Preliminary Notes On International Trade – 1 November 2006 Version Houston H. Stokes
11/1/2006 9:35 AM
1. Introduction
International Trade is concerned with exchange. Important topics include the mechanisms by which trade causes:
- Welfare changes in both countries.
- The distribution of income changes in both countries.
- Factor prices change in both countries.
- The range of goods produced changes in both countries.
- The relative prices of goods to change.
Key aspects of trade policy include:
-The effect of tariff on international trade.
-The effect of free trade areas (NAFTA), customs unions and economic unions on welfare.
Why do we need a theory of international trade?
Macroeconomics assumes:
1. economic agents maximize their self interest,
2. such agents are rational.
In trade theory more assumptions are needed.
Within a nation state it is assumed that labor and capital are free to move among regions. This may not be the case across countries.
Within a nation state there are normally no government-imposed barriers to shipment of goods (tariff)
The state of the economy within a nation state is usually the same for all regions. Across countries differences in a countries position in the business cycle can have major ramifications.
Within a country there is only one currency. Exchange rate changes complicate the analysis. (In world of fixed exchange rate and perfect capital mobility there is only one interest rate. In a world of flexible exchange rates, different interest rates across countries are possible.)
In period 1970-2000 share of exports + imports as a % of GNP (See Table 1.1
1970198019902000
- US 10.820.520.426.0
- Canada42.554.750.885.8
-Mexico17.423.740.764.0
- UK43.852.050.658.1
- Japan20.327.919.820.1
- Germany43.255.161.667.1
- France31.143.243.655.8
- Italy 30.544.139.455.7
US share is low but has increased substantially. Compared to most all other countries, US share is low. US is now being impacted by the world to an increased degree.
In the period 1970-2000 the total capital outflows of the US increased from 10.88 to 580.65. Inflows from 6.24 to 1024.23 (See table 1.2). These numbers are greater for UK (3.16 to 777.68 and 1.64 to 801.58). This data is nominal!!
US faces increased vulnerability to foreign shocks (such as 1974 oil price shock). Changes is exchange rates under the flexible exchange rate system provides a source of shocks to the US economy. (In early 80's high US interest rates attracted capital from abroad causing the dollar to appreciate and making sales overseas more difficult.)
Euro now gives Europe one currency like the US. EEC like what was setup in the US in 1796.US now faces a potential economic rival.
"Pure Theory" of International Trade provides a framework by which all kinds of exchanges can be analyzed, both graphically and using statistical (econometric) methods.
"Monetary Theory" of International trade is concerned with balance of payments adjustment.
Positive Economics
- Develops a framework of analysis
- Constructs various alternative hypothesis
- Tests hypothesis
Normative Economics
- Determines what ought to be
- Can lay out costs and benefits (defense vs welfare)
- Want to look at gains from exchange.
- Want to look at the costs and benefits of differing policies.
Trade can be shown from supply and demand analysis.
Figure 1
Def: An indifference curve drawn on the X and Y diagram contains the locus of points showing different bundles of X and Y to which the consumer (country) is indifferent. Assume barter ratio is fixed. Country at f producing and consuming oc of steel and od of food. The domestic relative price line is a a'. The world relative price line is a a'' . causing producers to stop producing food and go 100% to steel (o a). At position g the country consumes ob of steel and gives up ab of steel to get oe of food. Trade moved the country from U1 to U2. Trade is caused by the relative price differing between regions.
Figure 2
For complements the indifference curve approaches a 900 angle. For substitutes the indifference curve approaches a 1800 angle.
The above analysis assumes we have a community indifference curve. A major unsolved problem in economics is how to construct the community indifference curve.
Key idea: Normative economics is in the indifference curve and changes:
- Over time
- Due to advertising
- Due to consumption itself
Trade theory assumes exchange in the presence of some fixed factor. The fixed factor does not have to be location related. Examples are land, tastes, skills, climate.
Gains from trade can arise:
- Due to changing consumption patterns as a result of changes in relative prices.
- Changes in the degree by which a country specializes.
- Both changes in consumption patterns and specialization.
Changes is specialization imply changes in the returns to factors and thus possible dislocation.
This can cause political problems. Wheat farmers in Mass lost out to Iowa when US Constitution outlawed internal tariffs.
Growth. Sources of growth in the United States include:
- Population (immigration)
- Education (increases in technology)
- Resources
- Will of People (WWII increased productivity)
Some assumptions used to simplify analysis. (How sensitive are results to these assumptions?)
- Neutrality of Money: Real variables determined independently of monetary variables. Each sector looks at relative prices not absolute prices (which are a function of money supply).
- All prices are flexible (determined by competition)
- Assume initially the amount of factors of production are fixed.
- Assume initially that factors are immobile between countries.
- Assume initially that same technology is available to all consumers.
- Assume that initial income patterns are known.
- Assume initially no barriers to trade in form of transportation, information, communication.
Key questions:
- Direction of trade
- Volume of trade and prices of traded goods
- Effects of trade restrictions
- Effect of free trade and restricted trade on welfare
Approaches:
- Partial equilibrium approach uses supply and demand. The problem is that as you move on the supply and demand curve, the assumptions underlying these curves are not met resulting in the curves shifting. (See Above figure)
- General Equilibrium Approach. Uses production possibility curve (PPP), Community indifference curves, and relative price line to determine trade welfare. This approach will be the main focus of the course.
Technical problems is Trade Analysis:
- Time period of analysis. If the period is too short, then substitutes cannot be developed and analysis leads to misleading results. Example. Gas crisis in 1974. Gas prices increased and in the short run people drove old cars. In the longer run more fuel efficient cars were produced and demand for gas fell. => Negative balance of payments effects of an increase in import prices are most severe in the short run.
- Simultaneity Both supply and demand may be shifting. Need to identify the supply and demand curves using 2SLS or 3SLS methods.
- Errors of Measurement. Trade data may be poor. Example: US used value of disks and manuals to measure software sales.
- Aggregate elasticity. Aggregate elasticity measures biased toward zero since greatest price fluctuation is observed in goods with inelastic response => goods with inelastic S & D are likely to be given too much weight in the calculation of the aggregate price index.
- Adjustment. During the time path of adjustment we may see points not on the true curve.
- Elasticity measurement is critical. Assume two countries initially in equilibrium. The home country (A) imports X and exports Y. Define the income elasticity of demand in A as:
If then as A and B grow the balance of payments will move against B. It will be in B's interest to have growth in A increase. => Economic stagnation in the foreign country implies balance of payments problems in the home country. The lower the income elasticity of demand, the faster a country can grow and still maintain balance of payments equilibrium.
2. Why Nations Trade: Patterns from Trade and Gains from Trade
- Nations trade because they benefit from it.
- Adam Smith stressed that nations traded due to absolute advantage. Absolute cost advantage => the real cost (labor ) was less in one country than another. Smith was thinking in terms of labor theory of value. Modern economics (not Marxism) discards this approach and looks at other costs of production such as land and capital.
- Assuming labor is mobile, labor is the only input and competition within a single country => goods will trade at prices that are a direct proportion of their labor costs. This further assumes away retraining problems. Between countries labor is not mobile due to a number of reasons.
- Ricardo stated that absolute advantage was not a necessary condition for trade. Trade could occur due to comparative advantage. Ricardo's example:
ClothWine
Portugal 90 80
England100120
Portugal has absolute advantage in both goods since it takes less labor to produce cloth and wine that England.
In Portugal 90 hours of labor get you 9/8 of a wine barrel or 1C = (9/8)W.
In England 100 hours of labor get you 5/6 of a wine barrel or 1C = (5/6)W.
=> Portugal sell wine, England sell cloth or labor in Portugal (England) should move into production of wine (cloth).
Mill introduced demand to allows us to determine how much each country would trade.
- Set up example in terms of 1 unit of labor.
BroadclothLinen
England1015
Germany1020
-=> in England 10 broadcloth = 15 Linen
in Germany 10 broadcloth = 20 Linen
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Preliminary Notes On International Trade – 1 November 2006 Version Houston H. Stokes
- English broadcloth producers should exchange broadcloth for linen in Germany. Broadcloth produces will benefit if they can obtain more than 15 linen for 10 broadcloth. German liner producers note that to get broadcloth in Germans they have to trade 20 linen but if they trade with England they can only give up 15 linen for 10 broadcloth.
Specie Flow Mechanism. Assume national money is determined by gold stocks. Assume a two country world where trade in initially in balance. Here prices in each country are stable. Assume next that increased demand for A's goods causes gold to flow in. causes demand for A's goods to fall and demand for B's goods to rise. Specie Flow mechanism implies that (Marshall Lerner Condition). If this condition is not met, all gold will flow from B to A. This classical adjustment mechanism relied on change in gold flows to change national money to change prices and costs. The theory did not deal with output and unemployment effects.
Managed Adjustment. Keynes suggested that a change in demand could change the demand for imports (exports) without a change in prices. Taussig noted that before WWI the system appeared to adjust faster that the level of gold flows would suggest. Neuburger-Stokes (1979) presented time series evidence that suggested that central banks were using interest rate policy to speed the adjustment without having to resort to the level of gold flows that would other wise occur.
Historical notes: Earl Hamilton studied gold flows from the new world to Spain and hence to France and England. During wars (such as the Bullionist Controversy) many countries suspended the gold standard. In this century the gold standard was suspended during WWI. After the war the UK went back on gold at the prewar rate. The return was protracted and slow. In the late 20's the world moved into depression and countries moved off gold. After WWII the world moved to the gold exchange standard. Here countries pegged to either the pound or the dollar which in turn pegged to gold. Major problems included adjustment, confidence, and liquidity. In the fall of 1967 at the Rio Conference the SDR was setup. The SDR paid interest. No country was required to accept more that 2 times its quota. The SDR was designed to solve the liquidity problem. It did not address the confidence or adjustment problem. In Nov 1967 the pound was devalued from $2.80 to $2.40. In the 20's exchange rates moved in part as a result of changes in prices. This led to purchasing power parity theory or the "law of one price." The problem is that this theory is not general. It does not look at changes in demand, at changes in capital flows and at technological changes, all of which impact on exchange rates. Define as the dollar price of one unit of the foreign currency. Theory suggests that:
- Technological changes
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Preliminary Notes On International Trade – 1 November 2006 Version Houston H. Stokes
- Capital inflow
In 30's moved away from PPP since there were other causes of exchange rate movements. These included large scale speculative capital flows, competitive devaluations by both deficit and surplus countries and problems of exchange stability due to fears. Expectations can alter 's in countries.
- Before trade the relative prices of goods in A and B differ. After trade they adjust to be the same. Assume . This implies that A is willing to sell Y to
B and import X from B. The gains from trade include a consumption effect and a possible production effect. Assuming no changes in production in each country, trade can still result in a gain for both countries. If as a result of trade production changes in both countries there can be a still further production effect. To accurately measure the gains from trade we need:
- Community indifference curves in each country.
- Production functions in each country (Production possibility curves)
- Offer Curves (derived from community indifference curves and productionpossibility curves to determine the world trade price).
Partial equilibrium analysis such as figure 1 can be used to attempt to measure the gains from trade but there are serious problems in moving along country supply and demand curves without the curves themselves shifting. This course will use general equilibrium approach. Basic diagram is given in figure 3. We assume diminishing returns to scale which is seen by the country having a production possibility curve which is bowed outward. The country starts at k with oc of food and oi of steel. After trade with no production change the country is on higher indifference curve and consuming oe of food and on of steel. If production changes, country produces at g. Here food is ob and steel is of. After trade country gives up bd to food to get fp of steel. Country now on highest in difference curve. We assume here that the world trade price does not change as a result of trade (small country assumption).
Figure 3
Figure 4 shows equilibrium in a closed economy assuming constant returns to scale production.
Here in contrast to figure 3 we have a straight line production possibility curve.
Figure 4
Country reaches U1 by producing oa food and ob steel. Country is at point
C on the production possibility curve. Without trade country cannot get to U3.
Figure 5 shows effect of trade. Country was consuming and producing at k. After
Trade county reached higher indifference curve at g. Steel consumption increased from ob to om and food consumption did not change much. Country production point was now on Food and no steel. Na of food was sold for om of steel.
Figure 5
Historical Development of Trade Theory (See Metzler Article)
- Trade theory developed in four areas:
I. Balance of payments and theory of employment
II.Fluctuating Exchange rates
III.Price Theory and International trade
IV.Commercial Policy and The Theory of International Trade
I. Balance of payments and Theory of Employment
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Preliminary Notes On International Trade – 1 November 2006 Version Houston H. Stokes
- Prior to Keynes - Monetary theory (specie flow mechanism) suggested that system adjusted automatically. Gold out => and trade adjusts. The classical theory did have a role for interest rates. The mechanism was costs notoutput, employment
- Keynes attacked theory suggesting could have unemployment and over production.
- New theory. An external event which causes exports => imports withoutPd. The mechanism was exports => level of aggregate demand => imports . This theory covered the balance of payments effects being either or depending on and where is the income elasticity of the i th country.
- Taussig before WWI noted that the system appeared to adjust faster that gold flows would suggest. He had no theory to explain what was happening. After WWI elasticity measurements appeared to be low. Why did trade adjust? The Keynesian approach provided a missing link.
- Keynesian theory independent of banking policy and implied that banks cannot influence the system. The Keynesian theory did have antecedents in Ricardo and others.
- Capital flow effects. Keynesian theory => unless a disturbance (such as a capital flow) disturbs the circular flow of income (via a change in investment), it will have no effect on the system. The classical theory treated all flows as the same. In classical theory the gold flow => M and M => changes in prices and the balance of payments etc.
II. Fluctuating Exchange Rates
- During WWI gold standard suspended. After war world's return to the gold standard was protracted and slow. Next the world moved into depression => a period of fluctuating rates.
- In 20's exchange rate moved as a result of war causing prices to increase. This led to purchasing power parity theory (see contributions of Officer) that codified the "law of one price." PPP => exchange rates had to move. Problems with PPP included 1. not looking at effects of shifts in international demand on exchange rates, 2. not looking at effects of capital flows on exchange rates, 3. difficulty on selecting just what price should be used in the index.
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Preliminary Notes On International Trade – 1 November 2006 Version Houston H. Stokes
- In 30's many countries found depression caused changes in the exchange rate. There was a move away from PPP since here changes in the price level was not the cause of exchange rate movements. The income of all countries fell in the depression but not all countries balance of payments were effected the same. Keynesian theory on the effect of induced income changes implied: Balance of payments deficit => Y down => imports down => balance of payments improves. This line of reasoning suggested that changes in the exchange rate would not adjust the balance of payments. The situation was complicated by: