Lec 7

Stolper-Samuelson theorem - global trade liberalization would benefit developing countries

[increase demand for relatively unskilled labour, labour is well endowed]

*increased competition could, discourage innovation by lowering expected profits

Arguments supporting trade

- makes a country has access to a larger global market than the domestic market [many
products, production costs fall as the volume produced increases, beneficial for small
countries]
- encourages a more efficient allocation of resources
[countries are encouraged to concentrate on producing goods in which they are
internationally competitive]
- Imports increased consumption possibilities by expanding the variety of goods available
- incentives for new techniques and technologies to increase efficiency→ stimulates
growth
- exports earn foreign exchange that can purchase imported inputs and technology,
permitting domestic demand to grow faster without generating a balance of payments
deficit

Trade benefits in terms of:

a) Exports
- Encourage specialize in products which is relatively competitive and efficient
[comparative advantage, factor endowments]
- Access larger market and generating money to purchase imports
b) Imports
- Access to greater variety, higher consumer welfare
- Producers access to cheaper, better, quality inputs [competitive advantage, technology,
productivity, capital good]

Arguments against trade

- Exporters have to compete with producers from other countries

[no guarantee of access to the world market will lead to an increase in the value of
exports]
- Domestic producers also face more competition, access to an increased variety of
cheaper (than domestically produced), goods is a benefit to consumers but a challenge
to local producers of import-competing goods
- potential adjustment costs of trade liberalization on the macroeconomic side; if imports
grow faster than exports, the result is a balance of payments deficit that can have an
adverse effect on growth
Measures of trade

Measures of trade Evidence

Export/GDP
[Export + import]/GDP
[potential benefits of openness to imports with
the benefits of exports]
Dummy variable
[Trade liberalization reduces relative price
distortions, increases the return on exportable
and promotes economic growth]
high performing East Asian economies,
supports the existence of a positive correlation
between exports and growth
strong positive correlation between openness
and growth, although the causality is not so
evident
Weak evidence linking trade liberalization and
growth

2 Trade growth literature

- optimist
exports, is an engine of growth
Evidence: positive association between a measure of trade and growth, but this
evidence should be interpreted carefully (
- sceptics
Evidence: little support for a causal effect of trade on growth and, there is little evidence
that trade reform itself has a significant impact on growth

tariff-growth paradox - how protectionist tariff policy was associated with higher rates of economic
growth before 1914 in contrast to the negative relationship observed after WWII

*high tariffs at the period 1870-1914 did not stimulate economic growth - but there is equally little
evidence that other external factors were key determinants of economic growth.

Why trade barriers?

- Revenue needs
Formal/private wage and business sector is relatively small in low-income countries and
difficult to tax the informal sector and peasant agriculture, the border is often the
easiest point to levy taxes
- Political economy
influences favour tariffs as it can appear as if the taxes are being levied on foreign
products. Influential producer groups lobby for help from the government and tariffs are
a politically cheap way to assist them
- Infant industry arguments
Producer groups argue that they need protection from imports to become competitive,
and tariffs can be politically justified as supporting industrial development
Empirical outcomes: trade and growth

- trade (volume/exports) is positively associated with growth

- contribution of exports is evident in East Asia and Latin America (Brazil, Chile)
- firm-level support
* exporting associated with productivity
* importance of imported technology
* competing with imports encourages competitiveness
- difficult to demonstrate that increased trade has a causal effect on growth
[composition of exports (manufactures versus primary commodities]

Reasons for FDI

- getting close to final markets

- access to raw materials
- low labour cost
- risk diversion
- firm-specific knowledge
- trade policy

analysing FDI

- Assumptions
2 countries
2 factors of production [L, K]
Single homogenous good, free capital mobility
Marginal physical product of capital is decreasing
[labour is held constant]
 - Autarky, capital is scarce country 1, return of capital is higher in capital-abundant
country 2
- Capital movement allowed, capital flow from country 2 to 1, as long as country 2 get
higher return in country 1
- Country 1 output increases more than country 2 output
- Capital owner country 1 (2) lose [return on capital decrease (increase)], labour wins
(lose) [increased (decreases) capital increases (decreases) productivity and wages]

Advantages of FDI

- Increased output and wages

- Increased employment [if excess supply of labours exists]
- Increased exports
- Increased tax revenues
- realization of scale economies
- technical and managerial skill spill-offs
- weakening domestic monopoly

Disadvantages of FDI

- adverse terms-of-trade effect [if country is large, exporter FDI flows in/transfer pricing]
- decreased domestic saving
- crowding out domestic investment
- instability of exchange rate
- loss control over domestic policy
- increased unemployment [investment in capital-intensive techniques]

Forms of foreign capital

- official flows from bilateral sources [USAID, SIDA, DIFD]

- official flows multilateral sources [World Bank, IDA, ADB]
- FDI
- Commercial bank loans
Multilateral institutions for economic development and debt relief

- UNDP
- World bank (International Bank for Reconstruction and Development)
- IMF

International Bank for Reconstruction and Development [IBRD]

- to achieve equitable and sustainable economic growth in their national economies

- helps overcome poverty and improve standards of living primarily by providing loans,
risk management products and by coordinating responses to regional & global
challenges

International Development Association [IDA]

- funding supports countries’ efforts to boost economic growth, reduce poverty, and
improve the living conditions of the poor
- empirical: capture through foreign aid, policy, interaction term between foreign aid and
policy, institution

Aid effectiveness Theory

- The Chenery-Strout Two Gap model

Foreign aid closes saving and investment gap

Aid effectiveness: debate

No independent effect on growth Contributes to growth, magnitude of this effect

Positive contribution to growth only in
countries with high values for policy indicator
Conditionality does not work [donor/aid
leverage does not ensure that gov implement
good policies]
Aid should be given to those recipients already
implementing good policies
is small and insufficient to offset growth-
retarding features of poor countries
Economic policies contribute to growth and
increase aid effectiveness
Conditionality influences policy, but slowly
Sustained donor-recipient dialogue with flexible
conditionality, promote reform, increase aid
effectiveness