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

2. 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

3. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-3 Two globalization waves: end of 1800 and today (last 50 years or so)

4. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley Growth in trade partly boosted by lower transport and communication costs, particularly in the first half of the century

5. 11-5 Moore’s Law as Seen in Intel Microprocessors – how the availability of a global technology..

6. 11-6.. Has driven down the price of computers, hence the cost of information and communication processing

7. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-7 Globalization (especially in second half of century) also boosted by declining tariffs – hence role of policy

8. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-8 Despite progress towards freer trade, globalization is still very incomplete How do we know? Look at Law of One Price Domestic 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

9. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-9 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

10. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-10 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

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

12. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-12 Most international trades occur among rich countries which sell varieties of same goods to each other

13. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-13 Chinese - U.S. trade consistent with Hecksher- Ohlin U.S. export capital intensive goods and import labor intensive ones

14. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley Extent of Intra-industry trade (as a share of total trade) --- more important for rich countries

15. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-15 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 thing There 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

16. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-16 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

17. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-17 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?

18. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-18 Openness and GDP per Capita: a positive correlation – A proof of what?

19. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-19 Trade and growth Among closed economies, low growth and no sign of convergence

20. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-20 Trade and growth – Among open economies, higher growth and evidence of convergence

21. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-21 If capital perfectly mobile in a competitive world, MPK = r world. Hence:  Ak  -1 =r w

22. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-22 Remarks on the Solow model in the open economy In a closed economy: k ss would depend on domestic factors such as the saving rate In an open economy (with perfect capital mobility), domestic saving should be irrelevant k ss would only depend on the world interest rate So would y ss

23. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-23 Gdp in the steady state in the open- economy Solow model

24. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-24 How close is the real world to the open- economy Solow model? Not very close, seemingly. The link between saving and investment is tight

25. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-25 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

26. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-26 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 …

27. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-27 Cross-country wage differentials – a proof of exploitation …

28. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-28 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?

29. Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley 11-29 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)