Econ452 Learning Unit 12
- 1. Learning Unit 12 Applications of Standard Trade Model ECON452 International Economics
- 2. Objectives 1. Explain how changes in the terms of trade and economic growth affect the welfare of nations engaged in international trade 2. Determine an equilibrium pattern of trade in general equilibrium models 3. Explain an effect of terms of trade on a nation’s welfare 4. Apply the standard trade model to illustrate international borrowing and lending, where goods are exchanged over time.
- 3. Offer Curve • Offer curves (reciprocal demand curve): shows the willingness of the nation to import and export at various relative commodity prices. • Offer curves incorporate elements of both demand (preferences represented by indifference curves) and supply (production possibilities frontier). • Offer curve diagram is used to determine an equilibrium trade in both goods at the same time – General eqquilibrium.
- 4. Offer Curve Diagram – Set Up • On the offer curve diagram, an amount of export and import of each good is measured along each axis – export and import are a difference between production and consumption. • Home and Foreign trade cloth and food. – Amount of export and import of cloth along the horizontal axis. – Amount of export and import of food along the vertical axis.
- 5. Production, Consumption, and Trade • For a given relative price (PC/PF), Home chooses its production (Q) and consumption (D). Then, – Home’s export of cloth (Tc) = QC – QD – Home’s import of food (TF) = DF – QF • This corresponds to (T) on the Offer curve diagram. – Slope of OT line is equal to the relative price of cloth: TF/TC = (DF – QF)/( QC – QD) = PC/PF Tc Tc TF TF
- 6. Deriving Offer Curve • As the relative price changes, Home’s export and import change. The offer curve traces points. – At (PC/PF)1, Home trade between production point Q1 and consumption point D1. Home’s trade is TC 1 of cloth export and TF 1 of food import, corresponding Point T1 on Offer curve. – At (PC/PF)2, Home trade between production point Q2 and consumption point D2. Home’s trade is TC 2 of cloth export and TF 2 of food import, corresponding Point T2 on Offer curve. TC 2 TF 2 TF 2 TC 2 TF 1 TF 1 TC 1 TC 1
- 7. Deriving Offer Curve - Foreign • Foreign exports Food and imports Cloth. – The horizontal axis measures an amount of cloth Foreign imports. – The vertical axis measures an amount of food Foreign exports. • The offer curve of Foreign can be derived in the same way. T
- 8. Deriving Offer Curve (cont.) • A country’s offer curve bulges toward the axis measuring its exporting goods. – Home’s offer curve (C) bulges toward the horizontal axis measuring export and import of cloth. – Foreign’s coffer curve (F) bulges toward the vertical axis measuring export and import of food. Home’s Offer curve Foreign’s Offer curve
- 9. Equilibrium on Offer Curve Diagram • The international equilibrium is one that both countries face the same relative price and one’s export is equal to another’s import. QC - DC = DC* - QC* & QF* - DF* = DF – QF • It is an intersection of two offer curves. – At E, Home’s export of cloth is equal to Foreign’s import of cloth (OX). – Home’s import of food is equal to Foreign’s export of food (OY). – The relative price is a slope of line OE or OY/OX.
- 10. Equilibrium on Offer Curve Diagram • A crossing points of two offer curves is an equilibrium. – At any other relative price, the desired quantities of exports and imports of the two nations would not be equal. – Then, they would pressure on the relative price to move toward its equilibrium. – When a relative price of cloth is higher than the equilibrium relative price, Home wants to export more cloth, but Foreign wants to import less cloth. A surplus of cloth in the world market pushes a relative price of cloth down toward the equilibrium relative price.
- 11. Economic Growth • Economic growth occurs when – nations’ resources increase – its technology advances. • When the economic growth occurs – the nation is able to produce more goods. – the production possibility frontier expands outward.
- 12. Types of Economic Growth • Economic growth may be balanced or biased. • Balanced growth: the nation’s PPF shifts out evenly in all direction. – All factors increase at the same rate. – Technological progress affects productivity of all industries equally. • Biased growth: the nation’s PPF shifts out in one sector more than others.
- 13. Reasons for Biased Economic Growth • Growth is usually biased. – Factors increase differently. (e.g. capital increases faster than labor) – Technological progress occurs differently across industries and affects productivity of industries differently. (e.g. productivity increased more in manufacturing industries than service industries) – Rapid growth has occurred in U.S. computer industries but relatively little growth has occurred in U.S. textile industries.
- 14. Balanced Growth • Economic growth: An expansion of country’s production possibilities frontier from PPF to PPF* • Given the same relative price (PB), a country will produce two goods in the same ratio before and after growth. – At B, QC/QF = 130/20 = 6.5 – At B*, QC/QF = 260/40 = 6.5 • The slope of the old and new PPFs will be the same at any point where they are cut by a ray from the origin. – PB = PB* PPF PPF* B*
- 15. Biased Growth • Given the same relative price (PB), a country will produce different ratio of two goods before and after growth. – At B, QC/QF = 130/20 = 6.5 – At C, QC/QF = 270/10 = 27 • Along the ray the slope of PPF changes. – PB > PB* B* PB* PPF* PPF
- 16. Two Types of Biased Growth • Growth is biased when it shifts production possibilities out more toward one good than toward another. (a) Growth is biased toward cloth (b) Growth is biased toward food • When only the labor resource increases, the output of both goods increases, but the output of labor- intensive goods increases more than the output of capital-intensive goods.
- 17. Economic Growth and Relative Supply • Balanced growth will not change relative supply because two products will be produced at same proportion at the same relative price before and after an economic growth. • Biased growth causes relative supply to change. – When the economic growth is biased toward cloth industry, the relative supply curve of cloth will shift rightward because at the same relative price of cloth it will increase its production of cloth and decrease its production of food (QC/QF ↑).
- 18. Economic Growth and Terms of Trade • Biased growth and the resulting change in relative supply causes a change in the terms of trade. – Biased growth in the cloth industry (in either the home or foreign country) will lower the price of cloth relative to the price of food and lower the terms of trade for cloth exporters. – Biased growth in the food industry (in either the home or foreign country) will raise the price of cloth relative to the price of food and raise the terms of trade for cloth exporters.
- 19. Welfare Effect of Economic Growth • Since Home is a cloth-exporter and Foreign is a food-exporter, a cloth-biased growth lowers the terms of trade of Home and raises the terms of trade of Foreign, and makes Home worse-off and Foreign better-off. • This can happen when either Home or Foreign has a cloth-biased growth. • If labor-abundant country like Home experiences population growth and resulting an increase in labor resource, its terms of trade worsens by producing more labor intensive goods and depressing its relative price in the world market. • Since the relative price of cloth (labor-intensive good) decreases, the real income on labor also decreases.
- 20. Export-Biased and Import Biased Growth • Export-biased growth: growth that expands a country’s production possibilities dis-proportionately in that country’s export sector. – Biased growth in the cloth industry in Home is export-biased growth for Home. • Import-biased growth: growth that expands a country’s production possibilities dis-proportionately in that country’s import sector. – Biased growth in food production in Home is import-biased growth for Home.
- 21. Economic Effects of Biased Growth • Export-biased growth expands a country’s production possibilities dis- proportionately in that country’s export sector. – Decreases the price of exporting goods – Reduces a country’s terms of trade – Reduce its welfare and Increase the welfare of foreign countries. • Import-biased growth expands a country’s production possibilities dis- proportionately in that country’s import sector. – Decreases the price of importing goods – Increases a country’s terms of trade – Increase its welfare and Decrease the welfare of foreign countries.
- 22. Immiserizing Growth • Immiserizing growth: Export-biased growth by poor nations would worsen their terms of trade so much that they would be worse off than if they had not grown at all. – It does not mean that the country is producing and exporting at the price less that its opportunity cost. It is still exporting at its opportunity cost – its production is still on its PPF and tangent to the relative price line. – Instead, its export generates less revenue due to substantial fall in price, so that it can import less goods from other countries than before.
- 23. Causes for Immiserizing Growth • Immiserizing growth is more likely to occur when – growth tends to increase substantially the nation’s exports at constant terms of trade – the nation is so large that the attempt to exports substantially will cause a deterioration in its terms of trade – the income elasticity of the other nation’s demand for the nation’s export is very low – the nation is so heavily dependent on trade • Immiserizing growth is more likely to occur in developing countries than in developed countries. – Developing countries tend to depend on exports of natural resources. When their productivity of production of the resources increases, they may flood the resources in the world market and its price may plunge.
- 24. Immiserizing Growth - Diagram • Before an economic growth (PPF) – Home faces PC/PF of relative price of cloth – Export cloth and import food – Consumes at C • Home grows only toward production of cloth from PPF to PPF* (Export-biased growth). • After an economic growth (PPF*) – Home’s cloth production increases greatly – Relative price of cloth falls to PC/PF* (Flatter isovalue line) – Consume at C* – Home is worse-off because C* is below C • It is still better to trade than autarky. PPF PPF* PC/PF PC/PF PC/PF *
- 25. Implication of Biased Growth of the Rest of the World to the U.S. Economy • Export-biased growth in the rest of the world is good for the U.S. – Those goods that the U.S. imports will become relatively cheap as the rest of the world produce greater quantity. • Import-biased growth in the rest of the world is bad for the U.S. – If the rest of the world increases the production of goods that the U.S. produces and exports, their pieces become relatively cheap and the U.S. needs to produce and export more to pay for imports.
- 26. Economic Growth of China and Effects on the U.S. Economy • The data indicates that changes in the U.S. terms of trade have been small with no clear trend over the last few decades. • The terms of trade for China have deteriorated over the past decade, suggesting their recent growth may have been export-biased. • However, Chinese technological progress may make the U.S. worse off by eliminating trade between two countries.
- 27. Investment and Economic Growth • Economics growth occurs when a country invests on capital today. • An economy can consume or invest today – produce consumption goods or capital goods by allocating fixed resource. – Consumption goods: Goods consumed now and give satisfaction to consumers. – Capital goods: Goods used to produce other goods and do not give any satisfaction to consumers. – Any investment today leads to greater production of consumption goods in future. • Trade-off between current consumption and future consumption. – Economic growth is not free. – Current consumption is an opportunity cost of greater future consumption.
- 28. International Borrowing and Lending • Open economy has the third choice – without scarifying current consumption, it can still invest on capital today through borrowing goods (resources) from other country. – By borrowing now, the country promises to pay back in future by its output. • Intertemporal trade: a country exchanges goods today in return for some goods in the future. – Borrowing and lending can be considered as trading goods in different time. – Borrowing and lending are flows of IOUs. There must be flows of goods in opposite direction – Borrowers are importers of current goods.
- 29. Intertemporal Production Possibility Frontier Model • The standard trade model can be modified to analyze international borrowing and lending. – Two goods are current and future consumption (same good at different times), rather than different goods at the same time. • A special kind of production possibility frontier, an intertemporal production possibility frontier, depicts different possible combinations of current output and future output. Current Goods Future Goods
- 30. Shapes of Intertemporal Production Possibility Frontier • Countries usually have different opportunities to invest to become able to produce more in the future. • If a country has better opportunities to invest now to generate more output in the future, its production possibilities will be biased towards future output. – Home can produce more now, but does not have many investment opportunity for future production. – Foreign cannot produce much now, but has many opportunities for future production. Current Goods Future Goods Home’s IPPF Foreign’s IPPF
- 31. Shapes of Intertemporal Production Possibility Frontier • A country will choose the optimal combination of production and consumption today and future. – At A, a country chooses to produce and consume QC now and QF in future. • The slope of PPF indicates an opportunity cost of current consumption measured by forgone future consumption. – Slope = ΔQF / ΔQC Future Goods A Current GoodsQC QF
- 32. Optimal Intertemporal Production and Consumption Choice without International Lending and Borrowing • Without international borrowing and lending, a country chooses a point for current and future productions, which are current and future consumptions as well. • Given its preference between current and future consumption depicted in intertemporal indifference curves, a country chooses a point tangent to the highest indifference curve. – At A, a country chooses to produce and consume QC now and QF in future. • Even if a country has many investment opportunities, it may not undertake all opportunities since it has to consume some today. – No complete specialization toward Future Goods. More future goods production, higher the opportunity cost of such investment. Future Goods A Current GoodsQC QF
- 33. Optimal Intertemporal Production and Consumption Choice with International Lending and Borrowing • However, with international borrowing and lending, current consumption is not necessary be equal to current production. • If a country can borrow or lend at real interest rate of r, the quantity of repayment in the future will be (1+r) times the quantity borrowed today. • This means that 1 unit of future consumption is worth 1/(1+r) unit of current consumption. • The total value of production over the two periods in today’s value is V = QC + QF/(1+r)
- 34. Intertemporal Isovalue Line • Along the intertemporal iso-value line, total value of production over the two periods is same. • Points along the intertemporal isovalue line is possible through international borrowing and lending • Slope of intertemporal isovalue line = -(1+r). • A country chooses a point where an opportunity cost of current consumption is equal to its value – a tangent point along the PPF. Future Goods Current Goods
- 35. Intertemporal PPF, Intertemporal Indifference Curves, and Optimal Intertemporal Production and Consumption • Home and Foreign are different in the intertemporal production possibilities and their preference between current and future consumption. • Home has production possibilities biased towards current output, while Foreign has production possibilities biased towards future output. • Home prefers future consumption more than current, while Foreign prefers current consumption more than future. Current Goods Future Goods Home’s IPPF Foreign’s IPPF Home’s IIC Foreign’s IIC AF AH QC F QF F QC H QF H
- 36. Optimal Intertemporal Consumption Pattern and Real Interest Rates • Without international borrowing and lending, Home chooses a point at low real interest rate. – Intertemporal isovalue line is flatter. – An opportunity cost of current consumption is low. • Foreign chooses a point at high real interest rate. – Intertemporal isovalue line is steeper. – An opportunity cost of current consumption is high. • Home has a comparative advantage in current production, while Foreign has a comparative advantage in future production. – Foreign can borrow from Home at lower interest rate, while Home can lend to Foreign at higher interest rate. Current Goods Future Goods Home’s IPPF Foreign’s IPPF Home’s IIC Foreign’s IIC AF AH
- 37. Optimal Intertemporal Production with International Lending and Borrowing • At lower interest rate, Foreign chooses Point Q* for production, less current production and more future production than Point A*. • At higher interest rate, Home chooses Point Q for production, more current production and less future production than Point A. • Consumption choices with international lending and borrowing reflect each country’s preferences. Home Foreign Current Goods Current Goods Future Goods Future Goods
- 38. Optimal Intertemporal Consumption with International Lending and Borrowing • By borrowing from Home, Foreign chooses Point D* for consumption, more current consumption and less future consumption than Point A*. • By lending to Foreign, Home chooses Point D for consumption, less current consumption and more future consumption than Point A. • Consumption choices with international lending and borrowing reflect each country’s preferences. • Both countries gain from international lending and borrowing since both countries reach higher intertemporal indifference curve with international lending and borrowing. Home Foreign Current Goods Current Goods Future Goods Future Goods
- 39. International Lending and Borrowing as Intertemporal Trade Intertemporal Trade: • When Foreign borrows from Home, Foreign uses the borrowed funds to purchase current goods from Home. – Foreign imports DC*-QC* of current goods from Home. – Home produces more today and exports excess to Foreign today. • When Home receives payment back from Foreign in future, Home will use the fund to purchase future goods from Foreign. – Home will import DF-QF of future goods from Foreign. – Foreign produces more in future and will export excess to Home in future. Home Foreign Current Goods Current Goods Future Goods Future Goods
- 40. Determining Equilibrium Real Interest Rate with Borrowing and Lending • When international borrowing and lending are allowed, the relative price of current consumption (and the world real interest rate) is determined by the intersection of world relative demand and world relative supply. • Relative supply and demand of current goods measure – Relative price of current goods (PC/PF) is the slope of intertemporal isovalue line: (1+r). – Relative quantity of current goods is QC/QF. Relative price of Current Goods Current Goods Future Goods
- 41. Relative Supply and Relative Demand in International Borrowing and Lending Market • Relative Supply – Given real interest rate, Foreign has more investment opportunities – Foreign can produce relatively more future goods than Home (QC/QF is lower in Foreign) – Foreign’s relative supply curve lies left of Home’s relative supply curve. • Relative Demand is assumed to be equal between Home and Foreign. • Relative supply curve is upward-sloping: Higher the price of current goods, more production of current goods (higher QC/QF). • Relative Demand curve is downward-sloping: Higher the price of current goods, less consumption of current goods (lower QC/QF). Relative price of Current Goods Current Goods Future Goods
- 42. Equilibrium Real Interest Rate with Borrowing and Lending • The world relative supply curve with international borrowing and lending (RSWORLD) is between two relative supply curves without international borrowing and lending (RDFOREIGN and RSHOME). • The world real interest rate is determined by the intersection of world relative demand and world relative supply. – Equilibrium world real interest rate is between real interest rates of two countries. Relative price of Current Goods Current Goods Future Goods
- 43. Intertemporal Comparative Advantage Countries which borrow in international market: • Have a comparative advantage in future production because of low relative price of future goods. • Have a high real interest rate in absence of international borrowing and lending. – The high interest rate corresponds to a high return on investment. • Have more investment opportunities available relative to current productive capacity. • More likely to experience high economic growth (Greater production in future). • Import current goods: They have trade deficits in current goods.
- 44. Disclaimer Please do not copy, modify, or distribute this presentation without author’s consent. This presentation was created and owned by Dr. Ryoichi Sakano North Carolina A&T State University Disclaimer Please do not copy, modify, or distribute this presentation without author’s consent. This presentation was created and owned by Dr. Ryoichi Sakano North Carolina A&T State University