Thorvaldur Gylfason

International International Economic Economic IntegrationIntegration

Implications for Implications for NationalNational Economic Economic PoliciesPolicies

These slides – and more! – can be viewed on my website: www.hi.is/~gylfason

OutlineOutline

1.1. Globalization and its implications forGlobalization and its implications for National incomesNational incomes Prices and inflationPrices and inflation Interest ratesInterest rates

2.2. Policy coordinationPolicy coordination Monetary policies and institutionsMonetary policies and institutions Fiscal policiesFiscal policies

3.3. Agricultural policyAgricultural policy

But first: Some numbers

But first: Some numbers

Import Tariffs 1980-Import Tariffs 1980-20002000

0

5

10

15

20

25

Tariffs (% ofimports)

Tariffs (% oftax revenue)

1980

2000

11

Export Duties 1980-Export Duties 1980-20002000

0

1

2

3

4

5

Duties (% ofexports)

Duties (% oftax revenue)

1980

2000

Imports and Exports Imports and Exports 1960-2000 (% of GDP)1960-2000 (% of GDP)

0

10

20

30

40

50

Imports Exports

196019802000

FDI FDI 1919880-20000-2000 (% of (% of GDP)GDP)

0

2

4

6

8

10

FDI (net) FDI (gross)

198019902000

Further Evidence of Further Evidence of GlobalizationGlobalization

Economic integration followed by Economic integration followed by politicalpolitical integration integration Widening and deepening integrationWidening and deepening integration

Europe’s Europe’s common currencycommon currency rests, in part, rests, in part, on political arguments on political arguments ((Austria vs. SwedenAustria vs. Sweden))

Even in North America, there is an Even in North America, there is an ongoing debate about the ongoing debate about the pros and conspros and cons of adopting a common currencyof adopting a common currencyIs NAFTA not enough?Is NAFTA not enough?

But political and historical impetus is absentBut political and historical impetus is absent

The The

importance of importance of

languagelanguage

International Linkages

National incomes of trading partners tend National incomes of trading partners tend to move in tandemto move in tandemSuppose country A exports to country B, so Suppose country A exports to country B, so

A’s exports are B’s importsA’s exports are B’s imports

Then a boom in B increases demand for Then a boom in B increases demand for imports in B which means that exports – imports in B which means that exports – and output! – in A must also riseand output! – in A must also rise

Likewise, a slump in A can lead to a slump in Likewise, a slump in A can lead to a slump in BB

International business cyclesInternational business cycles, through trade, through trade

USUS

US’US’EUEU

GDP in EUGDP in EU

GD

P in

US

GD

P in

US

A

B

C

The Foreign MultiplierExtra Extra

boost in USboost in US

Imported Imported boost in EUboost in EU

Demand boom in US

Other Linkages: InflationPrices move togetherPrices move together

Inflation in country A increases the real Inflation in country A increases the real exchange rate (i.e., makes the home exchange rate (i.e., makes the home currency appreciate in real terms), thus currency appreciate in real terms), thus hurting exports which, in turn, diverts hurting exports which, in turn, diverts demand from imports to home demand from imports to home production in country B, hence production in country B, hence increasing aggregate demand and increasing aggregate demand and inflation in country Binflation in country B

Imported inflationImported inflation, through trade, through trade

Real exchange Real exchange

rate R = eP/P*rate R = eP/P*

Other Linkages: Inflation

USUS

US’US’EUEU

Price level in EUPrice level in EU

Pri

ce level in

US

Pri

ce level in

US

A

B

CExtra Extra inflation in inflation in USUS

Imported Imported inflation in inflation in EUEU

Demand boom in US

Two Cases

Fixed exchange rateFixed exchange rateP = P*/eP = P*/e

As P* rises, so does PAs P* rises, so does PWith fixed e, a rise in P* leads to real With fixed e, a rise in P* leads to real

depreciation, so BOP improves and M rises depreciation, so BOP improves and M rises

Hence, P rises: Hence, P rises: Imported inflationImported inflation

Flexible exchange rateFlexible exchange rateAs P* rises, e rises (nominal appreciation)As P* rises, e rises (nominal appreciation)

Real depreciation is partly reversedReal depreciation is partly reversed

Hence, M and P rise less than otherwiseHence, M and P rise less than otherwise

Real exchange Real exchange

rate R = eP/P*rate R = eP/P*

Still Other Linkages: Interest Rates

Interest rates move togetherInterest rates move togetherAn increase in interest rates in An increase in interest rates in

country A attracts capital inflows country A attracts capital inflows from country B, thus reducing the from country B, thus reducing the supply of capital in country B, and supply of capital in country B, and thereby driving up interest rates in thereby driving up interest rates in country Bcountry B

Interest parityInterest parity, through capital , through capital movementsmovements

Home countryHome country

Still Other Linkages: Interest Rates

rr

S, IS, I

SS

I

I’I’

Rise in I

AA

BB

r = real interest rateS = savingI = investment

Foreign countryForeign countryHome countryHome country

Still Other Linkages: Interest Rates

rr

S, IS, I

SS

I

I’I’

Rise in I

AA

BBrr

S, IS, I

SS

I

S’S’

Fall in S

AA

BB

Implications of LinkagesEconomic integration means that Economic integration means that

economic policy in one country, economic policy in one country, especially if the country is large, especially if the country is large, influences economic developments in influences economic developments in other countries, through international other countries, through international trade and investmenttrade and investment

Economic integration calls for political Economic integration calls for political integration, to some extent at leastintegration, to some extent at least

Important driving force behind European Important driving force behind European integrationintegration

22

Example of Environmental PolicyPollution respects no national Pollution respects no national

boundariesboundaries

Therefore, need international Therefore, need international cooperation on environmental cooperation on environmental protection and pollution controlprotection and pollution controlCase in point: Kyoto protocolCase in point: Kyoto protocol

Same general principle applies to Same general principle applies to some aspects of economic policysome aspects of economic policyAlso: Law enforcementAlso: Law enforcement

Exchange Rate PolicyCannot be conducted in a vacuumCannot be conducted in a vacuum

Unless your country is very smallUnless your country is very small

Country A’s decision to devalue its Country A’s decision to devalue its currency causes country B’s currency to currency causes country B’s currency to appreciate, through tradeappreciate, through trade

Therefore, countries may wish or need to Therefore, countries may wish or need to cooperate on exchange ratescooperate on exchange ratesCurrency unionsCurrency unions

Case in point: Europe’s single currencyCase in point: Europe’s single currency

Or they may want to be aloneOr they may want to be alone

Free Free capital movementscapital movements

Independent Independent monetary policymonetary policy

Fixed Fixed exchange rateexchange rate

Floating Floating exchange exchange raterate

1945-19721945-1972

Currency unionCurrency union

The Impossible TrinityThe Impossible Trinity

Fiscal PolicyGlobalization also presents a challenge to Globalization also presents a challenge to

fiscal policy through impending tax fiscal policy through impending tax erosionerosionE-commerce and electronic moneyE-commerce and electronic moneyOffshore activities and foreign shoppingOffshore activities and foreign shoppingFinancial capitalFinancial capital

Globalization may, however, facilitate new Globalization may, however, facilitate new and more efficient ways to collect revenueand more efficient ways to collect revenueTax harmonizationTax harmonizationPollution feesPollution fees

Monetary PolicyMain objective is price stabilityMain objective is price stability

Because high inflation hurts economic growth Because high inflation hurts economic growth as well as the external positionas well as the external position

Monetary restraint requires fiscal disciplineMonetary restraint requires fiscal discipline

Monetary policy under floating exchange Monetary policy under floating exchange rates and perfect capital mobility rates and perfect capital mobility Increased independence of central banks, and Increased independence of central banks, and

increased accountability increased accountability Banking supervision Banking supervision Inflation targeting Inflation targeting

Global Economic Performance since 1990: Four FeaturesI.I. World inflation has been brought World inflation has been brought down to its lowest level in 40 yearsdown to its lowest level in 40 years

Inflation dispersion has also diminishedInflation dispersion has also diminished

II.II. International integration and International integration and liberalization of financial marketsliberalization of financial markets

III.III. More complex financial linkages and More complex financial linkages and policy transmission mechanismspolicy transmission mechanisms

IV.IV. Flexible exchange rates have Flexible exchange rates have become more prevalentbecome more prevalent

Agricultural Subsidies Agricultural Subsidies per Farmer per Farmer 1999-2000 1999-2000 (USD)(USD)

0

5000

10000

15000

20000

25000

30000

35000

Iceland Norway EU US NewZealand

33

AgriAgriculturalcultural Subsidies Subsidies per Farmer per Farmer 1999-2000 1999-2000 (USD)(USD)

0

5000

10000

15000

20000

25000

30000

35000

Iceland Norway EU US NewZealand

AgricultureAgriculture

Industrial output (I)Industrial output (I)

Agriculturaloutput (A)

Agriculturaloutput (A)

DD

G

Domestic price ratio

Domestic price ratioE

C

HH

O

Slope = -PSlope = -PII/P/PAA

As PAs PII rises, I rises and A rises, I rises and A fallsfallsAs PAs PAA rises, A rises and I rises, A rises and I fallsfalls

Industrial outputIndustrial output

Agriculturaloutput

Agriculturaloutput

World price ratioWorld price ratio

DD

G

Domestic, distorted price ratio

Domestic, distorted price ratio

F

E

A B

C

Price distortionPrice distortion

HH

O

If output gain = If output gain = EE and price and price distortion = distortion = cc, , then then E = mcE = mc22

Output gain

OC = industrial outputCA = agricultural outputOA = total output

AgricultureAgriculture E = mcE = mc22

AgricultureAgriculture

Implication:Implication:

The output gain varies directly The output gain varies directly withwith

1.1. The magnitude of the transfer The magnitude of the transfer of resources between sectors of resources between sectors ((mm))

2.2. The extent of the original price The extent of the original price distortion (distortion (cc))

The greater the transfer of The greater the transfer of resources and the greater the resources and the greater the distortion, the greater is the distortion, the greater is the output gainoutput gain

Numerical ExampleNumerical Example

EE is the output gain from liberalization is the output gain from liberalizationmm is a constant equal to ½ is a constant equal to ½ timestimes the the

shareshare of the industrial sector in of the industrial sector in output after liberalization output after liberalization timestimes the the price price elasticityelasticity of industrial output of industrial output

cc is a measure of the price is a measure of the price distortiondistortion in percentin percent

The greater the initial distortion, the The greater the initial distortion, the more ambitious the liberalization, more ambitious the liberalization, and the more elastic the output, the and the more elastic the output, the greater the gaingreater the gain

The CAP: An The CAP: An ApplicationApplication

Suppose Suppose Farm protection keeps domestic Farm protection keeps domestic

agricultural prices 80% above world prices, agricultural prices 80% above world prices, so that so that c = 0.8/(1 + 0.8) = 0.44 c = 0.8/(1 + 0.8) = 0.44

Industrial sector’s share in GDP will rise to Industrial sector’s share in GDP will rise to 95% following farm policy liberalization95% following farm policy liberalization

Price elasticity of industrial output is 0.2Price elasticity of industrial output is 0.2 Accords with price elasticity of farm Accords with price elasticity of farm

output of 4output of 4

Output gain from liberalization is thenOutput gain from liberalization is thenE = 0.5*0.95*0.2*0.44E = 0.5*0.95*0.2*0.442 2 = 0.02, or 2%= 0.02, or 2%Larger effect if productivity gain is Larger effect if productivity gain is

includedincluded

The CAP: An The CAP: An ApplicationApplication

When productivity gain is included, When productivity gain is included, the total cost of the CAP rises to the total cost of the CAP rises to perhaps 3% of the EU’s GDPperhaps 3% of the EU’s GDP

Yet these cost estimates do not Yet these cost estimates do not includeincludeEnvironmental damage in agricultureEnvironmental damage in agriculture

Effects on CEECsEffects on CEECs

Effects on LDCsEffects on LDCs

Industrial outputIndustrial output

Agriculturaloutput

Agriculturaloutput

World price ratioWorld price ratio

DD

G

Domestic, distorted price ratio

Domestic, distorted price ratio

F

E

A B

C

Price distortionPrice distortion

HHJJ

ImportsImports

ExportsExports

O

KK

Welfaregain

Welfaregain

Output gain

Agriculture: Agriculture: Static GainsStatic Gains

Industrial outputIndustrial output

Agriculturaloutput

Agriculturaloutput

DD

G

F

E

A B

C

Price distortionPrice distortion

HHJJ

O

MN

Q

WelfaregainWelfaregain

Transition takes time: From E to F via M, N, and Q

Agriculture: Agriculture: Transitional PainsTransitional Pains

Industrial outputIndustrial output

Agriculturaloutput

Agriculturaloutput

DD

G

F

E

A B

Price distortionPrice distortion

JJ

O

Agriculture:Agriculture:Dynamic GainsDynamic Gains

H

World price ratioWorld price ratio

C

AB = static gainAB = static gainBC = dynamic gainBC = dynamic gainAC = AB + BC = total gainAC = AB + BC = total gain

Productivity gain

KK

WelfareWelfaregaingain

ConclusionConclusion

The EndThe End

Globalization means Globalization means interdependenceinterdependence

Policies influence not only those Policies influence not only those who make themwho make them

Need to find ways to share Need to find ways to share responsibility without giving up responsibility without giving up too much sovereigntytoo much sovereignty

Not easy, but we must tryNot easy, but we must try