Trade and the EconomyThe Macro-Economics of European Economies

MSc in Economic Policy StudiesJohn FitzGerald, March 2015

Course Outline

1. How does an economy work? JF 16-1-2015

2. The genesis of macroeconomics AM 23-1-2015

3. Modern macroeconomics AM 30-1-2015

4. Banks and financial markets AM 6-2-2015

5. The recent crisis AM 13-2-2015

6. The labour market JF 20-2-2015

7. Fiscal Policy JF 6-3-2015

8. Trade JF 13-3-2015

9. The economics of global warming JF 20-3-2015

10. The future of the Irish economy AM and JF 27-3-2015

Outline of Lecture

• Theory• Imports, exports and the goods market• Benefits of Trade• Comparative advantage• Other aspects of trade• Policy Instruments

• Applied – examples of comparative advantage, competitiveness etc.• Freeing of trade• Shifting comparative advantage• Openness• Drivers of exports – Vietnam and Ireland

The Goods market - 1

• Demand for Goods (and Services)• C+I+G : Closed economy• C+I+G+X : Open economy

• C=Private Consumption; I= Investment; G= Government consumption; X=Exports

• Supply of Goods (and Services)• Y : Closed economy• Y+M : open Economy

• Y = Domestic Output; M=Imports

• Disequilibrium?• Inflation, Current account of the balance of payments

The Goods market - 2

• Y=C+I+G (+X-M)• Y= GDP, output = expenditure = income – demand for goods (and services)

• Y=Q• Q= National output – supply of goods (and services)

• C=a + b(Y - T)• T=Government revenue; a and b are coefficients, where b is 0<b<1

• Y=a + bY – bT + I + G + (X - M) • Y(1-b)= a + I + (X - M) + G - bT

• Assumes output will respond to an increase in demand• is the “multiplier”

The Goods market - 3

• Y=C+I+G (+X-M)• Y= GDP, output = expenditure = income – demand for goods (and services)

• C=a + b(Y - T)• M=α + βY where α and β are coefficients, 0<β<1

• Y=a + bY – bT + I + G + (X - α - βY ) • Y(1-b+β)= a+ α + I + X - M + G - bT

• Assumes output will respond to an increase in demand• is the “multiplier”

The Goods market - 4

• The Multiplier measures the change in Y for a change in one of the components of final demand e.g. G,I,X

• is the “multiplier”• Assume b, the marginal propensity to consume, is .8• Assume a closed economy i.e. β=0• Then multiplier is • Assume propensity to import is β=.4• Then multiplier is 1.67• Leakage from imports makes a big difference• (Other leakages from multiplier include taxation)

Propensity to Import

• Import content differs by sector.• For 1998 for Ireland• Consumption: 0.34; Government:0.16; Investment, building: 0.26• Investment machinery: 0.63; Industrial exports: 0.53• For exports, in addition you have to deduct profits paid abroad: 0.25• Thus the value added sticking in Ireland from industrial exports was low• The value added sticking in Ireland from exports is even lower today• This makes interpreting export and import data difficult• Concentrate on change in current account of balance of payments

The benefits from trade

• Who gains?• Who loses?• Do the gains exceed the losses?

Free trade & welfare in exporting country

Domestic Supply

Domestic Demand

Price beforetrade

Price aftertrade

Price ofSoftware

Quantity of software

World Price

A

B

C

Consumer surplus before trade A+B

Producer surplus before trade C

Before Trade

Free trade & welfare in exporting country

Domestic Supply

Domestic Demand

Price beforetrade

Price aftertrade

Price ofSoftware

Quantity of software

World Price

A

B

C

Consumer surplus after trade A

Producer surplus after trade B+C+D

Exports

D

After Trade

How free trade affects welfare in exporter• Two conclusions:

• Domestic producers better off and domestic consumers worse off• Total welfare – of consumers and producers – is higher after trade• A+B+C+D>A+B+C

• How are the gains from trade shared?• How does it affect wage rates?• Redistribution by the state

Free trade & welfare in importing country

Domestic Supply

Domestic Demand

Price beforetrade

Price aftertrade

Price ofSoftware

Quantity of software

World Price

A

B

C

Consumer surplus before trade A

Producer surplus before trade B+C

Before Trade

Free trade & welfare in importing country

Domestic Supply

Domestic Demand

Price beforetrade

Price aftertrade

Price ofSoftware

Quantity of software

World Price

A

B

C

Consumer surplus after trade A+B+D

Producer surplus after trade C

After Trade

D

Imports

How free trade affects welfare in importer• Two conclusions

• Domestic producers are worse off and domestic consumers are better off• Trade improves overall welfare because gain of consumers exceeds producers’

loss (A+B+C+D>A+B+C)

• However, the distribution of these gains may be affected by:• The state, through taxation• Through changes in wage rates etc.

Gains and losses from Free Trade

• The gains of the winners exceed the losses of the losers in each case• However, how these gains are distributed is affected:

• By the behaviour of the economy• By Government action

• Lobbying• Enhanced imports good for consumers• Enhanced exports good for producers• EU entry – good for producers but consumers voted for it

• Gains and losses within producers and consumers• Moving from protection to free trade – incumbents (& their employees) may lose• Potential winners may not easily be identified

Law of Comparative Advantage

• Due to differences in productivity• Referred to as the Ricardian model• Simplified – one factor of production – labour• Comparative advantage

• Absolute v Comparative

Comparative advantage

Iron shirt Cook dinner

Barry 2 60

Ann 1 20

• Ann has an absolute advantage in both ironing and cooking – her productivity is higher

• Should she do it all?• Barry has a comparative advantage in

ironing. He would trade 30 shirts for 1 dinner

• Ann has a comparative advantage in cooking: 20 shirts for 1 dinner.

• By concentrating on their comparative advantage the total time spent (cost) is reduced.

• While the winner is Barry, he could compensate Ann (by washing the floor) and they would all be better off

Table shows productivity of Ann and BarryEach of them have:20 shirts to be ironed1 dinner to be cooked

If each do their own, Barry will spend 100 and Ann 40However, if Barry does the ironing and Ann the cookingBarry will spend 80 and Ann 40.By trading Ann is no worse off but Barry is much better off

Comparative advantage in action

• India is cheaper for producing clothing than Ireland• India is cheaper for producing software than Ireland• However, in Ireland there is a comparative advantage in software and in

India in clothing• What one would expect is that countries will tend to specialise in

sectors where their productivity is high relative to other sectors where it is low (and where they import)

• An examination of trade patterns can help identify where comparative advantage lies

• However, it can change. e.g. Ireland

Comparative cost trade theories

• We have discussed a model with one factor of production - labour:• Differences in labour productivity (Ricardo)• Additional model with two or more factors of production:• Differences in endowments of factors (Hecksher-Ohlin)

• Remuneration increases in factor employed most intensively in commodity where price increases

• e.g. returns to skilled labour• Implications for India and China – short skilled labour• India returns to skilled labour high• Should India specialise in software for export?• Ireland skilled labour is “abundant” returns to education much less than India

Some other effects of free trade

• Competition and contestability• Economies of scale (e.g. producing cars)

• Lower prices

• Greater product variety• Welfare / utility gains

• Infant industry argument• A long history• Will they ever be ready? Ireland 1930-60

Fragmentation of the production process• Thirty years ago Germany made cars, their transmissions, tyres etc.• Today Germany makes some parts of cars, much of the assembly takes place in Poland and

Slovakia• Increasingly the production process for goods & services is being split up: outsourcing• Previously you could choose German labour and capital or Polish labour and capital to make

cars. The choice depended on the relative abundance of factors or production – capital in Germany

• However, today by breaking up the production process you can mix Polish and German capital and labour to produce cars more efficiently

• The parts of the production process takes place in the country with the comparative advantage / relative factor abundance.

• Car assembly is more labour intensive that manufacturing car electronics – assembly takes place in Poland

Pricing

• Where firms are world leaders they can set the price • e.g. Siemens

• However, where there is perfect competition, firms are price takers• Butter producer

• Where firms have market power they can pass on some of costs• While they can set their price, competitiveness affects exports and, hence, output. Effectively they can

pass on some, but not all, of a cost increase

• However, where firms are price takers they take the world price• Given the price, if costs rise, profits fall. They produce only if profitable• Comparison of costs of production relative to foreign competitors important• Comparison of export prices may not be useful under these circumstances

• In Ireland most of manufacturing is a price taker• The foreign owner sets the price in dollars for all its factories

Terms of Trade

• Beginning with current account balance• Exports=imports

• If price of oil rises and nothing else changes• Imports> exports• There may have been no change in volume of trade but price changes matter

Trade Policy Instruments

• Quotas (what happens to rents)• Tariffs• Anti-dumping• Regulatory regimes

• “Industrial” policy• FDI

• FDI• Brings, capital, technology, management expertise

Examples

• Effects of freeing of trade and Irish EU entry 1973• EU Single Market 1992• Composition of trade• Comparative advantage• Openness matters• Trade and the Irish economy

EU Entry

• Between 1930 and 1960 very high protection• Quotas – created rents (Corruption?)• Very high tariffs• Industry developed for domestic market

• Low productivity• No exports• Were then infant industries – would they transition to free trade?

• Gradual opening culminating with EU entry 1973• Good for agriculture – opened a large market – much higher prices• Existing Irish manufacturing did not transition• FDI began before 1973, anticipating EU entry

EU Single Market 1992

• Changed rules on public procurement• Public sector buys cheapest• Allowed pharmaceuticals and health care and communications equipment• Allows more competition to supply government• Reduces cost of government• Difference with US

• Changed rule on trade in services• Massive growth in trade in services

• Improved harmonised regulation

Shifting comparative advantage

• Factors affecting composition of exports:• Factor endowment – skilled v unskilled labour• Changes in market access – EU and Single Market

Human Capital by Sector1966 2006

Agriculture, Forestry and Fishing 1.057 1.202Textiles, clothing, footwear and leather 1.074 1.259Building and Construction 1.077 1.252Mining 1.082 1.238Wood and wood products 1.087 1.271Glass, pottery and cement 1.095 1.265Manufacturing Industries 1.102 1.356Food 1.107 1.297Metals, metal products, machinery etc. 1.113 1.383Beverages and Tobacco 1.117 1.402Other Manufacturing (incl transport equip. 1.121 1.299Total at Work in all Industries 1.123 1.363Paper, paper products, & publishing 1.124 1.372Transport, Communications and Storage 1.124 1.308Other Industries 1.134 1.210Commerce 1.136 1.309Chemical, rubber and plastic products 1.148 1.426Electricity, Gas and Water 1.151 1.372Public Admin. and Defence 1.225 1.413Other Services (Total Professional and Personal Services)1.248 1.443Insurance, Finance and Business Services 1.259 1.501

Labour Force by level of education

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1966 1971 1981 1986 1991 1996 2002 2006

Primary Junior Leaving Third level

Merchandise and Services Exports: Ireland

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1970 1975 1980 1985 1990 1995 2000 2005 2010

Merchandise/Total exports Services/Total Exports

Composition of merchandise exports

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1973 1978 1983 1988 1993 1998 2003 2008 2013

Food (0) Drink (1) Crude materials (2)

Mineral fuels (3) vegetable oils (4) Chemicals (5)

Manufactured goods (6 less 65) Clothing etc (65) Machinery (7)

Miscellaneous (8) Commodities (9)

Openness of the economy

• Important in determining effects of outside world on economy• Easier to grow from a high base – relevant today

Exports as a % of GDP, Ireland

0

20

40

60

80

100

120

1970 1975 1980 1985 1990 1995 2000 2005 2010

Openness – Exports/GDP

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

1.1

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Ireland Germany Greece

Openness – Exports/GDP

0.5

0.6

0.7

0.8

0.9

1.0

1.1

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Ireland Estonia Netherlands

Openness Exports/GDP

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

1.1

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Ireland Italy Portugal

What drives trade

• Relative openness• Important – a 10% rise in exports has a bigger impact on GDP if open

• Sensitivity to growth in markets – price and income• Growth in relevant foreign markets• Competitiveness on foreign markets• Measure competitiveness by relative export prices OR relative production costs

• Example of Vietnam• Example of Ireland

Model of Vietnamese Exports

• Log(X)= -14.8+1.24log(YU)+1.28log(YC)-0.42log(P/PC)• Where X= exports, is YU is US GDP, YC is Chinese GDP, P is prise, PC is Chinese

prices

• A 1% increase in US GDP raises Vietnamese exports by 1.24%• A 1% increase in Chinese GDP raises Vietnamese exports by 1.28% • A 1% increase in Chinese prices raises Vietnamese exports by 0.4%

Chinese prices rise by 10%: Effect on Vietnamese GDP

0.4

0.5

0.6

0.7

0.8

0.9

1.0

1.1

1.2

1.3

01 02 03 04 05 06 07 08 09 10 11 12

GDP (Percent Deviation)

Ireland, Foreign Prices +1%2013 2014 2015 2016 2017 2018

Growth, prices, employmentGDP %Δ 0.5 0.6 0.7 0.8 0.8 0.8GNP %Δ 0.0 0.2 0.3 0.4 0.5 0.5Value added in industry %Δ 1.6 1.7 1.7 1.8 1.8 1.7Value added in market services %Δ 0.1 0.3 0.4 0.5 0.5 0.5Consumption %Δ 0.0 0.2 0.3 0.5 0.6 0.6Investment %Δ 0.4 0.6 0.8 0.8 0.7 0.7Exports of Goods and Services %Δ 0.0 0.3 0.4 0.4 0.4 0.4Consumption deflator %Δ 0.2 0.2 0.3 0.3 0.3 0.3Wages (non-agricultural) %Δ 0.0 0.2 0.4 0.5 0.6 0.6Total employment %Δ 0.1 0.2 0.2 0.2 0.2 0.2Employment in services sector %Δ 0.1 0.2 0.2 0.2 0.2 0.2BalancesUnemployment Rate (ILO) Δ -0.1 -0.2 -0.2 -0.2 -0.2 -0.1Current account of BOP as % of GDP Δ 0.2 0.3 0.4 0.4 0.4 0.5General Government Deficit as % of GDP Δ -0.1 -0.2 -0.2 -0.2 -0.2 -0.2General Government Debt as % of GDP Δ -1.5 -1.9 -2.1 -2.4 -2.5 -2.6Net Emigration Δ 0.0 0.1 -0.4 -0.7 -0.7 -0.5The shockForeign Prices * 1% 1% 1% 1% 1% 1%

Ireland, World Output +1%2013 2014 2015 2016 2017 2018

Growth, prices, employmentGDP %Δ 0.8 0.9 1.0 1.1 1.1 1.1GNP %Δ 0.5 0.7 0.8 0.9 1.0 1.0Value added in industry %Δ 1.3 1.3 1.3 1.3 1.3 1.3Value added in market services %Δ 0.9 1.2 1.3 1.4 1.4 1.5Consumption %Δ -0.1 0.2 0.3 0.5 0.6 0.6Investment %Δ 1.1 1.6 1.4 1.3 1.3 1.3Exports of Goods and Services %Δ 3.2 3.4 3.5 3.6 3.7 3.8Consumption deflator %Δ 0.0 0.1 0.1 0.1 0.1 0.1Wages (non-agricultural) %Δ 0.0 0.3 0.4 0.5 0.6 0.7Total employment %Δ 0.3 0.4 0.5 0.6 0.6 0.6BalancesUnemployment Rate (ILO) Δ -0.2 -0.4 -0.4 -0.4 -0.4 -0.4Current account of BOP as % of GDP Δ 0.1 0.2 0.2 0.2 0.2 0.3General Government Deficit as % of GDP Δ -0.1 -0.2 -0.2 -0.3 -0.3 -0.3General Government Debt as % of GDP Δ -0.9 -1.3 -1.6 -2.0 -2.2 -2.4The shockForeign Demand * 1% 1% 1% 1% 1% 1%

Questions

• Should a country diversify its markets• Is there a role for “industrial” policy• What could be the effect of a US-EU Trade deal?

Presentations

1. The origins and resolution of the current crisis in Estonia, Bulgaria, Greece and Spain (20th March)• What were the origins? How is it resolving? Look at disequilibria in markets

2. The origins and resolution of the current crisis in Latvia, Portugal, Spain and Italy (20th March)• What were the origins? How is it resolving? Look at disequilibria in markets

3. The crisis in Scandinavia (Finland, Sweden, Denmark) 1988-1995 (13th March)• What were the origins? How was it resolved? Look at disequilibria in markets

Reading for this lecture

• Basic text:• “International Economics, Theory and Policy”, Krugman, Obstfeld and Melitz.

Probably more theory than you need, but provides the basics• Chapters 3-5

• The rest of the reading discusses real economic situations.Look at one or two of these publications for the EU and its component economies• IMF World Economic Outlook, October 2014. http://www.imf.org/external/pubs/ft/weo/2014/02/pdf/text.pdf• OECD Economic Outlook, November 2014,

http://www.oecd.org/eco/outlook/General-assessment-of-the-macroeconomic-situation.pdf• European Commission: European Economic Forecast, Winter 2014

http://ec.europa.eu/economy_finance/publications/european_economy/2014/pdf/ee2_en.pdf• CPB World Trade Monitor• http://

www.cpb.nl/sites/default/files/cijfer/CPB%20World%20Trade%20Monitor%20%28including%20December%202014%29/cpb-world-trade-monitor-december-2014.pdf

AMECO Database

• Many annual variables for EU economies, US, Japan etc.• Don’t assume that the data are always right!• Where available, runs from 1960. Includes EU forecasts to 2016• Be careful that 2014 onwards are EU forecasts!

• Three approaches to accessing it:1. Online: http://ec.europa.eu/economy_finance/ameco/user/serie/SelectSerie.cfm

2. Excel File: AMECONov14.xlsx plus list_of_variables.pdf

3. Excel File: AMECOTCD.xlsx – a limited number of variables, 1 variable per sheet

• House prices from BIS database:• Online: http://www.bis.org/statistics/pp_detailed.htm#selected