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Introduction

IA 216The World Economy

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Lecture Objectives

• Discuss course content • Discuss evaluation• Examine the relationship of the US to the

world economy

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Prerequisites

• Not required But it helps if you have had Principles of Microeconomics (Econ 1B) and Macroeconomics (Econ 1A)

• Same holds for those of you without Econ 204.

• Basic algebra and geometry.

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Evaluation of Performance

• Two Take-Home Examinations (100 points each)– Content: Short answers and essays– Dates: First Exam: Handed out on March 17; due on March

31– Dates: Second Exam: Handed out on April 28; due on May 5.

• 4 Home works (100 points total). Dates given are due dates:– Homework #1: Feb 24; Homework #2: March 10; Homework

#3: April 7; Homework #4: April 28– Research Paper =200 points; Two Presentations = 40 points.

• 540 Total Points

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Current Events in the World Economy

• Read all the articles on Reserve + some of the articles that will be occasionally passed out as handouts.

• Read Stiglitz’s book plus relevant handouts that I will occasionally make available to you.

• The exams will contain questions drawn from supplementary reading in both of these.

• Read the Economist magazine at bookstores. Usually has very good articles.

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General Advice

• Keep current on the reading BUT read the text with industry and not as a novel!

• Do the homework• Ask (relevant) questions in class• Come see me during office hours if you

have questions that don’t get covered in class.

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Course Content and Goals

• This course offers a non-technical introduction to the analysis of international economic issues.

• The goal of the course is to increase your knowledge of these issues and your tools for analyzing them.

• While we will be primarily interested in developing standard microeconomic and macroeconomic approaches to these issues, we will also attempt to present a variety of other useful approaches from political science, sociology and less mainstream parts of economics.

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Course Content

The Course Has 5 Main Sections (12 topics)– Introduction– The Analysis of International Trade– The Analysis of Trade Policy– Open Economy Macroeconomics– Issues Facing Developing Countries

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Representative topics on the analysis of trade

• Comparative Advantage– Gains from trade– Directions of trade

• Factor endowments and trade• “Modern” Trade theory

– Intra-industry trade– Trade and geography

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Representative topics in Trade Policy

• Tariffs and Quotas• Arguments for commercial policy• Linkage between trade and other issues

– Trade and labor (wages, employment, etc.)– Labor standards (child labor etc.)– Trade and the Environment

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Representative Topics in Open Economy Macroeconomics

• Trade and the Balance of Payments• Exchange Rates and Exchange Rate

Systems• Analyzing Models of the Open Economy

(for fun and profit)

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Representative topics in world economy

• International financial crises• Globalization and reform in Latin America• International aspects of East Asian Growth

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Remainder of Introduction

• Next topic: Globalization and Its Impact on the US

• Next week: Globalization and Global Governance

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Globalization in Perspective

• What Do We Mean By “Globalization”?• Is the Current US Economy more

“Globalised” than in the Past?• What Measures Would We Use?

– Trade– Migration– Capital Flows

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What is Globalization?

• Peoples everywhere are increasingly subject to the disciplines of the global marketplace.

• A myth which conceals the reality of an international economy increasingly segmented into three major regional blocs in which national governments remain very powerful.

• States and societies across the globe experiencing a process of profound changes as they adapt to a more interconnected, but highly uncertain world.

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Generalization

“The widening, deepening and speeding up of worldwide interconnectedness in all aspects of contemporary social life, from the cultural to the criminal, the financial to the spiritual.”

• Chapter 2 focuses on the institutions and markets that “connect” nations’ economies.

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International Economic Integration

International economic integration refers to the extent and strength of real- sector and financial-sector linkages among national economies. Real-sector linkages occur through the international transactions in goods and services while the financial-sector linkages occur through international transactions in financial assets.

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On Trade Openness

• Since the end of WWII, world trade has grown much faster than world output.

• A Long View of Trade– Imports to GDP– Exports to GDP– Openness Index:

Imports + Exports: .GDP

Openness =

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FIGURE 1.1 Openness Index, United States, 1890–2000

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Imports to GDP: 1821-2001

1800 1850 1900 1950 2000 2050YEAR

0.00

0.05

0.10

0.15

Impo

rts to

GD

P

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Exports to GDP

1800 1850 1900 1950 2000 2050YEAR

0.00

0.05

0.10

0.15

Exp

orts

to G

DP

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Openness Index: Trade/GDP

1800 1850 1900 1950 2000 2050YEAR

0.00

0.05

0.10

0.15

0.20

0.25

Ope

nnes

s In

dex

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Trade Balance as a Percent of GDP

1800 1850 1900 1950 2000 2050YEAR

-50

0

50

100

Trad

e B

alan

ce to

GD

P

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Other Indicators of Trade Openness

• Law of One Price (LoOP)– Does it hold? Not even vaguely.– Does it hold more now than in the 19th

Century? Probably.• Home Market Bias and Border Effects

– Does the LoOP hold domestically more than internationally? Yes.

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Immigration and Openness

• How Global is the Market for Labor?– Very large labor flows– Large, and persistent, wage differentials

• How do we Evaluate Immigration?– Wage effects– Fiscal effects– Other– Debate in CA over immigration (legal and illegal)

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Immigration and Openness

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Foreign Direct Investment and OpennessUS FDI as a Share of GNP

Year US FDI Abroad FDI in US

1914 7 3-4

1929-1930 9 1

1960 6 1

1996 20 16

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International Financial Openness

• How global is the world financial market?– The market is huge, BIS, Daily Transactions:

• 1973 $15 billion; • 1998 $1.5 trillion.

– But how integrated is it?• Do International Parity Conditions Hold? No.• Portfolio nondiversification.• Feldstein-Horioka Puzzle: Savings-Investment

correlation.

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International Financial Openness: More or Less than 19th Century?

• 19th Century Characterized by Very Open Financial Markets– Gold Standard– Very few restrictions– After the transatlantic cable, quite good

communication links

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International Financial Openness: More or Less than 19th Century?

• The current environment is different– Many more financial instruments available today– In developed countries, transaction costs have dropped

dramatically• 24 hour, global market• Better information

– More timely– More reliable (i.e. accounting rules better) but with exceptions:

Enron, WorldCom• Better enforcement of contracts with exceptions: Yukos in

Russia

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International Financial Openness: More or Less than 19th Century? Developing

Countries?• Most were still colonies (US had gained

independence in 1776)– No financial instruments then and very few today– High transaction costs remain

• No 24 hour, global market• Limited information

– Less timely– Definitely not reliable (i.e. accounting rules are lax if any ) – Missing markets and incomplete contracts– Better enforcement of contracts with exceptions:THE ISSUE IS HOW TO DEVELOP INSTITUTIONS THAT

CAN BE USED TO COORDINATE MARKET ACTIVITIES.

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Why Should We Care About Openness?

• It is a substantial political issue– Politicians now use openness as an issue– Seattle, Doha, etc.

• There are real benefits and costs

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Growth of World Exports

-4

-2

0

2

4

6

8

10

12

70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Year

Ann

ual P

erce

ntag

e C

hang

e

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Capital Flows to Emerging Economies

-150

-100

-50

0

50

100

150

200

250

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Year

$ M

illio

ns

Direct Investment Portfolio Other

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Adam SmithWealth of Nations

• Sources of wealth• Sources of wealth

Division of labour Division of labour enhances efficiencyenhances efficiency

International tradeInternational trade→→ enlarges marketsenlarges markets→→ increases efficiencyincreases efficiency→→ increases wealth and growthincreases wealth and growth

““Nations tolerably well advanced as to skill, dexterity, and Nations tolerably well advanced as to skill, dexterity, and judgment, in the application of labour, have followed very judgment, in the application of labour, have followed very different plansdifferent plans in the general conductin the general conduct oror direction of it; and direction of it; and those plans have not all been equally favourable to the those plans have not all been equally favourable to the greatness of its produce.greatness of its produce.

‘‘

ADAM SMITHADAM SMITH

private enterpriseprivate propertygood governancefree trade

private enterpriseprivate propertygood governancefree trade

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Global Questions Related to Incomes, Poverty and Distribution

• Economists think about the determinants of income. Total income is related to its resource endowments (labor, physical capital, human capital) and productivity.

• Growth per capita (Output/Population) is expressed in terms of proximate variables: (a) physical capital deepening; (b) human capital accumulation; and (c ) productivity growth. Such decompositions (growth-accounting) ignores the fact that accumulation and productivity are endogenous. Over the past 20 years, economists have discovered that there may be deeperdeterminants of growth that had been previously been ignored.

• Question: Why now? 4 issues in the global economy

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The 4 issues

• 1.cross-national records for the last few decades show varying country experiences despite improvements in most proximate determinants. China has grown rapidly despite the absence of full-property rights; Indonesia has grown over a 30-year period despite weak institutions and economic policy; Brazil, Mexico did so well until the 80s and so poorly thereafter.

• 2. Countries with poor initial conditions before/after WWII (expected to do worse) have done well (Botswana, Mauritius) while countries with good initial conditions (expected to do well) have faired poorly (Argentina, Philippines).

• 3. Increased globalization and economic integration (more trade and openness) that was promoted as promising high growth rates and less poverty has produced perverse results: less growth and increasing poverty. Why?

• 4. The increasing gap between the world’s rich and poor countries: 2/3 of the world’s population lives in countries where per capita income is 1/10 the U.S. level. The starting point for most countries was not too far apart (exclude ex-colonies), these differences have not been narrowed by factor endowments or productivity.

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Global Distribution of Income (1999)

• See Handout, Figure 1

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Proximate Income Determination (1776-1980s)

• See Handout, Fig 2

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Deeper Income Determination (1980s+ )

• THREE factors seem t be good candidates to supplement the standard proximate variables

• 1. Geography – shapes the natural resource endowments and the country is largely shaped by it, that is, the quality of natural resources depends on geography (oli, diamonds, copper etc).

• Soil quality, rainfall determines the productivity of land. Geography and climate determine the inhabitant’s proclivity to disease (malaria etc). Geography influences growth and poverty in two additional ways: (a) integration with the world regardless of trade policies, and b) shapes institutions – colonialism (scramble for Africa) shaped by geography and political considerations. Natural resource curse/blessing issue.

• 2. Trade. Integration in the world economy (higher Index of Openness) as driver of economic growth. Sachs & Warner (1995): poor countries that are more open to trade experience unconditional convergence to the income levels of rich countries. This controversial stance has lent support to the lending institutions [IMF, WB], and WTO, OECD to push for more integration of poor countries as the surest way to prosperity! VERY CONTROVERSIAL IDEA.

• Basic trade theory does NOT support these claims: trade may sometimes hurt particular groups unless accompanied by capital flows, management and technical flows as well.

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Deeper (cont. )

• 3. Institutions – property rights, regulations, the quality and independence of the judiciary, bureaucratic capacity are not givens when countries engage more in trade or integration in a global economy!

• The idea that such institutions arise automatically and effortlessly as a by-product of economic growth due to trade, factor mobility in an integrated world are at best naïve (contrast China and Russia beginning 1990).

• Once one moves beyond this assumption, 4 questions arise• A) Which domestic institutions demand priority? Which international

institutions require reform? What kind of reforms?• B) What specific institutions are required NOW (as opposed to the end of the

WWII) ?• C) Do these institutions and their policies differ according to the level of

development, history, initial conditions, and their affiliation to existing ones in rich countries? E.G. ASEAN vs EU.

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Deeper Income Determination (1980s+)

• See Figure 3

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Questions raised by deeper variables in understanding growth and poverty in a global

economy• Which arrows matter the most and why? The ideas related to globalization and

its positive attributes that affect growth and poverty are about arguments pertaining to the relative strengths of the various arrows.

• Primacy of Geography argument (climate, resources, and health): emphasize arrows from that box to factor endowments, trade, institutions -- income (and also poverty reduction) through endowments and productivity.

• Integration (High Index of Openness via Trade): from trade to incomes and institutions. Supporters of this idea are supportive of free markets in most areas except in environmental standards, labor standards, and free labor mobility. Closely associated with the Washington Consensus (see Stiglitz’sbook for a stinging critique of this approach)

• The Institutionalists: primacy of institution building, stressing the idea that more trade and higher incomes and less poverty are a result (not a given) of better institutions. Supporters of this idea tend to be very critical of existing institutions (see Chapter 2).