Economics I Open Economy Foreigntrade and Currency Policy

Economics I Open Economy, Foreign-trade and Currency Policy (4 h)

Open Economy Foreign-trade and Currency Policy (4 h) • The aim of the first lecture is to examine aspects of openness of the economy; the main task is to answer the question on what basis is the international trade and why national economies specialize - what is the relationship between foreign trade and economy efficiency. There also explained the causes of the international movement of capital (financial assets) and defined the balance of payments, which provides information about international movement of goods, services, income and capital. • The objective of the second lecture lies in the analysis of foreign trade policy; task is to analyze its goals and tools to influence key macroeconomic variables. The objectives of the state, which are monitored in external trade policy, are part of the macroeconomic policy and represent partial steps how to achieve the basic objectives of macroeconomic stabilization policy. The main area is the regulation of foreign trade, international capital flow, and regulation of foreign exchange rates – in terms of the national economy and in terms of transnational coordination.

Content • introduction – defining the goals • the openness of the economy • international trade and the efficiency of the economy (theory of absolute and comparative advantages) • dynamization of comparative advantages • international capital flow • balance of payments • foreign trade policy, its objectives and instruments • protectionism - the objectives and consequences • regulation of exchange rates and international capital movements • international coordination of economic intervention • conclusion – summary, homework

The openness of the economy • = involvement in international economic relations (movement of production, labor and capital as financial assets across borders of national economies) • real 4 -sector model of the economy: AD = C + I + G + NX quantities for calculating the degree of openness of the economy: • • i. export/GDP ii. import/GDP iii. (export + import)/GDP low and high degree of openness of the economies in the world 4

International trade and the efficiency of the economy • causes of international trading: a. different natural and climatic conditions b. different preferences and tastes of consumers c. conflict between production and consumption d. implementation of the absolute advantage e. economies of scale • international division of labor: manufacturing and consumer possibilities of national economy are developing • theory of absolute advantage (the author is A. Smith) a. theory of comparative advantage (the author is D. Ricardo) – it is applied in economic practice → gains of trade 5

Principle of absolute advantage A. Smith (1723 – 1790) Model: 2 states (state A, state B) produce only two goods of the same quality, each state focus a half of its resources on the production of good x and second half of the resources on the production of good y, assuming constant returns to scale. Question. How to increase the efficiency of the economies of countries A and B? Or, How to increase aggregate production and consumption in both countries, A and B? Variable good x good y State A 5 3 State B 4 6 6

Principle of absolute advantage international division of labor and gains of trade State A focuses all resources on the production of good x and state B focuses all resources on the production of good y. GDP in both countries is higher and consumption is also higher (that is gains of trade). Variable good x good y State A 10 0 State B 0 12 7

Principle of comparative advantage D. Ricardo (1772 – 1823) Model: 4 states (A, B, C and D) produce only two goods of the same quality, each state focuses a half of its resources on the production of good x and second half of the resources on the production of good y, assuming constant returns to scale. It is obvious that state A has an absolute advantage in the production of both goods. If yes, how to apply the principle of absolute advantage? Question. How to increase the efficiency of the economies A, B, C and D? How to increase GDP and consumption in the countries? Variable good x good y State A 10 6 State B 2 3 State C 2 3 State D 2 3 8

Principle of comparative advantage international division of labor and gains of trade State A focuses all resources on the production of good x and states B, C and D focus all resources on the production of good y. GDP of all countries is higher and consumption is also higher (that means gains of trade). Variable good x good y State A 20 0 State B 0 6 State C 0 6 State D 0 6 9

International capital flow • the term „capital“ • the capital as financial assets • financial flows: payment for traded goods, services, transfers, flow of short -term and long-term capital • international capital flow: the change in receivables and liabilities of entities of the economy (residents) from abroad • the main variables affecting the movement of financial assets: expected return on financial assets, liquidity, risk 10

Balance of Payments • balance of payments records all economic transactions of entities in the domestic economy to foreign countries for a certain period • Balance of Payments (Czech Rep. ): http: //www. cnb. cz; Menu Statistics, Balance of Payments • balanced balance of payments = external balance of the economy • the structure of the balance of payments (according to IMF methodology) – horizontal (individual accounts) and vertical (debit and credit entries and change in foreign exchange reserves) 11

Horizontal and vertical structure of Balance of Payments • horizontal structure consists of single accounts of balance of payments (according the methodology of the IMF): – current account – capital account – financial account – errors and omissions exchange differences – change in reserves (exchange account), the negative sign means an increase in foreign exchange reserves • vertical structure: debit and credit entries and change in foreign exchange reserves: – credit entries (+): export, the influx of income and transfers, import of capital (increase in liabilities, decrease in receivables) – debit entries (-): import, the outflow of income and transfers, export of capital (reduction in liabilities, increase in receivables) – increasing foreign exchange reserves: sign (-) and reduction of foreign exchange reserves: sign (+) 12

The causes and forms of external imbalances current account imbalance, indicator: the share of current account deficit to GDP • – causes of current account imbalance: development of domestic and foreign GDP, the development of aggregate price level in the domestic economy and abroad, the development of exchange rates, external trade and monetary policy, changing consumer preferences. . . • Balance of Payments consists of current and capital account, there is a possibility of compensating balances • causes of imbalances: factors influencing NX and international capital flow 13

Consequences of external imbalance • NX > 0: the increase in foreign assets or a decrease in foreign liabilities (decrease in foreign debt ) • NX < 0: decline in foreign assets and increase in foreign liabilities (increase in foreign debt) • special conception of external equilibrium: NX deficit is compensated by the influx of FDI • long term external imbalance: imbalance of current account and capital account: change in foreign exchange reserves, influencing macroeconomic variables (GDP, and aggregate price level) 14

Foreign trade policy, its objectives and instruments • objectives of foreign trade policy: to influence macroeconomic variables (employment, general price level) • liberalization of foreign trade vs. protectionism • indirect (market) and direct (administrative) tools: 1. indirect tools: central bank interventions at foreign exchange markets, the macroeconomic policy with the effect on the balance of payments 2. direct tools – e. g. duties, import quotas, export premium (subsidies), tax relief, invisible barriers to imports… 15

Basic relationships between foreign-trade and currency policy and macroeconomic variables tariffs and quotas export subsidies, invisible barriers. . . price stability AS x AD employment currency interventions

Effect of imposition of tariff on imported production P AS (S) Pw – world price The distance AB represents import without imposing tariff. PE Pc Pw C D A Yd B YE Yw AD (D) The distance CD represents import after the imposition of the tariff. Y (Q) 17

Protectionism - the objectives • protection of domestic producers, maintaining employment • efforts to address the structural problems of the economy (the effort to keep the industry which would otherwise lapse, educational protectionism, efforts to reduce structural unemployment) • influence the evolution of terms of trade (Terms of Trade), assuming a decline in demand foreign goods and the consequent decrease in prices and consumption growth • retaliatory protectionism - imposition of retaliatory duties in response to reduced foreign demand, the introduction of import duties abroad, antidumping • non-economic objectives: military-political, environmental, support for research and development 18

Protectionism - the consequences • loss of consumer surplus (microeconomic view) • weakening enforcement comparative advantages → restriction of production and consumption potential of the economy • possible retaliation trading partners • reducing the competitiveness of domestic products (an inability to reduce costs), reducing net exports (NX) 19

Theorem of locomotive and the effect of imported inflation It means the interaction of output between 2 states (+ conditions). Yr MA of state A, „mpm“ is given current account worsens in state A and MB a XA and XB Yr in state B current account improves in state A… It depends on where the actual product is. If the economy reaches the level of potential output (Y*), theorem of locomotive moves in an effect of imported inflation. 20

Regulation of exchange rates and international capital flow • regulation of foreign exchange rates: central bank interventions at the international foreign exchange market (buying or selling foreign currencies in order to influence the exchange rate) • restrictions on the flow of “hot capital” • foreign exchange restrictions (extreme case - a ban on foreign access to domestic financial markets) • capital returns tax on international financial assets • changes in interest rates by the central bank • stimulation of FDI inflow - investment incentives (much discussed, usually limited in time) 21

Regulation of exchange rates • exchange rate can be fixed or flexible (free floating or managed floating) • depends on the exchange rate, the attitude of the authorities to the development of the exchange rate, with free float the central bank does not intervene at the foreign exchange market • sterilized and unsterilized foreign exchange intervention (sterilized foreign exchange intervention does not change the money supply) 22

International coordination of economic intervention • coordination in the global economy is desirable; international business development deepens the interdependence of national economies • reducing barriers to international trade: the free flow of goods and services, labor and capital, coordination of exchange rates • international monetary systems - the systems of foreign exchange markets, where capital flows and payments are funded within international trade and also exchange rates between national currencies are determined • macro-economic integration: the gradual blurring of national economies boundaries 23

Economic integration • microeconomic vs. macroeconomic integration • functionalist vs. institutional approach to economic integration • the degrees of economic integration: 1. 2. 3. 4. 5. free trade zone, customs union, united market, economic union, full economic integration (full economic and political integration) 24

Literature • FRANK, R. H. , BERNANKE, B. S. Principles of Macroeconomics. 3 rd Edition. Mc. Graw. Hill/Irwin: NY, 2007. ISBN 978 -0 -07 -319397 -7. 561 p. • MANKIW, G. N. Principles of Macroeconomics. 4 th ed. USA: Thomson South. Western, 2007. 583 p. ISBN 978 -0 -324 -23695 -8. • Mc. CONNELL, C. R. , BRUE, S. L. Economics: Principles, Problems, and Policies. 17 th ed. NY: Mc. Graw/Irwin. 716 p. ISBN 978 -0 -07 -312663 -0. • SAMUELSON, P. A. , NORDHAUS, W. D. Economics. 15 th ed. Mc. Graw-Hill, 1995.

Internet sources • Czech National Bank. Balance of Payments Statistics. Available at www: http: //www. cnb. cz. • World Trade Organization. Available at www: http: //www. wto. org. • The European Union. Available at www: http: //www. europa. eu.

Homework Exercise “Open Economy” • Assume an economy consisting only of two consumers: Adam and Eve. Adam and Eva work every day, Eva is able to catch 4 fish or collect 16 cups of berries per day, Adam is able to catch 6 fish or collect 12 cups of berries per day. Assuming constant returns to both consumers. If both consumers spend half a day for catching fish and half a day for the berry picking, what is their total output? How is the specialization of Adam and Eve on individual activities, if they want to achieve higher output? What is the maximum output they can reach after the specialization? • Discuss the effect of rising costs when increasing the volume of production within the gains of international trade, if countries decide to apply the principle of comparative advantage. • Find out on the internet, what the abbreviations GATT and WTO mean. Put down some notes.

Homework Exercise “Foreign-trade and Currency Policy” • Find the website of the Czech National Bank (http: //www. cnb. cz), menu Statistics, Balance of Payments Statistics, and record the balance of each account balance of payments in the last reporting quarter in CZK. What is the impact on macroeconomic variable if there is a negative balance of foreign exchange reserves? And what is the influence of a positive balance of foreign exchange reserves? Why does minus sign indicate an increase and why does plus sign indicate decrease in foreign exchange reserves? • Graph the situation at the aggregate market of an economy, which is characterized by greater efficiency in production and supplies its goods and services at lower prices in comparison with the prices at the world market. Describe the graph.