Trade and the Economy The Macro-Economics of European Economies MSc in Economic Policy Studies John FitzGerald, March 2015

Course Outline 1.How does an economy work? JF The genesis of macroeconomics AM Modern macroeconomics AM Banks and financial markets AM The recent crisis AM The labour market JF Fiscal Policy JF Trade JF The economics of global warming JF The future of the Irish economy AM and JF

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

The Goods market - 3

The Goods market - 4

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 before trade Price after trade Price of Software 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 before trade Price after trade Price of Software 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 before trade Price after trade Price of Software 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 before trade Price after trade Price of Software 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 shirtCook dinner Barry260 Ann120 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 Barry Each of them have: 20 shirts to be ironed 1 dinner to be cooked If each do their own, Barry will spend 100 and Ann 40 However, if Barry does the ironing and Ann the cooking Barry 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

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 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 Sector

Labour Force by level of education

Merchandise and Services Exports: Ireland

Composition of merchandise exports

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

Openness – Exports/GDP

Openness Exports/GDP

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)= log(Y U )+1.28log(Y C )-0.42log(P/P C ) Where X= exports, is Y U is US GDP, Y C is Chinese GDP, P is prise, P C 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

Ireland, Foreign Prices +1% Growth, prices, employment GDP%Δ GNP%Δ Value added in industry%Δ Value added in market services%Δ Consumption%Δ Investment%Δ Exports of Goods and Services%Δ Consumption deflator%Δ Wages (non-agricultural)%Δ Total employment%Δ Employment in services sector%Δ Balances Unemployment Rate (ILO)Δ Current account of BOP as % of GDPΔ General Government Deficit as % of GDPΔ General Government Debt as % of GDPΔ Net EmigrationΔ The shock Foreign Prices *1%

Ireland, World Output +1% Growth, prices, employment GDP%Δ GNP%Δ Value added in industry%Δ1.3 Value added in market services%Δ Consumption%Δ Investment%Δ Exports of Goods and Services%Δ Consumption deflator%Δ Wages (non-agricultural)%Δ Total employment%Δ Balances Unemployment Rate (ILO)Δ Current account of BOP as % of GDPΔ General Government Deficit as % of GDPΔ General Government Debt as % of GDPΔ The shock Foreign Demand *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 (20 th 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 (20 th March) What were the origins? How is it resolving? Look at disequilibria in markets 3.The crisis in Scandinavia (Finland, Sweden, Denmark) (13 th 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 OECD Economic Outlook, November 2014, macroeconomic-situation.pdfhttp:// macroeconomic-situation.pdf European Commission: European Economic Forecast, Winter CPB World Trade Monitor %29/cpb-world-trade-monitor-december-2014.pdf %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 Includes EU forecasts to 2016 Be careful that 2014 onwards are EU forecasts! Three approaches to accessing it: 1.Online: 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: