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Lecture 5 The Open Economy Li Gan Department of Economics Texas 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 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 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 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 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 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 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 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 27.5 0.1 270 Wheat (bushels/hour) 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 Free trade exploits less productive countries. 3. 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: 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 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 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 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 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: World price * P ee 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) 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 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 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.