ECON2915 Economic Growth Lecture 8 : Growth in the Open Economy. Andreas Moxnes University of Oslo Fall 2016 1 / 31
The Open Economy So far, ignored interactions between countries. But international linkages pervasive: Trade in goods and services. Final goods. Intermediate goods (outsourcing). Capital flows Foreign portfolio investment. Foreign direct investment (FDI). People flows. Transfer of technology and ideas. We will discuss: 1 What is the effect of openness on growth? 2 How does openness affect growth? 2 / 31
Measuring openness A closed economy: Autarky. Different degrees of openness: Free trade, not free flows of inputs into production. Restricted migration (most countries). Immigrant share of population (2013): Norway 13.8%, U.S. 14.3%, Sweden 15.9%, Canada 20.7%, New Zealand 25.1%, Switzerland 28.9%, Hong Kong 38.9%, UAE 83.7% Restricted capital flows (some countries). Two common ways of measuring trade openness: 1 Trade relative to GDP. But trade can be free even if no trade occurs. Small vs large countries. 2 Relative prices. If free trade, then law of one price should hold. Pros and cons? 3 / 31
Country income Gross Domestic Product (GDP) measures the income earned by all factors of production located in a country. Gross National Product (GNP) measures the income earned by the factors of production owned by residents of a given country. Makes a difference if e.g. large share of capital stock owned by foreigners. 4 / 31
GNP to GDP ratio 5 / 31
Globalization: The Facts Two waves of globalization: Mid 1800s to WW1. Inter war period: Protectionism. WW2 to today. 6 / 31
Globalization: Trade Openness in 1950 at same level as 1880. 7 / 31
Exports relative to GDP: Norway 0.5 0.45 0.4 0.35 Total Mainland 0.3 0.25 0.2 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 8 / 31
Foreign born relative to population: Norway 0.16 0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 1970 1980 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 9 / 31
Globalization: Capital Portfolio investment. Foreign direct investment (FDI). World inward FDI flows annual growth 1990-2006: 17%. World exports: 8% By 2010 the value added from multinational corporations amounted to a quarter of global GDP (UNCTAD, 2011). Half of US imports transacted within a multinational firm. 10 / 31
Globalization: Capital Developed economies Transition economies Developing economies World total 2 000 1 500 1 000 500 55% 0 1995 2000 2005 2010 2014 11 / 31
Globalization: Causes 1 Lower transport costs. 2 Freer flow of information. 3 Trade liberalization. 12 / 31
Globalization: Transportation costs New technologies: Railroads and steamship (1800s). Opening of Suez canal in 1869, Panama canal in 1914. Latest expansion of Suez in 2014-15 and Panama 2007-13 / 31
Globalization: Transportation costs New technologies: Railroads and steamship (1800s). Opening of Suez canal in 1869, Panama canal in 1914. Latest expansion of Suez in 2014-15 and Panama 2007- Container shipping (1950s-). 20-fold increase in the speed of loading. Containers can be shipped from truck train ship and back. 13 / 31
Globalization: Transportation costs New technologies: Railroads and steamship (1800s). Opening of Suez canal in 1869, Panama canal in 1914. Latest expansion of Suez in 2014-15 and Panama 2007- Container shipping (1950s-). 20-fold increase in the speed of loading. Containers can be shipped from truck train ship and back. Air freight (1950s-). Cost/ton fell by factor of 10 between 1955 and 2004. Dramatic reduction in shipping costs. From $95 to $29/ton between 1920 and 1990 according to IMF (1990 dollars). 13 / 31
Globalization: Transportation costs Maersk s Triple-E 14 / 31
Globalization: Information costs New technologies: Transatlantic telegraph (1866) Transatlantic telephone (1927) The internet. Dramatic reduction in communication costs. 3 minute phone call London-NYC $300 in 1930, $50 in 1960, $1 in 1996, $0 today (1996 dollars). enables trade in services. 15 / 31
Globalization: Trade policy Average tariff rates in industrial countries fell from 40% after WW2 to 6% in 2000. Large reductions negotiated under the GATT and WTO. Tariffs still high today in many poor countries... as well as in agricultural trade: 250% tariff on wheat in Japan. x% tariff on beef in Norway x% tariff on milk in Norway 16 / 31
Openness, US 17 / 31
The effect of openness on growth - empirics Are open economies richer than closed ones? Countries assigned 0 or 1 each year from 1965 to 2000 based on tariffs, exchange rate manipulation, government monopolies on exports etc. (Sachs and Warner, 1995) 18 / 31
The effect of openness on growth - empirics Does openness cause higher growth? Case studies: Japan autarky ended in 1858 Trade rose by 70x & rapid GDP growth & catchup with Europe. South Korea 1960s: Sweeping liberalization GDP doubled in 11 years China s integration in world economy and joining the WTO in Dec 2001. U.S. protectionism in 1930s contributing to the severity of the Great Depression. 19 / 31
The effect of openness on growth - empirics More evidence #1: Suez canal closed 1967-1975 in response to Egypt-Israel conflict. In effect, shipping distance increased for many country-pairs. E.g. Mumbai-London 6,200 10,800 nautical miles. The increase was exogenous, i.e. no reverse causality. Feyrer (2009a) estimates the impact on less trade (due to Suez closing) on country income. More evidence #2: Rise of air freight: 0% of U.S. trade in 1960 to 50% in 2000. The rise of air freight meant that country-pairs with very long sea shipping distance would benefit more than other country pairs. Japan-Germany versus Brazil-Spain. Feyrer (2009b) estimates the impact on more trade (due air freight) on country income. Both studies find economically large effects. 20 / 31
Theory: Openness and income How does openness affect income? Two main hypotheses: Factor accumulation. Productivity. We ll start with factor accumulation. 21 / 31
Openness and factor accumulation Let s extend the Solow model with perfect capital mobility. Saving Investment. Price of capital same everywhere. Assume small open economy: Price of goods and factors fixed. For now, ignore human capital. 22 / 31
Solow with perfect capital mobility Production function, intensive form: y = Ak α In competitive economy, the (value of the) marginal product of capital equals the rental rate on capital: r w = pmpk = pαak α 1 ( ) p 1/(1 α) k = αa, r w where p is the price of the final good. And output per worker is ( ) p α/(1 α) y = Ak α = A 1/(1 α) α r w 23 / 31
Solow with perfect capital mobility : Implications Capital and output per worker determined by the price of capital r w. The savings rate does not affect GDP per worker. But higher savings rate will boost GNP per worker. 24 / 31
Economic integration Let s go from autarky to perfect capital mobility. A country with k < k (e.g. low savings rate) k and y. A country with k > k (e.g. high savings rate) k and y. 25 / 31
Perfect capital mobility : An empirical test Strong positive correlation (Feldstein-Horioka puzzle, 1980). Savings retention coefficient = 0.89. What is the coefficient under autarky? 26 / 31
Openness and productivity Productivity is the main source of growth coming from openness. Example: Prices in Japan before and after 1858 opening to trade. Autarky: To get one pound of sugar, you had to produce one pound of tea. Opportunity cost of tea = 1 pund of sugar. Trade: To get one pound of sugar, you can export 1/3 pound of tea. Higher standard of living because of specialization. 27 / 31
Openness and technology In addition to gains coming from specialization.. Technology transfer: Foreign direct investment: Foreign firm brings technology and capital. Imports of inputs/capital that embody new technology. Transfer of soft technologies such as management techniques. Incentives for R&D and knowledge creation: Market size matters. It is not worth my while to manufacture [your engine] for three countries only; but I find it very worth my while to make it for all the world. (Matthew Bolton, the partner of James Watt, inventor of the steam engine) 28 / 31
Openness and efficiency In addition to gains coming from technology.. Exploiting economies of scale. Weakens monopoly power of domestic firms raising efficiency / reducing mark-ups. Imports 6% of sales in 1965, 27% in 1980. 29 / 31
Openness and costs We have analyzed economic gains from openness. What about the costs? Those that are hurt by trade. Workers with obsolete skills. The scarce factor typically loses. E.g. low-education workers in Norway / U.S. Need for adjustment assistance. Income inequality. Environmental concerns. Food miles. Exploitation of workers - Apple/Foxconn working conditions. Loss of national sovereignty - inability to raise taxes. 30 / 31
What s next Why do countries trade. Comparative advantage. Productivity differences. Factor endowment differences. How does openness affect growth. How can trade policy affect growth. 31 / 31