Thorvaldur Gylfason International Economic Integration Implications for National Economic Policies These slides – and more! – can be viewed on my website:

Outline 1.Globalization and its implications for National incomes National incomes Prices and inflation Prices and inflation Interest rates Interest rates 2.Policy coordination Monetary policies and institutions Monetary policies and institutions Fiscal policies Fiscal policies 3.Agricultural policy But first: Some numbers

Import Tariffs

Export Duties

Imports and Exports (% of GDP)

FDI (% of GDP)

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 The importance of language

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

US US’ EU GDP in EU GDP in US A B C The Foreign Multiplier Extra boost in US Imported boost in EU Demand boom in US

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 Real exchange rate R = eP/P*

Other Linkages: Inflation US US’ EU Price level in EU Price level in US A B C Extra inflation in US Imported inflation in EU Demand boom in US

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 Real exchange rate R = eP/P*

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

Home country Still Other Linkages: Interest Rates r S, I S I I’ Rise in I A B r = real interest rate S = saving I = investment

Foreign country Home country Still Other Linkages: Interest Rates r S, I S I I’ Rise in I A B r S, I S I S’ Fall in S A B

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 2

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

Free capital movements Independent monetary policy Fixed exchange rate Floating exchange rate Currency union The Impossible Trinity

Fiscal Policy Globalization also presents a challenge to fiscal policy through impending tax erosion E-commerce and electronic money E-commerce and electronic money Offshore activities and foreign shopping Offshore activities and foreign shopping Financial capital Financial capital Globalization may, however, facilitate new and more efficient ways to collect revenue Tax harmonization Tax harmonization Pollution fees 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 Increased independence of central banks, and increased accountability Banking supervision Banking supervision Inflation targeting 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 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 (USD) 3

Agriculture Industrial output (I) Agricultural output (A) Agricultural output (A) D D G Domestic price ratio E C H H O Slope = -P I /P A As P I rises, I rises and A falls As P A rises, A rises and I falls

Industrial output Agricultural output Agricultural output World price ratio D D G Domestic, distorted price ratio Domestic, distorted price ratio F E A B C Price distortion Price distortion H H O If output gain = E and price distortion = c, then E = mc 2 Output gain OC = industrial output CA = agricultural output OA = total output Agriculture E = mc 2

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/( ) = 0.44 Farm protection keeps domestic agricultural prices 80% above world prices, so that c = 0.8/( ) = 0.44 Industrial sector’s share in GDP will rise to 95% following farm policy liberalization Industrial sector’s share in GDP will rise to 95% following farm policy liberalization Price elasticity of industrial output is 0.2 Price elasticity of industrial output is 0.2 Accords with price elasticity of farm output of 4 Accords with price elasticity of farm output of 4 Output gain from liberalization is then E = 0.5*0.95*0.2* = 0.02, or 2% Larger effect if productivity gain is included 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

Industrial output Agricultural output Agricultural output World price ratio D D G Domestic, distorted price ratio Domestic, distorted price ratio F E A B C Price distortion Price distortion H H J J Imports Exports O K K Welfare gain Welfare gain Output gain Agriculture: Static Gains

Industrial output Agricultural output Agricultural output D D G F E A B C Price distortion Price distortion H H J J O M N Q Welfare gain Welfare gain Transition takes time: From E to F via M, N, and Q Agriculture: Transitional Pains

Industrial output Agricultural output Agricultural output D D G F E A B Price distortion Price distortion J J O Agriculture: Dynamic Gains H World price ratio World price ratio C AB = static gain BC = dynamic gain AC = AB + BC = total gain Productivity gain K K Welfaregain

Conclusion The End 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