
20.0
Low and Middle
Income
countries
10.0
0.0
2000
2005
2007
2008
Source: World Development Indicators database, September 2009
1-9
Trade as a percentage of GDP in China and
several developed countries
200.0
190.3
180.0
160.0
140.0
120.0
2000
2005
100.0
2007
80.0
2008
59.2
60.0
46.1
41.2
40.0
31.5
24.4
20.0
0.0
UK
US
Japan
France
Belgium
China
Source: World Development Indicators database, September 2009
1-10
US and China
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China: in 2007, GDP is 3.251 trillion
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Export 1.22 trillion, 37.5% of GDP
Import 956 billion, 29.4% of GDP
Trade surplus 262.2 billion
US  China (2007):
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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
300.0
251.3
250.0
229.5
200.0
150.0
140.4
123.3
124.6
112.1
100.0
81.3
75.8
62.3
50.0
57.8
0.0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009.1-9
1-12
Trade deficit with China in total deficit
Trade between US and China
Trade between US and China
400000
300000
billion $
200000
100000
0
-1000001988
1993
1998
-200000
-300000
Year
2003
2008
export
import
surplus
Trade between US and China
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Over last twenty years:
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
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
2500
2000
1946.03
1500
1000
500
0
1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007
-500
1-16
China’s foreign reserve
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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 China
Products 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
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
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.
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Sales per employee were therefore $92,000.
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This is the average for all U.S. apparel producers.
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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
27.5
0.1
270
Wheat (bushels/hour)
Comparative Advantage in Apparel,
Textiles, and Wheat
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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.
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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.
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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
Free trade exploits less productive countries.
3.
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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 + NX
Y – C – G = I + NX
S = 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:
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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*)
International capital movements
Average daily currency trading volumes
(in billions of dollars)
1-31
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
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Argentina
Australia
Brazil
Canada
China
France
Germany
India
Indonesia
Italy
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Japan
Mexico
Russia
Saudi Arabia
South Africa
Republic of Korea
Turkey
United Kingdom
United States
European central
bank
G-20 Summit
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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 Myungbak
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
2011 6
2012 7
Lee Myung-bak
Nicolas Sarkozy
Exchange rates
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
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
e  e *
P
The Big Mac Index
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Example: On 2/4/2009:
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
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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
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
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:
World price
*
P
ee 
P
Real exchange
rate
Domestic price
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)
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The strong version of PPP: real change
rate = 1
The weaker version of PPP: change in
real change rate = 0
The Big Mac Index
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Advantages:
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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
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Disadvantages:
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The Big Mac is essentially a non-tradable good.
But we know the trade would ensure the PPP
for tradable goods, not necessarily for nontradable goods. For example, housing (nontradable 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
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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
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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
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
Net exports are essentially
determined by national saving.
The long run exchange rate is
determined by relative prices
between two countries.