Apr 29

Ricardian trade theory

David Ricardo developed this international trade theory based in comparative advantage and specialization, two concepts that broke with mercantilism that until then was the ruling economic doctrine. He introduced this theory for the first time in his book “On the Principles of Political Economy and Taxation”, 1817, using a simple numerical example concerning the trade between Portugal and the England in the following way:

Let’s say the labour costs per unit of cloth (C) and wine (W) produced by England (E) and Portugal (P) are as those seen in the adjacent figure. Even though Portugal has an absolute advantage on wine and cloth production, England has a comparative advantage on cloth production.

Because of this advantage, both countries would benefit from international trade. This can be seen using an Edgeworth box, as seen in the figure below.

Without international trade, each country would only be able to produce (and therefore to consume) any amount of both wine and cloth inside or at the country’s production-possibility frontier (green for England and red for Portugal). For instance, point E cannot be reached by any of these countries, since it is outside their production-possibility frontier.

However, point E can be reached by trading goods.

Portugal would specialize on producing wine, which is relatively less costly to produce. This is, Portugal is better off producing more wine that it will consume in order to trade it for cloth, since production of cloth would be more costly than the production of the exported wine. For the same reason, England would specialize on cloth. Portugal would produce only wine, consuming C_w and exporting X_w to England, while England would produce only cloth, consuming C_c and exporting X_c to Portugal.

As a result of international trade, point E would become reachable, defining the terms of trade line, which shows how great the gains from trade are. The further from each production-possibility frontier, the better the terms of trade are, and therefore the gains from trade are also greater.

The implications of this theory were great as it meant a breakthrough in the economic science, especially, due to the contribution of the comparative advantage principle.

However, this theory is not spared of flaws as some critics pointed out. John Stuart Mill was concerned with reciprocal demand as he argued that it was not necessarily true that demand and supply across countries would be met. Furthermore, although Ricardian theory of comparative costs may show the limits within which the equilibrium must be, it does not show how to determine the terms of trade, and hence the price of the goods. As this is an unresolved matter, it considerably limits a model that aims to explain international trade. Nevertheless, as Jagdish N. Bhagwati pointed out in his article “The Pure Theory of International Trade: A Survey”, 1964, this model ought to be analysed form a normative point of view, since it does help prove the welfare proposition that trade is beneficial.

Apr 25

Lope Gallego

Comparative advantage

The principle of comparative advantage explains why countries obtain gains from international trade. This term was first mentioned by Adam Smith when talking about specialization, and later by David Ricardo, who developed the concept as we know it nowadays in his trade theory explained in his book “On the Principles of Political Economy and Taxation”, 1817.

When comparing two countries, even if one of them has absolute advantage in producing two goods compared to the other, it may be possible for both to obtain benefits from the trade of these two goods. The key is that each country should produce the good with the lowest opportunity cost. When a country specializes in the good for which it has a comparative advantage, total production rises.

Following the example by Ricardo, Portugal can produce cloth and wine with fewer inputs than England. However, for Portugal the opportunity cost of producing wine is lower than that of producing cloth, whereas, in the case of England the opportunity cost of producing cloth is lower than of wine. If Portugal specializes in producing wine and import cloth, and England specializes in producing cloth and import wine, both countries could make the most of its comparative advantage.

Let’s see a numerical example, following Ricardo’s hypothesis. If England requires 10 men for one year for the production of cloth (let’s say, one unit), and 12 men for the production of wine (also one unit), while Portugal requires 7 men for the production of one unit of cloth and 8 men for the production of one unit of wine, Portugal has an absolute advantage on the production of both cloth and wine, as seen in the adjacent figure.

However, we must consider the opportunity cost of producing each commodity. Comparative costs are 10/12=0.83 in England and 7/8=0.875 in Portugal; these are called the terms of trade.

We can easily see that Portugal produces at lower costs than England: for cloth, (10-7)/10=30% cheaper; and for wine, (12-8)/12=33.3%. Since it can produce both products at a lower cost, we know that Portugal has an absolute advantage in the production of both commodities. However, we can also see that Portugal has a comparative advantage in the production of wine, since it’s comparatively cheaper than cloth (33.3% for wine instead of 30% for cloth).

We obtain the same results with the opposite reasoning. England produces at higher costs: for cloth, (10-7)/7=42.8% more expensive; for wine, (12-8)/8=50% more expensive. Therefore, England has a comparative advantage in the production of cloth, since it’s comparatively less expensive than wine (42.8% for cloth instead of 50% for wine).

In this case, trade will benefit both countries as long as the terms of trade stay between 0.83 and 0.875 units of cloth per unit of wine. As a conclusion, trade can benefit every country because it allows each to specialize in the production of goods and services in which they have a comparative advantage.

Apr 22

Lope Gallego

IS-LM

The IS-LM (Investment Savings-Liquidity preference Money supply) model focuses on the equilibrium of the market for goods and services, and the money market. It basically shows the relationship between real output and interest rates.

It was developed by John R. Hicks, based on J. M. Keynes’ “General Theory”, in which he analysed four markets: goods, labour, credit and money. This model, firstly named IS-LL, appeared in his article “Mr. Keynes and the Classics: a Suggested Interpretation”, published in 1937 in the journal Econometrica.

In order to understand how this model works, we’ll first see how the IS curve, which represents the equilibrium in the goods market, is defined. Then, the LM curve, which represents the equilibrium in the money market. Finally, we’ll analyse how the equilibrium is reached.

IS curve: the market for goods and services

In a closed economy, the equilibrium condition in the market for goods is that production (Y), is equal to the demand for goods, which is the sum of consumption, investment and public spending. This relationship is called IS. If we define consumption (C) as C = C(Y-T) where T corresponds to taxes, the equilibrium would be given by:

Y = C(Y-T) + I + G

We consider that investment is not constant, and we see that it depends mainly on two factors: the level of sales and interest rates. If the sales of a firm increase, it will need to invest in new production plants to raise production; it is a positive relation. With regard to interest rates, the higher they are, the more expensive investments are, so that the relationship between interest rates and investment is negative. The new relationship is expressed as follows (where i is the interest rate):

Y = C (Y- T) + I (Y, i) + G

If we keep in mind the equivalence between production and demand, which determines the equilibrium in the market for goods, and observe the effect of interest rates, we obtain the IS curve. This curve represents the value of equilibrium for any interest rate.

An increasing interest rate will cause a reduction in production through its effect on investment. Therefore, the curve has a negative slope. The adjacent graph shows this relationship.

LM curve: the market for money

The LM curve represents the relationship between liquidity and money. In a closed economy, the interest rate is determined by the equilibrium of supply and demand for money: M/P=L(i,Y) considering M the amount of money offered, Y real income and i real interest rate, being L the demand for money, which is function of i and Y.

The equilibrium of the money market implies that, given the amount of money, the interest rate is an increasing function of the output level. When output increases, the demand for money raises, but, as we have said, the money supply is given. Therefore, the interest rate should rise until the opposite effects acting on the demand for money are cancelled, people will demand more money because of higher income and less due to rising interest rates.

The slope of the curve is positive, contrary to what happened in the IS curve. This is because the slope reflects the positive relationship between output and interest rates.

IS-LM model

At any point of these curves the equilibrium condition in the corresponding market is true, but only at the point where the two curves intersect, both equilibrium conditions are satisfied. We can see this intersection in the following graph:

The IS and LM curves undertake changes due to many factors, such as different kinds of economic policies. These variations will explain the changes in the values of production and of interest rates taking place in the economies.
For instance, if there is an increase in government spending, which is considered a fiscal policy, the IS curve will shift to the right, as seen in the graph in the left. This happens because more government spending means more production for any interest rate. This shift, as seen in the adjacent graph, will consequently change the equilibrium from point E₁ to point E₂, with a greater level of output, but also at greater interest rates.

On the other hand, if we consider a monetary policy, such as an increase in the money supply, the curve that shifts will be the LM curve, as seen in the graph in the right. An increase in the money supply will decrease the interest rate, shifting the LM curve to the right, thus increasing output.

Monetarists’ views on the IS-LM model:

Monetarists greatly criticized the IS-LM model, highlighting some different views regarding the elasticity (and therefore the slope) of both curves. In their opinion, the LM curve is very inelastic, while the IS curve is very elastic. The most important thing we derive from these different views is the different consequences and effectiveness of expansionary fiscal and monetary policies.

Monetarists argue that monetary policies are more effective. Take the same example as before, an increase in the money supply. This will shift the LM curve to the right, displacing the equilibrium from E₁ to E₂ in the figure below. However, monetarists consider also two other effects: direct and indirect wealth effect. The first one, also known as Pigouvian effect, considers that, because of the increase in money supply, people will consume more, shifting the IS curve and changing the equilibrium to point E₃. The second one considers that, because of the initial drop in the equilibrium interest rates, people will invest more, thus shifting even more the IS curve and changing the equilibrium to point E₄.

Now, monetarists are more sceptic than Keynesians about fiscal policy. This is because, as seen in the figure below, the initial shift of the IS curve (from point E₁ to point E₂) will be partly offset by a second shift of the same curve. This, known as crowding-out, happens because the increase in government spending increases interest rates, which decreases the attractiveness of investment. Therefore, the more the government spends, the less private capital will be invested, which moves the equilibrium from point E₂ to E₃. Also, because of higher output, money demand increases, which shifts the LM curve to the left, to point E₄.

Both views have a great army of researchers and professors defending them, as part of the modern division on such matters into two main doctrines: New Keynesian Economics and New Classical Macroeconomics. All the effects presented here must be taken into consideration when analysing the IS-LM model. However, it must be noted that some of these conclusions change when considering an open economy, which is analysed by the IS-LM-BoP or Mundell-Fleming model.

Apr 17

Lope Gallego

Absolute advantage

In international trade theory we say a country has absolute advantage in the production of a good with regards to another country when it can produce more units of this good with fewer inputs. Logically it all comes down to productivity ratios, as one country can produce more output with fewer inputs.

We will show an example with two countries. Let’s say England employs 10 units of labour to produce 1 unit of cloth and 12 units of labour to produce 1 unit of wine, while Portugal employs 14 units of labour to produce 1 unit of cloth and 8 units of labour to produce 1 unit of wine. As you can see in the adjacent figure, England has an absolute advantage in the production of cloth, while Portugal has an absolute advantage in the production of wine. Therefore, England will produce cloth and trade it with Portugal’s wine.

Under this theory for trade to happen between two nations, neither of them will have to have absolute advantage over all of the goods. Furthermore, if a country had either absolute advantage over production of all goods or over none, no international trade would happen, since countries would not gain from trading with each other. However in the first case this would be due to a lack of interest from the country to trade with the rest of the world, where as in the second case this would occur due to the opposite.

Adam Smith is considered the father of this theory due to his paper “An Inquiry into the Nature and Causes of the Wealth of Nations” 1776 where he only considered labour as a productive factor.

As opposed to this theory, the comparative advantage theory was developed by David Ricardo, where even if a party doesn´t have absolute advantage it may have comparative advantage and so trade would occur. While absolute advantage implies that one of the parties is better at producing a given good, comparative advantage relates to the opportunity cost of producing that particular good instead of producing some other good.

Apr 15

Lope Gallego

Exchange rate

The exchange rate can be understood as the price of one currency in terms of another currency. It is the ratio between two currencies, the rate at which one can be exchanged for another. This ratio is very important since it is widely used when dealing with international payments or transfers, as well as when analysing open economies.
We have to distinguish between the base and the counter currency. In the adjacent example, currency A (C_A) would be the counter currency while currency B (C_B) would be the base currency.

Exchange rates are usually shown in terms of the base currency, being this a direct quotation if C_A is the currency of our home country. This means, how many units of currency A I can get for one unit of currency B. The dollar is the most widely used currency as base currency, followed by the euro. Therefore, the exchange rate with another currency would be shown as follows:

C_B 1 = C_A 1.35

Exchanges rates can also be expressed using indirect quotation, which might make more sense depending on each people’s needs:

C_A 1 = C_B 0.7407

Nominal vs. Real exchange rate:

We can make a distinction between nominal and realexchange rates.

The nominal exchange rate determines the price of the domestic currency in terms of the number of units of a foreign currency. In other words, the rate at which someone can trade the currency of their country for the currency of some other country. When we can buy an increasing number of units of foreign currency with the same amount of our domestic currency, our country’s currency is undergoing an appreciation. Conversely, when we can buy a decreasing number of units of foreign currency, our country’s currency is experiencing depreciation.

The difference between the nominal and the real exchange rate is that the real exchange rate takes into account the domestic and foreign prices, as summarized in the following formula:

This real exchange rate quantifies the price of a basket of goods and services available in one country relative to the same basket of goods and services available in the foreign country. An easy way to understand real exchange rates and purchasing-power parity is using the BigMac index, which expresses costs of living by comparing BigMac prices over the world.

Fixed vs. Flexible exchange rates:

Depending on whether or not the exchange rate is constant over time we are in a fixed or flexible exchange rate system.

In a fixed exchange rate system, the central bank sets, explicitly or implicitly, a particular exchange rate. To achieve this goal, monetary policy is used, increasing or decreasing the amount of money in the economy. A reduction in the exchange rate is called devaluation and an increase revaluation. Another option is fixing the currency of a particular country to a basket of currencies.

When the exchange rate system is flexible, the currency floats freely, so the international currency market sets its value. In this case we speak of depreciation when we have a reduction in the exchange rate and of appreciation when we have an increase. Fluctuations help moderate the effects of foreign economic cycles, automatically adjusting the balance of payments. Nowadays, most economies in the world have flexible exchange systems, or are really close to a floating system.

Apr 10

Lope Gallego

Purchasing power parity

The purchasing-power parity (also known as PPP) theory states that a unit of any currency should purchase the same amount of goods in all countries. In the long run this theory may explain the behaviour of exchange rates.

The base of the purchasing-power parity theory is the law of one price. This principle asserts that a product should be sold at the same price in all markets, otherwise arbitrage opportunitiesappear and individual actions push prices to a point where they become equal again.

When using this theory we can conclude that, in the long run, real exchange rates are constant over time. Conversely, nominal exchange rates depend on the price levels in both countries. However, in the real world, exchange rates fluctuate not only due to changes in the price levels: the purchasing-power parity theory has constraints. These limitations are mainly that some products are not easily traded, and even if tradable, some goods are not perfect substitutes if they are produced in different locations.

Apr 8

Lope Gallego

Big Mac index

The Big Mac index was invented in 1986 by the magazine The Economist, and considers the Big Mac hamburger sold in McDonald’s as its basket of reference. This index is based on the purchasing power parity theory. When analysing exchange rates through this theory, we compare an homogeneous basket of goods (a Big Mac) available in the analysed countries.

Since Big Macs are sold all around the world and can be considered to be homogeneous, it allows us to make simple calculations. For example, if the price of a Big Mac in the US is $1.2 and in Brussels €1, the exchange rate should be 0.83 euros per dollar. By dividing the domestic currency price in each country by the price in dollars, we can calculate the purchasing-power parity, and comparing it with the current exchange rates test whether the currency is under or overvalued.

The results are not exact because there are other factors that influence them, for instance, the local preferences of the consumers. However, they give a reasonable approximation with a very simple calculation.

More on the Big Mac index in The Economist website.

Apr 2

Lope Gallego

Degree of openness

When defining the commercial relations that a country establishes with the rest of the world, we should look at its degree of openness. A closed economy is an economy that does not interact at all with other economies, which does not establish any exchange. Nowadays, closed economies are an exception, because most of the countries have an open economy. However, there are different degrees of openness, depending on the restrictions that the country imposes on free trade. A common basic measure of an economy’s degree of openness is the percentage that the sum of exports and imports represents over the GDP:

Nevertheless, there are two ways in which an open economy interacts with the rest of the world; buying and selling goods and services in the products markets; and buying and selling assets in the international financial markets. This equation just takes into account the first kind of interaction, but it may be used as a basic reference.

The reason why countries decide to open their economies is that they obtain clear benefits from it. International trade allows people to produce what they produce best and to consume a broad variety of products. These benefits can help raise living standards in all countries, because they produce those products in which they have a comparative advantage. This is one of the reasons why Ronald McKinnon, in his article “Optimum Currency Areas”, 1963, considered it as one of the conditions to have an optimum currency area.