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These slides – and more! – can be viewed on my website: www.hi.is/~gylfason International Economic Integration Implications for National Economic Policies Thorvaldur Gylfason Outline 1. Globalization and its implications for National incomes Prices and inflation Interest rates 2. Policy coordination Monetary policies and institutions Fiscal policies 3. Agricultural policy Import Tariffs 1980-2000 25 20 1980 15 2000 10 5 0 Tariffs (% of Tariffs (% of tax revenue) imports) Export Duties 1980-2000 5 4 1980 3 2000 2 1 0 Duties (% of exports) Duties (% of tax revenue) Imports and Exports 1960-2000 (% of GDP) 50 40 1960 1980 2000 30 20 10 0 Imports Exports FDI 1980-2000 (% of GDP) 10 1980 1990 2000 8 6 4 2 0 FDI (net) FDI (gross) Further Evidence of Globalization Economic integration followed by political integration Widening and deepening integration Europe’s common currency rests, in part, on political arguments (Austria vs. Sweden) Even in North America, there is an ongoing debate about the pros and cons of adopting a common currency Is NAFTA not enough? But political and historical impetus is absent International Linkages National incomes of trading partners tend to move in tandem Suppose country A exports to country B, so A’s exports are B’s imports Then a boom in B increases demand for imports in B which means that exports – and output! – in A must also rise Likewise, a slump in A can lead to a slump in B International business cycles, through trade GDP in US The Foreign Multiplier Extra boost in US C EU US’ Demand boom in US US B A Imported boost in EU GDP in EU Other Linkages: Inflation Prices move together Inflation in country A increases the real exchange rate (i.e., makes the home currency appreciate in real terms), thus hurting exports which, in turn, diverts demand from imports to home production in country B, hence increasing aggregate demand and inflation in country B Imported inflation, through trade Price level in US Other Linkages: Inflation Extra inflation in US C EU US’ Demand boom in US US B A Imported inflation in EU Price level in EU Two Cases Fixed exchange rate P = P*/e As P* rises, so does P With fixed e, a rise in P* leads to real depreciation, so BOP improves and M rises Hence, P rises: Imported inflation Flexible exchange rate As P* rises, e rises (nominal appreciation) Real depreciation is partly reversed Hence, M and P rise less than otherwise Still Other Linkages: Interest Rates Interest rates move together An increase in interest rates in country A attracts capital inflows from country B, thus reducing the supply of capital in country B, and thereby driving up interest rates in country B Interest parity, through capital movements Still Other Linkages: Interest Rates r = real interest rate S = saving I = investment Home country r B S Rise in I A I’ I S, I Still Other Linkages: Interest Rates Foreign country Home country r B r S Rise in I S’ S B Fall in S A I’ A I S, I I S, I Implications of Linkages Economic integration means that economic policy in one country, especially if the country is large, influences economic developments in other countries, through international trade and investment Economic integration calls for political integration, to some extent at least Important driving force behind European integration Example of Environmental Policy Pollution respects no national boundaries Therefore, need international cooperation on environmental protection and pollution control Case in point: Kyoto protocol Same general principle applies to some aspects of economic policy Also: Law enforcement Exchange Rate Policy Cannot be conducted in a vacuum Unless your country is very small Country A’s decision to devalue its currency causes country B’s currency to appreciate, through trade Therefore, countries may wish or need to cooperate on exchange rates Currency unions Case in point: Europe’s single currency Or they may want to be alone The Impossible Trinity Free capital movements Currency union Fixed exchange rate Floating exchange rate Independent monetary policy 1945-1972 Fiscal Policy Globalization also presents a challenge to fiscal policy through impending tax erosion E-commerce and electronic money Offshore activities and foreign shopping Financial capital Globalization may, however, facilitate new and more efficient ways to collect revenue Tax harmonization Pollution fees Monetary Policy Main objective is price stability Because high inflation hurts economic growth as well as the external position Monetary restraint requires fiscal discipline Monetary policy under floating exchange rates and perfect capital mobility Increased independence of central banks, and increased accountability Banking supervision Inflation targeting Global Economic Performance since 1990: Four Features I. World inflation has been brought down to its lowest level in 40 years Inflation dispersion has also diminished II. International integration and liberalization of financial markets III. More complex financial linkages and policy transmission mechanisms IV. Flexible exchange rates have become more prevalent Agricultural Subsidies per Farmer 1999-2000 (USD) 35000 30000 25000 20000 15000 10000 5000 0 Iceland Norway EU US New Zealand Agricultural Subsidies per Farmer 1999-2000 (USD) 35000 30000 25000 20000 15000 10000 5000 0 Iceland Norway EU US New Zealand Agriculture Slope = -PI/PA D Domestic price ratio H E Agricultural output (A) As PI rises, I rises and A falls As PA rises, A rises and I falls C O Industrial output (I) G Agriculture E = mc2 World price ratio D H If output gain = E and price distortion = c, then E = mc2 Agricultural output E Price distortion Output gain OC = industrial output CA = agricultural output OA = total output O Domestic, distorted price ratio F C Industrial output G A B Agriculture Implication: The output gain varies directly with 1. The magnitude of the transfer of resources between sectors (m) 2. The extent of the original price distortion (c) The greater the transfer of resources and the greater the distortion, the greater is the output gain Numerical Example E is the output gain from liberalization m is a constant equal to ½ times the share of the industrial sector in output after liberalization times the price elasticity of industrial output c is a measure of the price distortion in percent The greater the initial distortion, the more ambitious the liberalization, and the more elastic the output, the greater the gain The CAP: An Application Suppose Farm protection keeps domestic agricultural prices 80% above world prices, so that c = 0.8/(1 + 0.8) = 0.44 Industrial sector’s share in GDP will rise to 95% following farm policy liberalization Price elasticity of industrial output is 0.2 Accords with price elasticity of farm output of 4 Output gain from liberalization is then E = 0.5*0.95*0.2*0.442 = 0.02, or 2% Larger effect if productivity gain is included The CAP: An Application When productivity gain is included, the total cost of the CAP rises to perhaps 3% of the EU’s GDP Yet these cost estimates do not include Environmental damage in agriculture Effects on CEECs Effects on LDCs Agriculture: Static Gains World price ratio Welfare gain Exports D K J H E Price distortion Output gain Agricultural output Domestic, distorted price ratio Imports F C O Industrial output G A B Agriculture: Transitional Pains Transition takes time: From E to F via M, N, and Q Welfare gain D J H E M Agricultural output N Q Price distortion F C O Industrial output G A B Agriculture: AB = static gain Dynamic Gains BC = dynamic gain AC = AB + BC = total gain Welfare gain D World price ratio K J Productivity gain E Price distortion Agricultural output H F G O Industrial output A B C Conclusion Globalization means interdependence Policies influence not only those who make them Need to find ways to share responsibility without giving up too much sovereignty Not easy, but we must try