Unformatted text preview:

Lecture 26International TradeNoah WilliamsUniversity of Wisconsin - MadisonEconomics 312Spring 2010Williams Economics 312International TradeTwo important reasons for international trade:Static (“microeconomic”)Comparative advantageDifferent factor endowmentsSpecializationResults in simultaneous imports and exports.Dynamic (“macroeconomic”)Consumption smoothingForeign investmentResults in current account deficits and surpluses.Focus on a small open economy.Williams Economics 312A Static Small Open Economy ModelTo think about international trade, we first consider atwo-good static model. Similar to the static labor-leisuremodel at the beginning of the course.Suppose there are two types of consumption goods a, b.Each good produced with a possibly different technology:a = F(Ka, Na)b = G(Kb, Nb)Static model: suppose that capital is fixed in each sector.There is a total amount of labor to be allocated to eachsector: N = Na+ Nb.Williams Economics 312Production Possibilities FrontierAs in the labor-leisure model the PPF gives the amount ofone good that can be produced for a given amount of theother good.Here it can be found as:a = F(¯Ka, Na) ⇒ Na= F−1(a;¯Ka)Then we have:b(a) = G(¯Kb, N − Na)= G(¯Kb, N − F−1(a;¯Ka))Slope of the PPF gives the MRTa,bb0(a) = −GN(¯K , Nb)1FN(¯Ka, Na)So MRTa,b= GN/FN.So as Na→ N , then GN→ ∞, so PPF becomes vertical.As Na→ Nb, FN→ ∞, so PPF becomes horizontal.Williams Economics 312Copyright © 2008 Pearson Addison-Wesley. All rights reserved.13-4Figure 13.1 Production Possibilities Frontier for the SOEWilliams Economics 312Representative ConsumerSuppose representative household supplies laborinelastically, has preferences over the two goods a, b:U (qa, qb)As always, ratio of marginal utilities gives MRS:MRSa,b=UaUbAssume a small open economy, which means world pricesare taken as given.The terms of trade give the relative (world) price of good ain terms of good b:TOTab=papbWilliams Economics 312Household ProblemSince labor supply is inelastic, can think of income tohousehold as just output (a, b), so budget constraint is:paqa+ pbqb= paa + pbb⇒ TOTa,bqa+ qb= TOTa,ba + bHousehold maximizes utility by choosing (qa, qb) subject tobudget constraint.maxqa,qbU (qa, qb) − λ(TOTa,bqa+ qb− TOTa,ba − b)First order conditions:Ua= λTOTa,b, Ub= λOr in other words, combining them:UaUb= MRSa,b= TOTa,bWilliams Economics 312Firm Problem and EquilibriumFirm maximizes profit by choosing overall labor input Nand allocation of labor between sectors Na:maxN ,NahpaF(¯Ka, Na) + pbG(¯Kb, N − Na)iFirst order condition for Na:paFN(¯Ka, Na) = pbGN(¯Kb, N − Na)Or, rearranging:papb= TOTa,b= MRTa,b= GN/FNConditions are similar to closed economy, but with tradeproduction does not have to equal consumption.No trade: qa= a, qb= b.Williams Economics 312Copyright © 2008 Pearson Addison-Wesley. All rights reserved.13-8Figure 13.3 Equilibrium in the SOE with No TradeWilliams Economics 312Copyright © 2008 Pearson Addison-Wesley. All rights reserved.13-10Figure 13.4 Production and Consumption in the SOE with TradeWilliams Economics 312Trade, Welfare, and Terms of TradeThe terms of trade determine which good is imported,which is exported.Trade always increases welfare. The no-trade allocation isalways feasible. If it is not chosen, it must be becausewelfare is higher with trade.Changes in terms of trade may lead economy to switchfrom importing to exporting.Increase in terms of trade (increase in relative price of gooda) decreases welfare when a is initially imported, increaseswelfare when good b is initially imported.Williams Economics 312Copyright © 2008 Pearson Addison-Wesley. All rights reserved.13-12Figure 13.5 An Increase in Welfare When Good a Is ImportedWilliams Economics 312Copyright © 2008 Pearson Addison-Wesley. All rights reserved.13-13Figure 13.6 An Increase in Welfare When Good b Is ImportedWilliams Economics 312Copyright © 2008 Pearson Addison-Wesley. All rights reserved.13-15Figure 13.7 An Increase in the Terms of Trade when Good a Is Initially ImportedWilliams Economics 312Copyright © 2008 Pearson Addison-Wesley. All rights reserved.13-16Figure 13.8 An Increase in the Terms of Trade when Good b Is Initially ImportedWilliams Economics 312Dynamic Open Economy model of the Current AccountNow to analyze capital flows, abstract from trade in goods.A representative household lives for two periods:maxC ,C0U (C , C0)subject to C +C01 + r= Y +Y01 + r− T −T01 + rThe government must satisfy its budget constraintG +G01 + r= T +T01 + r.Y and Y0are exogenous endowments.r is the world interest rate, also exogenous.Williams Economics 312Open Economy IssuesThe domestic credit market does not have to clear:Y = C + I + G + NXIn this model, I = 0, so NX = Y − C − G.Net factor payments from abroad are zero:NX = CA = Y − C − G.Also NX0= Y0− C0− G0= −(1 + r)NX and CA0= −CA.Comparative statics:An increase in 1stperiod net endowment Y − G raises CA.An increase in 2ndperiod net endowment Y0− G0reducesCA.Taxes have no effect on CA (Ricardian equivalence).An increase in the world interest rate typically raises CA.Williams Economics 312Copyright © 2008 Pearson Addison-Wesley. All rights reserved.13-20Figure 13.9 The Two-Period Small Open-Economy ModelWilliams Economics 312Benefits of TradeInternational trade raises the representative household’sutility.A closed economy is insulated from fluctuations in the restof the world (r), but makes consumption smoothingimpossible.In a closed economy:CA = 0.r adjusts so that C = Y − G and hence C0= Y0− G0.In an open economy:The representative household can afford to live in ‘autarky’:C +C01 + r= Y +Y01 + r− G −G01 + rThe fact it chooses not to means it is made better off.Williams Economics 312Including InvestmentHousehold inelastically supplies labor N and N0.Investment equation K0= (1 − d)K + I .Also sell undepreciated assets in final period:I0= −(1 − d)K0.Market clearing conditions:C + I + G + NX = Y = zF(K , N )C0+ I0+ G0+ NX0= Y0= z0F(K0, N0)Closed economy production possibilities frontier:C0= z0F(K0, N0) + (1 − d)K0− G0,whereK0= zF(K , N ) + (1 − d)K − C − G.Williams Economics 312Real Intertemporal Small Open Economy ModelWorks the same as the real intertemporal model, exceptthe real interest rate is determined on world creditmarkets, and given to the small open economy.Current account surplus always adjusts so that theaggregate supply and aggregate


View Full Document

UW-Madison ECON 312 - International Trade

Download International Trade
Our administrator received your request to download this document. We will send you the file to your email shortly.
Loading Unlocking...
Login

Join to view International Trade and access 3M+ class-specific study document.

or
We will never post anything without your permission.
Don't have an account?
Sign Up

Join to view International Trade 2 2 and access 3M+ class-specific study document.

or

By creating an account you agree to our Privacy Policy and Terms Of Use

Already a member?