LECTURE 2: THE TRADE BALANCE IN PRACTICE

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1 LECTURE 2: THE TRADE BALANCE Question: Is the Marshall-Lerner condition satisfied in practice? 1) Historical example: Poland 2009 IN PRACTICE 2) Econometric estimation of elasticities OLS The J-curve 3) Both determinants together: Real exchange rate & income Keynesian model of the TB Estimation for the case of East Asian countries

2 Zloty/ Historical example: Poland s Exchange Rate Rose 35% when Global Financial Crisis hit in late I III V VII IX XI I III V VII IX XI I III V VII IX Source: Cezary Wójcik

3 Poland s trade balance improved sharply in 2009 while its European trading partners all went into recession. Trade balance in billions of euros Source: National Bank of Poland From FocusEconomics 2014 Contribution of Net X in 2009: 3.1% of GDP > Total GDP growth: 1.7% => Poland avoided recession.

4 A textbook case where depreciation was expansionary: Poland, the only continental EU member with a floating rate, was also the only one to escape negative growth in the global recession of % change in GDP Exchange Rate Poland f Floating (de facto) Lithuania f Fixed Latvia f Fixed Estonia f Fixed Slovakia f Euro Czech Republic Source: Cezary Wójcik, f Flexible

5 Empirical estimation of export & import elasticities log of X demanded log of EP*/P Price of foreign goods relative to domestic goods Coefficient estimated by OLS regression. In logs, so parameters are elasticities.

6 Common econometric finding Estimated trade elasticities with respect to relative prices often 1, after a few years have been allowed to pass. => Marshall-Lerner condition holds in the medium run. e.g., Marquez (2002). Some face a higher elasticity of demand for their exports: small countries, and producers of agricultural & mineral commodities or other commodities that are close substitutes for competitors exports.

7 Common empirical observation: After a devaluation, trade balance gets worse before it gets better. ε X + ε M > 1 Explanation: Even if devaluation is instantly passed through to higher import prices, buyers react with a lag. Also, in practice, it may take time up front before the devaluation is passed through to import prices. ε X + ε M < 1 ε X + ε M < 1 ε X + ε M > 1

8 The trade balance is a function of both the real exchange rate and income. Recall the Keynesian model of the trade balance from Lecture (iii) of the pre-semester Macro Review. Micro theory: The demand for the import or export good, as for any good, is a function of both price & income.

9 Keynesian Model of the Trade Balance Import demand is a function of the exchange rate & income. The same for exports: => X = X(E, Y*) M = M(E, Y). dx de 0 dm de 0. dx dy * m* 0 dm dy m 0 If the domestic country is small, Y* is exogenous.

10 Estimated income elasticities are mostly between Estimated price elasticities (LR) satisfy the Marshall-Lerner Condition.

11 END OF LECTURE 2: THE TRADE BALANCE IN PRACTICE

12 Professor Jeffrey Frankel, Kennedy School, Harvard University Appendix 1: An application of the marginal propensity to import Why did trade fall so much more sharply than income in the global recession?

13 Bussière, Callegari, Ghironi, Sestieri, & N.Yamano, 2013, "Estimating Trade Elasticities: Demand Composition and the Trade Collapse of " Why did trade fall so much more sharply than income in the global recession? 2009

14 Why did trade fall so sharply in the global recession?, continued Bussière, Callegari, Ghironi, Sestieri, & Yamano, 2013, "Estimating Trade Elasticities: Demand Composition and the Trade Collapse of " The usual explanations involve trade credit, inventories, and trade in intermediate inputs.

15 Bussière et al (2013) argue that Investment, which declined much more in 2009 than the other components of GDP, has a higher marginal propensity to import than the other components. Behavior of real components of GDP in the recession Consumption GDP Demand, adjusted for import-intensity Imports & Exports Investment Bussière, Callegari, Ghironi, Sestieri, & N.Yamano, "Estimating Trade Elasticities: Demand Composition and the Trade Collapse of

16 Trade growth continues to be slow, and slow investment continues to be a possible explanation. IMF WEO, 2016 Apr., Fig. 1.13