IPC3702-summary_international_Political_economics_theory_and_policy

IPC3702-summary_international_Political_economics_theory_and_policy.1. Introduction Throughout the study of international economics seven themes recur: (1) the gafrom trade, (2) the pattern of trade, (3) protectionism, (4) the balance of paymenexchange rate determination, (6) international policy coordination, and (7) the international capital market. International economics consists of two broad subfields: international trade andinternational money. While the first focuses on the transactions that involve a physical movement of goods, the latter focuses on the financial transactions. This book introduces the main concepts and methods of international economics. Much of the book is devoted to old ideas that are still valid as ever, such as the Ricardian model and David Hume’s monetary analysis. Due to the fact that many new challenges have been thrown up, some of these important concepts are rethought and updated. Finally, new approaches have emerged to old questions, such as the impacts of changes in monetary and fiscal policy. The study of international economics has never been as important as it is now. Nations are more closely linked through trade and investment in each other’s economies than ever. Both policy makers and business leaders must pay attention to the rapidly changing economic fortunes. A look at basic trade statistics shows that international trade has roughly tripled in importance compared with the economy as a whole. Moreover, both imports and exports have increased in the United States, backed up by money from foreign investments in the U.S. economy. Due to the economic crisis these imports and exports took a plunge around 2009, which clearly reflects the linkages between world trade and the world economy. 1.1. What Is International Economics About? Throughout the study of international economics seven themes recur: (1) the gafrom trade, (2) the pattern of trade, (3) protectionism, (4) the balance of paymenexchange rate determination, (6) international policy coordination, and (7) the international capital market. International economics uses the same fundamental methods of analysis as other branches of economics, because the motives and behavior of individuals are the same in international trade as they are in domestic transactions. However, international economics involves new and different concerns such as trade quotas or currency fluctuations, because these trades and investments occur between independent nations. Distributing prohibited | Downloaded by Filip Semrad () lOMoARcPSD| © StuD 15 The subject matter of international economics thus consists of issues raised by the special problems of economic interaction between sovereign states. Throughout the study of international economics seven themes recur: (1) the gains from trade, (2) the pattern of trade, (3) protectionism, (4) the balance of payments, (5) exchange rate determination, (6) international policy coordination, and (7) the international capital market. 1.1.1. The Gains from Trade The most important single insight in all of international economics is that there are gains from trade – or, when countries sell goods and services to each other there is almost always a mutual benefit. It is a common misconception that trade is harmful if there are large disparities between countries in productivity or wages. On the one hand, less technologically advanced countries worry that they won’t be able to compete in international trade. On the other hand, technologically advanced nations worry that lower-wage countries will drag their standard of living down. This book’s first model (Chapter 3) will demonstrate that two countries can trade to their mutual benefit despite any disparity. Chapter 5 will show that trade provides benefits by allowing countries to balance their import and export goods. The benefits of international trade are not limited to trade in tangible goods as international migration and borrowing and lending are also forms of mutually beneficial trade. Chapter 4 will deal with trade of labor for goods and services, while trade of current goods for the promise of future goods will be discussed in Chapter 6. Chapter 21 will show that the exchange of risky assets can benefit all countries by allowing them to diversify its wealth and reduce the variability of its income. Although countries generally benefit from international trade, it is possible that trade may hurt groups within nations through a strong effect on the distribution of income. Theorists point out that international trade can adversely affect owners of resources that are specific to industries that compete with imports. Chapters 4 through 6 will deal with the problem that the real wages of less-skilled workers have been declining in particular countries. 1.1.2. The Pattern of Trade Because economists cannot discuss the effects of international trade with any confidence unless they know their theory is good enough to explain the international Distributing prohibited | Downloaded by Filip Semrad () lOMoARcPSD| © StuD 16 trade that is actually observed, the pattern of international trade has been a major preoccupation of international economists. Some aspects of the pattern of trade, such as climate and resources, are easy to understand. Chapter 3 will show a powerful explanation of the pattern of trade in terms of international differences in labor productivity. Chapter 5 presents alternative explanations, such as the influential theory that links trade patterns to an interaction between the relative supplies of national resources such as capital and labor on one side and the relative use of these factors in the production of different goods on the other. Theories that suggest a substantial random component in the pattern of trade will be presented in Chapters 7 and 8. 1.1.3. How Much Trade? Since the emergence of modern nation-states, governments have worried about the effect of international competition on the prosperity of domestic industries and have often placed limits on imports. The single most consistent mission of international economics has been to analyze the effects of these so-called protectionist policies, and usually to show the advantages of freer international trade. In the 1990s this debate took a new direction when a broad policy of removing barriers to international trade was pursued that reflected the view that free trade was a force for promoting world peace. Major trade agreements such as the North American Free Trade Agreement (NAFTA) and the World Trade Organization were negotiated. Since that time, however, an international political movement that opposes ‘globalization’ has grown significantly. This movement has forced advocates of free trade to seek new ways to explain their views. Over the years, economists have developed an analytical framework for determining the effects of government policies that affect international trade. This framework, presented in Chapters 9 and 10, helps predicting the effects of trade policies while also allowing for cost-benefit analysis. Although governments do not necessarily do what the cost-benefit analysis of economists tells them they should, economic analysis can help make sense by showing who benefits and who loses from policies such as quotas and subsidies. The key insight of this analysis is that conflicts of interest within nations are usually more important in determining trade policy than conflicts of interest between nations. Chapters 4 and 5 shows that trade has strong effects on income distribution within countries, while Chapters 10 through 12 reveal that the relative power of different interest groups within countries often determines policies towards international trade. Distributing prohibited | Downloaded by Filip Semrad () lOMoARcPSD| © StuD 17 1.1.4. Balance of Payments A key difference between international economics and other areas of economics is that countries usually have their own currencies, whose relative values can change over time. Due to the fact that exchange rates were fixed by government action for a long time, the study of exchange rate determination is a relatively new part of international economics. Fixed-rate systems will be discussed in Chapter 18, Chapter 19 is devoted to the historical performance of alternative exchange-rate systems, and Chapter 20 to the economics of currency areas such as the EU. Chapters 14 through 17 focus on the modern theory of floating exchange rates. 1.1.5. Exchange Rate Determination A key difference between international economics and other areas of economics is that countries usually have their own currencies, whose relative values can change over time. Due to the fact that exchange rates were fixed by government action for a long time, the study of exchange rate determination is a relatively new part of international economics. Fixed-rate systems will be discussed in Chapter 18, Chapter 19 is devoted to the historical performance of alternative exchange-rate systems, and Chapter 20 to the economics of currency areas such as the EU. Chapters 14 through 17 focus on the modern theory of floating exchange rates. 1.1.6. International Policy Coordination Although all nations are free to choose their own economic policies, one country’s economic policies usually affect other countries as well. Differences in goals or a failure to coordinate policies may lead to losses and conflicts of interest. A fundamental problem in international economics is determining how to produce an acceptable degree of harmony among the international trade and monetary policies of different countries in the absence of a world government. Chapter 9 discusses the rationale for the World Trade Organization system. Chapter 19 is devoted to the theory of international macroeconomic coordination and the developing experience. 1.1.7. The International Capital Market In any sophisticated economy there is an extensive capital market: a set of arrangements by which individuals and firms exchange money now for promises to pay in the future. The growing importance of international trade has been accompanied by a growth in the international capital market. International capital markets differ from domestic capital markets as they must cope with special regulations that many countries impose on foreign investment. Special risks that are associated with international capital markets include the risk of currency fluctuations Distributing prohibited | Downloaded by Filip Semrad () lOMoARcPSD| © StuD 18 and national default. This book discusses the functioning of global asset markets (Chapter 21) and foreign borrowing by developing countries (Chapter 22). 1.2. International Economics: Trade and Money International economics consists of two broad subfields: international trade andinternational money. While the first focuses on the transactions that involve a physical movement of goods, the latter focuses on the financial transactions. The economics of the international economy can be divided into two broad subfields: the study of international trade and the study of international money. International trade analysis focuses primarily on those transactions that involve a physical movement of goods or a tangible commitment of economic resources. International monetary analysis focuses on the financial transactions such as foreign purchases of U.S. dollars. An example of an international trade issue is the conflict between the United States and Europe over Europe’s subsidized exports of agricultural products. In reality however, there is no simple dividing line between trade and monetary issues as most international trade involves monetary transactions. The first half of this book covers international trade issues. Part One develops the analytical theory of international trade, while Part Two applies trade theory to the analysis of government policies. The second half of the book is devoted to international monetary issues: Part Three develops international monetary theory, and Part Four applies this. Distributing prohibited | Downloaded by Filip Semrad () lOMoARcPSD| © StuD 19 2. World Trade: An Overview The gravity model relates the trade between any two countries to the sizes of theconomies. Using the gravity model also reveals the strong effects of distance ainternational borders – even friendly borders like that between the United StatesCanada – in discouraging trade. The model can be presented as following, wherea constant term, Tij is the value of trade between country i and country j, Yi is country i’s GDP, Yj is country j’s GDP, and Dij is the distance between the two countries. Tij = A x Yi x Yj / Dij International trade has grown significantly relative to the size of the world econdue to falling costs of transportation and communications. It has not grown in a straight line though: the world was highly integrated in 1914, but trade was greareduced by economic depression, protectionism, and war, and took decades to recover. Nowadays, trade is dominated by manufactured goods and trade in servhas become increasingly important. Developing countries, in particular, have shfrom being mainly exporters of primary products to being mainly exporters of manufactured goods. In 2008 more than 30 percent of all goods and services produced worldwide was sold across national border. The reason why countries export and import a lot of products and the benefits and costs of international trade will be examined in later chapters. This chapter will describe who trades with whom by using the gravity model. Afterwards the changing structure of world trade will be discussed such as the shift in the world’s economic center of gravity and the changes in types of goods that make up trade. 2.1. Who Trades with Whom? The gravity model relates the trade between any two countries to the sizes of theconomies. Using this model also reveals the strong effects of distance and international borders. 2.1.1. Size Matters: The Gravity Model The U.S. trades most heavily with Germany, the UK and France than any other country. This is due to the fact that they have the highest values of gross domestic product. There is a strong empirical relationship between the size of a country’s economy and the volume of both its imports and exports. Distributing prohibited | Downloaded by Filip Semrad () lOMoARcPSD| © StuD 20 Looking at world trade as a whole, economists have found that an equation of the following form predicts the volume of trade between any two countries fairly accurately, where A is a constant term, Tij is the value of trade between country i and country j, Yi is country i’s GDP, Yj is country j’s GDP, and Dij is the distance between the two countries. Tij = A x Yi x Yj / Dij That is, the value of trade between any two countries is proportional, other things equal, to the product of the two countries’ GDPs, and diminishes with the distance between the two countries. The name gravity model is the analogy to Newton’s law of gravity: the gravitational attraction between any two objects is proportional to the product of their masses and diminishes with distance. Economists often use the following more general gravity model: Tij = A x Yi a x Yj b / Dc ij This equation says that the three things that determine the volume of trade between two countries are the size of the two countries’ GDPs and the distance between the countries, without specifically assuming that trade is proportional to the product of the two GDPs and inversely proportional to distance. The gravity model works because large economies tend to spend large amounts in imports because they have large incomes. So other things equal, the trade between any two economies is larger, the larger is either economy. 2.1.2. Using the Gravity Model: Looking for Anomalies One of the principal uses of gravity models is to help identify anomalies in trade. A case study of the United States trade partners shows that the Netherlands, Belgium, and Ireland trade considerably more with the U.S than the gravity model would have predicted. Reasons for this can be found in cultural affinity (Ireland) or geography and transport costs due to location near the river Rhine (Belgium and the Netherlands).One of the principal uses of gravity models is to help identify anomalies in trade. A case study of the United States trade partners shows that the Netherlands, Belgium, and Ireland trade considerably more with the U.S than the gravity model would have predicted. Reasons for this can be found in cultural affinity (Ireland) or Distributing prohibited | Downloaded by Filip Semrad () lOMoARcPSD| © StuD 21 geography and transport costs due to location near the river Rhine (Belgium and the Netherlands). 2.1.3. Impediments to Trade: Distance, Barriers, and Borders All estimated gravity models show a strong negative effect of distance on international trade; typical estimates say that a 1 percent increase in the distance between two countries is associated with a fall of 0.7 to 1 percent in the trade between those countries. This partly reflects increased transport costs, but also tangible factors such as more personal contact between trade partners. This explains why the U.S. do so much more trade with its neighbors Canada and Mexico than with its European partners. Additionally, Canada and Mexico are part of a trade agreement (NAFTA) with the United States, which ensures that most goods shipped among the countries are not subject to tariffs or other barriers. Economists use gravity models as a way of assessing the impact of trade agreements on actual international trade: if the agreement is effective, it should lead to significantly more trade among its partners than one would otherwise predict given their GDPs and distances from one another. However, trade agreements rarely make national borders irrelevant and we can see that there is much more trade between regions of the same country than between equivalently situated regions in different countries. 2.2. The Changing Pattern of World Trade International trade is at record levels relative to the size of the world economy, thanks to falling costs of transportation and communications. Manufactured goodominate modern trade today. In the past, however, primary products were mucmore important. 2.2.1. Has the World Gotten Smaller? People often argue that modern transportation and communications have abolished distance, and made the world smaller. On the one hand, there’s some truth to this because everybody is easily and quickly connected. On the other hand, gravity models still show a strong negative relationship between distance and international trade. A global economy is nothing new, as economists point out two great waves of globalization, with the first wave relying not on jets and the Internet but on railroads, steamships, and the telegraph. This first wave came to an end due to world wars, protectionism and the Great Depression. Since 1970, world trade as a share of world Distributing prohibited | Downloaded by Filip Semrad () lOMoARcPSD| © StuD 22 GDP has risen to unprecedented heights mostly due to ‘vertical disintegration’ of production: before a product reaches the customer, it often goes through many production stages in different countries. 2.2.2. What Do We Trade? International trade is made up of manufactured goods, mineral products, agricultural products, services and so forth. While manufactured goods makes up the main share of world trade, agricultural products represent only a small fraction of the value of trade. In recent years new types of service trade, made possible by modern telecommunications have caused a rise of overseas call and help centers. Currently, manufactured goods dominate world trade and have taken over the dominant position of agricultural and mining goods. A recent transformation has been the rise of third world exports of manufactured goods. The term third world is applied to the world’s poorer nations. These countries in particular, have shifted from being mainly exporters of primary products to being mainly exporters of manufactured goods. 2.2.3. Service Offshoring One of the hottest disputes in international economics is whether modern information technology will lead to a dramatic increase in new forms of international trade such as performing economic functions at long range. Service offshoring is shifting a service previously done within a country to a foreign location. Additionally, producers must decide between setting up a foreign subsidiary and outsourcing services to another firm. The economist Alan Blinder argued that the key distinction for international trade will be between services that can be delivered electronically over long distances with little or no degradation of quality, and those that cannot. When we look at how big service outsourcing might get, we can expect that in the long run, trade in services, delivered electronically, may become the most important component of world trade. 2.3. Do Old Rules Still Apply? Although trade has changed, the fundamental principles still apply to economiesinternational trade. Chapter 3 will cover a discussion of the causes of world trade and an analysis of a model by the British economist David Ricardo. Even though much about international Distributing prohibited | Downloaded by Filip Semrad () lOMoARcPSD| © StuD 23 trade has changed, the fundamental principles discovered by economists at the dawn of a global economy still apply. The sources of modern trade are more subtle. Human resources and human-created resources are more important than natural resources. Political battles over trade typically involve workers whose skills are made less valuable by imports. Distributing prohibited | Downloaded by Filip Semrad () lOMoARcPSD| © StuD 24 3. Labour Productivity and Comparative Advantage: The Ricardian Model The Ricardian model is the simplest model that shows how differences betweencountries give rise to trade and gains from trade. In this model, labor is the only factor of production, and countries differ only in the productivity of labor in diffeindustries. Countries will thus export goods that their labor produces relatively efficiently and will import goods that their labor produces relatively inefficiently Trade benefits a country in either of two ways. First, we can think of trade as anindirect method of production. Second, we can show that trade enlarges a countconsumption possibilities, which implies gains from trade. The distribution of thegains from trade depends on the relative prices of the goods countries producesFurthermore, we can show that three commonly held beliefs about trade are wroFirst, a country gains from trade even if it has lower productivity than its tradingpartner in all industries. Second, trade is beneficial even if foreign industries arecompetitive only because of low wages. Third, trade is beneficial even if a countexports embody more labor than its imports. Extending the one-factor, two-good model to a world of many commodities doesalter these conclusions. It however becomes necessary to focus directly on the relative demand for labor to determine relative wages rather than to work via relative demand for goods. While some of the predictions of the Ricardian model are clearly unrealistic, its prediction has been confirmed by a number of studies. Countries engage in international trade for two basic reasons. First, countries trade because they are different from each other and can benefit from their differences by reaching an arrangement in which each does the thing it can do best. Second, countries trade to achieve economies of scale in production. The next four chapters develop tools to help understand how differences between countries give rise to trade through the concept of comparative advantage. This chapter will give a general introduction to this concept, then will develop a specific model of how the concept determines the pattern of international trade. 3.1. The Concept of Comparative Advantage In the Ricardian model, countries will export goods that their labor produces relatively efficiently and will import goods that their labor produces relatively inefficiently. Distributing prohibited | Downloaded by Filip Semrad () lOMoARcPSD| © StuD 25 The case of winter roses on Valentine day in the United States offers an excellent example of the reasons why international trade can be beneficial. Economists use the term opportunity cost to describe trade-offs: the opportunity cost of roses in terms of computers is the number of computers that could have been produced with the resources used to produce a given number of roses. The difference in opportunity costs of different countries offers the possibility of a mutually beneficial rearrangement of world production. Through this rearrangement the world’s economic pie can be enlarged, and hence it is possible in principle to raise everyone’s standard of living.