ECON 671 International Economics

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ECON 671 International Economics

• Issues, Definitions Strategies

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Historical Background to International Economics
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Mercantilism (1500-1750)

• Natl wealth countrys holdings of bullion
  (specie).
• Economic activity viewed as zero-sum game.
• Strong state power critical to economic success.
• Economic system consist of 3 sectors
• Manufacturing, rural, foreign colonies.
• Merchants for trade, Labor for production.
• Commodities priced by relative labor content.
• Need for state to regulate economic activity to
  ensure favorable (positive) trade balance.
• Positive trade balance means inflows of precious
  metal (specie)
• Increase national wealth, financing for military
  capability.
• Implicitly assuming that economy below full
  employment, no effects on inflation.

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Hume Price-Specie Mechanism

• David Hume (1752) attacks mercantilist views.
• Focuses on price-specie flow mechanism
• Trade surplus leads to inflows of specie to
  country.
• This will increase the countrys money supply
• This in turn will result in higher prices,
  reducing competitiveness of countrys goods.
• This will result in falling trade surplus.
• Exact opposite occurs in trading partner.
• Trade surplus/deficit is thus self-correcting.
• Essentially Quantity Theory combined with gold
  standard (fixed exchange rate).

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Adam Smith Absolute Advantage

• Smith (1776) Nations wealth arises from its
  labor productivity not its store of precious
  metal.
• Individual self-interest invisible hand of
  market leads to specialization higher
  productivity.
• Thus countries should also specialize.
• Export goods for which they have an absolute
  advantage, import where absolute disadvantage.
• Argument shows trade is positive sum game with
  mutual benefits. Powerful argument for expanding
  trade, used against mercantilist thought.
• Saw absolute advantage as deriving from a
  countrys unique endowments of factors of
  production.

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Ricardo Comparative Advantage

• Ricardo (1817) viewed mutual gains from trade as
  possible based on comparative advantage.
• Example above Portugal has absolute advantage in
  both goods, but trade still possible as England
  is relatively more productive in cloth than wine.

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Absolute vs. Comparative Advantage

• Absolute Advantage
• A country has an absolute advantage in good X if
  one unit of labor produces more X than is
  produced by one unit of labor in the other
  country.
• Comparative Advantage
• A country has a comparative advantage in good X
  if its opportunity cost of X in terms of Y is
  less than in the other country
• In previous the example Portugal had an absolute
  advantage in both goods but a comparative
  advantage in wine.

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Opportunity Costs and Advantage

• Comparative advantage arises from differing
  opportunity costs across countries.
• With total labor fixed, producing more of one
  good (Cloth) means producing less of other good
  (Wine).
• Tradeoff is opportunity cost and differs between
  the two countries.
• England
• 1 more unit of cloth requires giving up 5/6 unit
  of wine.
• Portugal
• 1 more unit of cloth means giving up 4/3 units of
  wine.
• Englands comparative advantage is producing
  cloth, while Portugals comparative advantage is
  in producing wine.

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International Trade in Goods Services
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Why Countries Trade

• Relative Differences in Labor Productivity
• Differential Technologies
• Differential Factor endowments
• Short-run fixity of factors
• Differential Tastes
• Increasing Returns to Scale
• Imperfect Competition
• Each factor influences the pattern of trade and
  determines distribution of gains/losses between
  within economies.
• We examine each of these factors separately
  evaluate their relative importance empirically.

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• An Overview of How Countries Differ

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Lesser Developed Countries (LDCs)

• LDCs are not a homogeneous group
• Fourth World vs. Third World Countries
• Fourth World countries are LDCs whose living
  standards are very low (sub-Saharan, Nepal,
  India)
• Second World vs. First World Countries
• Second World countries are previously non-market
  economies of central and Eastern Europe which
  exhibit characteristics of LDCs.
• Low Income - Per capita Incomes lt 725
• Lower-Middle Income - 726 lt Per capita Incomes
  gt 2,900
• Upper-Middle Income - 2901 lt Per capita Incomes
  lt 8,955
• High Income - Per capita Incomes gt 8,955

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Characteristics of LDCs vs Others
Source World Bank, World Development Report 1996.
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Trade and LDCs vs Others
Source World Bank, World Development Report 1996.
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Linder Demand Theory

• Linder Theory focuses on role of demand, rather
  than supply, on trade patterns.
• Assumes consumers tastes depend on their income
  levels.
• A nations income level yields pattern of demand
  for goods.
• The nations produce types of goods demanded
  within country, hence nations production
  reflects its income level.
• Trade between countries occurs in goods for which
  there is overlapping demand, i.e. consumers in
  both countries have a demand for these particular
  items.
• Implies that trade in certain goods should be
  more intense between countries with similar per
  capita income than between countries with
  dissimilar per capita incomes.
• Consistent with product cycle model.
• Consistent with empirical evidence generally
  for manufactures in particular.

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Per-Capita Income Demand Patterns
Source World Bank, World Bank Development
Report, 1990
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Static vs. Dynamic Effects of Trade

• Static Effects of Trade on Development
• Developed in Standard Trade Model.
• Mutual Gains by specializing in goods with
  comparative advantage.
• For LDCs this should expand sectors that are
  labor-intensive.
• Primary effect to reduce unemployment, not raise
  real wage.
• Trade acts as vent for surplus labor.
• Possible problems
• Greater instability in income if inelastic
  demand, undesirable terms of trade effects from
  export expansion.
• Dynamic Effects of Trade on Development
• Infant industry argument if economies of scale
  cost advantage.
• Free trade has positive antitrust effects,
  increased investment, dissemination of
  technology, builds market institutions.
• Assumes export sector is linked to rest of
  economy. If not, economy may develop export
  growth poles that do not spillover.

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International Capital Flows
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International Capital Mobility

• Two Types of Capital Movements possible
• Foreign Direct Investment (FDI)
• Movement of capital that involves ownership and
  control.
• Generally involves foreign subsidiary of
  Multi-National corporation (MNC)
• Flow of real capital primarily affects nations
  production or income.
• Foreign Portfolio Investment
• Capital flows that do not involve ownership or
  control.
• Flow of financial capital primarily affects
  nations Balance of payments or exchange rate.

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FDI Positions By Industry, Dec 31, 1995
Source U.S. Dept. of Commerce, Survey of Current
Business, 1996
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FDI Positions By Region, Dec 31, 1995
Source U.S. Dept. of Commerce, Survey of Current
Business, 1996
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Reasons for International Capital Flows

• Considerable international capital mobility
  today.
• Capital should flow to areas where expectation of
  higher return.
• Specific rationales for International Capital
  Flows
• Firms invest as response to large and growing
  international demand for their products.
• Developed country firms invest in countries with
  similar per-capita incomes, and so similar
  demands for products.
• Firms invest to secure access to mineral or raw
  material supplies.
• Firms invest abroad to access markets with high
  tariff or non-tariff barriers. EU Tariff
  factories to get behind the tariff wall.
• Firms invest in countries with low relative
  wages.
• Firms invest abroad as defensive measure to
  protect market share.
• Firms invest abroad as means of risk
  diversification against economic or exchange rate
  fluctuations.

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Benefits Costs of FDI

• Benefits
• Increased output, wages, employment, and exports.
• Assumes foreign capital produces goods with
  export potential.
• Realization of Scale economies and transfer of
  technical managerial skills to host nation.
• Potential to weaken existing domestic monopolies.
• Costs
• Adverse impact of hosts Terms of Trade.
• Decreased domestic saving or domestic investment.
• Instability in Balance of Payments or Exchange
  rate.
• Loss of control over domestic govt policies.
• Inadequate attention to development of local
  skills.
• MNCs may reserve skill positions for home
  country head office.

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Accounting for International Economics
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International Flows

• Interaction between economies involves
• Flows of goods and services, Net Exports, NX.
• Flows of capital, Net Foreign Investment, NFI.
• National income identities.
• Real GDP Y Cd Id Gd X
• Cd Consumption of Domestic output, etc.
• Imports Cf If Gf
• Cf Consumption of Foreign output, etc.
• Use C Cd Cf, etc. to rewrite Real GDP as
• Y C I G X - Im C I G NX

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International Relationships

• Savings Investment in an open economy.
• Output Equilibrium Y C I G NX
• Rewrite as Y - C - G S I
  NX
• Re-arrange as NFI S - I(r) NX
• If NFI negative, then inflow of foreign saving
  into domestic economy and trade deficit
  simultaneously.
• Balance of Payments
• Current Account Capital Account 0
• Current Account approx. equal NX.
• Capital Account approx. equal -NFI
• Need to understand why NX NFI due to paired
  transactions feature of intl flows

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Flows of Goods and Services

• Nations buy sell output from each other.
• Net Exports, NX Exports - Imports
• Exports Output produced domestically, sold
  abroad.
• Imports Output produced abroad, sold
  domestically.
• Net Exports sometimes termed the Trade Balance.
• Many factors affect Net Exports.
• Primary factor is the real exchange rate, e.
• Other factors are tastes technology, domestic
  foreign prices, cost of transport, govt trade
  policies.
• Net Exports, NX.

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Flows of Capital

• Nations buy sell assets from each other.
• Net Foreign Investment, NFI.
• Purchase of foreign assets by domestic residents
  minus purchase of domestic assets by foreigners.
• Foreign Direct Investment.
• Foreign Portfolio Investment.
• NFI depends on
• Real interest rates on foreign vs. domestic
  assets
• Economic political risks of foreign assets,
  govt policies affecting foreign ownership of
  assets.

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Balance of Payments Accounting

• Debit items (-) (Uses of Foreign Currency)
• Reflects transactions that give rise to payments
  outward from the home country.
• Credit items () (Sources of Foreign Currency)
• Reflects transactions that give rise to payments
  inward to the home country.
• 5 General Categories of Transactions
• Category I Goods and Services Accounts
• Category II Unilateral Transfers
• Category III Long-Term Capital Account
• Category IV Short-Term Private Capital Account
• Category V Short-Term Official Capital Account

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Balance of Payments Sub-Totals

• Trade Balance
• merchandise trade balance
• factors affecting trade balance include
• exchange rates rise in early 1980s of U.S.
• domestic monetary and fiscal policies
• unexpected supply shocks oil price shocks 1974,
  1979
• economys competitiveness vis a vis its trading
  partners 
• Balance on Services
• net trade in services for U.S.
• probably underestimated due to problems in
  tracking.
•  Balance on Investment Income
• net of investment income received by U.S.
  citizens from foreigners

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Balance of Payments Sub-Totals

• Current Account Balance (CAB)
• measures nations trade in goods services with
  the rest of world, taking into account unilateral
  transfers.
• CAB surplus (deficit) must be offset by a
  deficit (surplus) in the international balance on
  trade in assets (capital account).
• Capital Account Balance
• all international asset transactions except for
  those of monetary authorities in international
  reserves.
• capital account is strongly influenced by
  interest rates, exchange rate expectations, and
  risk perceptions.
• differentiate between short-term long-term
  capital accounts.

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Balance of Payments Sub-Totals

• Official Reserves Settlements Balance (ORS)
• Sum of the current and capital accounts (plus
  SDRs).
• An imperfect measure of the intervention of
  monetary authorities into the FX markets.
• Under Fixed EXR it is a fairly good indicator of
  actions.
• Under freely Floating EXR not an indicator at
  all, since central bank is not intervening.

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Example International Transactions

• Transaction 1 Home country exporters send 2,000
  of goods in exchange for check in foreign bank
  for equiv. amt
• Credit Category I.A. Exports of
  goods 2,000
• Debit Category IV.A. Increase S-T foreign
  assets -2,000
• held by home country individ.
• Transaction 2 Home country exporters send 2,000
  of goods paid by check on importers account in
  home country bank.
• Credit Category I.A. Exports of
  goods 2,000
• Debit Category IV.B. Decrease S-T foreign
  assets -2,000
• held by private foreigners

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Example International Transactions

• Transaction 3 Home country residents send 5,000
  of goods as disaster aid to foreign country.
• Credit Category I.A. Exports of
  goods 5,000
• Debit Category II.A. Unilateral transfers
  made -5,000
• Transaction 4 Home country individual buys L-T
  foreign corporate bond for 25,000. Pays with
  25,000 that foreign co. deposits in its account
  in home country bank.
• Debit Category III.A. Increase L-T foreign
  assets -25,000
• held by home country individ.
• Credit Category IV.B. Increase S-T home
  country 25,000
• assets held by private foreigners

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Example International Transactions

• Transaction 5 Foreign country bank (private)
  wishes to convert to own currency by selling to
  its own central bank. Transaction transfers
  account in home country bank to account of
  Foreign central bank (held in home country).
• Debit Category IV.B. Decrease S-T home
  country -25,000
• assets of private foreigner
• Credit Category V.B. Increase S-T home
  country 25,000
• assets held by foreign govt

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Assessing A Nations International Competitiveness
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A Nations Economic Position

• explore two ways to assess international economic
  status of a country
• Net Investment Position
• net balance of its foreign assets and liabilities
• this a stock measure, contrast to previous flow
  measures.
• External Competitiveness
• measure how competitive domestic products
  compared to foreign products are in terms of
  price.
• Involves defining appropriate exchange rate
  measures.

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International Investment Position

• International Investment Position
• nations Balance Sheet gives composition of a
  nations stock of assets and liabilities at a
  certain date.
• A. U.S. Assets Abroad
• All claims by U.S. residents on foreigners.
• includes U.S. official reserves, other foreign
  assets held by U.S. govt, and foreign assets
  held by U.S. private residents.
• direct foreign investment forms a signif. portion
  of these assets
• bank loans made to foreign countries or firms
• B. Foreign Assets in the U.S.
• All liabilities of U.S. resident to foreigners.
• Mirror images of U.S. assets abroad.

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U.S. Net Intl Investment Position

• Net Intl Investment Position
• difference between sum of value of its assets
  abroad and sum of value of all foreign assets in
  the country.
• If positive then country has more assets abroad
  than what foreigners have accumulated in the
  country.
• for the U.S. this position was positive in the
  1970s and early 1980s but has declined
  drastically since.
• foreign assets in U.S. grew much faster than did
  U.S. assets abroad in the 1980s.
• Is the U.S. is worlds greatest debtor nation?
• not necessarily much of investment in U.S. is in
  equity, hence not really indebtedness.
• actual value of position depends on the valuation
  methods used for the assets.

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U.S. Net Intl Investment Position

• U.S. Actual position, positive or negative,
  depends on the valuation method
• negative under current cost (-26.6 billion in
  1987)
• positive under market valuation (54.2 billion in
  1987)
• Net international investment position gives
  incomplete picture because only counts assets
  traded internationally.
• majority of wealth of individuals still held in
  domestic assets, despite growing openness in
  financial markets.
• in U.S., 93.9 of equity portfolio held in U.S.
  firms.
• in Japan, 98.1 of equity portfolio held in
  Japanese firms.